Gripping GAAP 2019

Gripping GAAP
Twentieth Edition
Cathrynne Service CA (SA)
BCompt (Hons) (C.T.A.) (UNISA) CA (SA)
University of Queensland
Acknowledgements and thanks:

Special thanks must go to:
Professor Dave Kolitz (from the University of Exeter) and
Gordon Adams CA (SA) (from the University of the Western Cape)
Aarthi Algu, Vanessa Gregory and Kerry-Less Gurr (from the University of KwaZulu-Natal)
Súne Diedericks and Suzette Snyders (both from the Nelson Mandela University)
Yusuf Hassan (from KPMG Technical)
Yusuf Seedat (from PWC Technical)
Bongeka Nodada, Mulala Sadiki, Sue Ludolph, Sandy van der Walt, Juanita Steenkamp and
Ewald Muller (from SAICA)
Heather de Jongh and Tara Smith (from KPMG)
Thank you for your valuable advice, suggestions and interpretations in the past.
Chief editing and technical review of this 2019 edition done by:
Steffen Wies, Sahil Bhaanprakash, Sohil Singh, Sian Mudaly
From University of KwaZulu-Natal
Georgina Patten-Service
From Nelson Mandela University
Gordon Adams
From University of Western Cape
Thank you to a super-dedicated and very talented team for your enthusiasm and expertise.
Editing of layout and formatting done by:
Michelle Guy, Roger Sowden, Guy Sowden
Thank you, too, for your expertise and the long, long hours!
Chief editing and technical review of prior editions done by:

Steffen Wies, Sian Mudaly, Jyoti Maharaj, Thabiso Mtshali, Farnaaz Shaikjee (from University of KwaZulu-Natal)
Justin Logie and Andile Ngwenya (from University of the Witwatersrand).
Arson J. Malola and Ayanda Ngwenya (from University of the Witwatersrand)
Jyoti Maharaj and Iman Moosa (from University of KwaZulu-Natal)
Gordon Adams (from University of the Western Cape).
Muhammad Muheeb Buckas; Muhammad Shihaab Buckas; Andile Ngwenya;
Yusuf Seedat; Farnaaz Shaikjee; and Khaya Sithole.
Khaya Sithole, Troy Halliday, Zaheer Bux, Errol Prawlall, Thivesan Govender, Deepika Panday,
Kamantha Vengasamy, Vidhur Sunichur, Zahra Moorad, Johannes Rice and Yusuf Seedat.
Tanweer Ansari, Trixy Cadman, Aphrodite Contogiannis, Zaid Ebrahim, Susan Flack, Haseena Latif,
Daleshan Naidoo, Thabo Ndimande, Dietmar Paul, Kate Purnell, Johannes Rice, Yusuf Seedat and Khaya Sithole.
Albertus Louw, Ayanda Magwaza, Trixy Cadman, Carla Tarin, Jade Archer, Marc Frank and Adrian Marcia.
Khaya Sithole, Ruan Gertenbach, Carla Tarin, Jade Archer, Fathima Khan,
Susan Flack, Preshan Moodliar, Prekashnee Brijlall, Nikky Valentine.
Ruan Gertenbach, Susan Flack, Gareth Edwardes, Artur Mierzwa, Nabilah Soobedaar, Nikky Valentine,
Prekashnee Brijlall.
Warren Maroun, Byron Cowie, Mahomed Jameel Essop, Nasreen Suleman,
Daveshin Chetty, Steve Carew, Justin Cousins, Jarrod Viljoen and Craig Wallington.
Warren Kemper, Byron Cowie, Gary Klingbiel, Alastair Petticrew, Catherine Friggens, Kerry Barnes and
Shiksha Ramdhin.
Tiffiny Sneedon and Ryan Wheeler.
Dhiren Sivjattan and Clive Kingsley.
Trixy Cadman, Phillipe Welthagen and Tarryn Altshuler.
Maria Kritikos, Lara Williams, Praneel Nundkumar, Brian Nichol, Pawel Szpak and Craig Irwin.
i
Gripping GAAP First edition: 2000
Second edition: 2001
Third edition: 2002
Fourth edition: 2003
Fifth edition: 2004
Sixth edition: 2005
Seventh edition: 2006
Eighth edition: 2007
Ninth edition: 2008
Tenth edition: 2009
Eleventh edition: 2010
Twelfth edition: 2011
Thirteenth edition: 2012
Fourteenth edition: 2013
Fifteenth edition: 2014
Sixteenth edition: 2015
Seventeenth edition: 2016
Eighteenth edition: 2017
Nineteenth edition: 2018
Twentieth edition: 2019
© 2019
ISBN softback 978 0 6390 0119 7
e-book 978 0 6390 0133 3
Copyright subsists in this work. No part of this work may be reproduced in any form or by any
means without the publisher’s written permission. Any unauthorised reproduction of this work
will constitute a copyright infringement and render the doer liable under both civil and criminal
law.
Whilst every effort has been made to ensure that the information published in this work is
accurate, the editors, authors, publishers and printers take no responsibility for any loss or
damage suffered by any person as a result of the reliance upon the information contained
therein.
Suggestions and comments are most welcome. Please address these to:
The author: Cathrynne Service Via Facebook:

• Accounting 911 by Kolitz and Service
Via LexisNexis:
• See contact details below
The publisher: LexisNexis Web address: www.myacademic.co.za

Mobi address: www.myacademic.mobi
Postal address:
LexisNexis
215 Peter Mokaba Road
Morningside
Durban 4001
Disclaimer
This text has been meticulously prepared, but in order for it to be user-friendly, the principles,
application thereof and disclosure requirements have been summarised.
This text should therefore not be used as a substitute for studying, first-hand, the official
International Financial Reporting Standards, including their interpretations.
ii
Gripping GAAP
Dedication
This book is once again dedicated to my very dear family and friends!
Writing it would simply not have been possible without

my parents, Roger and Jillianne,
who continually keep the home fires burning during the endless months of writing, and
my loving sons Roger and Guy
who have been extremely patient and understanding throughout.
And a sincere thanks to Scott for all your support and encouragement!
Too numerous to mention, are the rest of my family and friends,

who have all been subjected to the same boring excuse
‘sorry – I’m busy with my book …’.
And to my team of guardian angels who not only inspired this book but who have
provided me with the guidance and the super-human strength
that it has taken to update each year.
And finally, I wish to dedicate this book to those for whom I wrote it: You!
I sincerely wish that my book sheds the necessary light as you
fervently study towards your ultimate goal of
joining our country’s ranks of
‘counting mutants’
Our country needs you!
(‘counting mutants’ is a reference to accountants in the quirky comedy:

Mr Magorium’s Wonder Emporium)
iii
Gripping GAAP
Foreword
Another ‘Four Words’ to Gripping GAAP
My own lifelong – and appalling – inability to distinguish accurately between debits

and credits suggests that a) I was absolutely right not to consider accounting as a
career, and b) that I have little credibility – oh, let’s be honest, no credibility whatso-
ever – in being accorded the honour of penning a foreword to Gripping GAAP.
While I dread the thought that nepotism could be considered the rationale for such
distinction (I am closely related to the authoress!) I have at least, I hope, established
my monstrous lack of appropriate credentials. However, as a fellow writer (of fiction –
and is that so very different from latter-day accounting fact?), I feel thus qualified to
commend the work for its lucid and clearly understandable (even to me!) “unpacking”
of the arcane subject of Accountancy.
A sage of old opined that “money is the root of all evil” – a maxim which, like most
others, appears to have stood the test of time. Until recently, of late it would appear
that the accounting of money (on a worldwide basis) has much to answer for.
Hitherto trustworthy multinational financial edifices have been found wanting to an
alarming degree and the tendency to indulge in “creative accounting” has been rightly
indicted.
The vigour of youth (yours) coupled with a sincere passion to put right what has gone
wrong (also yours, I trust!) is the serious need that Gripping GAAP seeks to advance.
Balzac said “Behind every great fortune there is a crime!” Was he right? Winston
Churchill said “Success is the ability to lurch from failure to failure with no loss of
enthusiasm!” Was he right? Does it matter? Perhaps it does.
Certainly my personal hope is that those who, thousands of years ago, taught us all
to read and write with such fine precision will be the inspiration for your generation of
professionals to deal with an emerging global need to account with similar exactitude.
Carpe Diem!
Dr Roger Service
iv
Gripping GAAP
A note ttoo you from the author
To all you dear students, planning on joining the ranks of ‘the counting mutants’
South African accountants have done us very proud, having
South Africa was ranked the been ranked as the WORLD LEADERS in financial reporting
WORLD LEADER in auditing and auditing for seven years in a row! This highly prestigious
and financial reporting for accolade was given by the World Economic Forum, most
SEVEN years in a row! recently in the 2016–2017 Global Competitiveness Report. So,
World Economic Forum's 2016– before breaking the bad news, may I start by congratulating you
2017 Global Competitiveness on choosing to follow a career in which you can only flourish,
Report given that South Africa’s education and training in this field
are clearly the very best there is!
The bad news is that South Africa plummeted in the ‘2017–2018
rankings’, to 30th in the world, and more recently in the ‘2018
th
rankings’, to 55 in the world. Reading their assessment, it is clear the perception of declining investor
protection, ethical behaviour, efficacy of corporate boards and increasing evidence of corruption are the
main reasons. Given the news of corruption and scandals in 2017 and 2018, our new ranking was
obviously predictable. But as IRBA CEO, Bernard Agulhas, pointed out, we all need to “work together to
regain confidence in our markets, stimulate investment and reclaim our world class rankings”. The onus is
on all accountants, including you, a budding accountant. This is not a subject that you study to get 50% in
– it is imperative you grasp as much as you can and aim at full understanding of all principles. It’s rather a
serious business. Our economy is desperate for growth, and for this to happen, investor confidence is
essential. Accountants and auditors play a pivotal role in generating
such confidence, together, of course, with clear and sound economic Please visit our Facebook!
policies. (see page ii for details)
So, to the matter of the subject at hand: accounting. It is one of the
most misunderstood disciplines that you could choose to study, with
the general public’s perception being that it is dull and yet easy
because it is simply about ‘debits and credits’. And how hard can the principle of ‘debit-credit’ really be?
Well, it is safe to say that accounting is currently one of the fastest changing and most complex subjects
and is very interesting to those ‘in the thick of it’. The International Financial Reporting Standards are
currently a few THOUSAND pages long – and get longer every year. It is these IFRSs that Gripping
GAAP hopes to simplify for you. These IFRSs regulate how we communicate financial information and
are essentially the rules of accounting – and you may be interested to learn that nowhere in the literally
thousands of pages is any reference made to debits and credits!
Now, probably the most important thing I can tell you is that the clue to enjoying the study of any future
career may be summed up as follows: knowledge without understanding is much the same as a vehicle
without an engine – you just won’t be going anywhere! So, to help you understand the many principles,
I have included over 600 examples and tried my very best to make the frequently dry subject as easy to
read as possible. There are flowchart summaries and little
grey boxes, which I call ‘pop-ups’ throughout the chapters.
Support lectures and tutorials These pop-ups are designed to help you quickly identify core
are available – please contact me definitions (look for pop-ups with a picture of an apple core)
for details via Facebook and to help you find mini-summaries, showing the essence of
a section, important tips or interesting facts (look for pop-ups
with the picture of a happy face).
To see how you are progressing, please access the LexisNexis portal for free online questions. For
teamwork and information sharing, there is also a Facebook page (see page ii) on which you can
discuss both the IFRSs and Gripping GAAP with other students and from which you can contact me
directly with any queries or comments. I hope to see you
there! The more you visit, the more you will all benefit!
All you need is a positive attitude,
As an optional extra, I offer support lectures for those who would enthusiasm, commitment,
prefer extra assistance. Please contact me if you have requests perseverance ... and Gripping
or queries in this regard by using the same Facebook page.
In closing, please avoid becoming complacent. I predict that
the coming year of your studies will be dynamic and you will probably feel as though you are not studying
accounting at all but rather a form of complex law! In a way you will be right. So, it is at this crucial start,
as you embark upon your journey into the world of ‘GAAP’, that you maintain a positive attitude and
keep your wits about you … and keep Gripping GAAP as your guide.
Bon voyage! And remember that with enthusiasm, commitment and perseverance, success will
inevitably follow. Wishing you the very best for your studies!
v
Gripping GAAP
Introduction
The ongoing international harmonisation and improvements projects have seen a
proliferation of revised and re-revised standards, interpretations and exposure drafts.
This edition has been updated for all relevant standards in issue, together with any
amendments made up to 10 December 2018.
A number of new international standards and interpretations are expected to be
issued during 2019. Please watch the Facebook page for details (see page ii).
Since Gripping GAAP has gained international attention, the text has been updated
to be more country non-specific in terms of tax legislation. In this regard, students
may assume that the business entity is subjected to the following taxes (unless other-
wise indicated):
z A tax on taxable profits at 30%, (referred to as income tax);
z An inclusion rate of 80% for entities when dealing with capital gains tax (part of
income tax);
z A transaction tax levied at 15%, (referred to as VAT or value added tax).
Gripping GAAP uses the symbol ‘C’ to denote an entity’s currency but uses the sym-
bol ‘LC’ for an entity’s ‘local currency’ in any chapter dealing with foreign currencies.
Some chapters (e.g. chapter 1 & 23) include unavoidable reference to South African
legislation. Aspects of these chapters may possibly not be relevant to some of the
countries using this book. All principles are, however, international principles.
Paedagogical philosophy
Gripping GAAP is designed for those who wish to:
z fully understand the concepts and principles of accounting
z be able to study their syllabus without the aid of daily lectures (e.g. students
studying on a distance learning basis);
z qualify as chartered accountants; and
z keep abreast of the changes to international financial reporting standards.
Gripping GAAP can be successfully used with GAAP: Graded Questions, by
C Service and D Kolitz, and Gripping Groups, by C Service and M Wichlinski.
Gripping GAAP covers an enormous volume of work and is frequently studied over a
few years. It includes material that is covered at both undergraduate level and post-
graduate level.
The text has therefore been written so as to be as easy-to-read as possible and
includes more than 600 examples as well as both mini pop-up summaries and maxi
flowchart summaries, thus making it ideal for students studying on a distance basis.
Students must be able to see the ‘big picture’ and thus the flowchart summaries are
provided at the end of each chapter. These summaries are a good place to start
before reading any chapter or in preparation for lectures and are also good to read
over after having completed the reading of a chapter or after having attended a
lecture.
In order to help one remain focused whilst reading the chapters, which unavoidably
contain copious and complex detail, little grey pop-ups have been inserted to high-
light the relevant core definitions and the essence. These pop-ups have been pro-
vided in a bulleted format to enable quick assimilation of ‘fast-facts’. The pop-ups
with a graphic of an apple core generally identify core definitions whereas those with
the graphic of a smiling face provide summaries of core facts, principles and tips.
vi
Gripping GAAP
Paedagogical philosophy
• Chapter 1 explains the environment within which a ‘reporting accountant’ finds himself or herself (i.e.
where an accountant is affected by the IASB and various related legislation).
• Chapter 2 explains the Conceptual Framework (CF), which is the basic logic underpinning the design
of the IFRSs. Chapter 2 covers the new CF issued in 2018 and highlights important changes from the
prior CF. The IASB has not updated the pre-existing IFRSs for the 2018 CF. In this regard, the IASB
has reminded preparers that, in case of any resulting conflict between an IFRS and the new CF,
IFRSs must always override the CF. For this reason, the remaining chapters thus focus on the
relevant IFRS and simply identify any conflict with the 2018 CF.
• Chapter 3 explains how financial statements should be presented.
• Chapters 4–6 involve revenue from customer contracts and taxes. Since tax is integral to all topics, the
chapters on tax are included early on in the book. We first look at how to account for current tax
(chapter 5) and then explain how deferred tax arises and is accounted for (chapter 6).
• Chapters 7–13 involve various assets. These chapters are covered after having grasped deferred tax
since these assets have deferred tax consequences. That said, some institutions prefer to teach the
principles involving each of the asset types without these deferred tax consequences. For this
reason, the deferred tax consequences are presented in a separate section of each of these chapters
and examples are shown with deferred tax consequences and without deferred tax consequences.
We start with non-current assets and proceed to current assets (inventory). Impairment of assets is also
included in this set of chapters: it is inserted after the chapters covering property, plant and equipment,
intangible assets and investment properties but before non-current assets held for sale and inventories.
This is because the standard on impairments applies to the former assets but not the latter assets.
There are two chapters on property, plant and equipment: the first explains the basic concepts and
the cost model. The second chapter explains the revaluation model. The first part of this chapter
is designed to explain the very basics, focusing on non-depreciable assets. It then progresses to
depreciable assets. The deferred tax and disclosure consequences for both non-depreciable and
depreciable assets are also explained.
Some institutions are de-emphasising certain topics, such as borrowing costs and government grants.
However, it is essential that students understand the basic concepts and how these can topics affect
the measurement of various assets. For this reason, these topics are included at a basic level in the
asset chapters. For a more detailed understanding, see chapters 14 and 15.
• Chapter 14–17 deal with borrowing costs, government grants and leases (lessees and lessors). These
chapters may all have an impact on the recognition and measurement of assets.
• Chapters 18–19 cover provisions, contingencies & events after the reporting period and employee
benefits. Both chapters focus largely (but not entirely) on obligations (liabilities).
• Chapters 20–24: Chapter 20 deals with foreign currency transactions, where it explains how trans-
acting in a foreign currency can affect the measurement of items.
Since foreign currency transactions frequently require hedging, chapter 22 explains hedge account-
ing, by using the example of a currency forward exchange contract so as to link back to chapter 20.
However, since forward exchange contracts are a type of financial instrument, the student should
ideally first study financial instruments. The financial instruments topic is covered in chapter 21.
Share capital involves either equity instruments or financial liabilities and is thus best covered after
having grasped the various concepts in the financial instruments chapter and thus the concept of
share capital and liabilities is contained in chapter 23. Chapter 24 covers earnings per share: this
chapter is best covered after studying share capital.
• Chapter 25: Fair value measurement affects numerous prior chapters affected by fair value measure-
ments. This chapter may be referred to whilst studying these other affected chapters.
• Chapter 26: Everything we have learned thus far involves applying policies and making estimates
(and hopefully not too many errors!). This chapter now explains how you would account for a change
in an accounting policy or estimate and how to correct errors.
• Chapter 27: Statements of cash flows is distinct from all prior chapters since it applies the cash con-
cept rather than the accrual concept and is thus the penultimate chapter.
• Chapter 28: The final chapter is financial analysis and interpretation since it does not relate to an
IFRS but simply explains how users analyse and interpret the financial statements.
vii
Gripping GAAP
Contents
Chp. References Title of chapter Page
1 IASB, Companies The reporting environment 1

Act & King IV
2 Conceptual The conceptual framework for financial reporting 34

Framework
3 IAS 1 Presentation of financial statements 77

4 IFRS 15 Revenue from contracts with customers 121
5 IAS 12 Taxation: various types and current income tax 219
6 IAS 12 Taxation: deferred taxation 270
7 IAS 16 Property, plant and equipment: the cost model 361
8 IAS 16 Property, plant and equipment: the revaluation model 414
9 IAS 38 & IFRS 3 Intangible assets and purchased goodwill 469
10 IAS 40 Investment properties 510
11 IAS 36 Impairment of assets 549
12 IFRS 5 Non-current assets held for sale and discontinued operations 594
13 IAS 2 Inventories 653
14 IAS 23 Borrowing costs 716
15 IAS 20 Government grants and government assistance 741
16 IFRS 16 Leases: lessee accounting 775
17 IFRS 16 Leases: lessor accounting 833
18 IAS 37; IAS 10 Provisions, contingencies and events after the reporting period 891
19 IAS 19 Employee benefits 930
20 IAS 21, IFRS 9, & Foreign currency transactions 952
IFRS 7
21 IFRS 9, IFRS 7, & Financial instruments – general principles 976

IAS 32
22 IFRS 9, IFRS 7, & Financial instruments – hedge accounting 1067

IAS 32
23 IFRS 9 & IFRS 7, Share capital: equity instruments and financial liabilities 1103
IAS 32 & Co’s Act
24 IAS 33; Circ 2/15 Earnings per share 1127

25 IFRS 13 Fair value measurement 1167
26 IAS 8 Accounting policies, estimates and errors 1184
27 IAS 7 Statement of cash flows 1215
28 N/A Financial analysis and interpretation 1248
viii
Gripping GAAP The reporting environment
Chapter 1
The Reporting Environment

Main references: IFRS Foundation Constitution (2016); Due Process Handbook (2016);
www.IFRS.org; Companies Act 2008; Companies Regulations, 2011; King IV (2016) and JSE Listing
Requirements (November 2017) – all latest versions as at 1 December 2018
Contents: Page
1. Introduction 3
2. A brief history of accounting 3
2.1 Accounting is a language 3
2.2 Accounting has evolved 4
2.3 The difference between the double-entry system and GAAP 4
2.4 The difference between GAAP and IFRS 5
3. GAAP and IFRSs – the process of internationalisation 6
3.1 A brief history of the internationalisation of GAAP into IFRSs 6
3.2 International financial reporting standards (IFRSs) 6
3.2.1 Overview 6
3.2.2 The meaning of the term: IFRSs 6
3.2.3 The meaning of the term: Standards 7
3.2.4 The meaning of the term: Interpretations 7
3.3 Conceptual framework for financial reporting 7
3.4 Compliance with IFRSs (adoption) 7
3.4.1 What does compliance with IFRS involve? 7
3.4.2 Why would one comply with IFRS? 8
3.4.3 The extent of compliance with IFRS around the world 8
3.5 Harmonisation versus convergence 9
3.6 Adoption versus convergence 10
3.7 Development of IFRSs (standard-setting) 11
3.7.1 Overview 11
3.7.2 Standards developed to date 11
3.7.3 Interpretations developed to date 11
3.7.4 Due process 11
3.7.4.1 Overview 11
3.7.4.2 Principles of due process 11
3.7.4.3 The basic development cycle 12
3.7.4.4 Developing exposure drafts 13
3.7.4.5 Developing standards 13
3.7.4.6 Developing interpretations 14
3.7.4.7 Developing annual improvements 14
Chapter 1 1
Contents continued …
3.8 The IASB and the IFRS Foundation: a look at the structure 15
3.8.1 Overview 15
3.8.2 The IFRS Foundation 15
3.8.3 The IFRS Foundation: an organogram 16
3.8.4 The Trustees 16
3.8.5 The Monitoring Board 17
3.8.6 The International Accounting Standards Board (IASB) 17
3.8.7 The IFRS Interpretations Committee (IFRSIC) 17
3.8.8 The IFRS Advisory Council (IFRSAC) 18
3.8.9 The Accounting Standards Advisory Forum (ASAF) 18
4. The Companies Act and the Related Regulations 18
4.1 Overview 18
4.2 The Companies Act, 2008: some of the big changes 18
4.2.1 What about pre-existing par value shares? 19
4.2.2 What about pre-existing CCs? 19
4.3 The different categories of companies 20
4.4 Legal backing for financial reporting standards 21
4.5 Which financial reporting standards must we use? 22
4.6 Legal backing for differential reporting 23
4.6.1 An overview 23
4.6.2 What is a small and medium-sized entity (SME)? 23
4.6.3 The history of differential reporting in South Africa 24
4.6.4 How do the IFRS for SMEs help? 24
4.7 Does our company need an audit or independent review? 24
4.8 Company records 25
4.9 Accounting records 25
4.10 Financial year 26
4.11 Financial statements 26
4.12 Annual financial statements 27
4.12.1 Timing 27
4.12.2 Audit or independent review 27
4.12.3 Other documents included in the annual financial statements 27
4.12.4 Extra disclosure relating to directors or prescribed officers 27
4.12.5 Approval and presentation 29
5. JSE Listing Requirements 29
5.1 Overview 29
5.2 Section 3: Continuing obligations 29
5.3 Section 8: Financial information 29
6. King IV Report 30
6.1 Overview 30
6.2 King IV Report on remuneration 31
6.3 King IV Report on sustainability and integrated reporting 31
7. Summary 33
2 Chapter 1
1. Introduction
Many people think that working as an accountant will involve being locked away – alone – in
a small dusty room, armed with a calculator and reams of paperwork. However, the modern
accountant is incredibly important to business and he/she needs to be able to contribute to the
effective functioning of all facets thereof. Thus, accountants need a wide range of skills.
• Pervasive quality skills. These are divided into three areas: ethical behaviour and professionalism;
personal attributes; and professional skills.
• Specific competencies:
1. Accounting and external reporting; Accounting & external
2. Auditing and assurance; reporting AND Auditing and
3. Management decision-making and control; assurance are the primary
4. Financial management; skills to obtain
5. Strategy, risk management and governance; and
6. Taxation. Source: CA(SA) Training programme: Implementation guide & Structure of the Programme
This book focuses on the exciting and dynamic skill of ‘accounting and external reporting’:
• ‘Accounting’ refers to record-keeping, in other words, the process of documenting the
results of the business activities; and
• ‘External reporting’ refers to how we convert these records into the ‘story of the
business’, where this story is then told to those interested parties (external users) in a way
that will help them understand what occurred in the business during the period.
Having the specific skill of ‘accounting and external reporting’ requires a thorough
understanding of many related theories, principles and rules, including, for example:
• understanding the basic rules behind the double-entry system;
• understanding the accounting and reporting rules and principles referred to as
International Financial Reporting Standards (IFRSs);
• understanding that generally accepted accounting practice (GAAP) is simply an umbrella
term that refers to the accounting and reporting rules and principles that are applied in a
country or region: South African GAAP involves the application of IFRSs, whereas
another country, instead of applying IFRSs, may apply its own unique rules, i.e. its own
unique GAAP, which is would be referred to as that country’s own national GAAP;
• understanding that IFRSs are essentially a harmonisation of the various forms of national
GAAP, and where the intention is that IFRSs will replace all remaining national GAAPs.
This textbook assumes you understand the double-entry system and assumes that your business
will apply International Financial Reporting Standards (IFRSs) when preparing its financial
statements. It thus focuses solely on the application of (IFRSs. Each chapter in this textbook is
dedicated to an IFRS (or group of related IFRSs). However, before we become engrossed in
each of these chapters, this chapter first explains the wider environment affecting accounting
and external reporting. The remaining sections in this chapter are structured as follows:
• Section 2: A brief history of accounting
• Section 3: GAAP and IFRSs – the process of internationalisation
• Section 4: The Companies Act and its related Regulations
• Section 5: The JSE Listing Requirements
• Section 6: The King IV Report
2. A Brief History of Accounting
2.1 Accounting is a language

You may think accounting is dry and boring, but believe it or not, accounting has much in
common with possibly more exciting subjects such as language. If you’ll get back onto your
chair, I’ll explain... Through the ages, many languages developed, such as Latin, English and
Zulu, so that people could communicate with one another effectively. Communicating
effectively is essential! It helps avoid all sorts of misunderstandings.
Chapter 1 3
Accounting is just another language, one that is used Examples of typical users:
by accountants to ‘talk’ with other accountants and Shareholders: who may consider
interested parties (called ‘users’). Interested parties increasing or decreasing their
want to hear the business’s ‘story’. Thus, accountants investments,
need to be able to document the story (by debiting and Lenders: need to assess the risk of continuing
crediting) and be able to tell the story (by reporting). to provide credit,
The language we use depends on which country we Suppliers: who may want to assess whether or
are telling the story to – some countries need the not to continue supplying goods and services,
‘story’ told in their national GAAP, whereas others Customers: need to decide who best to give
need it in international GAAP (i.e. using IFRSs). The their business to.
intention is that, in time, there will be one accounting language – an international GAAP (IFRSs).
2.2 Accounting has evolved
The language of accounting has developed over thousands of years (some say more than
10 000 years and some as many as 20 000 years – we will never know for sure) and is
constantly evolving owing largely to a changing environment. The evolution so far:
• Accounting first started as a basic recording of items such as cattle and stores of grain,
using notches in clay tablets and sticks.
• Over time, this became slightly more detailed where it then involved a written record of
business transactions (i.e. using words and numbers rather than notches).
• And then came the double-entry system (i.e. using debits and credits).
The evolution of accounting came about due largely to the evolution The double-entry
of business. There are many stages that have been identified in this system came
about because it:
business evolution, but two significant stages include the introduction
• gives the detail and
of (1) corporations and (2) credit. The arrival of corporations and
checks & balances
credit meant that more detail was needed to satisfy those users who
• needed for those users
were not involved in the day-to-day management of the business:
• who are not involved in
• Initially businesses involved sole proprietors and family-run ‘day-to-day management’.
businesses, where record-keeping was a relatively simple affair
because the owners also managed the business and were thus intimate with the business’s
transactions. However, as businesses grew larger and corporations began appearing on the scene,
record-keeping had to become more detailed since the owners of these corporations were
shareholders who were generally not involved in the day-to-day management of the business.
This is known as the ‘agency problem’, which fair financial reporting aims to solve.
• Initially businesses worked purely on a cash basis. However, when ‘credit’ was introduced,
money-lenders wanted information that would help assess whether or not it was safe to continue
providing credit. Since money-lenders were not involved in the day-to-day management of the
business, they too demanded detailed record-keeping.
In summary, unlike earlier times, users of financial information today are often not involved
in the management process and thus demand more detailed financial information.
2.3 The difference between the double-entry system and GAAP
The double-entry system is a language that is centuries old and as Evidence
suggests that
relevant today as it was back then. Evidence of the first double-entry the double-
system came in the form of 2 ledgers dated the end of the 13th century: entry system
• a ledger created by Amatino Manucci, a Florentine (Italian) started:
merchant, at the end of the 13th century; and • in Italy
th
• a ledger created by Giovanino Farolfi & Company, a firm • in the 13 century!
of Florentine (Italian) merchants and moneylenders, dated of 1299-1300 (called the ‘Farolfi Ledger’).
To communicate properly in any language, we need to obey certain rules. These rules tell us
how to pronounce and spell words and how to string them together in the right order to make
a sentence that someone else will understand. Accounting is no different and thus rules on
how to ‘operate’ the double-entry system were developed.
4 Chapter 1
An Italian, Luca Pacioli, who worked closely with the artist and genius,
Leonardo da Vinci, is often referred to as the ‘father of accounting’. Pacioli is
However, Luca Pacioli did not design the double-entry system (since it called:
had already been in use for roughly 200 years). He simply appeared to
• the ‘father of
be the first to document how the double-entry system worked, accounting’, but
explaining it in his mathematics textbook (Summa de arithmetica, • he did not design the
geometria, proportioni et proportionalità, published in Venice in double-entry system, …
1494). Interestingly, however, it seems that there were previous books • he simply wrote about it!
on the double-entry system and that Pacioli’s book was simply more
widely distributed than these previous books.
Over time, more rules sprung up around this double-entry system. These rules became known
as generally accepted accounting practice (GAAP). Before globalisation, countries operated
very separately, each developing their own unique form of GAAP, in other words, their own
accounting language. Each country’s GAAP is referred to as that country’s national GAAP.
2.4 The difference between GAAP and IFRS
Since the beginning of the industrial revolution, businesses IFRSs are the
began to grow and expand across borders. Recent technology, result of:
• combining various
such as cell phones, tablet computers, email, jet engines and the national GAAPs into
internet, made it possible to communicate instantly with people • one global GAAP.
in countries that. Much of this ‘globe-shrinking technology’ has been around for many years
now, so communication is well underway between accountants of businesses in countries that,
only a few hundred years ago, did not even know each other existed.
This increased global communication between accountants gradually led them to realise that
they were ‘not talking the same language’. In fact, the national GAAP used in one country is
sometimes so different to that used in another country that it is like comparing the languages
of French and Chinese. In other cases, the differences are so minor that it is like comparing
American English with British English, where the words are the same but the accents differ.
However, all differences, no matter how small, will still result in miscommunication. Whilst
miscommunication at a personal level can lead to tragedies ranging from losing your keys to
divorce, miscommunication at a business level often leads to court cases, financial loss,
liquidation and sometimes even prison time for those involved.
The international communication amongst accountants has been growing exponentially over
the last few decades and eventually, in 1993, the effect of the different accounting languages
became painfully clear to the public. Let me tell you the story...
The Daimler-
Daimler-Benz Story:
Once upon a time, back in 1993, the German company ‘Daimler-Benz’ wished to list their
shares on the New York Stock Exchange (NYSE). This was the very first German
company to ever list on the NYSE. Excitement grew amongst US investors after Daimler-
Benz released its financial reports in German GAAP, reporting an exceptional profit of
DM615 million. As a result, US investors eagerly awaited the listing, each hoping to snatch
up shares as the company listed. Finally, the day arrived and with it came the required
financial reports, restated in terms of US GAAP. And immediately all excitement
vanished! The financial statements in terms of US GAAP reported a whopping loss of DM1.839 billion ... for the
self-same period. Which was it? An exceptional profit of a few million ... or an even more exceptional loss of a
few billion? Amazingly, both were correct! It depended on whether you ‘spoke’ German GAAP or US GAAP!
Although the gradual development of a single global GAAP had been underway for many
years, the recent and unprecedented surge in globalisation, resulting in examples such as this
‘1993 Daimler-Benz experience’, led to a renewed surge of support for the idea.
Currently, the various forms of national GAAP are in the process of being morphed into a single
global GAAP, referred to as the set of International Financial Reporting Standards (IFRSs).
These IFRSs have been developed and are regularly revised by the International Accounting
Standards Board (IASB). More about the IFRSs and the IASB can be found in section 3.
Chapter 1 5
3. GAAP and IFRSs – The Process of Internationalisation
3.1 A brief history of the internationalisation of GAAP into IFRSs

As already explained, due to the rapid globalisation and resulting increased communication of
a financial nature, global investors found that they needed a single global accounting
language, a global GAAP, without which comparability of financial results of global
companies seemed impossible.
The idea of this single global accounting language is not new!
• The 50’s: In the late 1950’s, calls for global GAAP History behind the
began, due largely to the increasing economic internationalisation:
integration after World War II and the resultant cross-
border flow of capital. Late 1950’s: calls for global GAAP
1967: AISG was formed
• The 60’s: In 1966, it was proposed that a group be 1973: IASC was formed
formed to focus on the idea of a global GAAP. As so, 2001: IASB replaced IASC
in 1967, the Accountants International Study Group (AISG) was established, comprising
the United Kingdom, the United States and Canada (represented by the Institute of
Chartered Accountants of England & Wales, American Institute of Certified Public
Accountants and Canadian Institute of Chartered Accountants respectively). This group
studied the differences in accounting practices between various countries, publishing
papers on their findings every few months.
• The 70’s: Now that it was clear that a global GAAP was needed, 1973 saw the
establishment of the International Accounting Standards Committee (IASC). It was
tasked with developing and publishing global accounting standards, which they called
International Accounting Standards (prefixed with ‘IAS’).
• The 00’s: This committee was re-organised and renamed the International Accounting
Standards Board (IASB) in 2001. This new board adopted all the work done by the
previous IASC and then proceeded to continue publishing global accounting standards.
All standards developed by this board were now called International Financial Reporting
Standards (prefixed with ‘IFRS’).
The process of distilling the world’s various national GAAPs into a single global GAAP (i.e.
IFRS) is referred to as harmonisation. This project is explained in section 3.5.
3.2 International Financial Reporting Standards (IFRSs)
3.2.1 Overview
International Financial Reporting Standards (IFRSs) contain the principles that are applied
by an accountant when:
• recording transactions and other financial information (accounting); and when
• preparing financial statements for external users (external reporting).
IFRSs are issued by the International Accounting Standards Board. The development of
IFRSs is explained in section 3.7.
3.2.2 The meaning of the term: IFRSs

It is important to realise that the term IFRSs may be used in many ways:
• It may be used in a narrow sense to refer to only those standards published by the International
Accounting Standards Board and thus prefixed with ‘IFRS’ (i.e. as opposed to standards published
by the previous International Accounting Standards Committee and thus prefixed with ‘IAS’).
• In its broader and more technical sense, the term is used to refer to the combination of
both standards and interpretations (i.e. it would refer to all the standards, prefixed with
IFRS or IAS, and all their interpretations, prefixed with SIC or IFRIC).
6 Chapter 1
However, when we state in a financial report that the financial The term IFRSs
statements comply with International Financial Reporting technically includes:
Standards, we are using the term in the broader more technical • Standards; AND
sense to refer to both the standards and the interpretations. • Interpretations.
3.2.3 The meaning of the term: Standards

Standards represent
the set of principles
Standards contain the principles to be applied by accountants.
applied by accountants.
These standards are not only issued by the International Accounting Standards Board (IASB)
but are also developed by the IASB. However, the development process follows strict due
process procedures that require much collaboration with national standard-setters from around
the world and other interested parties.
Standards are defined
As explained in a previous section, the IAS Board adopted all as:
the work done by the previous IAS Committee and thus some • Standards issued by the IASB.
of the standards are still prefixed with IAS while those issued • They comprise those prefixed
by the IASB are prefixed with IFRS. by IFRS and IAS.
Due Process Handbook: Glossary of terms
3.2.4 The meaning of the term: Interpretations
It can happen that a standard has confusing principles, the application of which needs some
explanation. Where an explanation is required, the IASB issues a document called an interpretation.
Interpretations are given the same authority as the standards. Interpretations:
Thus, if a standard comes with an interpretation, this standard • explain how to apply standards;
must be read together with its interpretation. • have the same authority as
standards.
Although interpretations are issued by the IASB, they are actually
developed by the IASB’s Interpretations Committee. As with the development of standards, the
development of interpretations follows strict due process procedures that require much collaboration
with national standard-setters from around the world and other interested parties.
Interpretations are
Since the IAS Board adopted all the work done by the defined as:
previous IAS Committee, some interpretations are prefixed
• ‘developed by the
with SIC and some are prefixed with IFRIC: Interpretations Committee
• The old IASC prefixed their interpretations with SIC, before being
being the acronym for the committee responsible for their • ratified & issued by the IASB.
• Interpretations carry the same
development: Standing Interpretations Committee. weight as a Standard.’
• The new IASB prefixes interpretations with IFRIC, being the Due Process Handbook: Glossary of terms
acronym for the committee that develops them: International Financial Reporting Interpretations
Committee.
3.3 Conceptual Framework for Financial Reporting

The Conceptual
When the IASB develops a new IFRS (i.e. standard or interpretation), Framework is not
it will use the concepts outlined in the Conceptual Framework for an IFRS!
Financial Reporting (CF) to guide the process. Thus, the framework The CF is simply used in the
is used in the development of IFRSs, and is technically not an IFRS. process of developing IFRSs.
(The CF is covered in chapter 2)
3.4 Compliance with IFRSs (adoption) Compliance with

IFRSs means
3.4.1 What does compliance with IFRS involve? compliance with:
• Standards (IAS/ IFRS); AND
To comply with IFRSs means to have adopted IFRSs. To be • Interpretations (SIC/IFRIC).
able to state in the financial report that the financial statements comply with IFRS, they must:
• comply with all IFRSs, and
• comply without any modifications (i.e. adaptations).
Chapter 1 7
Since interpretations have the same authority as standards and are thus to be read together
with the standards, when we make a statement in the financial report that the financial
statements ‘comply with the IFRSs’, we are actually saying they comply with both the:
• Standards, whether prefixed with IAS or IFRS; and
• Interpretations, whether prefixed with SIC or IFRIC.
When a set of financial statements is prepared in terms of IFRSs, a declaration of this

compliance must be included in the notes to the financial statements (this is a requirement
contained in IAS 1 Presentation of Financial Statements).
3.4.2 Why would one comply with IFRS? Compliance could

be:
There is no international body forcing compliance with IFRSs. A • Legislated: due to the
country’s specific national legislation may, however, require relevant national legislation
compliance with IFRSs. On the other hand, the national legislation of requiring compliance; or
some countries neither requires nor disallows compliance. On the • Voluntary: due to the
international credibility that
other end of the spectrum, there are some countries whose national compliance provides.
legislation actually disallows compliance (see section 3.4.3).
Where the national legislation requires compliance, the answer to ‘why would one comply
with IFRS’ is obvious. However, in situations where compliance is neither required and nor
disallowed, why would entities comply with it? The answer is simply that compliance with
IFRS gives credibility to the financial statements and makes them understandable to
foreigners, thus encouraging foreign investment.
For many years, South Africa’s legislation did not require compliance with IFRSs. Despite
this, the increased credibility gained from complying with IFRSs led many South African
companies to adopt IFRSs. However, a recent revision to South Africa’s legislation now
means that certain companies must comply with IFRSs while other companies may choose to
comply. [More information about the legislation may be found in section 4.]
Apart from a country’s legislative requirements, IAS 1 Presentation of Financial Statements
requires that where companies do comply with IFRSs (the standards and interpretations),
disclosure of this fact must be made in their financial statements. See IAS 1.16
By implication, those companies that do not comply, may not make such a declaration.
Since compliance with IFRSs lends international credibility to the financial statements, to be
able to make such a statement is desirable to most entities. [IAS 1 is covered in chapter 3.]
3.4.3 The extent of compliance with IFRS around the world
The term ‘International Financial Reporting Standards’ can be a bit misleading at present
since not all countries use them. In other words, these standards are technically not
‘international’ until all countries require the use thereof. The situation is currently as follows:
• At least 144 1 participating countries (as at 6 November 20181) already either permit or
require the use of IFRSs. Examples include South Africa, United Kingdom and all other
member states of the European Union, Australia, New Zealand, Canada, Saudi Arabia etc.2
• There are some countries that actually do not permit the use of IFRSs. Examples of some of
these include: Cuba, Indonesia, Iran, Mali, Senegal and Vietnam.2
• Some countries permit the use of IFRSs for some companies and disallow for others. For
example, the United States does not permit the use of IFRS by their domestic listed
companies but permits the use of IFRS by their domestic unlisted companies. 2
1 http://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/#analysis (accessed 6 November 2018)
2 https://www.iasplus.com/en/resources/ifrs-topics/use-of-ifrs (accessed 6 November 2018)
Some countries have adopted the IFRSs word-for-word as their own national GAAP. Others have
adopted IFRSs but with certain modifications that they consider necessary due to reasons that are
peculiar to that jurisdiction and which they thus believe have not been dealt with in the IFRSs.
8 Chapter 1
However, there are other countries that are not adopting the
IFRSs but are choosing to converge their national GAAP World-wide usage of IFRSs
with the IFRSs instead (e.g. United States, China and India). Some countries:
• require compliance with IFRSs
Thus, some countries have adopted IFRS but with • permit compliance with IFRSs
• do not allow compliance with IFRSs.
modifications and some countries use their own national
Sometimes countries that state they
GAAP that they argue has been, or is being, converged with support the use of IFRSs are using:
IFRSs. However, research has found that the difference • pure IFRSs,
between using pure IFRSs (i.e. pure adoption) versus using • modified IFRSs, or
• national GAAP that has been or is
modified IFRSs or a national GAAP that has been converged being converged with IFRSs.
with IFRSs can be significant, despite claims to the contrary.
As can be seen, the current status of the use of IFRSs is that there are still relatively divergent
practices around the world and the international harmonisation of the various national GAAP’s into a
single global GAAP (IFRSs) still has a long way to go.
The Constitution
3.5 Harmonisation versus Convergence
• refers only to convergence;
• does not refer to harmonisation!
Developing global standards requires close consultation
between the IASB and the national standard-setters and interested parties from all interested countries.
In this regard, two terms are commonly used: harmonisation and convergence.
Whereas ‘harmonisation’ was previously the buzz word, ‘convergence’ is now the new focus.
In fact, the Constitution of the IFRS Foundation refers only to the term ‘convergence’.
Ultimately, however, the purpose of both harmonisation and convergence is to create a single
set of high quality, global GAAP to be adopted world-wide.
The process of harmonisation involved the IASB and national standard-setters meeting to
analyse and compare the various principles and practices used across the world in order to:
• identify differences/ problems, and try to eliminate them; and
• help guide the development of the international standards (i.e. the IFRS would then
incorporate a combination of best practice and any new and improved ideas that may have
emanated from the process).
Essentially, the purpose of convergence is to try to reduce the differences between the IFRSs
(international GAAP) and the standards of that specific country (that country’s national
GAAP). It involves discussion and collaboration between that country’s standard-setters and
the IASB in order to assess the differences and reach an agreement on how to minimise them.
The IFRS Foundation’s
The IFRS Foundation’s constitution clarifies that the objective:
ultimate objective is adoption of IFRSs, and that • is not convergence; but rather
convergence is simply a means to achieve adoption. • is adoption.
Convergence is simply a stepping stone due to the resistance Convergence is simply a means
from some countries to adopting IFRSs. to achieve adoption.
Although most countries (at least 144 countries at November 2018 1) already either permit or require the
use of IFRSs (i.e. have adopted IFRSs), some countries are still resisting adoption of the IFRSs. The
reasons these countries are resisting vary, for example:
• Some countries resist adoption of IFRSs because the differences between that country’s
national GAAP and the IFRSs are so vast that the complications and related cost of
converting to IFRSs are expected to outweigh the benefits.
• Some countries resist because they believe their national standards are superior to the IFRSs.
•
The US argues that IFRSs are too principles-based and thus open to litigation as they are less
defensible than their more rules-based US GAAP. It has also been suggested that more powerful
countries are ‘less willing to surrender standard-setting authority to an international body’. 2
Where a country believes that it is unable to adopt the IFRSs, convergence is an option.
1
http://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/#analysis (accessed 6 November 2018)
2
Research: Why Do Countries Adopt International Financial Reporting Standards? (2009: Ramanna & Sletten)
Chapter 1 9
3.6 Adoption versus Convergence

Adopt or converge?
The IASB’s previous Director of International Activities (Mr Wayne Upton) explained: ‘While convergence may be
the necessary preparation for some countries to adopt IFRSs, the simplest, least costly and most straightforward
approach is to adopt the complete body of IFRSs in a single step rather than opting for long-term convergence.
Certainly, this is a significant change, but the alternatives may be more difficult and may be of less benefit to a
country in the long run. The main reason why most companies want to use IFRSs in their financial statements is
the ability to demonstrate to the investor community that their financial statements are IFRS-compliant. For that
purpose, it is not sufficient that the standards have converged. The only way to make a valid claim is to apply all
the standards as issued by the IASB and make the compliance representation required by IAS 1. Hence, while
convergence is good, adoption is necessary to be truly able to harvest the benefits of the change. 1
One country resisting the adoption of IFRSs is the United States. However, although the US was
initially completely opposed to the international standard-setting process, after numerous US corporate
collapses, the US Financial Accounting Standards Board (FASB) and the International Accounting
Standards Board (IASB) agreed to a process of convergence.
Convergence between US GAAP (issued by FASB) and IFRSs (issued by IASB) is commonly
referred to as ‘the Convergence Project’. However, it is a misconception that convergence refers only
to the convergence between US GAAP and IFRSs. Other countries involved in similar convergence
projects with the IASB include, for example, China and India. However, given that the US economy is
relatively large (being the second largest in the world, with the greatest being the European economy),
the convergence project between the IASB and the US’s FASB is ‘high profile’ and worth watching.
As mentioned, the US was initially opposed to IFRSs, but eventually, the IASB and the FASB
expressed their commitment to converge their standards. This commitment was documented in the
Norwalk Agreement of 2002. Although the convergence project between the IASB and the FASB has
a long way to go, the effects of having successfully reduced many differences between the IASB’s
IFRSs and FASB’s US GAAP have already been felt by foreign companies listed in the US since they
are no longer required to prepare the complex and time-consuming reconciliation between their IFRS-
based financial statements and the results that would have been achieved using US GAAP.
The US Securities Exchange Commission (SEC) was to decide in 2011 whether it would allow its
domestic companies listed in the US to use IFRSs, but subsequently postponed this to 2012. But in
October 2012, the SEC announced that, due to ‘the US Presidential Elections and other priorities in
Washington, it was unlikely that the SEC would return to the topic of domestic use of IFRSs until early
2013’.2 However, the last ‘joint IASB and FASB progress report’ was released in 2012 (correct as at
November 2018), suggesting that although further work is continuing, the issue of domestic use of
IFRSs is not high on the agenda.
The current views of the US on whether to adopt IFRSs or continue with the IFRS convergence
project, can possibly be summed up by the Chief Accountant of the SEC, Wesley Bricker, who
recently stated (August 2018) that, “for domestic companies (i.e. US-based), US GAAP best serves
their reporting (needs)”. He went on to say that he did not see any need to adopt IFRS in the
foreseeable future but that, due to the two frameworks having become more closely aligned in recent
years, “the impact of such a switch (adoption of IFRS) would not be as significant”. However, he
pointed out that, even though the US may not have adopted IFRSs, compliance with IFRSs is
obviously vital for multinational companies.3
Despite the difficulties in the convergence of the IASB and FASB, the top 20 economies in the world
(the G20), which includes countries such as the USA, South Africa, Australia, UK, have given their
total support to all convergence projects and called on ‘international accounting bodies to redouble
their efforts’ to achieve this objective ‘within the context of their independent standard-setting process’.
In particular, they asked the IASB and the US FASB to complete their convergence project.4
1 https://www.scribd.com/document/155503522/Adopt-adapt-converge
2 http://www.iasplus.com/en-gb/meeting-notes/ifrs-ac/ifrs-advisory-council-meeting-2014-22-23-october-2012/comments-from-
the-representative-of-the-us-securities-and-exchange-commission (accessed 4 December 2016);
3 https://www.cpajournal.com/2018/08/20/current-developments-at-the-sec/ (accessed 6 November 2018)
4 https://www.journalofaccountancy.com/issues/2010/aug/20103021.html
10 Chapter 1
3.7 Development of IFRSs (standard-setting)

3.7.1 Overview
IFRSs (standards and interpretations) are issued by the IASB, but their development occurs
either within the IASB or the IFRS Interpretations Committee (IFRSIC). Although the IFRSs
are developed by either the IASB or the IFRSIC, the development process involves
consultation with the various national standard-setters, regulators and other interested parties
from around the world and a careful analysis of the principles and practices contained in the
world’s various national GAAPs. This ensures that the IFRSs issued by the IASB are of a
high quality. This development process follows specific procedures referred to as due process.
Due process is explained in section 3.7.4.
3.7.2 Standards developed to date There are now 42
standards:
Standards are prefixed with either IAS or IFRS depending on • 25 are referenced as IAS 1
whether they were developed by the original International to IAS 41 (developed by the
old IAS Committee) &
Accounting Standards Committee (IASC) or the current
• 17 are referenced as IFRS 1
International Accounting Standards Board (IASB): to IFRS 17 (developed by
• The original International Accounting Standards Committee the new IAS Board).
(IASC) developed 41 global accounting standards, which were called International Accounting
Standards (thus prefixed ‘IAS’), only 25 of which remain, the rest having been withdrawn;
• The new International Accounting Standards Board (IASB) adopted these remaining IAS’s
and began developing further standards. So far, the newly created IASB has developed
17 new standards, referred to as the International Financial Reporting Standards (IFRS’s).
3.7.3 Interpretations developed to date There are now 20
interpretations:
Interpretations are prefixed with either SIC or IFRIC depending on
whether it was developed by a committee of the original IASC or • 5 are numbered SIC 1 – 34
(developed by the old sub-
the current IASB. committee); &
• Interpretations were previously developed by a committee of • 15 are numbered IFRIC 1 – 23
the IASC, called the Standing Interpretations Committee developed by the new sub-
committee).
(SIC). This committee developed 34 interpretations (SIC1 –
SIC34), only 5 of which remain, the rest have been withdrawn.
• Interpretations are now developed by a committee of the IASB. This committee was initially called
the International Financial Reporting Interpretations Committee (IFRIC), but changed its name in
2010 to the IFRS Interpretations Committee (IFRSIC). To date, this committee has developed
23 new interpretations (IFRIC 1 – IFRIC 23), 8 of which have already been withdrawn.
3.7.4 Due Process
3.7.4.1 Overview
Due process, which is set out in the Due Process Handbook, is concerned with the
development of IFRSs (standards, interpretations and improvements):
• New standards;
• Amendments to standards that are considered to be major amendments;
• Amendments to standards that are considered to be ‘minor or narrow in scope’; and
• Interpretations.
3.7.4.2 Principles of Due Process
Due process is based on the following principles:
1. Transparency: this is achieved by, for example,
• meetings of both the IASB and IFRSIC being open to the public and web-cast;
• rigorous voting processes; and
• various education sessions offered by the IASB.
Chapter 1 11
2. Full and fair consultation: the IASB and IFRSIC solicits support from a variety of
sources including, for example:
• various national and regional networks including the Accounting Standards Advisory
Forum and the IFRS Advisory Council;
• the public, through ‘invitations to comment’, as well as public hearings; and
• individuals such as preparers, auditors or investors, whom they approach through the
process of fieldwork (e.g. one-to-one interviews and workshops) and other initiatives.
3. Accountability: in this regard, the IASB is required, for example:
• to formally consider the likely ‘effects’ (cost and benefits) of proposed new or revised
standards throughout the development process;
• to provide the Basis for Conclusions (i.e. the IASB’s reasoning behind developing or
changing a standard as well as the IASB’s responses to the comments received when
the proposals were exposed); and
• to provide Dissenting Opinions (where IASB members disagreed with a standard,
they are required to provide reasons). Diagram: Basic development cycle:
3.7.4.3 The Basic Development Cycle Discussion Paper (optional)
Public consultation
Before development relating to standards or
interpretations can begin, a mandatory Proposal
Exposure Draft (ED) must first be released
for public comment. [See section 3.7.4.4]
Exposure Draft (mandatory)
Before proposing any development, however,
Public consultation
the IASB would normally publish a Discussion
Paper (DP) and first consider the comments Development: Standard/ Interpretation
received from that consultation process. A DP is
not mandatory, although reasons for not Public consultation/ problems arise on
publishing one would need to be explained to implementation
the Due Process Oversight Committee. Development: Interpretation
Importantly, public feedback is obtained at every step of the development cycle. It often happens
that, after public feedback, revised EDs, for example, may need to be issued for further public
comment before continuing with the next step.
When entities start applying new or amended Standards, practical issues in the
implementation thereof may arise that might confuse accountants and auditors. The issues that
may arise can be roughly categorised as follows:
• Minor or narrow-scope issues: these are then dealt with in the Annual Improvements; or
• Major issues: these require either a revised Standard or an Interpretation to be issued.
The IASB is responsible for issuing everything IFRS-related but it does not develop
everything. Exposure Drafts and Standards are developed by the IASB. Its sub-committee, the
IFRS Interpretations Committee (IFRSIC) is responsible for developing Interpretations.
Annual Improvements are normally developed by the IFRS Interpretations Committee but
may be developed by the IASB instead.
Diagram: Summary of who develops what:
IFRS: Previously developed by Now developed by
Exposure Drafts & IASC IASB

Standards
Improvements & SIC IFRSIC

Interpretations
12 Chapter 1
3.7.4.4 Developing Exposure Drafts

Exposure Drafts (EDs)
Exposure Drafts (ED) are defined in the Due Process
• are developed by the IASB.
Handbook as follows:
• are developed before developing
• A draft of a proposed Standard, amendment to a Standards/ Interpretations/ Annual
Standard or Interpretation. Improvements.
• always include invitations to comment.
• An Exposure Draft sets out a specific proposal and
includes a draft Basis for Conclusions and, if • must be approved by a ‘super majority’
of the IASB.
relevant, alternative views.
• An Exposure Draft is a mandatory due process step. Due Process Handbook: Glossary of terms
Exposure Drafts are developed by technical staff of the IASB and are developed in public meetings.
Once the Exposure Draft is complete, it is checked by the IASB and must be approved by a
supermajority (defined as: at least 10 of its 16 members, or 9 if the membership is 15 or less)
before being issued for public comment. Abstaining is treated as a vote against a proposal.
See Due Process Handbook: Glossary of terms
A published Exposure Draft includes:

• opinions of those IASB members who did not approve the Exposure Draft; and the
• basis for the conclusions by the IASB members who did approve the Exposure Draft.
Exposure Drafts are prepared in the form of the proposed new Standard. Since Exposure Drafts are
‘the IASB’s main vehicle for consulting the public’, the published Exposure Draft always includes
an invitation to comment. The comment period is normally a minimum of:
• 120 days when exposing a Standard and
• 90 days when exposing an Interpretation,
• but with special approval, it may be reduced to 30 days.
The public comments received are then thoroughly investigated. If the issues raised are considered
significant enough, the IASB may decide to issue a revised Exposure Draft for further comment.
After the comments on the Exposure Draft have been satisfactorily resolved, development or
amendment to a Standard or Interpretation may begin.
3.7.4.5 Developing Standards Standards
• are developed by the IASB.

Standards are defined in the Due Process Handbook as follows: • are normally exposed for
• Standards issued by the IASB. comment for 120 days.
• They are prefixed with IFRS or IAS.See Due Process Handbook: Glossary of terms • must be approved by a
‘supermajority’ of the IASB
before being issued.
Before a standard is developed, an Exposure Draft is issued for
public comment.
The period for public comment on an Exposure Draft of a Standard is generally a minimum of
120 days, but with special approval, this can be reduced to a minimum of 30 days.
Once the IASB has reached satisfactory conclusions on all issues arising from comments on
the Exposure Draft, the IASB votes to instruct the technical staff to draft the Standard.
The draft Standard is normally reviewed by the Interpretations Committee (IFRSIC).
Then the near-final standard is posted on the IFRS website for public scrutiny, after which the
IASB votes on the Standard before formally issuing the final version.
This final Standard must be approved by a supermajority of the IASB (defined as ‘at least
10 of its 16 members, or 9 if the membership is 15 or less’) before being issued.
Chapter 1 13
3.7.4.6 Developing Interpretations Interpretations are

published:
Interpretations are defined in the Due Process Handbook as: • only if the issues are not
• Interpretations are developed by the Interpretations Committee ‘narrow scope/ minor’.
(IFRSIC) before being ratified and issued by the IASB.
• Interpretations carry the same weight as a Standard. Due Process Handbook: Glossary of terms
After a Standard has been issued, problems in applying it may be identified, such as errors,
ambiguities, omissions and concerns regarding the existence of, for example, too many options:
• An Interpretation may need to be developed if the problems identified relate to confusion
regarding how a Standard is to be implemented.
• A revised Standard may need to be developed if the problems identified suggest that a
major amendment/s to a Standard may be needed.
• An Annual Improvement may need to be issued if the problems identified suggest that a
minor or narrow-scope amendment/s to a Standard may be needed.
Interpretations have the same authority as standards and thus
extreme care is exercised when publishing an interpretation. Interpretations:
The publication of an interpretation follows its own due • are developed by the IFRSIC.
• are normally available for
process, summarised below. See S7 of the Due Process Handbook, 2016 comment for 90 days.
• must be approved by a
The publication of an interpretation starts with members of the ‘supermajority’ of the IASB
technical staff drafting a ‘paper’ that summarises the matters to be before being issued.
addressed. This is then presented to the IFRSIC to consider.
When the IFRSIC reach agreement on the matters to be addressed, the technical staff members then
present this ‘paper’ to the IASB. In the meantime, the IFRSIC decides if the staff should prepare an
Exposure Draft of an Interpretation.
If a draft Interpretation is to be prepared, the IFRSIC will be required to vote on the draft
Interpretation (no more than 4 members of this committee may disagree with the draft).
Once this draft Interpretation is passed by the IFRSIC, it is presented to the IASB. The IASB
then votes on the draft Interpretation. On condition that no more than 3 members of the IASB
disagrees with the draft, the draft Interpretation is then issued for public comment.
The period for public comment on an Exposure Draft of an Interpretation is generally 90 days,
but with special approval, this can be reduced (although it may never be shorter than 30 days.
The comments received are then considered by the IFRSIC after which the Interpretation is adjusted
for any amendments that may be necessary. If the comments are significant, it may mean that the
Interpretation needs to be re-exposed for public comment.
The final Interpretation must be approved by a supermajority of the IASB (defined as: at least
10 of its 16 members, or 9 if the membership is 15 or less) before being issued. Abstaining
would be considered as a vote against a proposal. See Due Process Handbook: Glossary of terms
Annual improvements
3.7.4.7 Developing Annual Improvements are published:
• for ‘narrow scope/ minor’ issues.
Annual Improvements (AIs) are defined in the Due Process
Handbook as follows:
• narrow-scope or minor amendments to Standards or Annual improvements
Interpretations • are developed by the IFRSIC (or
• that are packaged together and exposed in one document IASB).
even though the amendments are unrelated. • follow the same due process
Due Process Handbook: Glossary of terms used for all other
amendments to IFRSs.
14 Chapter 1
These amendments are limited to changes that either:

• clarify the wording in a Standard; or
• correct relatively minor unintended consequences, oversights or conflicts between
existing requirements of Standards. IASB Due Process Handbook, 2016: para 6.11
The due process that applies to Annual Improvements is the same that which applies to all
other amendments to Standards. However, due to their relatively minor nature, the level of
consultation and community outreach may be limited to the request for comment letters.
The most recent publication of a set of Annual Improvements (AIs cycle 2015 - 2017)
occurred during December 2017. The next set of annual improvements (AI cycle 2018-2020)
has not yet commenced.
3.8 The IASB and the IFRS Foundation: a look at the structure
3.8.1 Overview
The International Accounting Standards Board (IASB) is the independent standard-setting
body responsible for issuing IFRSs (standards and interpretations). It is represented by many
nations and has its head-office in London.
The IFRS Foundation is the over-arching legal body which exists purely for the purpose of
enabling the IASB to function.
The IFRS Interpretations Committee (IFRSIC) assists the IASB in improving financial reporting
and is responsible for developing interpretations (which are approved and issued by the IASB).
Both the IASB and its IFRSIC are assisted by technical staff members, who are employed by
the IFRS Foundation.
The Trustees of the IFRS Foundation oversee the operations of the IASB and its IFRSIC.
The trustees report to a Monitoring Board (MB), which is constituted by various
representative public authorities.
The development of the IFRSs requires much collaboration with interested parties. In this
regard, there are two advisory bodies: the IFRS Advisory Council (IFRSAC) and the
Accounting Standards Advisory Forum (ASAF).
3.8.2 The IFRS Foundation
The IFRS Foundation exists as the legal entity under which the IASB operates. It is described
as ‘an independent, not-for-profit private organisation working in the public interest’.
The IFRS Foundation Constitution details its objectives and the objectives of each of its
bodies (IASB, IFRSIC, the IFRS Advisory Council, the Trustees and the Monitoring Board)
and how each is to operate and how each is governed.
(an extract from its Constitution, published in 2016)
The Objectives of the IFRS Foundation
The objectives of the IFRS Foundation are:

(a) to develop, in the public interest, a single set of high quality, understandable, enforceable and globally
accepted financial reporting standards based upon clearly articulated principles. These standards should
require high quality, transparent and comparable information in financial statements and other financial
reporting to help investors, other participants in the world’s capital markets and other users of financial
information make economic decisions.
(b) to promote the use and rigorous application of those standards.
(c) in fulfilling the objectives associated with (a) and (b), to take account of, as appropriate, the needs of a
range of sizes and types of entities in diverse economic settings.
(d) to promote and facilitate adoption of International Financial Reporting Standards (IFRSs), being the
standards and interpretations issued by the IASB, through the convergence of national accounting
standards and IFRSs.
Chapter 1 15
3.8.3 The IFRS Foundation: an organogram
IFRS Foundation Monitoring Board 1: 1. Public accountability

Should be at least 5 members (from 5 Members of the MB appoint and monitor the
specific bodies) & 1 non-voting observer trustees, and meet the trustees once a year.
- membership is currently constituted by 8 Members of the MB are not paid.
various global standard- bodies plus 1 observer
2. Governance and oversight

1 chair. Appointments
IFRS Foundation Trustees2

setting bodies (unpaid)
Representatives from
12 members plus
Trustees appoint members to IFRSAC, IASB

for 3 year terms
Should be 22 trustees (there are currently and IFRSIC; oversee their processes and
ASAF
22 trustees) ensure financing. They meet at least twice a

Trustees are appointed by the Monitoring year and report to the MB. Trustees are
independent and may not influence the
Board
decisions of the various committees.
Appointed for 3-yr terms (renewable once) Trustees are paid an annual fee, a fee per
meeting and their travel expenses are paid.
IFRSAC normally meets 2 times pa. IFRSAC members are unpaid. They
advise the IFRS Foundation and the IASB: they prioritise the IASB’s
3. Independent standard-setting &

work, advise the IASB on their views on major standards, and give
IFRS Foundation3
IFRS Advisory Council: currently +- 50 people
related activities
Appointments are for a renewable term of 3 years.
International Accounting The IASB develop & publish exposure drafts

(EDs) & standards, and they also approve
Standards Board (IASB): the publication of interpretations. They need
Should be 14 members (13 voting & 8 votes if there are 13 members or less or
1 voting chairman) – there are 9 votes if there are 14 members to get an
currently 14 members ED, standard or interpretation published.
The IASB members are full-time employees,
other advice to the IASB and the Trustees.
Appointed by trustees for 5-yr terms paid by the IFRS Foundation (although a
(renewable for further 3 yrs) max of 3 members may be part-time).
.
IFRS Interpretations Committee The IFRSIC develop interpretations after

(IFRSIC): getting public comments. Interpretations
must be approved & issued by the IASB.
Should be 15 members (14 voting Before applying for final approval from the
members and 1 non-voting IASB, the IFRSIC need a quorum of 10
chairman) - there are currently 15 members and must not have more than 4
members votes against the interpretation. The IFRSIC
reports to the IASB. The IFRSIC members
Appointed by trustees for 3-yr terms are unpaid but have travel expenses repaid.
(renewable)
Adapted from: http://www.ifrs.org/about-us/our-structure/
3.8.4 The Trustees

Trustees:
There are currently 22 trustees that govern the IFRS • are selected so that they reflect a mix
Foundation, overseeing the operations of both the IASB of professions and geographic areas.
and its IFRSIC. The Constitution sets out the • govern the operations of the IFRS
Foundation (IASB and its IFRSIC), &
responsibilities of the trustees, some of their main
• use their DPOC to assist in monitoring
responsibilities being: compliance with due process.
• appointing members of the IASB, the IFRSIC and
the IFRSAC;
• establishing and amending the operating procedures, consultative arrangements and due
process for the IASB, the IFRSIC and the IFRSAC;
• reviewing annually the strategy of the IASB and assessing its effectiveness;
• ensuring the financing of the IFRS Foundation and approve annually its budget. 1
1: http://www.ifrs.org/groups/trustees-of-the-ifrs-foundation/#members (accessed 6 November 2018)
The Constitution requires that these trustees reflect a mix of professional backgrounds (e.g.
auditors, preparers, users and academics) and geographical areas (one from Africa, six from the
Americas, six from Europe, six from the Asia/ Oceania region and three from any other area as
long as the geographical mix remains balanced). Africa was represented by a South African,
Professor Wiseman Nkuhlu (a SA chartered accountant) whose term expired in December 2018.
16 Chapter 1
These trustees have a committee called the Due Process Oversight Committee (DPOC). This DPOC
is responsible for ensuring that the IASB and its IFRSIC comply with due process procedures.
The trustees are accountable to the Monitoring Board.
3.8.5 The Monitoring Board
A further structure, the Monitoring Board, ensures that the IFRS Foundation and the IASB’s
decision-making are independent. According to both the Constitution and the Monitoring
Board’s Charter, the Monitoring Board's main responsibilities include:
• ensuring the Trustees discharge their duties as defined by the Constitution;
• approving the appointment or reappointment of Trustees;
• meeting with the Trustees at least once a year (or more often if appropriate). 1
There are 9 bodies represented on the Monitoring Board. These include the Basel Committee
on Banking Supervision as a non-voting formal observer plus 8 bodies with voting power:
• European Commission,
• Japanese Financial Services Agency (JFSA), The Monitoring Board:
• US Securities and Exchange Commission (SEC),
• Board of the International Organization of Securities • Members come from Europe, the US,
Commissions (IOSCO), Japan, Brazil, Korea and other
emerging markets.
• Growth and Emerging Markets Committee of IOSCO
• The MB effectively monitors the
• Ministry of Finance of People’s Republic of China, functioning of the Trustees.
• Brazilian Securities Commission (CVM), and
• Financial Services Commission of Korea (FSC). 2
Admitting further members to the Monitoring Board and selecting its chairman require the
consensus of these existing member)s. Membership of this board may only include:
• authorities responsible for setting the form and content of financial reporting in their
jurisdictions;
• those responsible for protecting and advancing public interest; and
• those who are strongly committed to the development of high quality IFRSs. 2
1 http://www.ifrs.org/groups/ifrs-foundation-monitoring-board/ (Accessed 6 November 2018)
2 Monitoring Board Charter, 2016
3.8.6 The International Accounting Standards Board (IASB)
The International Accounting Standards Board (IASB) is the The IASB:

standard-setting body. It is responsible for • develop & issue IFRSs & EDs;
• issuing Exposure Drafts, Standards and Interpretations, but and
is only responsible for • issue Interpretations.
• developing Exposure Drafts and Standards (the Interpretations are developed by the IFRS
Interpretations Committee).
They use a team of technical staff (employed by the IFRS Foundation) to prepare the IFRSs.
3.8.7 The IFRS Interpretations Committee (IFRSIC) The IFRSIC develop

the interpretations.
The IFRS Interpretations Committee (IFRSIC) – or simply called
the Interpretations Committee – is a committee within the IASB.
The IFRSIC is essentially responsible for developing interpretations.
In this regard, it assists the IASB in improving financial reporting by reviewing ‘on a timely basis
implementation issues that have arisen within the context of current IFRS’ and providing
‘authoritative guidance (IFRIC Interpretations) on those issues’. 1
1. https://www.ifrs.org/groups/ifrs-interpretations-committee/#about (Accessed 6 November 2018)
Chapter 1 17
3.8.8 The IFRS Advisory Council (IFRSAC) The IFRSAC act as

advisors to the IASB
A separate IFRS Advisory Council (IFRSAC) exists as the forum for and the trustees
organisations and individuals interested in international financial reporting. Membership should include
at least 30 persons, who are expected to meet at least twice per year. It is currently represented by 43
organisations, constituted by 50 individuals from diverse geographical and professional backgrounds.
See IFRS Foundation Constitution: 2016: para 43 - 45
The Constitution states that the IFRSAC must:
• advise the IASB on its agenda decisions and help prioritise its work;
• inform the IASB of its members’ views on major standard-setting projects; and
• give other advice to both the IASB and trustees. See IFRS Foundation Constitution: 2016: para 43
3.8.9 The Accounting Standards Advisory Forum (ASAF) The ASAF provide
technical advice &
The membership of the Accounting Standards Advisory Forum feedback to the IASB
(ASAF) includes 12 global accounting standard-setters plus a
chairman. The 12 members are nominated in a way so as ‘to ensure a broad geographical
representation and balance of the major economic regions in the world’. The ASAF are
expected to meet roughly 4 times a year. See ASAF: Terms of Reference
The main purpose of the ASAF is to provide technical advice and feedback to the IASB. The
reason behind this forum is that the IASB was involved with numerous bilateral
communications with each of the various national standard-setters and it became clear that
this communication would be streamlined if it could be handled via a single forum.
4. The Companies Act and the Related Regulations
4.1 Overview
The Companies Act 71 of 2008 (Companies Act 2008) became effective on 1 May 2011,
replacing the Companies Act of 1973 and the Corporate Law Amendment Act of 2006. A
number of errors and anomalies were discovered in this Companies Act (2008) which were
then corrected via the Companies Amendment Act of 2011. Further amendments have been
incorporated into the recently issued Companies Amendment Bill 2018.
The Companies Act of 2008 regulates many aspects of a company’s existence and conduct. It
is separated into nine chapters and five schedules, of which, Chapter 2 and Schedules 2 and 5
are most important to accounting financial reporting. Some of the sections relevant to
accounting from these chapters and schedules will now be discussed.
4.2 The Companies Act, 2008: Some of the big changes

The Companies Act of 2008, together with the Companies Regulations, 2011, includes
provisions that have eradicated some fundamental aspects of the old Companies Act. Some of
the most noticeable changes are the following:
• Shares may no longer be issued with a par value; see Companies Act S35
• Close corporations (CCs) may no longer be created although existing CCs may choose
either to convert to a company or remain as a CC until dissolution or deregistration;
• Companies are divided into non-profit companies and profit companies; see Companies Act S8
• Financial statements will need to be published within 6 months after the financial year-
end (previously this was 9 months); see Companies Act S30
• The Fourth Schedule disclosure requirements fall away; and
• Companies now have the contractual powers of a natural person. Therefore so-called
‘ultra vires acts’ will no longer apply (‘ultra vires’ is a Latin term meaning ‘beyond the
powers’ and allowed companies to argue, for example, that they could not be held
responsible for certain acts on the basis that they did not have the relevant power/
authority). See Companies Act S19 and S20
18 Chapter 1
4.2.1 What about pre-existing par value shares? (Co’s Act: Sch 5: S6 and Regulation 31)
Companies may not authorise any new par value shares (also known as shares having a
nominal value) on or after the effective date (1 May 2011). However, what happens to pre-
existing authorised par value shares depends entirely on the situation:
• Companies that had authorised par value shares that were already in issue on the effective
date may leave these par value shares in issue, although the company also has the option
of converting them instead. See Companies Act Schedule 5 S6(2)
• Companies that had authorised par value shares in existence on the effective date that had
not yet been issued by this date, must apply the following rules:
- If none of the authorised par value shares have yet been issued or some have been
issued but all of these have subsequently been re-acquired, then none of these
unissued par value shares may be issued – these shares will first need to be converted
into shares of no par value. See Companies Regulations 31(3)
- If some of the authorised par value shares have been issued with some still remaining
unissued, these remaining unissued par value shares may still be issued...but only
until such time as the company chooses to convert these shares into no par value
shares and publishes a proposal to this effect. See Companies Regulations 31(5)
4.2.2 What about pre-existing CCs? (Companies Act: Schedule 2)
New ‘close corporations’ (CCs) may not be created after the effective date (1 May 2011).
However, CCs that were already in existence on this effective date may either:
• continue as a CC; or
• convert into a company.
The fact that CC’s were given the option to continue as CCs instead of all being forced to
convert to companies is no doubt due to logistical reasons. There are roughly 2 million CCs in
South Africa compared to roughly only 400 000 companies. To cater for the massive
conversion of 2 million CCs into companies would simply not have been possible!
CCs that choose not to convert into a company must note that the Close Corporations Act has been
amended such that CCs will have to comply with most sections of the Companies Act and related
Regulations as if the CC were a company. For example, CCs will be subject to the same criteria as
companies when deciding what reporting standards to use and whether an audit or independent
review is required.
When considering whether or not to convert a CC into a company, one should consider the
effect of such a conversion on their legal status. The following extract from the Companies
Act explains what happens if one opts to convert a CC into a Company:
(1) Every member of a close corporation converted under this Schedule is entitled to become
a shareholder of the company resulting from that conversion, but the shares to be held in
the company by the shareholders individually need not necessarily be in proportion to the
members’ interests as stated in the founding statement of the close corporation concerned.
(2) On the registration of a company converted from a close corporation:
(a) the juristic person that existed as a close corporation before the conversion continues to exist
as a juristic person, but in the form of a company;
(b) all the assets, liabilities, rights and obligations of the close corporation vest in the company;
(c) any legal proceedings instituted before the registration by or against the corporation, may be
continued by or against the company, and any other thing done by or in respect of the close
corporation, is deemed to have been done by or in respect of the company;
(d) any enforcement measures that could have been commenced with respect to the close
corporation in terms of the Close Corporations Act, 1984 (Act No. 69 of 1984), for conduct
occurring before the date of registration, may be brought against the company on the same
basis, as if the conversion had not occurred; and
(e) any liability of a member of the corporation for the corporation’s debts, that had arisen in
terms of the Close Corporations Act, 1984 (Act No. 69 of 1984), and existed immediately
before the date of registration, survives the conversion and continues as a liability of that
person, as if the conversion had not occurred. Companies Act: Schedule 2: S2
Chapter 1 19
4.3 The different categories of companies (Companies Act: s8 and s11)

There are two main categories of companies:
• profit companies; and
• non-profit companies.
Profit companies are then sub-divided into four sub-categories.
The following is a summary comparing the descriptions of all these types of companies:
Category of company: Definition
Definition and Description:
Description:
1. Profit companies Definition: A company incorporated for the purpose of financial
gain for its shareholders Companie
Companies
mpanies Act: S1
1.1 A state-owned company Definition: A company is a state-owned company if it is:

(a) listed as a public entity in Schedule 2 or 3 of the Public
Finance Management Act, 1999; or
(b) owned by a municipality, as contemplated in the Local
Government: Municipal Systems Act, 2000 and similar to a
public entity, as described above. Companies Act S1
Company name: must end with ‘SOC Ltd’. Companies Act: S11(3)
S11 (3)
Other interesting facts: All sections in the Companies Act that

refer to public companies apply equally to state-owned
companies, except that the Minister may grant exemptions from
one or more provisions of the Act. S9
1.2 A private company Definition: A company is a private company if:
(a) it is not state-owned company; &
(b) its Memorandum of Incorporation (MOI):
− prevents it from offering its securities to the public; and
− restricts the transfer of its securities. Co’s Act: S8 (See note 1)
Company name: must end with either ‘Proprietary Limited’ or
‘(Pty) Ltd’. Companies Act: S11
Other interesting facts: A private company is no longer restricted to
50 members (i.e. it may now have more than 50 members!).
1.3 A personal liability company Definition: A company is a personal liability company if:
(a) it is a private company; and
(b) its Memorandum of Incorporation (MOI) states that it is a
personal liability company. Companies Act: S8
Company name: must end with ‘Incorporated’ or ‘Inc’. Co’s Act: S11
1.4 A public company Definition: A company is a public company if it is:
(a) A profit company that is
(b) not a state-owned company, a private company or a personal
liability company. Companies Act: S1
Company name: must end with ‘Limited’ or ‘Ltd’. Co’s Act: S11
2 Non-profit companies Definition: A company is a non-profit company if:
(a) it is incorporated for a public benefit or other object as
required by item 1(1) of Schedule 1; and
(b) its income and property are not distributable to its
incorporators, members, directors, officers or persons
related to any of them except to the extent permitted by item
1(3) of Schedule 1. Companies Act: S1
Company name: must end with ‘NPC’. Companies Act: S11
Other interesting facts: Some sections of the Companies Act do
not apply to non-profit companies. Companies Act: S10
Note 1: Securities are defined as any shares, notes, bonds, debentures or other instruments, irrespective of their
form or title, issued or authorised to be issued by a profit company for the purpose of raising capital.
Shares are simply one of the possible types of security and are defined as ‘one of the units into
which the proprietary interest in a profit company is divided’. See Companies Act: S1
20 Chapter 1
4.4 Legal backing for financial reporting standards (Companies Act: S29 and Reg. S27)
For many years, South Africa had both:

• a national standard-setter (called the Accounting Practices Board: APB Note 1) which
would publish SA accounting standards (SA GAAP) Note 2; and
• a monitoring panel (originally called the GAAP Monitoring Panel: GMP, but since
renamed the Financial Reporting Investigation Panel: FRIP) which ensured that listed
companies complied with accounting standards.
Unfortunately, the efforts of the GMP and the APB were that of a classic toothless tiger
because the previous Companies Act did not require companies to comply with these
standards. However, the Companies Act of 2008 now requires compliance with financial
reporting standards (FRSs), and the related Companies Act Regulations 2011 stipulate what
specific standards constitute these so-called financial reporting standards.
The Companies Act states
The Regulations (S27) refers to four different kinds of that:
financial reporting standards (FRSs) to be used by • any person involved in the
companies, depending on the nature of the company: • preparation, approval,
dissemination or publication
• IFRSs: International Financial Reporting Standards; • of any financial statements
• IFRS for SMEs: IFRSs for Small and Medium-sized • will be guilty of an offence
Entities; • if those f/statements do not
• SA GAAP Note 2; and comply with IFRSs when they
should comply. See Co’s Act S29
• Any financial reporting standard of the company’s
choosing (this is only allowed for certain companies with a public interest score of less
than 100 – see section 4.5).
This means that, with the introduction of the new Companies Act, certain companies are now
legally required to comply with IFRSs. Furthermore, by requiring other companies to choose
between using either IFRS or IFRS for SMEs, the new Companies Act has effectively
provided legal backing for what is referred to as differential reporting in South Africa.
Differential reporting is explained in more detail in section 4.6.
Where the FRSs are stipulated to be the IFRSs, the Financial Reporting Investigation Panel (FRIP) (a
joint initiative between the SA Institute of Chartered Accountants and the JSE Securities Exchange),
investigates and advises the JSE on alleged cases of non-compliance with IFRSs and also pro-
actively reviews the financial reporting of all companies listed on the JSE at least once every 5 years.
Note 1: The APB has since been replaced by the FRSC

The FRSC (Financial Reporting Standards Council) was established in 2011, replacing the Accounting Practices
Board (APB).
Note 2: SA GAAP was identical to IFRSs and has thus since been withdrawn.
Although SA GAAP is referred to in the Regulations as one of the options, it is identical to IFRSs
except for a few documents designed specifically for South Africa (the AC-500 series), and it has thus
been agreed that SA GAAP will be withdrawn..
Who decides what the financial reporting standards should be in SA?
The Companies Act 2008 specifies that all Public Companies must comply with IFRSs, but in all other cases, it
simply requires a company to comply with FRSs.
The Regulations then specify what specific standards the term ‘FRSs’ refer to.
The decision as to what the term ‘FRSs’ refers to, is made by the Minister of Trade and Industry, on advice
from two legal bodies:
• The Financial Reporting Standards Council (FRSC); and
• The Companies and Intellectual Property Commission (CIPC).
Chapter 1 21
The Companies Act 2008 imposes an obligation on the Minister of Trade & Industry to establish a body known
as the Financial Reporting Standards Council (FRSC). See Companies Act: S203.
The FRSC is responsible for:
a) receiving and considering information relating to the reliability of, and compliance with, financial
reporting standards and adapting international reporting standards for local circumstances*;
b) advising the Minister of Trade and Industry on financial reporting standards matters; and
c) consulting with the Minister on the making of regulations that would establish the financial
reporting standards. See Companies Act S204 (slightly reworded)
*:The FRSC has since decided that its responsibility in terms of S204(a) could never apply to public
companies, since public companies must comply with IFRSs, and cannot apply where IFRSs do not allow
for adaptations. Instead, the FRSC pledged that it would issue Financial Reporting Pronouncements
(FRPs) to account for SA-specific circumstances and issues not yet addressed by IFRS, but only on
condition that these do not contradict the IFRSs. The FRSC concluded that if it has the view that an
adaptation to an IFRS is advisable, that it would take this up through its liaison relationships with
various professional bodies that have a stake in standard setting. One such professional body is The
Companies and Intellectual Property Commission (CIPC), see below for more detail. See FRSC Rule of Procedure
The Companies and Intellectual Property Commission (CIPC) is tasked with promoting the reliability of
financial statements by, among other things:
(a) monitoring patterns of compliance with, and contraventions of, financial reporting standards; and
(b) making recommendations to the Council for amendments to financial reporting standards, to secure
better reliability and compliance. See Companies Act: S187(3)
4.5 Which financial reporting standards must we use? (Companies Act: S29 and Reg. S27)
The Companies Act states that companies must use Financial Reporting Standards (FRS).
The Regulations explain that the ‘FRSs’ will depend on the category of company.
Essentially, Financial Reporting Standards may refer to IFRS or IFRS for SMEs. This use of a
variation of reporting standards is referred to as differential reporting (see section 4.6).
The following table summarises which standards are to be used for which SA companies (this
table is extracted and slightly adapted from the Companies Act Regulations, section 27(4)).
Since SA GAAP (AC Standards) effectively does not exist (other than the few documents remaining
in the AC 500 series), the reference in the Regulations to SA GAAP being an option is largely
outdated. Thus, any reference to SA GAAP has been removed from this amended table.
Category of company: Financial Reporting Standards

1. Profit companies
1.1 A state-owned company IFRS, but in the case of any conflict
with any requirement in terms of the
Public Finance Management Act, the
latter prevails
1.2 Public companies listed on an exchange IFRS
1.3 Public companies not listed on an exchange One of –
(a) IFRS; or
(b) IFRS for SMEs Note 1
1.4 Profit companies, other than state-owned or public One of –
companies, whose public interest score (PIS) for the (a) IFRS; or
particular financial year is at least 350 OR who holds (b) IFRS for SMEs Note 1
assets in excess of R5m in a fiduciary capacity.
1.5 Profit companies other than state-owned or public One of –
companies, whose public interest score for the particular (a) IFRS; or
financial year is at least 100 but less than 350 (b) IFRS for SMEs Note 1
22 Chapter 1
1.6 Profit companies other than a state owned or public One of –

companies, whose public interest score for the particular (a) IFRS; or
financial year is less than 100, and whose statements are (b) IFRS for SMEs Note 1
independently compiled
1.7 Profit companies other than state owned or public The Financial Reporting Standard
companies whose PIS for the particular financial year is less (FRS) as determined by the company
than 100 and whose statements are internally compiled. for as long as no FRSs are prescribed.
2. Non-profit companies
2.1 Non-profit companies that hold assets in excess of R5m in IFRS, but in the case of any conflict
a fiduciary capacity OR are state or foreign controlled OR with any requirement in terms of the
perform a statutory or regulatory function Public Finance Management Act, the
latter prevails
2.2 Non-profit companies other than those contemplated in One of –
the first row above whose PIS for the particular year is at (a) IFRS; or
least 350 (b) IFRS for SMEs Note 1
the first row above whose PIS for the particular financial (a) IFRS; or
year is at least 100 but less than 350 (b) IFRS for SMEs Note 1
the first row above, whose public interest score for the (a) IFRS; or
particular financial year is less than 100, and whose (b) IFRS for SMEs Note 1
statements are independently compiled
2.5 Non-profit companies other than those contemplated in the The Financial Reporting Standard
first row above whose PIS for the particular financial year is (FRS) as determined by the company
less than 100 and whose statements are internally compiled. for as long as no FRSs are prescribed
Note:
1 Where the use of IFRS for SMEs is presented as an option, it may only be used if the company meets the
scoping requirements outlined in the IFRS for SMEs standard. Thus, if it does not meet the scoping
requirement in the IFRS for SME standard, the company will be forced to comply with IFRS instead.
4.6 Legal backing for differential reporting Legal backing for

differential reporting
4.6.1 An overview means that whereas
• some companies must use IFRS,
The Companies Act 2008 has effectively given legal • other companies may choose to use
backing for differential reporting by allowing the use of IFRS for SMEs.
both IFRSs and IFRSs for SMEs.
Differential reporting stems from the acceptance that the content of financial statements is
driven by the needs of the users of financial statements. IFRSs are designed primarily for
preparing the financial statements of public companies. Thus, the level of complexities in the
IFRSs are often unnecessary, irrelevant and very costly for non-public companies to
implement. This led to the development of IFRSs for Small and Medium Entities (IFRS for
SMEs), which provides a simpler set of international standards.
4.6.2 What is a small and medium-sized entity (SME)? (IFRS for SMEs)
What distinguishes a SME from another entity is that it has no

public accountability but yet it still produces general purpose SMEs are entities
financial statements for external users. See IFRS for SMEs
• with no public accountability, but that
The IFRS for SMEs (section 1) explains that an entity has public • produce general purpose financial
accountability if: statements for external users.
(a) its debt or equity instruments are publicly traded (or it is in
the process of issuing such instruments); or
(b) one of its primary businesses is to hold assets in a fiduciary capacity (i.e. having the legal
authority and duty to make financial decisions) for a broad group of outsiders.
Chapter 1 23
Examples of entities that have public accountability include banks, credit unions, insurance
companies, securities brokers/dealers, mutual funds and investment banks. See IFRS for SMEs
Please note that if your entity has no public accountability but is a subsidiary:
• whose parent uses full IFRSs, or
• forms part of a consolidated group that uses full IFRSs on consolidation,
you can still choose to use IFRS for SMEs for your own entity’s financial statements.
4.6.3 The history of differential reporting in South Africa South Africa was
the first country in
Although the Companies Act of 2008 allows differential reporting, the world to adopt
the South African Accounting Practices Board (APB) had already IFRS for SMEs!
approved differential reporting in 2007.
Given the extreme pressure placed on smaller companies to comply with complex IFRSs, the APB
felt it necessary to authorise the use of the IASB’s exposure draft (i.e. before it became released as
an official IFRS), entitled IFRSs for Small and Medium-sized Entities (SMEs).
South Africa adopted this Exposure Draft verbatim and was thus the very first country in the world
to allow simpler accounting for SMEs (SAICA press release 3 October 2007). The final IFRS for
SMEs was released on 9 July 2009 (i.e. replacing the Exposure Draft) and had been subsequently
amended on 21 May 2015.
4.6.4 How do the IFRS for SMEs help?
Small and medium sized entities (SMEs) do not have the need for certain complexities that
are covered in the IFRSs and generally do not have the complex systems needed to provide
the information needed for recording and presenting some of the more complex aspects. Thus,
the IFRS for SMEs was created.
The IFRS for SMEs is a selection of simplified IFRSs to be used by SMEs and which:
• provides disclosure relief (i.e. less detail needs to be provided in the financial statements);
• simplifies many recognition and measurement criteria;
• removes choices for accounting treatments; and
• eliminates certain topics that are generally not relevant to SMEs.
4.7 Does our company need an audit or independent review? (Co’s Act: S30; Reg: 28 - 29)
Some companies must be audited, some simply require an independent review, and some
require nothing at all.
Apart from state-owned and public companies, which must always be audited, whether an
audit or independent review is required for the remaining categories of companies depends on
that company’s public interest score (PIS) and other factors.
The table below summarises the factors that are considered when determining if a company
needs an audit, independent review or neither. Please note, however, that if the Act does not
require an audit, an audit would still be needed if a company’s Memorandum of Incorporation
states that an audit is required.
Category of company: Audit? By who?

who?
1. Profit companies
1.1 State-owned companies Audit RA
1.2 Public companies Audit RA
1.3 Profit co’s, other than state-owned or public companies, that: Audit RA
− hold assets in excess of R5m in a fiduciary capacity; Note 1 OR
− have a PIS for the particular financial year of at least 350.
24 Chapter 1
Category of company continued … Audit? By who?

who?
1. Profit companies continued …
1.4 Profit co’s other than state-owned or public companies, whose:
− PIS for the particular financial year is at least 100 but less
than 350 and:
a) AFS is internally compiled: Audit RA
b) AFS is independently compiled and company is not owner- Independent review RA/ CA
managed
c) AFS is independently compiled and company is owner- No audit or independent -
managed and can apply the S30(2A) exemption for review – just prepare the AFS
owner-managed companies
1.5 Profit co’s other than state-owned or public companies whose:
− PIS for that financial year is less than 100 and:
a) is not owner-managed Independent review RA/ CA/ AO
b) is owner-managed and can apply the S30(2A) exemption No audit or independent -
for owner-managed companies review – just prepare the AFS
2. Non-profit companies
2.1 Non-profit companies that: Audit RA
− hold assets in excess of R5m in a fiduciary capacity; Note 1 OR
− are state or foreign-controlled; OR
− perform a statutory or regulatory function; OR
− have a PIS for the year of at least 350
2.2 Non-profit co’s other than those referred to in 2.1 above, whose:
− PIS for the particular financial year is at least 100 but less
than 350 and:
a) AFS is internally compiled: Audit RA
b) AFS independently compiled Independent review RA/ CA
2.3 Non-profit co’s other than those referred to above whose: Independent review RA/ CA/ AO
− PIS for the particular financial year is less than 100
Acronyms used in the table:
CA: Chartered Accountant CA(SA) RA: RA Registered auditor AO:
AO Accounting officer PIS: Public interest score
Reference: A table produced by the SA Institute of Chartered Accountants; reproduced and adapted with their kind permission.
Note 1: Assets held in a fiduciary capacity must be held in the ordinary course of the company’s primary business, (not
incidental thereto), on behalf of third parties not related to the company. Fiduciary capacity implies being able to make decisions
over the use of the assets but that third parties have the right to reclaim the assets.
4.8 Company records (Companies Act: S24)

Company records
Section 24 deals with company records in general. Company must:
records include accounting-related records. The requirements • be in writing (or be able to
specific to accounting-related records include: be converted into writing)
• all company records (including accounting records) must be • be kept for at least 7 yrs.
in writing or in a form that is convertible into writing within a reasonable period of time
(e.g. electronic form); and
• all company records must be kept for a period of 7 years:
- annual financial statements: for 7 years after the date of issue*;
- accounting records: for the current year plus the previous 7 completed years*; and
- reports presented at an annual general meeting: for 7 years after the meeting*.
*: Or shorter period if the company has existed for a shorter period.
4.9 Accounting records (Companies Act: S1 and S28)

Section 1 defines accounting records as:
• Information in written or electronic form
• concerning the financial affairs as required in terms of this Act,
• including but not limited to: purchase and sales records, general and subsidiary ledgers
and other documents and books used in the preparation of financial statements.
Chapter 1 25
Section 28 requires that accounting records:

• must be accurate and complete;
• may be produced in any one of the country’s official languages;
• must be kept in the prescribed manner and form;
• must be in a form that enables the financial statements to be prepared in accordance with
this Act or any other law; and
• must be kept at, or be available from, the company’s registered office.
4.10 Financial year (Companies Act: S27)
Financial statements of companies reflect the financial information arising over the course of
its financial year (also referred to as its accounting or reporting period). This financial year
(i.e. a period of 12 months) ends on the reporting date.
Each company must decide when its reporting date will be. This reporting date must be
decided upon when the company is incorporated and must be stipulated in the company’s
Notice of Incorporation.
Although it is possible to subsequently change the reporting date set out in the company’s
Notice of Incorporation, it may not be changed:
• without filing a notice of that change;
• more than once during any financial year;
• to a date that precedes the date on which the notice is filed;
• if it will result in the very next financial period being more than 15 months.
A financial year is normally 12 months, but this is not always the case.
A financial year ends
For example: in the very first year of operation, a company’s on the reporting date
accounting period starts on the date of incorporation and ends on (RD).
the reporting date set out in the company’s Notice of • Each co must state its RD in its
Incorporation. In this case, unless the company’s date of Notice of Incorporation.
• RDs may be changed.
incorporation is exactly 365 days prior to the reporting date, the
• A financial year is normally 12
company’s first financial year will not be a perfect 12 months. months but may end up longer
or shorter, but may never
Another example of when a financial year will not be 12 exceed 15 months.
months is if the reporting date is changed.
The financial year may, however, never exceed 15 months because a financial period of more than
15 months will delay the release of its financial statements which would disadvantage its users.
4.11 Financial statements (Companies Act: S29 and Reg. 27)

Financial statements must:
• satisfy the Financial Reporting Standards, where these have been prescribed;
• may be compiled internally or independently; Reg. 27 Persons involved in the
• fairly present the company’s state of affairs and preparation, approval,
dissemination or
business; publication of any f/statements,
• explain the company’s transactions & financial position; • will be guilty of an offence
• show the company’s assets, liabilities, equity, income • if these financial statements (or
and expenses and any other prescribed information; summaries thereof)
• include the date they were produced; - do not comply with S29 or
• include the accounting period to which they apply; - are materially false/misleading.
• include, on the first page:
- a notice indicating whether or not the statements have been audited or independently
reviewed in compliance with this Act, and
- the name, and professional designation, if any, of the individual who prepared, or
supervised the preparation of, those statements.
26 Chapter 1
4.12 Annual financial statements (Co’s Act: S30 & Reg. 38)
4.12.1 Timing Annual financial
Annual financial statements must be prepared within 6 statements
months of the financial year-end (or a shorter period to • must be prepared within at least 6
provide adequate notice for an annual general meeting). months after year-end;
• may need to be audited or
4.12.2 Audit or independent review independently reviewed;
• must contain an auditors’ report
The annual financial statements of: (if applicable), a directors’ report
• state-owned and public companies must be audited. and details relating to directors
• other companies may need an audit, independent and others holding a prescribed
office in the company.
review or neither. (See section 4.7)
4.12.3 Other documents included in the annual financial statements
Annual financial statements (as opposed to financial statements) must also include an
auditor’s report (where applicable), a directors’ report and details relating to directors or
individuals holding any prescribed office in the company.
4.12.4 Extra disclosure relating to directors or prescribed officers
For audited financial statements, further particulars must be disclosed where they relate to:
• directors, or
• individuals holding any prescribed office of the company:
− The Companies Act allows the Minister to make any office a prescribed office.
− Prescribed officers are defined as having:
− general executive control over and management of a significant portion of the company; or
− regularly participating therein to a material degree. See Co’s Regulation 38
The particulars to be disclosed: D & PO NOTE 1 Disclose the: Reference:
• remuneration NOTE 2 and NOTE 3 current Amounts S30(4)(a)
• benefits paid or payable NOTE 2 current Amounts

S30(4)(a)
S30(4)(b)(i)
• pensions paid or payable current and past Amounts
S30(4)(b)(ii)
• payments to pension funds on behalf thereof current and past Amounts
S30(4)(c)
• compensation for loss of office paid current and past Amounts
Number issued; S30(4)(d)
• securities issued current and
their relatives class issued;
amt received by the co in
exchange for the securities
S30(4)(e)
• service contracts current the details
Remuneration includes: D and PO Reference:
S30(6)(a)
• directors’ fees for services to or on behalf of the company: amount Current
S30(6)(b)
• salary, bonuses and performance-related payments: amount Current
S30(6)(c)
• expense allowances for which the director need not account: amount Current
S30(6)(d)
• contributions to any pension scheme not otherwise needing separate Current and past
disclosure: amount
Current, past, future S30(6)(e)
• options or rights given directly or indirectly: the value thereof
and all relatives
Current, past, future S30(6)(f)
• financial assistance for the subscription of options or securities or
the purchase of securities: amount and all relatives
S30(6)(g)
• any loans (including loans made by third parties where the company Current, past, future
is a guarantor) and any other financial assistance: the amount being: and all relatives
- the interest deferred, waived or forgiven; or
- the difference between the:
- reasonable & market-related interest in an arm’s length transaction,
- and the interest actually charged
Acronyms used in the tables: D and PO: Directors and Prescribed Officers
Notes: Note 1: the details relating to directors and prescribed officers must be separately disclosed. S30(4)
Note 2: the remuneration and benefits must be disclosed separately for each director. S30.4(a)
Note 3: the term ‘remuneration’ includes a variety of items – these are detailed in the table above. S30(6)
Chapter 1 27
The disclosure of the abovementioned remuneration and benefits paid or payable to directors or
prescribed officers of the company must include the remuneration and benefits for:
• services as director of the reporting company;
• services while being a director of the reporting company and providing:
- services as director of other companies within the group, and
- other services to the reporting company and to other group companies. S30(5)
What is interesting here is that the amount of remuneration that is recognised in a company’s
financials differs from the amount that is disclosed in the company’s financials.
For example: a director of Co A may also be involved as a director in a subsidiary company, say
Co B. This would then mean that when preparing the financial statements for Co A:
• the amount recognised as an expense in company A’s statement of comprehensive income
will include only the amount incurred by company A; but
• the amount disclosed as directors’ remuneration in company A’s notes to the financial
statements will include the amount paid to the director by company A and by company B
since company B is in the same group as company A. See Companies Act: S30(5)
It is clear that the Companies Act requires disclosure of certain details relating to directors, but
it is just one of 4 documents demanding director-related disclosure:
• the Companies Act 2008: S30: explained above;
• the JSE Securities Exchange (JSE) Listing Requirements: see section 5 of this chapter;
• the King IV Report: see section 6 of this chapter; and
• IAS 24 on related parties: this standard is not covered in Gripping GAAP.
Since there are many disclosures required regarding directors, it is important to understand who
would be considered to be a director. The King IV Report defines a director by using the same
definition of director that is provided in the Companies Act:
• a member of the board of a company, as contemplated in S66 (of the Companies Act), or
• an alternate director of a company and
• includes any person occupying the position of a director or alternative director, by whatever
name designated. See King IV Glossary of Terms and Companies Act, Section 1
A more detailed discussion regarding some of the director-related disclosure requirements of
the JSE Listing Requirements and the King IV Report is included in each of their relevant
sections (section 5 and section 6). However, it is interesting to compare the disclosure
requirements relating to directors at this point:
• the Companies Act 2008 requires that the disclosures relating to directors’ remuneration be
provided per director; but
• the JSE Listing Requirements takes it one step further and requires that the disclosures relating to
directors’ remuneration be provided per director, and also in aggregate, and where the company
must also distinguish between executive and non-executive directors [section 8.63(k) & 7.B.7].
This requirement obviously only affects those companies wishing to be listed on the JSE.
The definitions of executive and non-executive directors are provided in the JSE Listing
Requirements [section 3.84 (e)]
• executive directors are: directors that are involved in the management of the company
and/or in full-time salaried employment of the company and/or any of its subsidiaries;
• non-executive directors are: directors that are:
- not involved in the day to day management of the business; or
- not full-time salaried employees of the company and/or any of its subsidiaries.
The JSE Listing Requirements also define a third category of director (i.e. over and above executive
directors and non-executive directors). This third category, which the JSE refers to as independent
directors [section 3.84 (e) (iii)] and which King IV refers to as independent non-executive directors
(see King IV’s Glossary of Terms: ‘independence’), is a category that is not required for purposes of
disclosing the directors’ remuneration, but simply relates to the composition of the Board of Directors.
See King IV Principle 7
28 Chapter 1
4.12.5 Approval and presentation (Companies Act: S30(3))
Financial statements must be:

• approved by the board and signed by an authorised director; and
• presented to the first shareholders’ meeting after approval thereof. There is an exemption,
however: it need not be presented at this first shareholders’ meeting if every person who
is a holder of, or has a beneficial interest in, any securities issued by the company is also a
director of the company.
5. JSE Listing Requirements
5.1 Overview
JSE Listing requirements are very detailed and will obviously only apply to companies wishing to be
listed or remain listed on the JSE. The purpose of this section is to simply give you a general
understanding of how these requirements may affect the annual financial statements.
The objective of the JSE is to provide facilities for the listing of securities (including
securities issued by both domestic and foreign companies) and to provide the JSE users with
an orderly market place for trading in such securities and to regulate the market accordingly.
The Listing Requirements of the JSE (as at 2017) is made up of 22 sections containing the
rules and procedures governing new applications, all corporate actions and continuing
obligations applicable to issuers of securities (including specialist securities). Thus, they aim
to ensure that the business of the JSE is carried on with due regard to the public interest.
There are two main sections of the JSE Listing Requirements that affect our financial
statements: Section 3: Continuing obligations; and Section 8: Financial Information.
5.2 Section 3: Continuing obligations
Section 3 of the JSE Listing Requirements lists the continuing obligations that an issuer has
once any of its securities have been listed on the JSE. This section is divided into a variety of
paragraphs dealing with a variety of areas. The continuing obligations that involve the area of
our annual financial statements are provided in paragraphs 3.19 – 3.22.
Probably the most significant to us as financial accountants is paragraph 3.19, which
stipulates when the financial statements are due to be published. In this regard, it states that
every issuer shall, within 4 months after each financial year-end and at least 15 business days
before the date of the company’s annual general meeting, distribute to all holders of securities
and submit to the JSE both:
• a notice of the annual general meeting ; and
• the annual financial statements for the relevant financial year-end (where these financial
statements must have been reported on by the auditors of the company).
5.3 Section 8: Financial information
Section 8 of the JSE Listing Requirements sets out the financial information that must be
included in a prospectus/ pre-listing statement/ circular. It also sets out the following
continuing obligations relating to matters of a financial nature:
• reporting historical financial information,
• pro-forma financial information,
• profit forecasts and estimates,
• reporting accountant’s report,
• minimum content of interim reports,
• preliminary reports,
• provisional annual financial statements and abridged annual financial statements,
• minimum contents of annual financial statements, and
• Financial Reporting Investigations Panel (FRIP).
Chapter 1 29
The minimum contents of annual financial statements is contained in paragraph 8.62. This
paragraph requires that:
• the annual financial statements (AFS) of a company must:
a) be drawn up in accordance with the national law applicable to a listed company;
b) be prepared in accordance with IFRS and the SAICA Financial Reporting Guides (as issued
by the Accounting Practices Committee: APC) and Financial Pronouncements (as issued by
the Financial Reporting Standards Council: FRSC);
c) be audited in accordance with International Standards on Auditing (ISAs), or in the case of
foreign companies, in accordance with national auditing standards are acceptable to the JSE;
d) be in consolidated form if the listing company has subsidiaries, unless the JSE otherwise
agrees, although the listed company’s own financial statements must also be published if
they contain significant additional information; and
e) fairly present the financial position, changes in equity, results of operations and cash flows
of the group.
• the annual report must:
− include a statement describing compliance with the King Code (currently King IV);
− comply with all details that are listed in paragraph 3.84 of the JSE Listing Requirements;
− comply with International Financial Reporting Standards (IFRSs);
− comply with S30 of the Companies Act; and
− include certain extra minimum disclosures.
6. King IV Report
6.1 Overview
King IV deals with:
The King IV Report on Corporate Governance (King IV) was
• Ethical culture
published on 1 November 2016, effective for all financial years • Good performance
commencing on or after 1 April 2017. This report serves as the • Effective control
benchmark for corporate governance in South Africa. King IV • Legitimacy
replaces King III in its entirety but it is not based on a completely King IV:
• has no legal backing; but
new philosophy – instead, it has simply developed and refined • is a JSE Listing Requirement.
some of the concepts discussed in King III.
King IV has been designed in a way that enables it to be easily applied in any organisation,
regardless of the manner and form of incorporation: whether private or public, small or big, profit or
non-profit. More general terminology has thus been used, for example, reference is made to
‘organisations’ and ‘governing bodies’ as opposed to ‘companies’ and ‘boards of directors’.
Supplementary information has also been included to assist organisations in interpreting and
applying the King IV recommendations to suit their individual circumstances.
As with the previous King Reports, there is no legal requirement forcing companies to comply, but
since it forms part of the JSE Listing Requirements, all companies wishing to be listed on the JSE
Securities Exchange must comply with the recommendations in this report.
King IV has been simplified from 75 principles (in King III) to only 17 principles. These principles
provide guidance on what the organisation should strive to achieve by applying the
recommendations made by the King Report. Recommended practices supporting each principle are
provided, which makes the King IV Report a lot easier to carry out in practice.
A further change is that King IV has now adopted an ‘apply and explain’ approach, whereas King III
previously used an ‘apply or explain’ approach. Thus, instead of allowing entities to choose not to
apply and to simply explain why it has not been applied, it now requires compliance and requires
entities to substantiate their claim that they have followed good governance practices. This has a
twofold effect: it allows stakeholders to make better informed decisions on an entity’s governance;
and it encourages entities to see that a more mindful approach to corporate governance is necessary
and that it should not be seen as a mere compliance burden.
Essentially, the purpose behind King IV is to achieve, through its application, four
‘governance outcomes’: ethical culture, good performance, effective control and legitimacy.
30 Chapter 1
King IV has a significant impact on the reporting by those entities that are either required (e.g.
companies listed on the JSE) or choose to comply with King IV. For example, it requires a
‘remuneration report’ and an ‘integrated report’. Each of these will now be briefly discussed.
6.2 King IV Report on Remuneration (Principle 14)
The King IV Report states that governing bodies should King IV on
ensure that the organisation remunerates all employees remuneration:
fairly, responsibly and transparently, so as to promote the • Should be fair, responsible and
creation of value in a sustainable manner. transparent.
• Remuneration report: enhanced
There is a call for increased accountability for remuneration accountability on remuneration
which is achieved through the increase in disclosure • Executive remuneration should be
requirements. With this in mind, a remuneration report is now responsible relative to other employees
required which focuses on three specific areas:
• A background statement, which provides the context of an organisation’s remuneration;
• An overview of the main provisions of the organisation’s remuneration policy; and
• An implementation report detailing the remuneration and benefits awarded to governing
body members and prescribed officers. See King IV Report: principle 14, practices 32 - 35
King IV also recognises the need to address the remuneration gap between executive management
and all other employees. It therefore requires entities to disclose how they have addressed the issue
and how they have remunerated their executives in relation to overall employee remuneration.
6.3 King IV Report on Sustainability and Integrated Reporting (Principle 5)
There has been growing local and international attention
to sustainability with many companies opting to publish King IV emphasizes the
‘sustainability reports’. importance of
sustainability by:
A sustainability report involves the practice of measuring, • reiterating the importance of the
disclosing and being accountable to both internal and Integrated Report,
external stakeholders for organizational performance • which involves the integration of
sustainability reporting with its
towards the goal of ‘sustainable development’. financial and other reports
According to the Brundtland Report, the goal of sustainable development is:

• ‘to meet the needs of the present
• without compromising the ability of future generations to meet their own needs’.
King IV emphasises the importance of sustainability reporting but notes that a sustainability
report is ‘critical but insufficient’. It thus recommends ‘the move from siloed reporting to
integrated reporting’.
Siloed reporting tends to result in a variety of lengthy reports
(e.g. financial reports, sustainability reports, audit reports, King IV defines integrated
reporting as:
directors’ reports etc) that lack cohesion. Annual reports that
contain ‘siloed’ information make it difficult for users to • a process founded on integrated
bring all the relevant information together in a way that thinking
• that results in a periodic
enables them to make informed decisions, which are really integrated report by an
only possible if one can view the company in a holistic way. organisation
Financial information presents only part of the business • about value creation over time.
• It includes related communications
story whereas there are also other important forward-looking • regarding aspects of value creation
issues regarding strategies of sustainability relating to social
and environmental issues. Thus, an integrated report better reflects the reality ‘that the resources or
capitals used by organisations constantly interconnect and interrelate’.
The integrated report is viewed by King IV as the ‘first reference point for stakeholders’ who
want to understand how the organisation creates value. It is therefore intended to be a report
that provides a holistic view of the future of the entity by bringing all the information together
into one central and primary report from which all other more detailed reports flow (e.g.
annual financial statements and sustainability reports).
Chapter 1 31
A useful analogy used by SAICA in explaining the integrated report is an octopus: ‘the head
is the integrated report and each arm is a detailed report or detailed information set (e.g.
governance information).’
Whilst King III has already introduced the idea of integrated reporting, King IV has since
refined the issue, and sees it as an outcome of integrated thinking, which looks at the
interdependencies of all the factors that affect an entity’s ability to create value. There are
three concepts which stem from ‘integrated thinking’:
• the organisation operates as an integral part of society;
• stakeholder inclusivity: the interdependency between an entity’s ability to create value for
itself and value creation for others; and
• good corporate citizenship.
King IV uses the same philosophy and terminology developed internationally on integrated
reporting. In this regard, the International Integrated Reporting Council (IIRC) has developed
the International Integrated Reporting Framework (IIRF) to provide a foundation for
establishing integrated reporting.
The International Integrated Reporting Framework has provided the following guiding
principles that underpin the preparation of the integrated report:
• Strategic focus and future orientation: An integrated report should provide insight into the
organization’s strategy, and how it relates to the organisation’s ability to create value in
the short, medium and long term, and to its use of and effects on the capitals
• Connectivity of information: An integrated report should show a holistic picture of the
combination, interrelatedness and dependencies between the factors that affect the
organisation’s ability to create value over time
• Stakeholder relationships: An integrated report should provide insight into the nature and
quality of the organisation’s relationships with its key stakeholders, including how and to
what extent the organisation understands, takes into account and responds to their
legitimate needs and interests
• Materiality: An integrated report should disclose information about matters that substantively
affect the organisation’s ability to create value over the short, medium and long term
• Conciseness: An integrated report should be concise
• Reliability and completeness: An integrated report should include all material matters,
both positive and negative, in a balanced way and without material error
• Consistency and comparability: The information in an integrated report should be
presented: (a) on a basis that is consistent over time; and (b) in a way that enables
comparison with other organisations to the extent it is material to the organisation’s own
ability to create value over time.
An integrated report typically contains:

• Annual financial statements; • Risk disclosures;
• Directors’ report; • IT reporting;
• Directors’ statement of responsibility • Remuneration report;
• Management and directors’ commentary; • Statement by the company secretary;
• Report from the audit committee; • Terms of reference of committees; and
• Sustainability report • Ethics statement.
• Chairman’s report
An integrated report can either be a standalone document (remember the analogy of the octopus) or
it may be presented as a distinguishable and easily accessible part of another report.
See Principle 5: Recommended Practice 12
Although King IV refers to principles and practices that are merely recommended, the JSE
Listing Requirements requires compliance with King IV. See JSE listings requirements: 2017: paragraph 3.84
This means that, whereas in most countries, sustainability reports and integrated reports are
‘nice to have’, King IV makes these a ‘need to have’ for all South African listed companies.
32 Chapter 1
7. Summary
About IFRSs
IFRSs:
• We’re moving slowly towards global GAAP: • Include: standards & interpretations.
IFRSs
• Are issued by the IASB (the IASB’s legal body
• Some countries have adopted IFRSs is the IFRS Foundation).
• Development follows strict due process.
• Some countries are resisting the adoption of − Standards: developed by the IASB.
IFRSs – some of these have agreed to a − Interpretations: developed by IFRSIC.
process of convergence (e.g. the US) − Annual improvements: developed by either
the IASB or its IFRSIC.
Other topics covered (i.e. in addition to the 2008 Companies Act)
• IFRSs for SMEs: an overview of differential reporting
• JSE Listing requirements: an overview of the paragraphs affecting

annual financial statements,
• King IV: a brief overview of the general principles including:

− remuneration
− sustainability and integrated reporting
The 2008 Companies Act
Some of the big changes in the 2008 Act Certain selected sections
• No further CC’s There are many sections, however, some of the

• No further par value shares main sections affecting financial reporting include:
• New company categories S8: Categories of companies
• Legal backing for IFRS S24: Company records
• Legal backing for differential reporting S27: Financial year
• Fourth Schedule disclosure falls away S28: Accounting records
S29: Financial statements
S30: Annual financial statements
Chapter 1 33
Gripping GAAP The conceptual framework for financial reporting
Chapter 2
The Conceptual Framework for Financial Reporting
Reference: Conceptual Framework for Financial Reporting (2018) (including any amendments to 1 December 2018)
Contents: Page
1. Introduction 36
1.1. General overview 36
1.2. Purpose of the CF 36
1.3. The new CF and the history behind it 36
2. General-purpose financial reporting 37
2.1. Objectives and limitations of general-purpose financial reporting 37
2.2. Information to be provided in general-purpose financial reports 38
2.2.1. Overview 38
2.2.2. Information about resources, claims and changes helps in both assessments 38
2.2.3. Information about management efficiency and effectiveness helps in both assessments 39
2.3. Information about resources, claims and changes: position, performance or other 39
2.3.1. Overview 39
2.3.2. Resources and claims: financial position 39
2.3.3. Changes in resources and claims: financial performance or other 40
2.3.4. Presenting financial performance: accrual accounting and cash flow accounting 41
3. General-purpose financial statements 41
3.1. Overview 41
3.2. Financial statements versus financial reports 41
3.3. Objective of financial statements 42
3.4. Structure of financial statements 42
3.4.1. Statement of financial position 42
3.4.2. Statement of financial performance 43
3.4.3. Other statements and notes 43
3.4.4. Summary of how information is structured in financial statements 43
3.5. Summary comparison: financial statements versus financial reports 44
3.6. The reporting entity 44
3.7. The reporting period 45
3.8. The going concern assumption 45
4. Qualitative characteristics and constraints 46
4.1. Overview 46
4.2. Fundamental qualitative characteristics 46
4.2.1. Relevance (which involves materiality) 46
Worked example 1: Materiality is entity-specific (quantitative materiality) 47
4.2.2. Faithful representation 47
4.2.2.1. Complete 47
4.2.2.2. Neutral (involves prudence) 47
4.2.2.3. Free from error 48
4.2.3. Applying the fundamental qualitative characteristics 48
Worked example 2: Relevant information that is also a faithful representation 49
Worked example 3: Balancing relevance and faithful representation 49
4.3. Enhancing qualitative characteristics 49
4.3.1. Comparability 49
4.3.2. Verifiability 50
4.3.3. Timeliness 50
4.3.4. Understandability 50
4.3.5. Applying the enhancing qualitative characteristics 51
4.4. The cost constraint on useful information 51
34 Chapter 2
Contents continued … Page

5. Elements 51
5.1. Overview 51
5.2. Asset definition 52
5.2.1. Overview 52
5.2.2. Asset definition discussed in more detail 53
Example 1: Asset – rent prepaid 55
Example 2: Asset – various 55
5.3. Liability definition 57
5.3.1. Overview 57
5.3.2. Liability definition discussed in more detail 58
Example 3: Liability – rent payable 59
Example 4: Liability – various 60
5.4. Equity definition 61
5.5. Income and expense definitions 63
Worked example 4: Income definition 63
Worked example 5: Expense definition 64
Example 5: Expense – arising from a payable 64
Worked example 6: Income and expense – part of equity reserves 64
6. Recognition and derecognition 65
6.1. Recognition 65
6.1.1. The meaning of the term ‘recognition’ 65
Worked example 7: Recognising an asset and a liability 65
6.1.2. Recognition criteria 65
6.1.3. When an element is not to be recognised 67
6.2. Derecognition 67
7. Measurement 67
7.1. Overview 67
7.2. Different measurement bases 68
7.2.1. Overview 68
7.2.2. Historical cost 69
7.2.3. Current value 69
7.3. Factors to consider when selecting a measurement basis 70
7.3.1. Overview 70
7.3.2. Relevance 70
7.3.3. Faithful representation 70
7.3.4. Other considerations 7
8. Unit of account 71
9. Presentation and disclosure principles 72
9.1. Recognition versus presentation and disclosure 72
9.2. The principles of presentation and disclosure 73
10. Concepts of capital and capital maintenance 74
10.1. Capital 74
10.2. Capital maintenance and determination of profit 74
11. Summary 75
Chapter 2 35
1. Introduction (CF: SP1.1-1.5)
1.1 General overview Status of the CF:

x not an IFRS!
The Conceptual Framework for Financial Reporting (CF) is x forms the basis of IFRSs.
technically not an IFRS (i.e. it is neither a standard nor an x may not override an IFRS.
interpretation) but simply the foundation on which all IFRSs are built. The CF:
x states the ‘objective of general-purpose financial reporting’; &
x explains the various ‘concepts’ that underpin financial reporting. See CF SP1.1
The ‘objective of general-purpose financial reporting’ (which, essentially, is to provide users with
useful information: see section 2.1) forms the foundation of the CF in that the concepts contained in
the CF all flow from this stated objective. See CF SP1.1
To achieve a successful set of general-purpose financial reports, we must apply IFRSs, where these IFRSs
are based on the concepts contained in the CF and where these concepts flow from the stated ‘objective of
general-purpose financial reporting’. We could say that these reports essentially have 3 foundations.
Foundation 1: Objective of General-Purpose Financial Reporting (see section 2):
is to provide useful information.
Foundation 2: Conceptual Framework (see this chapter):

includes concepts that achieve usefulness and provide the basis on which IFRSs are ‘built’.
Foundation 3: IFRSs (including interpretations) (see chapters 3 - 27):

are the foundation on which financial reports are prepared.
Goal: General-Purpose Financial Reports, which includes financial statements (see section 2):
aim to achieve the objective (foundation 1) by applying the IFRSs (foundation 3), and
where the development of the IFRSs were based on the concepts in the CF (foundation 2)
1.2 Purpose of the CF The purpose of the CF is

to assist:
The CF states what the objective of financial reports is and x the IASB to develop IFRSs.
explains various concepts – but why is this necessary? x preparers to create
accounting policies (rare)
Well, the CF is basically a tool that has three purposes: to
x all parties to understand and
help the IASB in developing IFRSs, to help those preparers interpret IFRSs. See CF SP1.1
of financial statements who may need to create their own
accounting policies (i.e. when either a suitable IFRS does not exist or an existing IFRS allows an
alternative policy) and to help all parties to understand and interpret the IFRSs. See CF SP1.1
1.3 The new CF and the history behind it
Conflicts with the CF
The IASB issued a new CF in 2018. The IASB decided a If the wording of an IFRS is in
conflict with a concept in the CF,
new CF was needed since the IASB uses the concepts in follow the IFRS – NOT the CF!
the CF when it develops IFRSs, and, over the years, the
IASB had noticed that many of the concepts in the original CF (issued in 1989) seemed to be
unclear, incomplete and to have become outdated. As an interim measure, it issued a partly revised
CF in 2010. This has now been replaced by the completely revised CF in 2018. However, a CF will
always be a work-in-progress and thus further revisions may be needed from time-to-time. See CF SP1.4
The ‘2018 CF’ clarifies certain concepts (e.g. prudence), includes new concepts (e.g. derecognition)
and has updated certain concepts (e.g. the asset and liability definitions and recognition criteria).
Interestingly, IFRSs issued before 2018, having been based on either the 1989 CF or 2010 CF, have
not been updated for this new CF. Thus, some of the wording in the older IFRSs may now conflict
with the wording of the new CF (e.g. IAS 37 is a standard that specifically quotes the 1989 liability
definition and is thus now in conflict with the 2018 liability definition). In all cases, where the IFRS
conflicts with the new CF, we must follow the wording of the IFRS rather than the wording of the
CF (i.e. the CF never overrides the IFRS). The IASB intends to gradually resolve any such conflicts.
36 Chapter 2
Concepts currently contained in the CF include the:

x Objective of general-purpose financial reporting (CF: ch 1);
x Qualitative characteristics of useful financial statements (CF: ch 2);
x Financial statements and the Reporting entity (CF: ch 3);
x Elements of financial statements (assets, liabilities, equity, income, expenses) (CF: ch 4);
x Recognition and Derecognition (CF: ch 5);
x Measurement bases that may be used when measuring the elements (CF: ch 6);
x Presentation and Disclosure (CF: ch 7);
x Capital and capital maintenance (CF: ch 8).
The new CF (2018) is immediately effective for the IASB (and its Interpretations Committee), and
thus new IFRSs will be based on the new CF, but preparers who need to create their own accounting
policies need only implement the new CF when preparing annual financial statements for periods
beginning on or after 1 January 2020 (earlier application is permitted). See IASB’s CF ‘Project Summary’
2. General-Purpose Financial Reporting (CF: Chapter 1 & CF: Chapter 3)
2.1 Objectives and limitations of general-purpose financial reporting

The ‘objective of general-purpose financial reporting’ is to give users information that they
will find useful in their decision making. However, this objective is not to provide all possible
users with all possible kinds of information for all possible kinds of decisions.
The CF explains that when talking about the ‘objective The objective of ‘general-
1
purpose financial reporting’
of general-purpose financial reporting’, these reports: is:
x need to be designed for only 3 primary users; x to provide financial information
x need only provide financial information; and x about the ‘reporting entity’ (RE) 2
x need only provide information that will help in making x that is useful to existing and potential
decisions about providing resources to the entity. ‘investors, lenders & other creditors’ 3
x in making decisions relating to providing
resources to the entity. CF 1.2
There are many users who may find our general-purpose
This chapter will simply refer to the:
financial reports (financial reports) useful, but we only need to ‘entity’, ‘users’ and ‘financial reports’.
design them for 3 primary users: investors, lenders and other
creditors (existing or potential). These primary users are those who are unable to demand that the entity
‘provide information directly to them’. Examples of other users who we need not consider include:
x management (they already have access to internal financial information); and
x tax authorities (they are given other information based Examples of some of the
on tax legislation). See CF 1.2 & 1.5 & 1.9-10 limitations of general-
purpose financial reporting:
As the name suggests, financial reports need only include x Only provides financial information
financial information. Other information that our users x Not designed for all users
may need include, for example, information about the x Not designed for all decisions
industry in which the entity operates, the political stability xx Not exact information
Only provides historic information
of the country in which it operates, general economic x Not designed to show the entity’s value!
conditions and even climatic conditions (especially useful
for agricultural businesses). Users will need to find this information elsewhere. See CF 1.2 & 1.6
There are many decisions that primary users may need to make, but when preparing the financial reports, we
need only provide information that will help users make decisions about whether to provide resources to the
entity. The resources the users may consider providing the entity are categorised into:
x equity/ debt instruments: whether to buy them, or if they already have, whether to sell or not;
x loans/credit: whether to provide financing or, if already provided, whether to require settlement;
x management actions: whether they wish to try to influence management actions that may affect
the entity’s economic resources (e.g. a user may have the right to vote on certain management
actions and would thus need to decide whether to exercise these rights). See CF 1.2
Another important aspect of the objective of financial reports is that we are not trying to provide an exact
depiction of transactions and events. Instead, reports are filled with ‘estimates, judgements and models’,
which we base on the concepts contained in the CF (i.e. these concepts are our goal). See CF1.11
Chapter 2 37
2.2 Information to be provided in general-purpose financial reports

2.2.1 Overview (CF 1.4; 1.3 & 1.12 – 1.23) Users make decisions based
on their potential returns…
The information included in general-purpose financial
A user’s potential returns is
reports is driven by the needs of users in making decisions based on the user’s assessment of the
about whether to provide the entity with resources entity’s:
(section 2.1). However, the specific decision depends on x Prospects of future net cash inflows
who the user is (e.g. an investor or lender) and thus what x Management stewardship See CF 1.3
potential return he will be needing to predict. For For users to make this assessment,
example, an investor may need to predict potential future they need financial reports to contain
dividends and capital growth whereas a lender may need information about the entity’s:
to predict the potential return of the loan principal amount x economic resources (A),
claims (L and Eq) and
plus interest income. See CF 1.3
changes in these resources & claims (I, E
& other transactions & events)
In order to make these predictions (of a specific potential x management‘s efficiency & effectiveness
return), users need information. In order to meet these in using the entity’s resources See CF 1.3-1.4
needs, financial reports must include information about both the entity’s:
x economic resources, claims against the entity, and changes in those resources and claims See CF 1.4
x management’s efficiency and effectiveness in performing their responsibility to use the
entity’s economic resources. See CF 1.4
Both types of information will then be used by users in their assessment of:
x ‘the prospects for future net cash inflows to the entity’ (let’s call this ‘assessment 1’); and
x ‘management’s stewardship of the entity’s economic resources’ (this is basically how
management has cared for and handled the resources) (let’s call this ‘assessment 2’). See CF 1.3
Interestingly, one assessment may also give insight into the other assessment. For example,
information that leads a user to assess management’s stewardship as being poor (assessment 2),
may lead the user to an unfavourable assessment of the prospects of future net cash inflows
(assessment 1) (see sections 2.2.3).
Financial reports ≠ Financial statements (See section 3)

x Financial statements are a form of financial report
x Financial statements do not need to include such a wide array of information – they only
need to show information about elements (assets, liabilities, equity, income and
expenses). See CF 3.1 and 4.2
The terms economic resources, claims and changes ≠the elements (See section 5)
x ‘economic resources’ (ER) is similar to ‘assets’ (A), but not all ERs will meet the
asset definition (A).
x ‘claims against the entity’ (claims) is similar to ‘equity (Eq) and liabilities (L)’, but
not all claims will meet either the equity definition (Eq) or liability definition (L).
x ‘changes in these resources and claims’ (changes) are often caused by income
and expenses, but, even then, not all such changes will actually meet the income
definition (I) or expense definition (E).
2.2.2 Information about resources, claims and changes helps in both assessments
Information about the state of the entity’s resources, claims against the entity and how and why these
have changed over time will help the user in making both assessments (section 2.2.1):
x Assessment 1: Users need to assess the likelihood that the entity can create future net cash
inflows and this assessment is partially achieved by looking carefully at:
existing claims and the resultant expected cash outflows (e.g. future loan repayments);
existing resources and the resultant expected cash inflows (e.g. the user would consider the
amount and uncertainty of the various cash inflows that could be expected from each of the
resources, such as inventory, accounts receivable and interest-bearing bank accounts);
38 Chapter 2
changes in the resources and claims and the extent to which they were caused by
financial performance (i.e. profit) compared with other events and transactions since
this will give insight into the potential for future net cash inflows (e.g. an increase in
resources that arose mainly due to the entity making profits would typically be a better
indicator of future net cash inflows than an increase in resources that was mainly due to
issuing shares).
x Assessment 2: Users need to assess management stewardship over the entity’s resources, and
often, a fairly accurate reflection of this is achieved by studying the balance between the entity’s
level of resources and claims and how or why these changed since the prior period/s.
2.2.3 Information about management efficiency and effectiveness helps in both assessments
Information about management efficiency and effectiveness will help the user in making both
assessments (section 2.2.1):
x Assessment 1: Users need to assess the potential for the entity to create future net cash
inflows. In this regard, management’s efficiency and effectiveness in using entity
resources will have a direct bearing on this potential (e.g. management may have used the
entity’s resources in a way that will grow the resources, or may have made bad
investment decisions, such as investing in technologically obsolete inventory that the
entity will battle to sell). Since financial reports only provide users with historic
information, users can only observe management’s past ‘efficiency and effectiveness’.
However, this past is useful as a predictor of management’s future ‘efficiency and
effectiveness’ and is thus also useful in a user’s assessment of the entity’s ‘prospects for
future net cash inflows’.
x Assessment 2: Users need to assess management’s stewardship of the entity’s economic
resources (i.e. how management has cared for and handled these resources). In this
regard, information about management’s efficiency and effectiveness in using the entity’s
resources is a reflection of this stewardship. Stewardship of an entity’s resources does not
simply mean saving resources. Instead, responsible stewardship involves using them in a
way that protects and/ or grows the entity, such as, incurring appropriate expenses,
investing in appropriate assets, settling debts timeously and generally making decisions
that do not put the entity at risk (e.g. through technological obsolescence). Thus, users
want to see that management has used the resources well.
2.3 Information about resources, claims and changes: position, performance or other
2.3.1 Overview
As mentioned above (section 2.2.1), financial reports provide two types of information:
x information about the entity’s economic resources, claims against it and the changes
therein, and
x information about the efficiency and effectiveness of management in using the resources.
However, the information about the resources, claims and changes therein deserves a little
more explanation. See CF 1.12
2.3.2 Resources and claims: financial position (CF 1.12 – 1.14)

Comparing an entity’s economic resources with the claims against it, gives a user a good idea
of what is referred to as the entity’s financial position.
When one talks about an entity’s financial position, one is referring to a variety of strengths
and weaknesses, such as the entity’s:
x liquidity (the user can look at the nature of its assets to assess the entity’s ability to
convert its assets into cash if needed);
x solvency (the entity’s ability to pay its liabilities); and
x need for financing.
Chapter 2 39
When a user assesses the economic resources and claims, he will not only be interested in the
amounts thereof but will also be interested in the nature thereof. In other words, users will assess
these strengths and weaknesses by analysing:
x the nature of the specific resources (e.g. an analysis of the entity’s resources may reveal that
management has invested in assets yielding high returns or, perhaps that it has invested
technologically obsolete equipment and slow-moving inventory) and
x the nature of the specific claims against these resources (e.g. some loans are repayable soon
and some are repayable in a few years).
The balance between these resources and claims will also be important for a user to assess (e.g.
having assets that are difficult to convert into cash while at the same time having liabilities that are
repayable soon is not a good balance).
2.3.3 Changes in resources and claims: financial performance or other (CF 1.15 – 1.21)
The changes in an entity’s ‘economic resources and claims’ are caused by a combination of:
x the entity’s financial performance, being the net effect of:
income earned, and
expenses incurred; and
x other events and transactions unrelated to financial performance:
equity contributions (e.g. issuing of equity instruments);
equity distributions (e.g. dividends declared); and
changes in assets and liabilities that did not increase or decrease equity. See CF 1.15 & 4.2
When a user analyses the financial information at Changes in:

reporting date, he not only wants to look at the resources x econ. resources (A's) &
currently held by the entity and what claims are currently x claims (Ls & Eq)
held against it, but he will want to know the amount by are caused by either / both:
which these resources and claims have changed since the x financial performance (e.g. profits)
prior reporting date. Furthermore, the user will want to x other reasons (e.g. issue of shares)
know what caused the changes in these amounts.
The transactions and events that caused these changes can be categorised into those that relate
to the entity’s financial performance and those that having nothing to do with financial
performance. Financial performance refers to the income generated by the entity compared
with the expenses that have been incurred by the entity.
It is important for users to be able to distinguish between these two causes (financial
performance and other reasons). The reason is best explained by way of an example…
Consider two entities (A and B) whose resources each increased by C10 000: if entity A’s
resources increased purely because it issued shares of C10 000 and entity B’s resources
increased purely as a result of the generation of profits of C10 000, which entity would you
feel most comfortable investing in? Typically, a user would prefer to invest in B because it is
the changes that result from financial performance that reflect the ‘return on economic
resources’, and this return generally reflects on management’s abilities and past success
which has a direct bearing on the future success of the entity (i.e. users will look at whether
management grew the entities resources by generating a return, or whether they just increased
the resources by raising share capital).
Financial performance is thus an indicator of the return on an entity’s economic resources.

Providing detail about what makes up the return (e.g. whether the income was purely from
sales or from a combination of sales income and interest income) will further help users to
assess the level of uncertainty regarding future cash flows. See CF 1.15-16
The transactions and events that make up this financial performance must be presented using
both the accrual basis of accounting and the cash basis of accounting (see section 2.3.4).
40 Chapter 2
Information about the transactions and events that changed an entity’s resources and claims,
but were not caused by financial performance, must also be presented because it is useful to
users to have the complete picture of what caused all the changes. Examples of changes to
resources or claims that arise due to transactions that are not related to performance include:
x the receipt of a bank loan increases cash (resources) and increases loan liability (claims);
x an issue of ordinary shares increases cash (resources) and increases share capital (claims).
2.3.4 Presenting financial performance: accrual accounting and cash flow accounting
There are two methods of presenting financial performance: using accrual accounting and using
cash flow accounting:
x accrual accounting involves recording the effects of these transactions and events in the
period in which they occur even if the related cash flow occurs in another period: this
basis of accounting involves presenting income and expenses.
x cash accounting involves recording the effects of these transactions and events in the
period in which the cash flows occur: this basis of accounting involves presenting the
cash effects from operations, investing or financing activities. See CF 1.17 – 20
Assessing past financial performance is generally useful in predicting future returns, but it is
believed that financial performance that has been depicted using accrual accounting is the best
indicator of both past and future performance. On the other hand, depicting financial performance
using cash flow accounting continues to be useful in that it assists in assessing liquidity and solvency
and helps assess and understand the entity’s operations, investing and financing activities. See 1.17-1.20
Comparison of the two methods of accounting:
Accrual accounting depicts: Cash flow accounting depicts:
x the effects of transactions and other events and x cash receipts and cash payments
circumstances x in the periods in which they occur.
x on a reporting entity’s economic resources and claims This cash basis provides additional useful
x in the periods in which those effects occur, information, which some argue is
x even if the resulting cash receipts and payments essential because the accrual system is
occur in a different period. See CF 1.17 inherently flawed in that it allows for the
manipulation of profits through using various
accounting policies and measurement methods.
3. General-Purpose Financial Statements (CF: Chapter 3)
3.1 Overview Financial statements (FS)

are a form of
So far, we have discussed financial reports. However, Financial report (FR)
this section deals with financial statements. FR’s give info about ‘economic phenomena’
FS’s give info about ‘elements’
The following sections explain the difference between
financial reports and financial statements, the financial statement objective, the term
‘reporting entity’ and ‘reporting period’, the basic structuring of the financial statements
(financial position, financial performance and ‘other’) and the different methods of
accounting for financial performance.
3.2 Financial statements versus financial reports (CF: Chapter 1, 2 & 3)
General-purpose financial reports (financial reports) are

A ‘general-purpose financial
not the same as general purpose financial statements statement’ is defined as:
(financial statements).
x a particular form of general-purpose
financial report
Financial reports is an ‘umbrella term’ that includes x that provides information about the
financial statements: financial statements are simply a reporting entity’s:
‘particular form’ of financial reports. assets, liabilities, equity,
income and expenses CF Defined terms
Chapter 2 41
Financial reports provide a wider variety of information

than financial statements: The ‘economic phenomena’
of an entity refers to its
x Financial reports provide information about:
Economic resources, claims, and changes in these x Economic resources;
x Claims against it; and
‘economic resources and claims’
x Changes in these resources and claims
(the three of these are referred to as information See CF 2.2
about the entity’s ‘economic phenomena’); and

Management efficiency and effectiveness in using resources. See CF 2.2 & CF 3.1
x Financial statements provide information about:
Only those economic resources that meet the definition of an asset,
Only those claims that meet the definition of either a liability or equity, and
Only those changes in resources and claims that meet the definition of income or expenses. See CF 3.1
Thus, whereas ‘financial reports’ give information about all economic phenomena as well as
management efficiency and effectiveness, ‘financial statements’ give information about only those
economic phenomena that meet the definition of the elements: assets, liabilities, equity, income and
expenses (see section 5). See CF3.1
Important: an element is not always recognised!
Not all transactions and events are elements and not all elements are recognised.
x For a transaction or event to be an element, it must meet the definition of an element (see section 5).
x For an element to be recognised (which means recording it in the journals and ledgers), it must
also meet the recognition criteria (see section 6).
If useful, financial statements must provide information about all elements, whether recognised or not.
3.3 Objective of financial statements (CF 3.2)

The objective of financial
statements (FSs) is:
The objective of financial statements is to provide users with
useful financial information about the reporting entity’s x to provide financial information
elements: assets, liabilities, equity, interest and expenses. x about the reporting entity’s
x assets, liabilities, equity, income & expenses
Financial statements must provide information about all x that is useful to users of FSs
transactions and events that have met the definition of an - in assessing the prospects for ‘future
net cash inflows’ to the reporting
element (see section 5), whether it has been recognised (i.e. entity, and
recorded in the journals) or not (see section 6). - in assessing ‘management’s stewardship’
of the entity’s economic resources. CF 3.2
3.4 Structure of financial statements (CF 3.3)
To provide information about these elements in a way that will be useful to users, the financial
statements are provided as a set of individual statements containing carefully categorised
information about these elements. The CF does not dictate
the title that must be used for each or the detail to be A set of FSs includes a:
contained in each, but the CF refers to them as the:
x statement of financial position, x Statement of financial position
x statement of financial performance, x Statement of financial performance
x other statements and notes. See CF 3.3 x Other statements and notes
3.4.1 Statement of financial position

The statement of financial position contains information about the assets, liabilities and equity
that have been recognised. See CF 3.3 (a)
x Assets are the economic resources that meet the asset definition. Examples include
goodwill, equipment, trade receivables and cash. (See section 5.2)
x Liabilities are the claims against an entity that meet the liability definition. Examples
include borrowings, trade payables and bank overdrafts. (See section 5.3)
x Similarly, equity reflects the claims against an entity that meet the equity definition.
Examples include ordinary share capital. (See section 5.4)
42 Chapter 2
By subtracting the total liabilities and equity from the total assets, we get what is referred to
as the entity’s financial position. Ideally, the assets will exceed the liability and equity.
As was explained previously, users analyse the economic resources and claims to gain
valuable insight into the entity’s strengths and weaknesses such as its liquidity, solvency and
need for financing (see section 2.3.2). See CF1.13
If an economic resource meets the definition of an asset and if a claim meets either the
definition of a liability or equity, and the recognition criteria are met, it will appear in the
statement of financial position. If it meets the definitions but does not meet the recognition
criteria, but is considered to be useful information, it will be presented in the notes to the
statement of financial position (see section 3.4.3).
3.4.2 Statement of financial performance
The statement of financial performance contains information about the income and expenses
that have been recognised. See CF 3.3 (b)
x Income reflects the changes in the resources and claims that meet the income definition.
Examples include sales, rent and interest earned. (See section 5.5)
x Expenses reflects the changes in the resources and claims that meet the expense
definition. Examples include the cost of sales, rent and interest incurred. (See section 5.5)
Although the CF refers to this as the ‘statement of financial performance’, the CF does not
stipulate that this must be the title of the statement. In fact, this statement could even be
presented as either one statement or two statements. A variety of titles are possible (e.g.
income statement, statement of profit or loss, statement of comprehensive income etc). In this
textbook, we will generally present the statement on financial performance as a single
statement and will use the title ‘statement of comprehensive income’. This is covered in more
detail in chapter 3.
3.4.3 Other statements and notes
We use other statements and notes to the financial statements to provide the following extra
information:
x the nature of and any risks arising from assets and liabilities that have been recognised Note 1
x the nature of and any risks arising from assets and liabilities that have not been recognised Note 1
x anything else that the IFRSs may require us to disclose regarding any of the five elements
(assets, liabilities, equity, income and expenses) that have been recognised Note 1
x how the various estimates in the financial statements were made, in other words, information
about the methods, assumptions and judgements used Note 1
x information about the cash flows Note 2
x information about the contributions from and distributions to holders of equity claims. Note 3
Notes:
1. This information will be found in the notes
2. This information will be found in the statement of cash flows and in the notes
3. This information will be found in the statement of changes in equity and in the notes
3.4.4 Summary of how information is structured in financial statements
Financial statements include information about the elements, where this information is
categorised into information that reflects on the entity’s:
x financial position,
x change in financial position that arose due to:
– the entity’s performance and
– other reasons.
Chapter 2 43
Element Description
Assets Economic resource that meets the definition of an asset Section 5.2 Position
Liabilities Claims that meet the definition of a liability Section 5.3 Position
Equity Claims that meet the definition of equity Section 5.4 Position
Income Changes in economic resources and claims that meet the Section 5.5 Performance
definition of income*
Expense Changes in economic resources and claims that meet the Section 5.5 Performance
definition of expense *
Other items Changes in economic resources and claims that do not meet Section 5.5 Other
the definition of income/ expense because they are:
- Contributions from holders of equity claims (e.g. an
issue of shares to ordinary shareholders)
- Distributions to holders of equity claims (e.g.
dividends declared to ordinary shareholders) *
* Notice: information relating to the ‘changes in economic resources and claims’ is presented in two separate categories – those
that arose due to performance and those that arose due to other reasons.
3.5 Summary comparison: financial statements versus financial reports

Financial statements are more narrowly-focussed than financial reports, as illustrated in the
table below, which compares their definitions and objectives:
Reports versus statements – comparison of their definitions and objectives
General-purpose financial reports General-purpose financial statements

Are defined as: Are defined as:
x a report x particular form of general-purpose financial reports
x that provides financial information x that provides information
x about the reporting entity’s: x about the reporting entity’s:
economic resources, claims against the entity and assets, liabilities, equity, income and expenses.
CF Defined terms
changes in those economic resources and claims
x that is useful to primary users
x in making decisions relating to providing resources
to the entity. CF Defined terms
The objective is to: The objective is to:
x Provide financial information x Provide financial information
x About the reporting entity x About the reporting entity’s:
x That is useful to users Assets, liabilities, equity, income and expenses
x In making decisions about providing resources to x That is useful to users
the entity See CF 1.2 x In assessing:
To make these decisions, users will need to assess: x Prospects for future net cash inflows to the
x Prospects for future net cash inflows to the entity; and
entity; and x Management’s stewardship of the entity’s
x Management’s stewardship of the entity’s economic resources See CF 3.2
economic resources See CF 1.3
3.6 The reporting entity (CF: Chapter 3) A reporting entity is:

Financial statements are prepared for a specific reporting entity, x an entity that
x is required/ chooses to
which is an entity that either chooses or is required to prepare x prepare F/Ss. CF 3.10
financial statements. These statements need to clearly define the
reporting entity to which it relates. A reporting entity can be a variety of things including a single
entity, part of an entity or even a group of entities. If the reporting entity is a group of entities:
x in which one of the entities has control over the other/s (the controlling entity is called a
parent and the rest are called subsidiaries), then the financial statements are called
consolidated financial statements.
x in which there is no control involved, then the financial statements are called combined
financial statements.
44 Chapter 2
If an entity is a parent in a group of entities, but it wishes to provide information about its own
elements, separately from that of the group, then it can do so in the notes to the consolidated
financial statements or it can produce an entirely separate set of financial statements about itself, in
which case these ‘single-entity’ financial statements must be called unconsolidated financial
statements so as not to be confused with its consolidated financial statements. See CF 3.11 and 3.17
Conflict between CF and pre-existing IFRS:

The heading unconsolidated financial statements conflicts with the requirements of pre-existing IFRSs
where the heading separate financial statements are used instead (see IAS 27). However, wherever
conflicts arise between the CF and pre-existing IFRSs, we must remember to apply the pre-existing IFRS.
3.7 The reporting period (CF 3.4 – 3.7)
Financial statements provide information about an entity for a ‘specified time-period’, called
a reporting period. The reporting period is normally one year (annual reporting) but may also
be provided for longer or shorter time-periods, such as 6-months (interim reporting). Financial
statements obviously need to clearly define the reporting period to which it relates.
Information relates to the reporting period through the presentation or disclosure about:
x assets, liabilities and equity (whether recognised or not) that:
existed at the end of the reporting period, called the reporting date (if they are
recognised, we present their closing balances as at the last day of the reporting period
in the statement of financial position and if they are not recognised, their values on
this day will be disclosed in the notes)
existed during this period (this information would appear in the reconciliations
between the opening and closing balances, disclosed in the notes)
x income and expenses for the entire time-period. See CF 3.4
Predictions: Financial statements include historic information covering the reporting period and would
only include forward-looking information to the extent that it is useful in understanding the historic
information (i.e. assets, liabilities and equity at the reporting date, and income and expenses for the
reporting period). For example, if an asset’s balance at reporting date (a historic figure) is measured
based on future cash flows, disclosure of these future cash flows may be considered useful to the user
and may thus be included in the notes to the financial statements. However, management’s strategies and
budgets for the future are not included in the financial statements. See CF3.6
Events after the reporting period: Obviously, after the reporting period ends and while we are busy
preparing the financial statements, transactions and events continue to occur. If a transaction or event
that occurs after the reporting period ends that we believe provides information that relates to the
elements included in the financial statements and which may be considered useful to users, we would
include this information in the financial statements. For example, we may have included a liability at the
end of the reporting period that relates to a future court case and this court case may now have begun.
Information about this court case, even though it has begun after the reporting period has ended, may be
considered useful to our users. See CF3.7
Prior reporting periods: To help users assess whether the entity is improving or deteriorating,
information relating to at least one prior period must be provided as comparative information. See CF 3.5
3.8 The going concern assumption (CF 3.9)
Unless the financial statements state otherwise, users may assume the financial statements
provide information about a reporting entity that ‘is a going concern that will continue in
operations for the foreseeable future’. In other words, users may assume that the entity does
not need/intend to liquidate or cease operating. If this assumption is inappropriate, this fact
plus the basis upon which the financial statements were then prepared (e.g. measuring assets
at liquidation values instead of fair values) must be disclosed.
Chapter 2 45
4. Qualitative Characteristics and Constraints (CF: Chapter 2)
4.1 Overview There are 2 types of QC

x Fundamental QCs
Qualitative characteristics and constraints affect all forms these are essential for usefulness
of financial information, whether contained in financial x Enhancing QCs
these improve usefulness
statements or other financial reports. This chapter and
remaining textbook focuses on financial statements.
For financial statements to be useful to its users, it must have certain qualitative characteristics,
which the CF separates into two types:
x Fundamental qualitative characteristics: Those that are essential for usefulness
x Enhancing qualitative characteristics: Those that improve usefulness. See CF 2.4-2.5
Let us now look at the detail of each of these two fundamental characteristics, how to apply them
and consider the cost constraint facing an accountant when trying to achieve these characteristics.
4.2 Fundamental qualitative characteristics (CF 2.5)

There are only 2
For financial statements to be useful, the information contained Fundamental QCs:
therein must be relevant and must be a faithful representation. x Relevance; &
We always start by looking at what information is most x Faithful representation. See CF 2.5
relevant and then checking to make sure that information
provides a faithful representation of the economic phenomenon it purports to represent.
4.2.1 Relevance (which involves materiality) (CF 2.6- 2.11)

Relevant information is:
When deciding what is relevant, we must consider whether x ‘capable of making a difference
it could make a difference in users’ decision-making. See CF 2.6 x in the decisions made by users’.
CF 2.6
Relevant information must have:

Financial information is capable of making a difference if
x Predictive value; and/or
it has either of the following or both: x Confirmatory value. See CF 2.7
x Predictive value: the information need not include
predictions or forecasts but must simply be information that users can use as ‘inputs’ in their own
predictions and forecasts.
x Confirmatory value: the information is confirmatory if it is information users can use as ‘feedback’
on their previous predictions. For example, giving information about the current year’s revenue
helps users assess if their previous revenue predictions were accurate or not. See CF 2.7 – 2.9
Information is material:
Incidentally, information that is confirmatory can also be
x if omitting/ misstating/ obscuring it
predictive. For example: information about the current x could reasonably be expected to
year’s revenue not only helps users confirm their previous influence decisions
predictions but also helps users predict the future. x that the primary users of general
purpose financial reports make
IAS 1.7 (extract)
Relevance is obviously affected by materiality.
Materiality is a term you will encounter very often in your studies and is thus important for you to
understand.
Materiality is not a qualitative characteristic but is simply used in deciding what information would
be relevant to our users. When deciding if something (in terms of its nature or magnitude, or both) is
material, and thus relevant, we ask ourselves whether it would be reasonable to expect that omitting,
misstating or obscuring it might change our primary users’ decisions. There is no one specific
materiality threshold because information that is material to one entity may not be material to
another entity and also depends on the situation: materiality is entity-specific. Clearly, deciding
whether something is material will need our professional judgement. Materiality is explained in
more detail in chapter 3. See CF 2.11 & IFRS Practice Statement 2
46 Chapter 2
Worked example 1: Materiality is entity-specific (quantitative materiality)

Entity A is a small business with total income of C50 000. It decides all income types with totals
exceeding C15 000 are individually material. Thus, it separately discloses its ‘sales income’
(C22 000) and ‘service income’ (C18 000) and aggregates all remaining income types (e.g. interest, dividends,
rental), which it discloses as ‘other income’ (C10 000).
Entity B is a larger business with total income of C1 400 000. It has many different types of income, each of
which exceeds C90 000, but its main source of income is sales of C850 000. Entity B decides an appropriate
materiality threshold for its income is C800 000, thus disclosing two types of income: ‘sales income’
(C850 000) and ‘other income’ (C550 000).
Comment: The materiality threshold of C15 000 used by A is clearly not appropriate for B, otherwise B would
need to list each of its many income types, and thus clutter its financial statements with irrelevant information.
Cluttering the financial statements with immaterial information would also risk obscuring material information.
Thus, a quantitative materiality level (magnitude) is entity-specific. Please note, however, that qualitative
materiality (nature) would also be entity-specific.
4.2.2 Faithful representation (CF 2.12 – 2.19)

Faithful representation
Faithful representation refers to the depiction of substance means information must:
over form. This means, if something’s legal form differs from ‘faithfully represent the
its substance, then we must rather portray its substance… not substance of the phenomena
its legal form. that it purports to represent’.
See CF 2.12
For example: a legal contract may state that an entity is To be a faithful representation, the
information will need to be:
leasing an item from someone (legal form = lease), but the x complete,
entity may be leasing the item for its entire useful life, in x neutral and
which case, the essence of the transaction is that the entity has x free from error. See CF 2.13
actually purchased the item from someone who has also helped the entity finance its purchase
(substance = purchase). In this case, instead of recording the lease payments as a rental expense
(legal form) we would record both the purchase of the asset and the resultant liability (the substance),
with the so-called lease payments being recorded as a repayment of the liability. See CF 2.12
In order to achieve faithful representation, the financial information given to users must be complete,
neutral and free from error. See CF 2.13
4.2.2.1 Complete (CF 2.4)

Complete means depicting:
x all information
Financial statements must be complete. Completeness means x necessary for a user to
giving all information (words and numbers) that a user needs x understand the phenomenon
to understand whatever phenomenon is being described. For being depicted CF 2.14
example, if the phenomenon is an asset, we should:
x describe the nature of the assets e.g. machines (describe nature);
x give relevant numerical information e.g. cost, depreciation etc (amounts);
x describe what the numbers mean e.g. depreciated cost (describe the information);
x explain how we got to these amounts e.g. depreciated cost is calculated at cost less depreciation
calculated using a nil residual value and a ten-year useful life (explanations).
4.2.2.2 Neutral (involves prudence) (CF 2.15-17)

Neutral means:
x free from bias.CF 2.15
For financial statements to be neutral, we must not select
or present information in a way that is biased. When there Bias means :
x manipulation to get a
is bias in the financial statements, it means the information has response that is either
been manipulated, whether consciously or subconsciously, so x favourable/ unfavourable.
that users interpret it in a favourable or unfavourable way (this
could happen by merely over-emphasizing one piece of information or de-emphasizing another!).
Chapter 2 47
To help us remain neutral, we must exercise prudence. Prudence is the:

x exercise of caution when
Exercising prudence means that, wherever there is a level of x making judgements
uncertainty in the information, we must exercise caution. x under conditions of
Being prudent (cautious), means we are being careful not to: uncertainty.CF 2.16
x overstate assets and income and understate liabilities and expenses (i.e. take care not to
be biased towards showing a favourable picture); or
x understate assets and income and overstate liabilities and expenses (take care not to be
biased towards showing an unfavourable picture).
4.2.2.3 Free from error (CF 2.18-19) Free from error means:
x no errors/ ommissions in
x description of phenomena &
To be useful, information must be a faithful representation, and x selection & application of
to be a faithful representation means it must be ‘free from processes used to
error’. However, information that is ‘free from error’ does not produce the information.
CF 2.18 (reworded)
mean it must be 'accurate in all respects’.
Free from error ≠ perfect
Sometimes amounts in our financial statements are directly observable and thus accurate (e.g. an
investment in listed shares could be valued accurately at the share price quoted on a stock exchange).
However, in other cases, there is no directly observable price and our amounts will need to be
estimated (e.g. a provision for costs relating to a lawsuit).
Having estimates in our financial statements is entirely normal but it does introduce what is referred
to as ‘measurement uncertainty’. By its very nature, at the time of making an estimate, we could
never prove it is accurate. However, even very high levels of measurement uncertainty do not
necessarily mean the information is not ‘free from error’.
‘Free from error’ simply means that there are no errors or omissions in either the description of the
phenomenon or the selection and application of the processes used to produce the information. This
means that estimated amounts in our financial information can be said to be free from error if:
x the financial information describes it as an estimate,
x the financial information describes the nature and limitations involved in making the
estimate (e.g. we explain that a provision relates to a legal claim where the court case is
still in progress and thus that we are relying on our lawyer’s estimations), and
x there are no errors in the selection and application of the process used to develop them. See CF 2.18
4.2.3 Applying the fundamental qualitative characteristics (CF 2.21-22)
The information cannot be useful if it is relevant but not a faithful representation, or vice
versa. It must be both. The CF explains that the best way of achieving both is to:
Step 1 Identify the economic phenomenon that has the potential to be useful to the user.
Step 2 Identify what type of information would be most relevant.
Step 3 Determine whether the information is available and can be faithfully represented.
If the most relevant information is available and can be faithfully represented, you will have
satisfied the fundamental qualitative characteristics. If not, then identify the next most
relevant type of information and repeat the process (i.e. figure out whether this type of
information is available and then figure out whether it can be faithfully represented).See CF 2.21
There is often a trade-off between presenting relevant information that is also a faithful
representation of the phenomenon, and vice versa. For example, sometimes the most relevant
information about a phenomenon has such a high degree of measurement uncertainty that we
must question if it is a faithful representation of its value. In some cases, we may be able to
conclude that it is still a faithful representation by simply highlighting that this information is
an estimate and explaining all the related uncertainties. However, in other cases, we may need
to give up on the idea of presenting that piece of information and choose the next most
relevant information that has a lower level of measurement uncertainty and which allows us to
conclude that it is a faithful representation of the phenomenon.
48 Chapter 2
Worked example 2: Relevant information that is also a faithful representation

The government gives us land at no cost. Land is the phenomenon that we need to depict.
We can faithfully represent this land (the phenomenon) at its nil cost, but we decide cost is not the
most relevant information and thus cost on its own is not very useful. We decide that the most relevant
information is its fair value. We establish that we can estimate this based on current market valuations of similar
properties and decide that the measurement uncertainty relating to this estimate is low enough for us to
conclude that it is a faithful representation of the land.
Conclusion: relevance + faithful representation = useful information See CF 2.4
Worked example 3: Balancing relevance and faithful representation

An entity invests in land. This investment property is the phenomenon we need to depict.
We decide that the most relevant information about this land is its fair value. However, its fair value
is not directly observable and thus we would need to estimate it. Unfortunately, there are no similar properties
or market valuations available and thus, we would need to make an estimate based on other data. We also
realise that this estimate would have such a high degree of measurement uncertainty that we would not be able
to conclude that it is a faithful representation of the property’s fair value.
In this case, we decide that the next most relevant information about this property is its cost and conclude that
since this requires absolutely no estimate, cost is a faithful representation of the property. We thus conclude that
the information we must provide is cost, since it is both relevant and a faithful representation, and is thus useful.
Conclusion: This is an example of where we had to reduce the relevance of the information in order to
achieve a faithful representation (i.e. we were forced to provide information that was not as relevant as
we would have liked). [Relevance + unfaithful representation ≠ useful information]
4.3 Enhancing qualitative characteristics (CF 2.23 - 38)

Enhancing QCs (4):
Once information is both ‘relevant’ and ‘faithfully represented’
x Comparability
(fundamental qualities), we have useful information. x Verifiability
x Timeliness
We then try to enhance this usefulness by ensuring that the x Understandability
information is also comparable, verifiable, understandable and See CF 2.23
produced on a timely basis. These are the 4 enhancing qualitative characteristics. See CF 2.23
4.3.1 Comparability (CF 2.24-29) Comparability enables

users to:
Comparability allows users to identify similarities and x ‘identify & understand
differences among items. Being able to compare items will x similarities in items, &
x differences among items’.
assist users in choosing how to proceed with their decisions CF 2.256
(e.g. whether to invest in one entity or another entity).
Consistency is not the same as comparability…it simply helps achieve comparability. See CF 2.26
‘Comparisons’ require at least two items whereas Comparability ≠ Consistency

‘consistency’ refers to the same methods being applied to x Comparability is the goal;
one specific item, either: x Consistency helps achieve the
CF 2.26
goal.
x in a single entity across multiple periods (comparing
one year to the next); or
x across multiple entities in a single period (comparing one entity to the next).
In other words, users find information more useful if they can make comparisons:
x from one year to the next: Transactions of a similar nature should be recognised, measured
and presented by an entity in the same way that they were Consistency helps enable
in prior years (consistently) (e.g. an entity should ideally comparisons:
use the same methods to measure inventory each and x between multiple entities; and
every year). This consistency allows comparisons from x between multiple periods.
one year to the next, which may help identify trends See CF 2.26
(e.g. a trend in profitability and liquidity may help

creditors decide whether they can increase or should decrease credit limits).
Chapter 2 49
x from one entity to the next. Ideally, entities should all apply the same IFRSs and methods, so
that when comparing entities, accurate comparisons would be guaranteed (e.g. this would be
useful to potential investors who are deciding which entity to invest in). Unfortunately, not all
entities comply with IFRSs and even within the IFRSs, there are so many methods permitted
that would still result in faithful representation, that this level of comparability is difficult.
4.3.2 Verifiability (CF 2.30-32)
Verifiability helps assure users that the information has been independently assessed by
knowledgeable observers and found to be faithfully represented. Thus, verifiability provides users
with a measure of confidence in the information presented. Verifiability means that:
x ‘different knowledgeable and
An amount need not be a ‘single point estimate’ to be independent observers
verifiable. Instead, a range of possible amounts and their x could reach consensus,
probabilities could be verifiable. See CF 2.30 although not necessarily
complete agreement,
Some information may not be verifiable (e.g. predictions and x that a particular depiction
(e.g. description/ amount) is a
certain explanations). If information is not verifiable, it should faithful representation’.
be clearly identified as such so that users can decide if they CF 2.30
want to use this information in their decision-making. See CF 2.32

Verification could be direct or indirect:
x Direct verification means verifying something (e.g. an amount) through direct
observation: for example, a bank balance can be verified by checking the bank statement;
x Indirect verification means verifying something (e.g. an amount) by checking inputs and
recalculating the outputs: for example, an inventory balance can be verified by checking
the inputs (number of units on hand and cost per unit), checking the correct process to be
applied (e.g. the first-in-first-out formula) and recalculating the balance. See CF 2.31
4.3.3 Timeliness (CF 2.33) Timeliness means
information is:
Information needs to be made available timeously so that users x ‘available to decision-makers
are able to use it in their decision-making. Most information x in time to be capable of
needs to be available soon after year-end to be useful. influencing their decisions’.
For example: the ‘2016 financial statements’ of a business are CF 2.33
not relevant to a user who is trying to decide, in 2019, whether

or not to invest in that business. However, old information can actually still be useful for users who
are looking at trends.
Interestingly, this race against time may impair other qualities (e.g. rushing the publication of
financial statements may result in faithful representation being adversely affected).
4.3.4 Understandability (CF 2.34-36) Understandable

information is:
Since our ultimate objective is usefulness, it makes sense x Classified, characterised &
that information must be understandable. For information presented
to be understandable, it must be clear and concise. See 2.34 x Clearly & concisely. CF 2.34
However, some information, by its very nature, may be difficult to understand. We may not simply
leave it out on the basis that it is not easily understandable. This is because this would mean that the
financial statements would not be complete and thus potentially misleading. Thus, if something is
difficult to understand, we simply need to take extra care in how we present it and give extra
disclosure if we believe it may improve the understandability thereof. See 2.35
As preparers of financial statements, when we try to explain inherently difficult information,

the CF allows us to assume that the user:
x is reasonably knowledgeable;
x will carefully review and analyse the information we provide; and
x will seek help from an advisor for complex issues. See CF 2.36
50 Chapter 2
4.3.5 Applying the enhancing qualitative characteristics (CF 2.37-38)

Information that does not have the fundamental qualitative characteristics (FQCs) is not useful and
cannot be made useful simply by ensuring it has the enhancing qualitative characteristics (EQCs).
Conversely, if we have a phenomenon that we could describe in two different ways, each way being
equally relevant and faithfully represented (i.e. meeting both FQCs), we could then consider the
enhancing qualitative characteristics (EQCs) of each way to help us decide which way is ultimately a
better way of describing it.
We must maximise the enhancing qualitative characteristics We must try to maximise

where possible. However, this process involves a balancing act, the enhancing QCs but also
because to apply one enhancing qualitative characteristic may be careful because:
mean that another one (an EQC or even a FQC) is diminished. x maximising one QC (e.g.
For example: understandability)
x may reduce another QC (e.g.
x for information to be a faithful representation (a FQC), it timeliness).
may mean that it is not as timely (a EQC) as we wanted;
x for information to be more relevant (a FQC) in the long-term, we may need to apply a
new IFRS, and this may need to be done prospectively, which would mean comparability
(a EQC) may need to be temporarily reduced.
4.4 The cost constraint on useful information (CF 2.39-43)
There are often huge costs involved in reporting financial information. These costs obviously
increase as one tries to achieve perfection in the financial statements. We therefore need to be
careful that the benefit justifies the cost. At the same time, however, we must also bear in
mind that if we, as the providers of financial information, do not incur these costs then our
users would bear extra costs by having to obtain missing information from elsewhere.
Financial reporting that is relevant and a faithful representation allows users to make
decisions with confidence. This in turn improves the overall economy.
When the IASB develops the various IFRSs that stipulate the information to be provided, it
carefully considers the expected costs involved in applying these standards. Thus, in general,
the cost of providing information required by IFRSs will normally be justified by the benefit.
This is, however, a subjective issue due to the peculiarities of each entity (what may be cost-
effective for a large multi-national entity may be too expensive for another smaller entity).
Professional judgement is thus necessary to decide if the benefit justifies the cost.
5. Elements (CF: Chapter 4)
5.1 Overview
Just as there are 26 letters in our alphabet, which we use to communicate all sorts of information,
there are 5 elements in our accounting system that we use to communicate financial information.
Using financial statements, we describe an entity’s:
x financial position using just 3 elements: assets, liabilities and equity.
x financial performance using just 2 elements: income and expenses.
As mentioned in previous sections, transactions and events lead to an entity’s economic
phenomena: its economic resources, claims against the entity and changes in these resources
and claims (see section 3).
x Economic resources are similar to assets, but not all resources are assets. For a resource
to be an asset, it must meet the definition of an asset.
x Claims could be liabilities or equity, but not all claims will meet one of these definitions.
x Similarly, changes in resources and claims could be income or expenses, or even JUST a
movement in equity, but these changes will not necessarily meet these definitions.
Chapter 2 51
Whereas financial reports include all the entity’s economic phenomena, the financial statements
include only those economic phenomena that meet the definition of one of these elements. If an
economic phenomenon meets the definition of one of these elements, we then need to decide
whether to recognise (i.e. journalise) it. In other words, some elements might not get recognised. An
element will only be recognised if it meets the recognition criteria (see section 6). If it is not
recognised, the element will not be included in either the statement of financial position or statement
of financial performance, but may be included in the notes to the financial statements.
The new 2018 CF has introduced new definitions for these elements. These are depicted below. A
comparison of the new definitions (per the new 2018 CF) with the old definitions (per the old 2010
CF) is included in the summary at the end of this chapter (see section 11).
Please note! IFRSs that were developed prior to the publication of the 2018 CF (i.e. pre-
existing IFRSs) have not been updated by the IASB for the new definitions. The reason for
this is that the IASB believes the outcome will, in most cases, be the same whether we apply
the old definitions or the new definitions. However, the IASB has stated that it will update
these pre-existing IFRSs over time, as and when conflicting outcomes are identified. In the meantime, the
IASB is immediately applying these new definitions when developing new IFRSs and interpretations. On the
other hand, the IASB has emphasized that preparers of financial statements should continue applying
these pre-existing IFRSs and that, wherever there is a conflict between the requirements of a pre-
existing IFRS and the new 2018 CF, the prepares must remember that the requirements of an IFRS must
always override the principles in the CF.
Asset Liability
CF 4.3 – 4.25 CF 4.26-4.47
Note 1
x A present economic resource x A present obligation Note 2
Note 1
x Controlled by the entity x To transfer an economic resource
x Resulting from past events x Resulting from past events
Note 1: An economic resource is defined as: Note 2: An obligation is:
x a right that has x a duty that the entity has
x the potential to produce economic benefits x no practical ability to avoid.
Equity
CF 4.63-4.67
x The residual interest in the entity’s assets

x After deducting all its liabilities
Expense Income
CF 4.69 & 4.71-72 CF 4.68 & 4.71-72
x A decrease in assets or increase in liabilities x An increase in assets or decrease in liabilities

x Resulting in decreases in equity x Resulting in increases in equity
x Other than distributions to x Other than contributions from
holders of equity claims holders of equity claims
5.2 Asset definition (CF 4.3-4.25)

5.2.1 Overview
The new 2018 CF has introduced a new asset definition. A comparison of the new asset definition
with the old asset definition, per the previous 2010 CF, is shown below.
OLD 2010 CF NEW 2018 CF
An asset was defined as: An asset is defined as:
x Resource x A present economic resource Note 1
x Controlled by the entity x Controlled by the entity
x As a result of past events x Resulting from past events See CF 4.3
x From which future economic benefits are Note 1: An economic resource is defined as:
expected to flow to the entity x a right that has
See CF 4.4
x the potential to produce economic benefits
52 Chapter 2
For an asset to exist there must be a present economic resource (defined as ‘a right that has the
potential to produce economic benefits’) and it must be controlled by the entity as a result of past
events (in other words, the event that lead to the control must have occurred before reporting date).
The most important aspects of this asset definition are to identify: Economic resource (ER):
x whether there is an economic resource (which is a right), An ER exists if there is:
x whether the entity controls this right, and x a right (not an object):
x that the right exists at reporting date because of a past event. e.g. right to use an asset
x that has the potential (even
The most significant change brought about by the new asset if it is remote) to produce
economic benefits (EB):
definition is that, when trying to decide whether an asset exists, e.g. cash inflow or a reduced
we no longer focus on the ‘object’ but rather the ‘rights’ that it cash outflow
represents (i.e. an asset is an ‘economic resource’, and an
‘economic resource’ is a ‘right that has the potential to produce economic benefits’).
A right could be many things, such as a right to receive cash, a right to use an asset or right to sell an
asset etc.
However, the right must have the potential to produce economic benefits for the entity in order for it
to be an ‘economic resource’. Depending on what the right is, the potential for economic benefits
could come in many forms, such as the right to simply receive cash (or another economic resource),
produce a cash inflow or avoid a cash outflow
For example, inventory represents:
x the right to sell the asset and
x this ‘right to sell’ has the potential to produce economic benefits, (e.g. in the form of cash), in the
event that the entity is able to sell the inventory.
The potential to produce economic benefits does not have to be certain Control over the ER
or even likely for it to meet this aspect of the asset definition. Thus, Control exists if we can:
even if the abovementioned inventory was very unlikely to be sold, the x direct the use of the ER &
x obtain its benefits
entity would still conclude that it has an asset.
Generally able to prove control
For a right to meet the definition of an asset, it must be controlled through the ‘ability to enforce
legal rights’
by the entity. The entity has control over a right if it has the
‘ability to enforce legal rights’ (e.g. if the right arises through a legal contract). However, if the entity
cannot establish that it has a legal right that can be enforced, then the entity will simply have to prove
that it can both ‘direct the use’ of the resource (i.e. that it has the ability to decide how it is used) and
‘can obtain the benefits’ from the resource.
5.2.2 Asset definition discussed in more detail

Let us know look at the definition in more detail.
x There must be a present economic resource
An economic resource is defined as ‘a right that has the potential to produce economic benefits’
The right:
The fact that an economic resource is a ‘right’ means it is not a physical object. The right
must have the potential to produce economic benefits for the entity in order for it to be an
‘economic resource’ For example, if we own inventory, the economic resource is not the
physical goods but rather the right to sell them. Thus, depending on the item, the right could
be many things.
For example:
x Accounts receivable represents the right to receive cash
x Expenses prepaid represents a right to receive goods or services
x Property, plant and equipment or intangible assets may represent a right to use an object,
or lease it or sell it etc
x Inventory represents a right to sell an object.
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Interestingly, since an asset is no longer an ‘object’ but rather the ‘right’ that it represents, it
means that, whereas in the past a single object would have been identified as a single asset, a
single object that includes multiple rights (called a ‘bundle of rights’ or ‘set of rights’), may
now need to be identified as multiple assets. For example, a contract (the object) may give
the entity a right to receive certain contractual cash flows, and also the right to use an asset
and perhaps even a right to sub-lease an asset to someone else. In this case, the ‘object’,
which is the contract, could be identified as three assets. However, the CF concedes that
where a set of rights arises from ‘legal ownership’ of an object, it will generally make sense
to account for the ‘set of rights’ as one asset (i.e. as one single ‘unit of account’). For
example, if the entity owns a vehicle (the ‘object’) it has the right to use the vehicle, sell the
vehicle or even lease the vehicle to someone else. In this case, it would not make sense to
identify these rights as separate assets but to rather identify the ‘set of rights’ as the asset.
Similarly, the CF also notes that describing this ‘set of rights’ as the physical object (i.e.
describing it as a vehicle rather than as ‘the right to use a vehicle’ will ‘often provide a
faithful representation of those rights in the most concise and understandable way’. See CF 4.12
The various forms that rights might take can be categorised into those that correspond to an
obligation of another party, and those that do not:
x rights that correspond to an obligation of another party include, for example, a right to
receive cash (e.g. accounts receivable represents the right to receive cash, but there is
another party who has the obligation to pay us the cash), and the right to receive
services (e.g. electricity prepaid represents the right to receive electricity, but there is
another party who has the obligation to provide us with the electricity; and
x rights that do not correspond to an obligation of another party include, for example, the
rights involving physical or intangible objects, such as the right to use property, plant
and equipment, investment property and inventory (physical objects) or the right to use
patents, trademarks and intellectual property (intangible assets). See CF 4.6
A right may arise through any number of ways. For example, a right could arise as a result
of a contract or through legislation or could arise as a result of the entity simply creating the
right (e.g. creating a ‘secret recipe’ that the entity then has the right to use). See CF 4.7
Potential to produce economic benefits:
The right must have the potential to produce economic benefits.
For this potential to exist, the existing right must, in simply one circumstance, be able to
produce benefits for the entity (in excess of the benefits available to all other parties).
The economic benefits that the right might produce could be many things. For example,
inventory is the right to sell the item, and where the potential economic benefits that could
be produced as a result of this ‘right to sell’, could be ‘cash inflows’. However, a right could
also produce the entitlement or ability to, for example, avoid a cash outflow or receive
another type of economic resource (i.e. another right).
Importantly, this potential for economic benefits does not need to be certain or even likely –
the potential could even be just a remote possibility. Remember that, at this stage, when we
are looking at the asset definition, all we are trying to assess is whether an asset exists. If
there is a low probability of producing benefits, this would be considered when deciding:
x whether to recognise the asset (if information about this asset would still be considered
useful by our users, despite the low probability of benefits, we might still recognise it:
see section 6: recognition), and
x how it is to be measured (see section 7: measurement).
x This resource must be controlled by the entity
An entity has control if it has the present ability to both:
x direct the use of the economic resource (i.e. can the entity decide how to use the right), and
x obtain the benefits that flow from the resource (e.g. can the entity receive the benefits).
54 Chapter 2
Control also arises if you can prevent others from directing the use and obtaining the benefits.
The easiest way to prove control is if we have the ‘ability to enforce legal rights’. For example:
We can control a right to use an asset being leased from someone else, because of the
existence of the lease contract, which gives us the ability to enforce our legal rights.
Similarly, prepaid insurance gives us the right to receive future insurance cover (an
economic resource), which is a right that we can control because of the existence of the
insurance contract, since this contract gives us the ability to enforce our legal rights. See CF4.22
However, the ability to enforce legal rights is not necessary for there to be control. For example,
an entity may have a secret recipe that it has not patented (i.e. there is no legal document), but if
the entity can keep it secret and thus prevent others from directing the use of it and obtaining the
benefits from it, then control exists. See CF 4.20 & 4.22
x This resource must arise as a result of a past event
For a resource to be a present economic resource, it must have arisen from a past event, being an
event that occurred on or before the reporting date (last day of the reporting period).
Example 1: Asset – rent prepaid

Alfa rents office space from a landlord, at C10 000 per month. It uses this space to run a business
selling financial advice. At 31 December 20X4, it pays for the rent for January 20X5.
Required: From Alpha’s perspective, prove that this payment is an asset at 31 December 20X4.
Solution 1: Asset – rent prepaid

Alpha has made a payment that has created an asset:
x There is a present economic resource
x There is a right to occupy the office space in January 20X5
x This right has the potential to produce economic benefits: the right to occupy the office can be
used to produce cash (e.g. through using the space to meet clients and sell financial advice)
x This resource is controlled by the entity
An entity has control if it has the present ability to:
direct the use of the economic resource (i.e. whether the entity can decide how to use it); and
obtain the economic benefits that flow from the resource (e.g. whether the entity has the ability
to receive the flow of cash from the financial advisory business).
In this case, the entity’s ability to direct the use and obtain the economic benefits can be proved
through its ability to enforce legal rights. This is because of the combined existence of the rental
agreement and the prepayment of the rent. (P.S. depending on the terms of the contract, the
existence of one without the other, would not give us this right i.e. if the contract existed but we
had not paid for the January rent, then, at reporting date, we would not have the right to decide
how to use the office space or obtain any benefits from the office space in January 20X5)
x This resource is a result of a past event
There are two events that have led to the economic resource: the signing of the rental agreement
and the prepayment of cash (as explained above, depending on the terms of the contract, the
signing of a rental agreement without paying for the January rent would typically not result in the
right to occupy the space in January). Both these events are past events since both events occurred
on/before reporting date (31 December 20X4).
Example 2: Asset - various

The accountant is concerned that the new asset definition in the CF will result in certain items,
which are currently considered to be assets, no longer meeting the asset definition, and vice versa.
Chapter 2 55
Required:
a) Briefly explain to the accountant whether his concerns are valid.
b) Using the ‘new’ asset definition per the 2018 CF, briefly explain how to prove that the following
items are assets:
(i) Inventory
(ii) Trade receivables
(iii) Cash at bank
(iv) Land
(v) Equipment
(vi) Investment in shares (less than 10% holding)
(vii) Investment property
Solution 2: Asset - various

a) The accountant’s concerns are not valid. The application of the new asset definition is expected to
result, in most cases, in the same outcome had the ‘old’ definition per the 2010 CF been applied
instead. Irrespective of this fact, the existing IFRSs continue to be applied by preparers of financial
statements and these new CF definitions will only be used by the IASB to develop new IFRSs and
interpretations. See CF BC4.21
b) The following are brief explanations of how certain existing assets will continue to meet the asset definition:
(i) Inventory
x The present economic resource is
- the right to sell the inventory
- where the right has the potential to produce economic benefits through the inflow of
cash, or another economic resource, when the inventory is sold
x It is controlled through legal ownership
x The past event is the purchasing and obtaining control of the inventory.
(ii) Trade receivable
- the right to collect the amount owed
- where this right has the potential to produce economic benefits through the receipt of cash
x It is controlled through a legal contract of sale
x The past event is the performance of our obligations (e.g. delivering the goods).
(iii) Cash in savings account
- the right to receive the cash from the bank
- where the right has the potential to produce economic benefits through the use of the
cash (e.g. the cash could be used on its own, or with other resources, to produce
inventory or enhance plant and equipment)
x It is controlled through a legal contract with the bank
x The past event is the acceptance of the contract with the bank and the depositing of the
cash with the bank.
(iv) Land
- the right to direct the use of the land (e.g. we can decide when to use it and how to use
it: we could decide to use the land as a public market-place or we could decide to use
it by building a new manufacturing plant on the land)
- where the right has the potential to produce economic benefits: these benefits could be
in the form of an inflow of cash (e.g. cash inflows from the rental of display tables, if
we used it as a market-place), or it could be in the form of an inflow of other economic
resources (e.g. if we used it to construct a manufacturing plant, the land would,
together with the plant, be generating inventory, which is another economic resource)
x The past event is the purchasing and obtaining control of the land.
56 Chapter 2
(v) Equipment
- the right to direct the use of the equipment (e.g. we can decide when to use it and how
long to use it for – or even whether to keep it or sell it)
- where the right has the potential to produce economic benefits, which could, for
example, be in the form of an inflow of other economic resources such as inventory (if
the equipment was used to manufacture inventory) or could be in the form of an
enhancement of another economic resource (e.g. if the equipment was used to
construct another asset, such as a manufacturing plant), or it could be in the form of a
cash inflow (e.g. if the equipment was used to provide services).
x The past event is the purchasing and obtaining control of the equipment.
(vi) Investment in shares
- the right to hold or sell these shares
dividends or capital appreciation that will be realised through sale
x It is controlled through legal ownership (the share certificates)
x The past event is the purchasing and obtaining control of the shares.
(vii) Investment property
- the right to direct the use of the property
cash when the lease rentals are paid
x The past event is the purchasing and obtaining control of the property.
5.3 Liability definition (CF 4.26-4.47)

5.3.1 Overview
The new 2018 CF has introduced a new liability definition. A comparison of the new liability
definition with the old liability definition, per the previous 2010 CF, is shown below.
A liability was defined as: A liability is defined as:
Note 1
x Present obligation of the entity x A present obligation of the entity
x As a result of past events x To transfer an economic resource
x From which future economic benefits are x As a result of past events See CF 4.26
expected to flow from the entity
Note 1: A present obligation is a:
x a duty or responsibility that an entity
x has no practical ability to avoid See CF 4.29
For a liability to exist the entity must have a present obligation to transfer an economic resource as a
result of a past event. The ‘present obligation’ is a duty or responsibility that the entity has no
practical ability of avoiding. See CF 4.26 & .29
The most significant change brought about by the new liability definition is possibly the clarification
of the meaning of ‘present obligation’. The CF now emphasizes that an obligation exists if the entity
has a duty or responsibility that it has no practical ability of avoiding. In other words, if the only way
to avoid an obligation is, for example, to liquidate or cease trading, then we conclude that we do not
have a practical way of avoiding it and must accept that we have an obligation. This is in contrast
with the previous concept of an obligation, where we would conclude that an obligation did not exist
if there was, in theory, a way we could avoid it, even though we might know that avoiding it, in that
way (e.g. through ceasing trade), would not be practical (See IAS 37 Provisions and contingent
liabilities et al).
According to the liability definition, the obligation must involve a transfer of economic resources.
The economic resource can be a variety of things, such as the rights to cash, goods or services.
Chapter 2 57
Furthermore, in terms of the liability definition, the obligation is only considered to be a present
obligation (i.e. an obligation that ‘presently’ exists as at reporting date) if there is a past event (in
other words, an event that has occurred on or before reporting date). However, unlike the asset
definition, the liability definition provides criteria that must be met before we conclude that a past
event has occurred. We could describe these criteria as the ‘cause and effect’ criteria. These criteria
are:
x the entity must have either obtained a benefit or taken an action (i.e. the entity has received
something or done something – the cause), and
x this must mean that, as a result, the entity may have to transfer an economic resource that it
would otherwise not have had to transfer (i.e. as a result, the entity may have to give up an asset
– the effect).
5.3.2 Liability definition discussed in more detail

Let us know look at the definition in more detail.
x There must be a present obligation
An obligation exists if the entity has

a duty or responsibility that it has
no practical ability of avoiding. See CF 4.28-29
Obligations always involve a duty or responsibility that is owed to a third party, though it is not
necessary to know who this party is.
The obligation could be a legal obligation, constructive obligation or even conditional.

x Legal obligations arise if the entity cannot practically avoid a duty or responsibility to
another party because that other party can legally enforce the entity’s duty or responsibility
to them (e.g. if we receive cash from a customer for the delivery of inventory, we are legally
bound to perform our duty to either deliver the inventory or return the cash).
x Constructive obligations arise if an entity has no practical ability to act inconsistently with
its own ‘customary practices, published policies or specific statements’ (e.g. if we cause
environmental damage and have a published policy of rehabilitating any areas that we may
damage, then we would have a constructive obligation to rehabilitate the environment).
x Conditional obligations arise if an entity’s duty or responsibility to transfer an economic
resource is conditional on the entity’s own future actions, but where the entity has no
practical ability of avoiding these future actions. Sometimes, the duty or responsibility can
only be avoided by the entity ceasing trading or liquidating, in which case simply preparing
financial statements on a going concern basis is sufficient to conclude that the conditional
obligation is a present obligation. See CF 4.31-32
x The obligation must have the potential to require a transfer of an economic resource
The obligation must have the potential to require the entity to transfer an economic resource.
Notice that the term ‘economic resource’ is part of the definition of an ‘asset’ (a right that has the
potential to produce economic benefits). So basically, the liability definition is saying that, for us
to conclude that there is a liability, we will have to prove that the obligation has the potential to
require the entity to transfer an asset. For example: in the case of ‘accounts payable’, there is an
obligation to transfer cash; in the case of ‘income received in advance’, there is an obligation to
deliver inventory or services … or even just to return the cash (remember that, in both examples,
we are referring to the transfer of the rights inherent in these ‘objects’).
The potential transfer of economic resources does not have to be certain or even probable – the
potential could even be just a remote possibility. A low probability of a transfer of resources
being required is not a consideration when deciding if the item meets the liability definition.
58 Chapter 2
Instead, a low probability of a transfer of resources, will be considered when deciding:

x whether to recognise the liability (if information about this liability would still be considered
useful by our users, despite the low probability of a transfer of resources being required, we
might still recognise it: see section 6: recognition), and
x how it is to be measured (see section 7: measurement).
This is the same principle that we apply when identifying whether an item meets the asset
definition (see section 5.2).
x This obligation must arise as a result of a past event
For an obligation to be a present obligation, it must have arisen from a past event. In the case of
the liability definition (unlike the asset definition), there are criteria that need to be met before
we can conclude that there has been a past event:
x The entity must have already either:
obtained an economic benefit, or
taken an action, and
x As a result, the entity will, or may, have to transfer an economic resource* that it would
otherwise not have had to transfer.
*: As explained previously, the term ‘economic resource’ refers to ‘a right that has the potential
to produce economic benefits’ (i.e. it is part of the definition of an asset). So basically, the
liability definition is saying that, for us to conclude that a past event has occurred, the entity
must have entered into an exchange contract whereby it obtained some kind of benefit, or
took some kind of action, and as a result, the entity may potentially have to transfer an ‘asset’.
Consider the following examples:
x An entity receives, before reporting date, cash in advance from a customer for the delivery
of inventory (i.e. ‘income received in advance’).
The entity has already obtained an economic benefit: it has received the cash.
As a result of the cash receipt, the entity will have to transfer an economic resource that
it would otherwise not have had to transfer: the entity has to either deliver the inventory
to the customer (i.e. transferring the rights inherent in the inventory to the customer) or
refund the cash to the customer (i.e. transferring the rights inherent in the cash).
x An entity, before reporting date, causes damage to the environment by leaking poison into a
river (e.g. ‘provision for rehabilitation’):
The entity has already taken an action (leaking poison into the river).
As a result of this action, the entity will, or may, have to transfer an economic resource
that it would otherwise not have had to transfer: the entity may now be obliged to
rehabilitate the environment. If so, the entity will or may be required to rehabilitate the
area, which will result in an outflow of economic resources: the transfer of economic
resources would typically be in the form of cash. For example, if it chose to employ the
services of a rehabilitation agency to perform the rehabilitation work on behalf of the
entity, the entity would have to pay cash to the agency for the rehabilitation work done.
Example 3 Liability – rent payable

Beta rents office space from a landlord, at C10 000 per month. It uses this space to run a business
selling financial advice. At 31 December 20X4, it still owes the rent for December 20X4.
Required: From Beta’s perspective, prove that this payable is a liability at 31 December 20X4.
Solution 3: Liability – rent payable

At 31 December 20X4, Beta has not yet paid for the December 20X4 rent and thus has a liability:
x There is a present obligation
x the entity has a duty to pay the landlord monthly rental; and
x the entity has no practical ability of avoiding this duty since this duty is legally enforceable
through a rental agreement.
Chapter 2 59
x The obligation involves transferring an economic resource:

The obligation requires a transfer of economic resources, in the form of a payment of cash to the landlord.
x The obligation is as a result of a past event/s
x the entity has already obtained the benefits since it was able to use the office space during
December 20X4, and
x as a result, Beta will be required to transfer an economic resource, in the form of a cash (i.e. the
right to use the cash will be transferred from Beta to the landlord).
Example 4: Liability - various

The accountant is concerned that the new liability definition in the CF will result in certain items,
which are currently considered to be liabilities, no longer meeting the definition of a liability, and
vice versa.
Required:
Using the ‘new’ liability definition per the 2018 CF, briefly prove that the following items are
liabilities:
a) Trade payables
b) Provision for legal costs due to the entity taking a competitor to court over a patent infringement.
c) Bank overdraft.
Solution 4: Liability - various

a) Trade payables
x The entity has a present obligation, because:
- the entity has the duty to pay the pay the supplier (i.e. the creditor)
- the entity has no practical ability of avoiding the duty due to the legal contract of purchase
x The obligation has the potential to result in a transfer of an economic resource: in this case the
obligation requires the entity to transfer cash
x There is a past event because the potential transfer of economic resources is as a result of the
entity having either obtained an economic benefit or taken an action (i.e. there is cause and
effect): in this case, the entity has already obtained the benefit by having purchased and taken
possession of the inventory.
b) Provision for legal costs
- the entity has the duty to pay the contracting lawyer/law firm
- the entity has no practical ability of avoiding the duty due to the legal contract (e.g. the
entity effectively enters into a service agreement with the lawyers who agree to provide
legal advice or services)
effect): in this case, the potential transfer of resources is because the entity has taken an action
by instituting legal proceedings against a competitor and/ or engaging the services of a lawyer.
c) Bank overdraft
- the entity has the duty to pay the bank
- the entity has no practical ability of avoiding the duty due to the legal nature of
overdrafts/credit granted
effect): in this case, the potential transfer of economic resources is because the entity has
obtained an economic benefit by using the overdraft facility.
60 Chapter 2
5.4 Equity definition (CF 4.63–4.67)

Equity is:
x the residual interest in the assets of the entity
x after deducting all its liabilities. See CF 4.63
The equity definition in the 2018 CF is the same definition that existed in the 2010 CF.
When we look at the financial position of an entity, we are comparing its total assets with its total
liabilities. If the total assets exceed the total liabilities (i.e. it has net assets), the entity has equity
(positive equity). If the total liabilities exceed its assets (i.e. it has net liabilities), the financial
position is very unhealthy, and we say it has negative equity. The equity is often referred to as the
entity’s ‘net wealth’.
The entity’s total equity, total assets and total liabilities all appear in the statement of financial
position, using the following two headings: ‘assets’ and ‘equity and liabilities’. The following is an
extremely abridged version of the statement of financial position.
Entity name
Statement of financial position
As at 31 December 20X2
20X2 20X1
C’000’s C’000’s
ASSETS 140 000 90 000
EQUITY AND LIABILITIES 140 000 90 000
Equity 100 000 70 000
Liabilities 40 000 20 000
In the above statement of financial position, the entity’s equity was C70 000 at the end of 20X1 and
this grew to C100 000 at the end of 20X2. This total equity, in terms of the equity definition, is:
x End of 20X1 = Assets: 90 000 – Liabilities: 20 000 = Equity: C70 000
x End of 20X2 = Assets: 140 000 – Liabilities: 40 000 = Equity: C100 000
Although this equity represents the entity’s ‘net assets’, it also represents the total of the entity’s
‘issued share capital and reserves’.
Using the same example above, let us assume that 20X1 was its first year of operations and that,
during this year, the entity issued ordinary share capital of C50 000 and that it earned profits of
C20 000 (these profits are included as a retained earnings reserve within equity). During 20X2, the
entity did not issue any further shares and made a further profit of C30 000. Thus, the total equity, at
the end of each year will be broken down, in the statement of financial position, as follows:
Entity name
20X2 20X1
C’000’s C’000’s
ASSETS 140 000 90 000
EQUITY AND LIABILITIES 140 000 90 000
Equity 100 000 70 000
x Issued share capital 50 000 50 000
x Retained earnings (20X2: O/b 20 000 + profit: 30 000) 50 000 20 000
Liabilities 40 000 20 000
Another way of looking at the entity’s financial position, is that the entity’s assets (economic
resources), have been funded:
x through liabilities (obligations) and
x through equity (which does not involve any obligations).
Chapter 2 61
To illustrate this point, let us look at 20X1 again. Let us assume that the entity had raised a loan of
C20 000, on the last day of 20X1. This is reflected on the statement of financial position as the total
liabilities of C20 000. The receipt of the funds from this loan, will have led to the recognition of:
x an asset, due to the receipt of the loan increasing the entity’s economic resource (the cash in its
bank account), and also
x a liability, due to the fact that there will be a legal loan agreement, which means that the entity
has an obligation to repay this cash.
Since both the asset and the liability increase, we say that there is no equity involved in this
transaction:
Debit Credit
Bank (A) 20 000
Loan liability (L) 20 000
Loan from bank
By contrast, the share capital of C50 000 that was issued during 20X1, does involve equity. This is
because entities do not have an obligation to repay cash that is received in exchange for ordinary
shares. Since this transaction increases the entity’s economic resources (cash in bank) but does not
increase its liabilities, we say that the transaction has resulted in the recognition of equity :
Debit Credit
Bank (A) 50 000
Ordinary share capital (Eq) 50 000
Issue of ordinary shares
The above transaction, involving the issue of ordinary shares, is called an equity claim.
x This equity claim means that, at 31 December 20X1, these ordinary shareholders (who are also
called ‘holders of equity claims’) have a claim on C50 000 of the entity’s net assets of C70 000.
x The entity’s net assets are calculated as the total assets, of C90 000, after taking into account all
those other parties to whom the entity has an obligation of C20 000 (Net assets = Assets –
Liabilities = 90 000 – 20 000 = C70 000).
x In other words, the ordinary shareholders have a right to the residual interests in the economic
resources (assets) after deducting all the obligations (liabilities).
An equity claim, as opposed to equity, is ‘a claim on the residual interest in the entity’s assets after
deducting its liabilities’. The term equity claims is also described as ‘the claims against the entity that
do not meet the definition of a liability’ (i.e. a claim that does not involve an obligation). In short, an
equity claim is not the same as equity.
To illustrate this point, look at the same above example. At the end of 20X1, we have economic
resources (assets) of C90 000, of which C20 000 will have to be transferred to third parties due to the
obligations (liabilities).
x Thus, the equity, which is the ‘residual interest in the assets after deducting its liabilities’ is
C70 000.
x However, the equity claim at 31 December, based on the share issue transaction, shown above,
is C50 000. These ordinary shareholders (who have contributed C50 000 to the entity) are
referred to as ‘holders of equity claims’. The entity’s receipt of cash from the issue of ordinary
shares is thus referred to as a ‘contribution from holders of equity claims’.
Different classes of equity claims are possible, such as ordinary and preference shares, depending on
the rights attached to the them (e.g. rights to dividends, profit-sharing and liquidation rights). A
dividend paid to an ordinary shareholder, for example, would be referred to as a ‘distribution to
holders of equity claims’.
Please note that the entity can also generate economic resources through making its own profits.
These profits are also part of total equity. The generation of profits involves an understanding of
the definitions of income and expenses (profit = income - expenses). This is explained in the
next section.
62 Chapter 2
5.5 Income and expense definitions (CF 4.63–4.67)
The new 2018 CF has introduced a new income and expense definition. A comparison of these new
definitions with the old definitions, per the previous 2010 CF, is shown below.
Income was defined as: Income is defined as:
x Increases in economic benefits x Increases in assets, or

x During the accounting period x Decreases in liabilities
x In the form of x Other than those relating to
inflows or enhancements of assets or contributions from holders of equity claims.
decreases of liabilities See CF 4.68
x That result in increases in equity,

x Other than those relating to
contributions from equity participants. See CF 4.25 (a)
Expenses were defined as: Expenses are defined as:
x Decreases in economic benefits x Decreases in assets, or

x During the accounting period x Increases in liabilities
x In the form of x Other than those relating to
outflows or depletions of assets or distributions to holders of equity claims.
incurrences of liabilities See CF 4.69
x That result in decreases in equity,

x Other than those relating to
Distributions to equity participants. See CF 4.25 (b)
There are no significant changes in the essence of these definitions other than now referring to
‘holders of equity claims’ instead of ‘equity participants. The new definitions have simply become a
lot clearer:
Income arises from increases in equity (increases in assets or decreases in liabilities) that do not
result from contributions from holders of equity claims.
Expenses arises from decreases in equity (decreases in assets or increases in liabilities) that do
not result from distributions to holders of equity claims.
The logic behind these definitions is best explained by example.
Worked example 4: Income definition

If an entity receives C100 in cash (an asset), but this transaction does not simultaneously increase
liabilities (or decrease another asset), then, by definition, it has increased equity (Equity = Assets –
Liabilities = 100 – 0 = 100).
If this increase in equity represents a contribution from a holder of an equity claim (e.g. if the cash
was from the issue of shares to ordinary shareholders), then it is excluded from the definition of
income and would be journalised as follows (see section 5.4)
Debit Credit
Bank (Asset) 100
Issued share capital (Equity) 100
Receipt of proceeds from a share issue (equity – not income!)
However, if this increase in equity does not represent a contribution from a holder of an equity claim,
then the transaction meets the definition of income. Examples of income include sales, interest
earned or rent earned. If the income was rent income, the journal would be as follows:
Debit Credit
Bank (Asset) 100
Rent income (Income) 100
Receipt of proceeds from a sale (income!)
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Worked example 5: Expense definition

If an entity pays C100 in cash (an asset), but this transaction does not simultaneously decrease
liabilities (or increase another asset), then, by definition, it has decreased equity (Equity = Assets –
Liabilities = -100 – 0 = -100).
If this decrease in equity represents a distribution to a holder of an equity claim (e.g. if the cash
related to a dividend payment), then it is excluded from the expense definition and would be
journalised as follows (see section 5.4)
Debit Credit
Dividends declared (Equity distribution) xxx
Bank xxx
Payment of a dividend (equity distribution – not expense!)
However, if this decrease in equity does not represent a distribution to a holder of an equity claim,
then the transaction meets the definition of an expense. Examples of expenses include cost of sales,
interest incurred or rent incurred. If the expense was a rent expense, the journal would be as follows:
Debit Credit
Rent expense (Expense) 100
Bank 100
Receipt of proceeds from a sale (income!)
Example 5: Expense – arising from a payable

This example follows on from example 3: Beta rents office space from a landlord, at C10 000 pm.
It uses this space to run a business selling financial advice. At 31 December 20X4, it still owes the
rent for December 20X4.
Required: Prove that Beta’s payable results in an expense at 31 December 20X4.
Solution 5: Expense – arising from a payable

The solution to example 3 proved that a liability exists at 31 December 20X4 (due to the fact that Beta
has not yet paid the December rent on this date). This liability also leads to the existence of an expense:
x There is an increase in liabilities: The payable increases Beta’s liabilities
x The increase in liabilities results in a decrease in equity: The transaction increased the liabilities
but did not change the assets, and thus equity does decrease.
x The decrease in equity is not a distribution to a holder of an equity claim: This payable involves a
landlord and not a holder of an equity claim (e.g. ordinary shareholder) and thus is not a
distribution to a holder of an equity claim.
The journal would be: debit rent expense and credit rent payable liability.
Remember, income and expenses are accumulated together to reflect the profit or loss for the
period (although some income and expenses are excluded from ‘profit or loss’ and are
included in ‘other comprehensive income’ instead – see chapter 3 for more detail).
This profit or loss will then be transferred to retained earnings. Retained earnings is a reserve
account within equity (i.e. the total equity on the statement of financial position would reflect
the total of the ‘issued share capital’ plus the ‘reserves’ (see section 5.4).
The journals showing how the income and expense accounts are closed off to ‘profit or loss’, and
how this ‘profit or loss’ is transferred to ‘retained earnings’, are illustrated in the example below.
Worked example 6: Income and expense – part of equity reserves

An entity begins operations in 20X1. During this year, it earns only one type of income (sales income:
C85 000) and incurs only one type of expense (cost of sales expense: C65 000). This means that the
entity makes a profit of C20 000 (income 85 000 – expenses: 65 000), which will then be transferred to
retained earnings. Since the entity was in its first year of operations, it means that the retained earnings
opening balance will be nil, and thus the closing retained earnings at the end of 20X1 will be C20 000.
64 Chapter 2
The closing entries and transfer will appear as follows:

Debit Credit
Sales (Income) 85 000
Cost of sales (Expense) 65 000
Profit or loss (Closing account) 20 000
Closing entry: income and expenses closed off to profit or loss
Profit or loss 20 000
Retained earnings 20 000
Profit or loss transferred to retained earnings (equity reserve)
6. Recognition and Derecognition (CF: Chapter 5 )
6.1 Recognition (CF 5.21 – 5.25) Recognise = Journalise
6.1.1 The meaning of the term ‘recognition’ An element may only be recognised if it
meets both the relevant:
To recognise an item involves the process of: x Element definitions; and
x capturing in the financial statements, (specifically x Recognition criteria.
either the statement of financial position or statement of financial performance),
x an item that meets the definition of an element
x in such a way that:
it is depicted in both words and amount (either alone or in aggregation with other
items); and that
this amount is included in one or more totals in the specific financial statement
(position or performance). See CF 5.1
Since financial statements (statement of position and performance) are essentially a summary
of the balances in the ledger and since the ledger balances result from the various journals
that are processed, the question of whether to recognise an element essentially means whether
to actually process the journal entry (i.e. to record the effects of the transaction or event).
Worked example 7: Recognising an asset and a liability
A transaction involving the credit purchase of a machine involves two elements: an asset
(machine) and a liability (payable). If the machine meets the definition of an asset and the
recognition criteria and if the payable meets the definition of a liability and the recognition criteria, the
elements must be recognised.
To recognise these elements, a journal entry must be processed debiting the asset and crediting the
liability. Once this journal has been posted to the ledger, the two elements involved in the transaction
(asset and liability) will appear in the ledger, trial balance and ultimately the financial statements (in
this case, both elements appear in the statement of financial position).
6.1.2 Recognition criteria (CF 5.6-5.25)
Before recognising a transaction or event, we first identify the elements and check they meet the
definitions thereof (see section 5), and then secondly, we ensure they meet the recognition criteria.
In this regard, the new 2018 CF has introduced new recognition criteria. A comparison of the new
recognition criteria with the old recognition criteria, per the previous 2010 CF, is shown below.
Recognition criteria were: Recognition criteria are:

At item that meets the definition of an element Assets and liabilities, and any resulting income,
should be recognised if: expenses or changes in equity, must only be
x The future economic benefits are probable recognised if the user would find this information
x The item has a cost or value that is reliably useful, i.e. we only recognise the elements if it
measurable. means we are providing information that is:
x relevant; and
x a faithful representation. See CF 5.7 (paraphrased)
Chapter 2 65
Meeting the recognition criteria means making sure that, by recognising an element, we will
be providing the user with useful information, in other words:
x relevant information about the asset or liability, and any resulting income, expenses or
changes in equity; and a
x faithful representation of the asset or liability, and any resulting income, expenses or
changes in equity. See CF 5.7
We must also consider the effects of the cost of recognising the element versus the benefits of
providing the information (the benefits must outweigh the costs).
The most significant change from the 2010 CF is that we no longer have to achieve what was
referred to as a ‘probability’ threshold or ‘reliable measure’ threshold. Instead, we now focus on
whether the information will be useful.
The recognition of elements is thus based on achieving the two fundamental qualitative
characteristics: relevance and faithful representation (see section 4.2).
The issues of uncertainty that were ignored when we assessed whether an item met the
definition of an element, are now taken into account when we decide whether that element
should be recognised. For example: we ignored, in the case of an asset, the fact that the potential
to produce economic benefits may be very remote (often referred to as ‘outcome uncertainty’).
The uncertainties that we consider when deciding whether an element should be recognised, can
be summarised as follows:
x Outcome uncertainty Recognition criteria:
x Measurement uncertainty The information recognised
must be
x Existence uncertainty. x relevant; and
x a faithful representation..
Relevance See CF 5.7
The relevance of information is affected by:

x existence uncertainty (e.g. the existence of an obligation may be the content of a legal
dispute); and
x outcome uncertainty (e.g. we may be certain the element exists, but the probability of the
flow of economic benefits may be low or even remote – outcome uncertainty relates to
the amount or timing of the flow of economic benefits).
Both types of uncertainty, (i.e. where we may be unsure of whether the element exists, or if it
does, whether there will be a flow of economic benefits), may result in us concluding that the
user would find the information irrelevant.
Faithful representation
A faithful representation of the information is affected by:

x measurement uncertainty.
Measurement uncertainty arises when the amounts presented in the financial statements
cannot be observed directly and must be estimated. However, most amounts in the financial
statements actually involve some degree of estimation and this does not mean that the
information is not useful. What is important is that, when we recognise information, the level
of measurement uncertainty must be considered to be acceptable.
The trade-off between relevance and faithful representation
The level of measurement uncertainty not only affects whether we believe the information is a
faithful representation of the transaction or event, but it has a knock-on effect on relevance. For
example, it can happen that the most relevant information that a user would want, has an
unacceptable level of measurement uncertainty and thus we conclude that it would be better to
provide the user with the information that is slightly less relevant but a more faithful representation.
66 Chapter 2
An example of this might be land (an asset), where the user may ideally want to see the fair value
(most relevant information), but where the measurement uncertainty involved in measuring fair
value might be so high that we conclude that information about the fair value would not be a faithful
representation of the land. In this case, we might conclude that we will simply have to provide the
user with information about the land’s cost instead. In this case, although information about the
land’s cost is less relevant to the user, because it is the only information that is able to be measured
with an acceptable level of measurement uncertainty, it is the only information that is a faithful
representation of the land. See section 4.2 for more examples.
6.1.3 When an element is not to be recognised
Elements that do not meet the relevant definitions and recognition criteria in full may not be
recognised in the financial statements. Information about them may, however, still be
considered ‘useful’ to the user, in which case they should still be disclosed in the notes.
If information is not recognised, it may cause a recognition inconsistency (also called an

‘accounting mismatch’. If this occurs, explanatory information would need to be included in
the notes to explain the uncertainties that existed, which prevented it from being recognised.
See CF 5.25 and .23
An element that fails to be recognised because the recognition criteria are not met may be
recognised in a subsequent period if the recognition criteria are then subsequently met.
6.2 Derecognition (CF 5.26 – 5.33)
Derecognition refers to the ‘removal of all or part of a recognised asset or liability from the
statement of financial position’. This normally happens when the asset or liability
subsequently fails to meet the relevant definition. In the case of an asset, this normally
happens ‘when the entity loses control’ over the asset (or part thereof). In the case of a
liability, this normally happens ‘when the entity no longer has a present obligation for all or
part of the recognised liability’. See CF 5.26
If part of the asset or liability remains, we must take care to faithfully represent both:
x The assets and liabilities that remain; and
x The change in the assets and liabilities that result from the transaction or event that caused
the derecognition. See CF 5.26
7. Measurement (CF: Chapter 6)
7.1 Overview
Financial statements present information about the entity’s financial position and performance:
x The financial position reflects the elements: assets, liabilities and equity;
x The financial performance reflects the elements: income and expenses.
All five elements are ‘quantified in monetary terms’. To quantify an element means to
measure the element. There are many measurement bases possible. In order to assist in this
process, the CF has introduced a new section on measurement, which:
x Describes various different measurement bases; and
x Provides factors to consider when selecting a measurement basis.
The CF identifies two main categories of measurement bases:

x the historical cost (i.e. the price of the transaction that gave rise to the recognition of the
element) and
x the current value (e.g. fair value, value in use and current cost).
Chapter 2 67
Our focus when choosing a measurement basis is to ensure that the information provided will
be useful (i.e. the information must be relevant and a faithful representation). However, other
factors are also considered. Some of the other factors to consider are explained in section 7.3.
The choice between the various measurement bases will require significant judgement.
It should be noted that this section in the CF is mainly used by the IASB: the IASB will use
this section when it develops IFRSs and decides which measurement bases are most suitable
for those IFRSs. Normally IFRSs are fairly prescriptive as to which measurement basis to use,
and thus the preparer need not always consider this section of the CF that deals with
measurement. However, if an IFRS allows preparers of financial statements to choose
between measurement bases (e.g. IAS 40 Investment properties allows preparers to choose
between the cost model and the fair value model), having guidance in the CF that provides
explanations about the meaning and purpose of the different measurement bases and what
factors to consider in choosing between them, is very helpful.
7.2 Different measurement bases
7.2.1 Overview
The CF describes two measurement bases but emphasizes that it does not prefer one over the
other – both are useful measurements. However, although both measurement bases can
provide predictive and confirmatory value, depending on the particular situation, one of these
measurement bases may provide more useful information than the other.
The two main measurement bases are:

x Historical cost
x Current value
The CF gives three examples of measurement bases that use the current value approach:
x Fair value
x Value in use
x Current cost.
The ‘historical cost’ and ‘current cost’ (the latter is a measurement basis using the current value
approach) both reflect what is referred as an ‘entry price’ (the price to acquire the asset or liability).
x The ‘historical cost’ is a measurement that is based on the actual acquisition price on the historic
transaction date (e.g. in the case of an asset, it is a measurement that is based on the actual
historic price that was incurred to acquire that asset), whereas
x The ‘current cost’ is a measurement that is based on the theoretical acquisition price on the
current measurement date (e.g. in the case of an asset, it is a measurement that reflects how
much it would cost to acquire, on measurement date, an equivalent asset based on the current
age and condition of the entity’s asset – in other words, it is the price to acquire an equivalent
second-hand asset at measurement date).
By contrast, the ‘fair value’ and ‘value in use’ both reflect what is referred to as an ‘exit price’.
This can be summarised as follows:
Measurement base Entry price/ exit price

x Historical cost Entry price
x Current value
Current cost Entry price
Fair value Exit price
Value in use Exit price
68 Chapter 2
Although the CF refers to the above measurement bases, these are not an exhaustive list. In
this regard, we must remember that, the measurement of assets and liabilities are generally
dictated by the requirements set out in the specific IFRSs, which often reflect a combination
of the ideas underlying the measurement bases listed in the CF. For example:
x Assets purchased with the intention of resale are measured in terms of IAS 2 Inventories: IAS 2
requires inventories to be initially measured at ‘cost’ and subsequently measured at the ‘lower of
cost or net realisable value’.
x Assets purchased to be used over more than one period are measured in terms of IAS 16 Property,
Plant and Equipment: IAS 16 requires this asset to be initially measured at cost and subsequently
measured using either its historical cost or fair value as the basis for the various calculations, where
its fair value could be based on a discounted future cash flow technique (i.e. present value), or an
active market (i.e. current cost).
7.2.2 Historical cost
As mentioned earlier, the historical cost is based on ‘the price of the transaction or other event
that gave rise to the asset or liability’. See CF 6.24
The historical cost is useful in the sense that, if the transaction was ‘a recent transaction on
market terms’, it will typically reflect:
x in the case of an asset, the minimum economic benefits that the entity expects to recover
(i.e. the economic benefits that the entity expects to flow into the entity will be at least the
carrying amount of the asset); and
x in the case of a liability, the maximum economic benefits that the entity expects to
transfer out in order to settle the liability. See CF 6.25
The measurement of an asset at historical cost often includes:

x transaction costs, and
x reductions in the cost to reflect consumption (depreciation and amortisation) and
impairments. See CF 6.26
Examples of assets and liabilities that are measured using the historical cost approach include:
x property, plant and equipment measured under the cost model in terms of IAS 16 (cost
less subsequent depreciation and impairment losses),
x inventory measured at cost (in terms of IAS 2), as well as
x financial liabilities measured by applying the amortised cost model (in terms of IFRS 9).
7.2.3 Current value
A measurement that is based on current values reflects the ‘current conditions’ at

measurement date. This differs from the historical cost approach, which derives its value
from the original transaction that gave rise to the item being measured: the current value
approach derives its value from circumstances and conditions that exist on measurement date.
The CF refers to three different methods that fall under the current value approach. These are
the fair value method, the value in use and fulfilment value method, and the current cost
method. These are described below:
x Fair value is defined in IFRS 13 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. See CF 6.12
Examples of assets or liabilities that could possibly be measured at fair value include:
investment property under the ‘fair value model’,
property plant and equipment measured under the ‘revaluation model’, and
certain financial assets and financial liabilities held for trading measured at ‘fair value
through profit or loss’.
Chapter 2 69
x The value in use of an asset is the present value of the cash flows, or other economic benefits
that an entity expects to derive from the use of an asset and from its ultimate disposal. See CF 6.17
The fulfilment value of a liability is the present value of the cash, or other economic resources,
that an entity expects to be obliged to transfer as it fulfils a liability (i.e. ‘fulfilment value’ is the
equivalent of the ‘value in use’, but from the perspective of a liability). See CF 6.17
Those amounts of cash, or other economic resources, include not only the amounts to be
transferred to the liability counterparty, but also the amounts that the entity expects to be obliged
to transfer to other parties to enable it to fulfil the liability.
Value in use is used to test certain assets for impairment.
Examples of assets that are tested for impairment in this way include, for example:
Property, plant and equipment
Intangible assets
x The current cost of an asset is the cost of an equivalent asset at the measurement date,
comprising the consideration that would be paid at the measurement date, plus the transaction
costs that would be incurred at that date. See CF 6.21
The current cost of a liability is the consideration that would be received for an equivalent
liability at the measurement date, minus the transaction costs that would be incurred at that date.
See CF 6.21
Example: An entity acquired a plant three years ago for C200. The current price that the
entity would have to pay for such a three-year-old plant may be 40% of the cost of a
brand new one, being C250. Thus, in this case, the current cost is C100.
7.3 Factors to consider when selecting a measurement basis
7.3.1 Overview
When selecting a measurement basis, we must keep in mind the ultimate objective of
providing useful information. Thus, the measurement base must provide information that is:
x Relevant; and a
x Faithful representation of the substance of the transaction.
The choice between the various measurement bases will require significant judgement. The
CF states that when applying this judgement, we must ‘consider the nature of the information
that the choice of measurement basis will produce in both the statement of financial position
and the statement of financial performance’. See CF 6.23 & .43
7.3.2 Relevance
The CF states that ‘the characteristics of the asset or liability’, and how it ‘contributes to
future cash flows’ are two of the factors that can affect whether a particular measurement
basis provides relevant information. See CF 6.49
For example, if an asset is sensitive to market factors, fair value might provide more relevant
information than historical cost. However, depending on the nature of the entity’s business
activities, and thus how the asset is expected to contribute to future cash flows, fair value
might not provide relevant information. This could be the case if the entity holds the asset
solely for use or to collect contractual cash flows rather than for sale, in which case a
measurement based on amortised cost might be more relevant.
7.3.3 Faithful representation
The CF explains that, although information that is a ‘perfectly faithful representation is free
from error’, we are not aiming at a ‘perfectly faithful representation’. It emphasizes that even
a high level of measurement uncertainty does not mean a particular measurement basis is not
a faithful representation. However, the most important aspect is that we are striking a balance
between relevance and faithful representation. See CF 6.59-60
70 Chapter 2
It should be noted, however, that if an asset and liability are ‘related in some way’, that
measuring the assets and liabilities using different measurement bases may result in a
‘measurement inconsistency’ (also called an ‘accounting mismatch’) that results in the
information not being a faithful representation. See CF 6.58
7.3.4 Other considerations
In addition to aiming to choose a measurement basis that produces relevant information that is
also a faithful representation, when choosing the measurement basis, we should also be
striving, to the extent possible, to achieve information that is:
x Comparable
x Verifiable
x Timely. See CF6.45
A further important consideration is that although we may use one particular measurement
basis to measure an asset or liability in the statement of financial position and use another
different measurement basis to measure the related income or expenses in the statement of
financial performance, it cautions us to remember that information may be more useful if the
same measurement basis is used in both statements. See CF 6.58
Similarly, when choosing a measurement basis, one should also consider both the initial
measurement and subsequent measurement. See CF 6.48
Uncertainty also feeds into the measurement basis chosen. There are three identified
uncertainties: measurement uncertainty, outcome uncertainty and existence uncertainty.
Outcome uncertainty and existence uncertainty may or may not contribute to measurement
uncertainty. For example, consider an investment in shares: if the share price is quoted within
an active market, it means that there is no measurement uncertainty at all. However, there is
still a level of outcome uncertainty since there is no way of knowing what cash inflow will
eventually be achieved through this asset. See CF 6.61-62
When selecting a measurement basis, there is no single factor that is considered more
important than another. The relative importance of each factor will depend on facts and
circumstances. Professional judgement will be needed. See CF6.44
8. Unit of account (CF 4.48 – 4.55)
In terms of the CF, the term, ‘unit of account’ is defined as ‘the right or the group of rights,
the obligation or the group of obligations, or the group of rights and obligations, to which
recognition criteria and measurement concepts are applied.’ See CF 4.48
The above definition refers to ‘rights’ and ‘obligations.’. If you recall, these two words form
the basis of the asset and liability definitions:
x An asset is a present economic resource controlled by the entity as a result of past events.
An economic resource is a right that has the potential to produce economic benefits.
x A liability is a present obligation of the entity to transfer an economic resource as a result
of past events. In order for a liability to exist, three criteria must be met, the first of which
is that an obligation must exist.
Therefore, units of account relate to those two elements and their recognition and
measurement in terms of IFRS.
A unit of account is selected for an asset or liability when considering how recognition criteria and
measurement concepts will apply to that asset or liability and to the related income and expenses. In
some circumstances, it may be appropriate to select one unit of account for recognition and a
different unit of account for measurement. For example, contracts may sometimes be recognised
individually but measured as part of a portfolio of contracts.
Chapter 2 71
As explained earlier in the chapter, the objective of general-purpose financial reporting is to

provide financial information about the reporting entity that is useful (see section 2.1).
Keeping that objective in mind, a unit of account is chosen, with the following implied:
x the information provided about the asset or liability and about any related income and
expenses must be relevant; and
x the information provided about the asset or liability and about any related income and
expenses must faithfully represent the substance of the transaction or other event from
which they have arisen. See CF 4.51
The recognition criteria of an asset or liability are similarly phrased, with really, the substance
being equivalent to the above statement. With that in mind, we can further join the dots in this
long document and see that, at the heart of it, are some very basic, but fundamental principles.
If those principles can be grasped early, understanding the Conceptual Framework, and
understanding accounting, becomes much easier.
9. Presentation and Disclosure Principles (CF: Chapter 7)
9.1 Recognition versus presentation and disclosure
As mentioned earlier, the term ‘recognition’ means the actual recording (journalising) of a
transaction or event. Once recorded, the element will be included in the journals, trial balance
and then channelled into
x one of the financial statements presented on the accrual basis:
statement of comprehensive income, Presentation & disclosure
statement of changes in equity, or refers to the level of
statement of financial position; as well as detail in the information
given about elements that are:
x the financial statement presented on the cash basis: x Recognised;
statement of cash flows. x Not recognised but still relevant.
The presentation of financial statements (e.g. how they are structured and the level of detail in
terms of line-items presented) is dictated by IAS 1 Presentation of financial statements and is
explained in chapter 3.
The term ‘disclosure’ typically refers to extra detail provided in the notes to the financial statements.
Disclosure refers to giving detail about specific transactions or events that are either:
x already recognised in the financial statements; or
x not recognised in the financial statements but are considered to be relevant to the users thereof.
Some items that are recognised may require further disclosure. Where this disclosure
involves a lot of detail, this is normally given in the notes to the financial statements.
Other items that are recognised may not need to be separately presented and/ or disclosed. For
example, the purchase of a computer would be recorded in the accounting records and the statement
of financial position. Unless this computer was particularly unusual, however, it would be included
in the total of ‘property, plant and equipment’ line-item on the face of the statement of financial
position, but would not be separately disclosed anywhere in the financial statements since it would
not be relevant to the user when making his economic decisions.
Conversely, some items that are not recognised may need to be separately disclosed. This
happens where either the definition or recognition criteria (or both) are not met, but yet the
information is still expected to be relevant to users in making their economic decisions. For
example: a possible obligation arising from environmental legislation may not have been
recognised because it was subject to an unacceptable level of measurement and/ or existence
uncertainty, but it may need to be disclosed if this information could be useful to users in
making their economic decisions
72 Chapter 2
Recognition process
Is the definition of an element met? Would recognising the element provide

information that is:
x Relevant; and
x A faithful representation?
Are both the definition and recognition
criteria met?
Yes No
x Recognise; and where applicable Is the item relevant to the user?

x Present and disclose separately (if required
by a IFRS or if it is considered to be useful
information)
Yes No
Disclose Ignore
9.2 The principles of presentation and disclosure (CF chapter 7)
In the same way that effective communication is vital for healthy relationships, it is also
fundamental in the process of financial reporting. A key component of this effective
communication is how elements are presented and/or disclosed to the users of the financial
information. This new section in the 2018 CF provides us with a principles-based approach to
presentation and disclosure.
Please note that these principles apply equally to elements that are recognised (i.e. those that
meet the definitions and recognition criteria) and to elements that are not recognised (i.e.
elements which failed the recognition criteria), but where it is believed that information about
these elements should be disclosed because users may find it useful.
The main principle, as always, is on providing information that is relevant and a faithful
representation of the transaction and events (i.e. providing information that is useful). In order
to achieve this, the entity must:
x focus on presentation and disclosure objectives and principles rather than focussing on rules;
x classify information in a manner that groups similar items and separates dissimilar items; and
x aggregate information in such a way that it is not obscured either by unnecessary detail or by
excessive aggregation.
The CF has stated that, in order to facilitate this effective communication between the
reporting entity and the users of its financial information, the IFRSs will be designed in such a
way that a balance is struck between:
x giving entities the flexibility to provide relevant information that faithfully represents the
entity’s assets, liabilities, equity, income, and expenses; and
x requiring information that is comparable, both from period to period for a reporting entity and
in a single reporting period across multiple entities.
As stated above, the CF guides entities towards a principles-based approach in presenting

information. In this regard, the principles stipulated in this CF are that:
x Entity-specific information is more useful than standardised descriptions; and
x Duplication of information in different parts of the financial statements is usually unnecessary
and can make financial statements less understandable.
Chapter 2 73
10. Concepts of Capital and Capital Maintenance (CF: Chapter 8)
10.1 Capital
There are two possible concepts of capital:

x Financial concept of capital: capital relates to the net assets or equity of the company.
This concept is adopted by most entities in preparing their financial statements.
x Physical concept of capital: capital is regarded as the productive capacity of the entity, for
example 500 units of output per day.
The choice between these concepts depends on the needs of the users. If users are more
interested in the net worth of the company, then the financial concept makes more sense. If
users are more interested in the production capability, then the physical concept would be
more appropriate.
10.2 Capital maintenance and determination of profit
Capital and profits are inter-linked. Each affects the other. The measurement of profits is
affected by the measurement of capital. Only the net inflow of assets that exceed the amounts
needed to maintain the capital base are regarded as profit. This, in a nutshell, is the concept of
capital maintenance. In other words, the concept of capital maintenance is a reflection of how
a particular entity ‘defines the capital that it seeks to maintain’. Thus ‘profit is the residual
amount that remains after expenses, including any maintenance adjustments, have been
deducted from income’. A loss arises if these expenses, including maintenance adjustments,
exceed income. See CF 8.4
Thus, if the capital base is bigger at the end of the year compared to the beginning, a profit
has been made. How one measures this capital growth will thus affect the measurement of the
profit (or loss):
x Financial capital maintenance: a profit is earned if the financial (money) amount of the
net assets is greater at the end of the period than at the beginning of the period, after
excluding any distributions to, or contributions from, owners during the period (e.g.
dividends and share issues). This can be measured in nominal monetary units or units of
constant purchasing power. See CF 8.3 (a)
x Physical capital maintenance: a profit is earned only if the physical productive capacity of
the entity (or the resources or funds needed to achieve that capacity) at the end of the
period exceeds the capacity at the beginning of the period, after excluding any
distributions to, or contributions from, owners during the period. See CF 8.3 (b)
Capital maintenance adjustments are the revaluations or restatements of assets and liabilities
that give rise to increases or decreases in equity.
74 Chapter 2
11. Summary
Conceptual Framework for Financial Reporting

x objective of general-purpose financial reporting
x qualitative characteristics of useful financial information
x financial statements and the reporting entity
x the elements of financial statements
x recognition and derecognition
x measurement
x presentation and disclosure
x concepts of capital and capital maintenance
Objective of Qualitative Financial statements Measurement

general-purpose characteristics and the reporting
financial reporting entity
x provide financial info Fundamental: Financial statements: Measurement:
x about the entity x Relevance. Something is x The objective of x historical cost
x that is useful to the relevant if it makes a financial statements x current cost
users * difference to user’s is to provide financial x value in use (assets)
x in making decisions decision-making, which information about the x fulfilment value
about providing will be the case if it has: reporting entity (liabilities)
resources to the predictive value x That is useful to x fair values
entity confirmatory value users of financial
Relevance is related to statements The last 3 are ‘current
* Users (primary) = materiality (which is entity A reporting entity: values’
existing and potential specific) x Is an entity that is
investors, lenders and x Faithful representation required, or chooses Measurement of an
other providers of Complete to, prepare financial element can involve a
capital Neutral statements mixture of
Free from error x A reporting entity is measurement methods
Enhancing: not necessarily a legal e.g. initial measurement
x Comparability entity at cost and subsequent
x Verifiability measurement at fair
x Timeliness value
x Understandability
Elements
(that have met the definitions)
Is the information relevant? Is the information a faithful representation?
Are both recognition criteria met?
Yes No
x Recognise; and where applicable Is information about the element

x Present separately and disclose extra useful to the user?
information (if required by a IFRS or if it is
considered necessary for fair presentation)
Yes No
Disclose Ignore
Chapter 2 75
Comparison of old 2010 CF with new 2018 CF: Definitions and Recognition Criteria
OLD 2010 CF - DEFINITIONS NEW 2018 CF - DEFINITIONS

An asset was defined as: An asset is defined as:
x Resource x A present economic resource
x Controlled by the entity x Controlled by the entity
x As a result of past events x Resulting from past events See CF 4.3
x From which future economic benefits are An economic resource is defined as:
expected to flow to the entity x a right that has
See CF 4.4
x the potential to produce economic benefits
A liability was defined as: A liability is defined as:

x Present obligation x A present obligation of the entity
x Of the entity x To transfer an economic resource
x As a result of past events x As a result of past events See CF 4.26
x From which future economic benefits are
A present obligation is a:
expected to flow from the entity
x a duty or responsibility that an entity
x has no practical ability to avoid See CF 4.29
Equity was defined as: Equity is defined as:

x Assets less x Assets less
See CF 4.63 (reworded)
x Liabilities x Liabilities
Income was defined as: Income is defined as:

x An increase in economic benefits x Increases in assets, or
x During the accounting period x Decreases in liabilities
x In the form of increases in assets or decreases x Other than those relating to
in liabilities contributions from holders of equity claims.
See CF 4.68
x Resulting in increases in equity
x Other than contributions from equity
participants
Expenses were defined as: Expenses are defined as:

x A decrease in economic benefits x Decreases in assets, or
x During the accounting period x Increases in liabilities
x In the form of decreases in assets or increases x Other than those relating to
in liabilities Distributions to holders of equity claims.
See CF 4.68
x Resulting in decreases in equity
x Other than distributions to equity participants
OLD 2010 CF – RECOGNITION CRITERIA NEW 2018 CF - RECOGNITION CRITERIA
Recognition criteria were: Recognition criteria are:
x Future economic benefits probable Information must be:
x Reliably measurable x Relevant; and a
x Faithful representation
Measurement bases Example Entry price/ exit price
x Historical cost Entry price

Cost Land or inventory Entry price
Depreciated cost Plant under the cost model Entry price
x Current value Entry/ Exit prices

Current cost Replacement cost of an item of plant Entry price
Fair value Investment property under the fair value model Exit price
Value in use Use for certain assets when testing for impairment Exit price
76 Chapter 2
Gripping GAAP Presentation of financial statements
Chapter 3
Presentation of Financial Statements
Reference: IAS 1, IAS 10 and IFRIC 17 (including amendments to 1 December 2018)
Contents: Page
1. Introduction 79
2. Objective of IAS 1 and purpose of financial statements 79
3. Scope of IAS 1 79
4. Complete set of financial statements 80
5. General features 80
5.1 Overview 80
5.2 Fair presentation and compliance with IFRSs 81
5.2.1 Achieving fair presentation 81
5.2.2 Compliance with IFRSs 81
5.2.3 Departure from IFRSs 81
5.2.3.1. When departure from an IFRS is required and allowed 82
5.2.3.2. When departure from an IFRS is required but not allowed 82
5.3 Going concern 82
5.4 Accrual basis of accounting 83
5.5 Materiality and aggregation 83
5.5.1 Accountancy involves a process of logical summarisation 83
5.5.2 Deciding whether an item is material and needs to be segregated 84
5.5.2.1 Materiality 84
5.5.2.2 Materiality and aggregation versus segregation 84
Example 1: Items with different nature, but immaterial magnitude 85
Example 2: Items that are material in magnitude, but not in nature or function 85
5.5.3 What to do with immaterial items 85
Worked example 1: Aggregation of immaterial items 85
5.6 Offsetting 86
Example 3: Offsetting – discussion 86
Example 4: Offsetting – application 86
5.7 Frequency of reporting 87
5.8 Comparative information 87
5.8.1 Minimum comparative information 87
Worked example 2: Comparative information 87
5.8.2 Voluntary additional comparative information 87
5.8.3 Compulsory additional comparative information 88
Example 5: Reclassification of assets 89
5.9 Consistency of presentation 89
6. Structure and content: financial statements in general 90
7. Structure and content: statement of financial position 90
7.1 Overview 90
7.2 Current versus non-current 90
7.3 Assets 91
7.3.1 Current assets versus non-current assets 91
Example 6: Classification of assets 91
7.4 Liabilities 92
7.4.1 Current liabilities versus non-current liabilities 92
Example 7: Classification of liabilities 92
7.4.2 Refinancing of financial liabilities 93
Example 8: Loan liability and a refinancing agreement 93
Example 9: Loan liability and the option to refinance 94
7.4.3 Breach of covenants and the effect on liabilities 94
Example 10: Loan liability and a breach of covenants 95
7.5 Disclosure: in the statement of financial position 95
Example 11: Presenting line-items 96
Chapter 3 77
Contents continued ...: Page

7.6 Disclosure: either in the statement of financial position or notes 96
7.6.1 Overview 96
7.6.2 Disclosure of possible extra sub-classifications 96
Example 12: Presenting further sub-classifications 97
7.6.3 Further disclosures for share capital and reserves 97
7.7 A typical statement of financial position 98
8. Structure and content: statement of comprehensive income 98
8.1 Total comprehensive income, profit or loss and other comprehensive income 98
8.2 Presentation: one statement or two statements 99
8.2.1 Overview 99
8.2.2 Single statement layout 99
8.2.3 Two-statement layout 100
Example 13: Statement of comprehensive income: two layouts compared 100
8.3 Line items, totals and sub-headings needed 101
8.3.1 Overview 101
8.3.2 Minimum line items for: P/L 102
8.3.3 Minimum line items for: OCI 102
8.4 Analysis of expenses 103
8.4.1 Overview 103
8.4.2 Nature method 103
8.4.3 Function method 104
8.5 Material income and expenses 104
8.6 Reclassification adjustments 105
8.6.1 Explanation of reclassification adjustments 105
Worked example 3: Reclassification adjustments 105
8.6.2 Disclosure of reclassification adjustments 106
Example 14: Statement of comprehensive income: reclassification adjustments 106
8.7 Adjustments to a prior year profit or loss 107
8.8 A sample statement of comprehensive income 107
8.9 A consolidated SOCI: the ‘allocation section’ 108
9. Structure and content: statement of changes in equity 109
9.1 Overview 109
9.2 General presentation requirements 109
9.3 Dividend distributions 110
9.4 Retrospective adjustments 110
9.5 A sample statement of changes in equity 110
9.6 A consolidated statement of changes in equity 111
10. Structure and content: statement of cash flows 112
11. Structure and content: notes to the financial statements 112
11.1 Overview 112
11.2 Structure of the notes 112
11.3 Basis of preparation 113
11.4 Significant accounting policies 114
11.4.1 Overview 114
11.4.2 Measurement bases 114
11.4.3 Significant accounting policies are those that are relevant 114
Worked example 4: Significant accounting policy despite immaterial amount 114
11.5 Judgements made in applying accounting policies 115
11.6 Judgements involving estimates: sources of estimation uncertainty 116
11.7 Capital management 117
11.8 Puttable financial instruments classified as equity instruments 117
11.9 Unrecognised dividends 118
11.9.1 Disclosure of unrecognised dividends 118
11.9.2 Why are some dividends not recognised? 118
11.10 Other disclosure required in the notes 118
12. Summary 119
78 Chapter 3
1. Introduction
This chapter covers IAS 1 Presentation of Financial IAS 1 explains how to

Statements. It is the first standard (IFRS) in the set of IFRSs present FSs in general
terms:
and is such an important standard that I call it one of the ‘two
Recognition, measurement, disclosure
pillars of accounting’. The other ‘pillar’ is the Conceptual and more specific presentation
Framework for Financial Reporting (CF) (see chapter 2). requirements are explained in the
remaining IFRSs.
The CF is a pillar since it explains the concepts that IAS 1 sets out the:
provide the foundation on which all other IFRSs are x objective of IAS 1;
built. Similarly, IAS 1 describes the presentation x purpose of f/statements;
requirements that apply to all other IFRSs. Thus, x statements that make up a complete
understanding the CF and IAS 1 is essential to set of f/statements;
x structure & minimum content of
understanding the IFRSs. each of these statements;
x general features of f/statements.
Some concepts in the CF (chapter 2) appear again in this
chapter. The reason for this is that the CF is actually not an IFRS but the foundation for all
IFRSs and thus it makes sense to see these concepts continually appearing in each of the
IFRSs.
2. Objective of IAS 1 and Purpose of Financial Statements (IAS 1.1 & 1.9)
The objective of IAS 1, which is designed to be used when presenting general-purpose financial
statements, is to:
x achieve comparability between the entity’s financial statements and:
its own financial statements in prior periods; and
other entities’ financial statements
x by setting out the: Interesting observation:
overall requirements for their presentation;
guidelines for their structure; & Comparability appears in both:
minimum requirements for their content. See IAS 1.1 x IAS 1, as the ultimate objective of
good presentation; and
The purpose of financial statements is to be a: x The CF, as an enhancing qualitative
characteristic.
x structured representation
x of an entity’s financial position and performance and that also shows the results of
management’s stewardship of the resources entrusted to it;
x with the objective thereof being:
to provide information about the financial position, performance and cash flows
that is useful to a wide range of users in making economic decisions. See IAS 1.9
3. Scope of IAS 1 (IAS 1.2 - .6)
IAS 1 is used for general-purpose financial statements, General purpose

and is ideally suited for (but not limited to) entities: f/ statements are defined
x whose share capital is equity; as those intended to:
x that are profit-oriented. See IAS 1.5-6 x meet the needs of users
x who are not in a position to require an
Some entities involve financial instruments and share capital entity to prepare reports tailored to
their particular information needs.
that do not meet the definition of equity (e.g. mutual funds See IAS 1.7
and co-operative entities). Similarly, some entities are not

profit-orientated. These entities may need to amend some of the descriptions used in IAS 1.
IAS 1 is not designed for interim financial statements although certain of the general features
set out in IAS 1 do still apply. Interim financial statements are covered in IAS 34 (this is not
covered in this textbook).
Chapter 3 79
4. Complete Set of Financial Statements (IAS 1.10 & .10A & IAS 1.BC17)
There are five main statements in a complete set of financial statements, where each statement
must reflect information for at least the current year and the prior year (comparative year):
x the statement of financial position (SOFP); Note 1, Note 3
x the statement of comprehensive income (SOCI); Note 2, Note 3
x the statement of changes in equity (SOCIE); Note 3
x the statement of cash flows (SOCF); Note 3
x the notes to the financial statements (Notes). Note 3
Note 1. The SOFP reflects the entity’s financial position at a point in time. It normally includes
balances as at the end of the current period and end of the prior period. However, it must
also reflect balances at the beginning of the prior period if there is a retrospective change in
accounting policy, restatement of items or reclassification of items. There would be 3 sets of
balances in the SOFP. This is covered in detail in the chapter on ‘Accounting policies,
changes in accounting estimates and errors’. IAS 1.10(f)
Note 2. The SOCI reflects the entity’s financial performance. The Conceptual Framework actually
calls it the ‘statement of financial performance’, but clarifies that this is not the required title.
IAS 1 states that financial performance could, in fact, be presented either:
x in a single statement: the ‘statement of comprehensive income’; or
x in two separate statements, one called the ‘statement of profit or loss’ and the other
called the ‘statement of comprehensive income’. See IAS 1.10A
This textbook uses a single statement approach and calls it the ‘statement of comprehensive
income’ (SOCI). Please see section 8.2 for more detail regarding the two approaches.
Note 3. The titles of the statements making up a set of financial statements are not ‘set in stone’ and
other titles such as balance sheet and income statement are still acceptable. See IAS 1.10
5. General Features (IAS 1.15 - .46)
5.1 Overview
The 8 general features:
Financial statements should have eight general features:
They should: x fair presentation & compliance with IFRSs;
x be fairly presented and comply with IFRSs, x going concern;
x accrual basis;
x be presented on the going concern basis only if x materiality and aggregation;
appropriate (i.e. management must assess if the entity is x offsetting;
a going concern – if it isn’t, then another basis plus extra x frequency of reporting;
disclosure is required) x comparative information; and
x be prepared using accrual accounting (except when x consistency of presentation.
preparing the statement of cash flows)
x be presented with items of a similar nature or function having been aggregated into classes that
are then presented separately from other dissimilar classes only if the classes are material (i.e.
first aggregate into classes of similar items and, if material, segregate these from other classes
when presenting) with immaterial classes and items presented in aggregate,
x not offset assets and liabilities or income and expenses unless required or permitted by IFRSs
x be presented annually (and include extra disclosure if the period is shorter or longer than a year)
x include comparatives (for at least one prior period although an additional period may be needed)
x present and classify items consistently from one year to the next unless this needs to change
because another method thereof becomes more appropriate or an IFRS requires a change.
As you read more about these general features (see below), notice how they often involve concepts from the
CF (chapter 2). For example, IAS 1 explains that fair presentation, one of the general features, requires
faithful representation (see section 5.2), which is a qualitative characteristic per the CF (see chapter 2).
Similarly, IAS 1 refers to the going concern as a general feature, whereas the CF refers to a ‘going concern assumption’.
80 Chapter 3
5.2 Fair presentation and compliance with IFRSs (IAS 1.15 - .24)
5.2.1 Achieving fair presentation (IAS 1.15 & .17)

Fair presentation is
Financial statements must fairly present the financial generally achieved by:
position, performance and cash flows of an entity. x application of the IFRSs, with
x extra disclosure if needed. See IAS 1.15
IAS 1 states that fair presentation is presumed to be achieved
by ‘the application of IFRSs, with additional disclosure when necessary.' It then explains that
additional disclosure is necessary if, despite the IFRS requirements, we think our users may still not
be able to understand the financial position and performance. The requirement for ‘additional
disclosure when necessary’ puts the burden of ensuring that the financial statements are fairly
presented squarely on the accountant’s shoulders. In other words, compliance with the IFRSs may
not necessarily be enough. See IAS 1.15
If we are unsure if we have achieved fair presentation, IAS 1 tells us to refer to the Conceptual
Framework (CF), which explains that ‘fair presentation requires faithful representation of the effects
of transactions, other events and conditions in accordance with the definitions and recognition criteria
for assets, liabilities, income and expenses set out in the framework’. See IAS 1.15
These two terms look similar, but fair presentation (a general feature) is more than faithful
representation (a qualitative characteristic): fair presentation is a goal and faithful representation is one
of the characteristics needed to achieve this goal. For more information on how to achieve faithful
representation (i.e. complete, neutral and free from error), please refer back to chapter 2 and the CF.
IAS 1 explains that, in addition to IFRS compliance and giving extra disclosure if needed, to achieve
fair presentation we must also present the information in a
Fair presentation needs:
way that ensures we are giving our users relevant, comparable,
compliance with IFRSs and
understandable and reliable information. Interestingly, three of extra disclosure where
these adjectives, are qualitative characteristics referred to in the needed, but it also needs:
CF: ‘relevance’ is a fundamental qualitative characteristic, x Application of the CF’s definitions
whereas ‘comparability’ and ‘understandability’ are enhancing and recognition criteria;
qualitative characteristics. The CF used to refer to the x Faithful representation (complete,
neutral and free from error);
requirement that an item be ‘reliably measurable’ before one x Relevance, comparability,
could recognise it, but with the new 2018 CF, this reference to understandability and reliability.
See IAS 1.15 & 1.17(b)
‘reliability’ has since fallen away.
Although IAS 1 states that fair presentation is presumed to be achieved when we comply with IFRSs
and provide additional disclosures if needed, it emphasizes one particular IFRS: IAS 8. In this regard,
we are told to use IAS 8 when selecting and applying accounting policies and to also use the hierarchy
of guidance contained in IAS 8 if there is no suitable IFRS for an item. (IAS 8 is the standard that
explains how to account for accounting policies, estimates and errors and is explained in chapter 26).
5.2.2 Compliance with IFRSs (IAS 1.16)
Disclosure regarding compliance with the IFRS must be made in the financial statements if
absolutely all standards and interpretations have been complied with in full.
5.2.3 Departure from IFRSs (IAS 1.19 - .24)
In very rare circumstances, management may believe that
applying an IFRS will make the financial statements so Although rare, compliance with IFRS
misleading that they will no longer meet the objective of may actually lead to information that is
so misleading that it conflicts with the
financial reporting (in essence, this objective is to provide objective of financial reporting (i.e. the
users with useful information - see chapter 2). In making information is no longer useful)!
this decision, management must consider:
x why the objective of financial reporting is not achieved in the entity’s situation; and
x how the entity’s circumstances differ from those of other entities that have successfully
complied with the IFRS’s requirement/s. See IAS 1.24 and CF1.2
Chapter 3 81
If management believes that the application of an IFRS would be so misleading that the
objective of financial reporting would not be met, the obvious solution would be to depart from
the IFRS, but this is not always allowed. The process to follow when departure from an IFRS
is allowed and when departure from an IFRS is not allowed is explained below.
5.2.3.1 When departure from an IFRS is required and allowed (IAS 1.19 - .22)
Departure from IFRS:
An entity shall depart from an IFRS: If compliance will be so
x if compliance with an IFRS is expected to result in misleading that it conflicts
financial statements that are so misleading that the with the objective of
financial statements:
objective of financial reporting won’t be met (essentially
that the financial information won’t be useful), and x depart from the IFRS; unless
x the relevant regulatory framework
x if the relevant regulatory framework (e.g. the legislation prohibits departure. See IAS 1.19 & 1.23
of the relevant country) requires or otherwise does not
If you depart, extra disclosure will be
prohibit such a departure. See IAS 1.19 needed to explain the departure.
If you do not depart, extra disclosure
The following extra disclosure is required when departure
will be needed to explain why you felt
from an IFRS is allowed: you should depart and the adjustments
x management’s conclusion that the financial statements you would have liked to make but didn’t.
‘present fairly the entity’s financial position, financial performance and cash flows’;
x a declaration that the entity ‘has complied with applicable IFRSs except that it has departed from
a particular requirement so as to achieve fair presentation’;
x the title of the IFRS from which the entity has departed;
x the nature of the departure,
x the treatment that was required by the IFRS and the reason why that treatment was considered to
be so misleading that the objective of financial reporting would not have been met;
x the alternative treatment adopted; and
x the financial impact of the departure on each item for each period presented that would
otherwise have had to be reported had the entity complied with the requirement See IAS 1.20
These disclosures (with the exception of management’s conclusion and the declaration referred to
above) are required every year after the departure where that departure continues to affect the
measurement of amounts recognised in the financial statements. See IAS 1.21 - .22
5.2.3.2 When departure from an IFRS is required but not allowed (IAS 1.23)
It may happen that although departure from an IFRS is necessary for fair presentation, the
regulatory framework in that jurisdiction does not allow departure from IFRSs. In such
situations, since our objective is to provide useful financial information, the lack of fair
presentation must be remedied by disclosing:
x the name of the IFRS that is believed to have resulted in misleading information;
x the nature of the specific requirement in the IFRS that has led to misleading information;
x management’s reasons for believing that the IFRS has resulted in financial statements that
are so misleading that they do not meet the objective of financial reporting; and
x the adjustments management believes should be made to achieve faithful representation
for each period presented.
5.3 Going concern (IAS 1.25 - .26)
Management must assess whether the entity is a going concern (GC). This assessment:
x is made when preparing the financial statements;
x is based on all available information regarding the future (e.g. budgeted profits, debt repayment
schedules and access to alternative sources of financing); and
x includes a review of the available information relating to, at the very least, one year from
the end of the reporting date.
82 Chapter 3
If the entity has a history of profitable operations and ready access to funds, management need not
perform a detailed analysis. See IAS 1.26
Going concern (GC):
The entity is a going concern unless management: Management must assess
x voluntarily or involuntarily (i.e. where there is no whether:
realistic alternative): x the entity is a going concern
x the entity is not a going concern
x plans to:
x there is significant doubt as to
- liquidate the entity; or whether the entity will be able to
- cease trading. See IAS 1.25 continue as a going concern or not.
Results of management’s assessment of whether the entity is a going concern (GC): See IAS 1.25)
If the entity is a going concern: If the entity is not a GC: If the entity is a GC but there is
significant doubt that it will be
continue operating as a GC:
The financial statements: The financial statements: The financial statements:
x are prepared on the GC x are not prepared on the GC basis; x are prepared on the GC basis;
basis. x must include disclosure of: x must include disclosure of:
the fact that it is not a GC; the material uncertainties
the reason why the entity is causing this doubt.
not considered to be a GC;
the basis used to prepare the
financial statements (e.g. the
use of liquidation values).
5.4 Accrual basis of accounting (IAS 1.27 - .28) The accrual basis:
Is used for all financial
The accrual basis means recognising elements (assets, statements except the
liabilities, income, expenses and equity) when the definitions statement of cash flows, which
uses the cash basis.
and recognition criteria are met. Thus, for example, the date
a transaction or event would need to be recorded would not necessarily be the date on which the
related cash (if any) is received or paid.
5.5 Materiality and aggregation (IAS 1.29 - .31)
5.5.1 Accountancy involves a process of logical summarisation

To summarise information, is Accounting starts with a transaction or event that is recorded
to combine (aggregate) items
that we believe are not
on a source document (e.g. a receipt). This document is
material enough to show recorded in a journal (e.g. receipts journal). This journal is
separately. posted into the relevant accounts in the ledger (e.g. bank and
income). Posting into ledger accounts involves aggregating transactions into different classes based
on their nature or function (e.g. separate accounts are used for inventory and equipment). We then
extract a trial balance, which is a list of the ledger account balances (i.e. classes). This trial balance is
then condensed into line-items to be presented in the financial statements. Detailed financial
statements are prepared for internal users (e.g. management), whereas more summarised general
purpose financial statements are prepared for the external primary users. When preparing general-
purpose financial statements, items or classes of items that are material to users should be presented
separately, whereas those that are immaterial, should be aggregated with other items.
Diagram: Summary of the accounting process:
Transaction/ event
Source document
Journal
Ledger
Trial balance
Financial statements
Chapter 3 83
5.5.2 Deciding whether an item is material and needs to be segregated (IAS 1.7 & 1.29 - .31)
5.5.2.1 Materiality (IAS 1.7)
Information is material:
Materiality is a term that is used to help entities
decide whether to include information in their x if omitting, misstating or obscuring it
financial statements. In other words, the materiality of x could reasonably be expected to
influence decisions
information helps us decide if the information is relevant. x that the primary users of general
If you recall, relevance is one of the fundamental purpose financial statements make.
qualitative characteristics listed in the CF (see chapter 2, IAS 1.7 (extract)
section 4.21).
Both the CF and IAS 1 define information as being material if the decisions of the primary
users could reasonably be expected to be influenced if it was omitted, misstated or obscured.
Thus, to be safe, when assessing the materiality of information, we consider both its nature
and magnitude (i.e. the amount). In other words, either the nature or magnitude (or both)
could result in information being regarded as material. However, this materiality is entity-
specific and thus the nature or magnitude of something may be material to one entity but not
necessarily material to another.
It is important to note the definition of materiality does not only refer to the omission or misstatement
of information but also to obscuring it. Information is considered obscured if it is ‘communicated in
a way that would have a similar effect for primary users of financial statements to omitting or
misstating that information’. Information can be obscured in many ways, such as aggregating it
inappropriately with other information, hiding material items with immaterial items, or scattering
information about a material item throughout the financial statements. See IAS 1.7
5.5.2.2 Materiality and aggregation versus segregation (IAS 1.7)
We use materiality to assess whether an item or class of items should be included with another class
(aggregated) or presented separately (segregated). Classes of items are items grouped together based
on their nature or function (e.g. equipment and buildings are both assets, but they are different
classes of asset because each has a different nature and function and thus they are recorded
separately). When preparing financial statements, we further summarise these classes into those
classes that will either be aggregated with other classes or need to be presented separately.
Immaterial items or classes of items should be aggregated with other classes whereas material items
or classes should be presented separately (segregated) in the financial statements.
Deciding what is material, and thus requires separate presentation (segregation), is sometimes a
subjective decision requiring professional judgement. For example, an entity may be facing two court
cases, but whether to present the expected obligation relating to each case, or to present the total
obligation from both court cases, is a subjective decision that would be considered based on the
nature of each court case and the magnitude of the related obligation.
A class of items that is material may require disclosure as a separate line-item on the face of the
financial statements (e.g. property, plant and equipment) whereas another class of items, although
material, may only require separate disclosure in the notes (i.e. equipment and buildings).
As mentioned above, materiality is an entity-specific concept that considers both an item’s nature
and magnitude. When considering whether the magnitude of a certain class of items means it is
‘material’, entities sometimes apply a materiality threshold to that class. This materiality threshold
would differ from entity to entity. For example, an entity may have a materiality threshold for
revenue of C100 000, meaning that, if the total amount of a particular class of revenue exceeds
C100 000, this class of revenue is material and may need to be separately presented. Another entity
may use a materiality threshold of C500 000.
Information could be material ‘either individually or in combination with other information’, and
must be considered ‘in the context of its financial statements taken as a whole’. Deciding whether
information could reasonably be expected to influence the decisions of primary users requires an
entity to consider the characteristics of these users and also the entity’s own circumstances.
84 Chapter 3
Example 1: Items with different nature, but immaterial magnitude

The carrying amount of furniture is C100 000, and the carrying amount of plant is C50 000.
The entity’s materiality limit is C300 000 for both types of asset.
Required: Describe how to decide whether or not the furniture and plant should be disclosed separately.
Solution 1: Items with different nature, but immaterial magnitude
Furniture and plant are two different classes of asset since their nature or functions differ: one functions in
the office and the other in the factory. Whether to segregate or aggregate these classes depends on the
materiality of the information, which depends on the nature or magnitude of the information. Although
both classes fall below the entity’s materiality threshold of C300 000, suggesting that the magnitude of the
information is not material and thus that these two classes could possibly be aggregated, this is simply one
aspect of materiality: we must also consider the nature of the information. Thus, if knowledge of the
nature of these two classes of assets could reasonably be expected to affect a primary user’s decisions
(bearing in mind the entity’s own circumstances, such as the nature of its business), then each class would
be considered material and require separate disclosure. Professional judgement is needed.
Example 2: Items that are material in magnitude, but not in nature or function
An entity has set a materiality threshold for items of property, plant and equipment of
C300 000. The total carrying amount of its:
x factory machinery is C500 000, including machine A, with a carrying amount of C450 000;
x office furniture is C300 000; and
x office equipment is C310 000.
Required: Explain whether or not:
A. machine A should be disclosed separately from the other machinery.
B. office furniture should be separately disclosed from office equipment.
C. these assets should be segregated on the face of the statement of financial position or in the notes.
Solution 2: Items that are material in magnitude, but not in nature or function
A. Machine A and the other machinery:
Machine A and the other machines are not different classes of asset since their nature and functions do not
differ. However, whether to provide separate information about this item (machine A) depends on the
materiality of the information, which depends on the nature or magnitude thereof. Although machine A is
material in magnitude, machine A should probably not be presented separately from the other machines since
machine A is not materially different from the other machines in terms of nature. Describing each machine
would be technical information rather than financial and would be irrelevant to primary users.
B. Office furniture and office equipment:
Despite the materiality of the magnitude of the carrying amount of each class involved (relative to the
entity’s financial statements as a whole), office furniture and equipment should probably be aggregated
because their natures are not materially different. The decision always requires professional judgment
in assessing materiality in context of the entity’s own circumstances.
Please note: It is not necessary for a class or item to be material in both nature and magnitude.
C. Aggregation or segregation on the face or in the notes:
Although office furniture and equipment versus factory machinery represent two dissimilar classes
based on their different nature or function (office versus factory use) and these two classes are
individually material (based on both nature and magnitude), they should be aggregated on the face of
the statement of financial position because, at this overall level of presentation, the individual natures
becomes immaterial. What is more important on the face, is that different categories of assets, (e.g.
‘property, plant and equipment’ and ‘inventory’) are separated. The segregation of the material classes
within the categories of property, plant and equipment and inventory are included in the notes.
5.5.3 What to do with immaterial items (IAS 1.30 - .31)
A class of items that is immaterial must be aggregated with other items. Furthermore, if an
IFRS requires certain disclosures for a class of items but the class is immaterial, we must
ignore these disclosure requirements. IAS 1 is very specific in that we must be careful not to
obscure (hide) material information through the presentation of immaterial information.
Worked example 1: Aggregation of immaterial items
The value of each item of furniture is not listed separately but is aggregated into one line-item
called ‘furniture’ because their natures are so similar that users would not find segregated
information useful but would find the total value of furniture more useful. If furniture was also
immaterial in magnitude, it may be aggregated with another line item (e.g. ‘furniture and equipment’).
Chapter 3 85
5.6 Offsetting (IAS 1.32 - .35)

The process of offsetting means subtracting an expense from an income or subtracting a liability
from an asset, and presenting the net amount. This means that if we offset items, we are effectively
classifying (grouping together) dissimilar items and thus we should not offset items unless an IFRS:
x requires offsetting; or
x permits offsetting and this offsetting will reflect the substance of the transaction.See IAS 1.32 - .33
Presenting items (e.g. an asset) net of a valuation allowance (e.g. presenting receivables net of a
related expected credit loss allowance, previously called ‘doubtful debt allowance’) is not considered
to be offsetting. Valuation allowances merely help measure the item.
Example 3: Offsetting – discussion
Offsetting is only allowed if permitted or required by an IFRS and ultimately results in
reflecting the substance of the transaction or event.
Required: Give an example of:
A. Offsetting of income and expenses that is allowed;
B. Offsetting of income and expenses that is not allowed;
C. Offsetting of assets and liabilities that is allowed; and
D. Offsetting of assets and liabilities that is not allowed.
Solution 3: Offsetting – discussion
A. Set-off of income and expenses that is allowed: If you sell a non-current asset (i.e. a sale that is not part of
the entity’s ordinary activities, and thus where the income is not ‘revenue’), the income (sale proceeds)
may be set-off against the related expense (i.e. the carrying amount of the asset now expensed), to reflect
the profit or loss on the sale since this reflects the substance of the transaction.
B. Set-off of income and expenses that is not allowed: When earning revenue from the sale of inventory
(income), the related cost of the sale (expense) may not be offset since, in terms of the relevant standard
(IAS 1 Presentation of financial statements), revenue must be presented separately.
C. Set-off of assets and liabilities that is allowed: If a person buys from us on credit (i.e. a debtor) and also
sells to us on credit (i.e. a creditor), we could offset the receivables (asset) and the payable (liability) if by
offsetting these balances, we were showing the substance of the transactions. Offsetting of these balances
would reflect the substance if, for example, we had an agreement giving us the legal right of set-off (i.e.
only the net balance need be paid to or received from this person).
D. Set-off of assets and liabilities that is not allowed: If we owe the tax authorities an amount of VAT (i.e.
VAT payable, a liability) but the tax authorities owe us a refund of income tax (i.e. income tax receivable,
an asset), we are not allowed to offset the payable and receivable unless the tax legislation allows VAT and
Income Tax to be paid on a net basis. Since this is not allowed in South Africa, the offsetting of these
balances is not allowed in SA since it would not reflect the substance of the transactions.
Example 4: Offsetting – application
Don Limited sold a machine during 20X2 for C30 000. The machine was a non-current
asset with a carrying amount of C20 000.
Required: Disclose the above transaction in the statement of comprehensive income assuming:
A. the machine was inventory;
B. the machine was an item of property, plant and equipment.
Solution 4: Offsetting – application

Don Limited
Statement of comprehensive income
For the year ended …. (extract)
Part A Part B
20X2 20X2
C C
Revenue from sale of inventory A: given 30 000 xxx
Cost of sales A: given (20 000) xxx
Other income
- Profit on sale of machine B: 30 000 – 20 000 xxx 10 000
86 Chapter 3
Comment:
Part A: Since the sale of machines is part of the entity’s ordinary activities (i.e. the machine would be
‘inventory’), the disclosure of the income would be governed by IFRS 15 Revenue from contracts
with customers, and must thus be shown gross (i.e. not net of expenses).
Part B: Since the sale of the machine is not part of (i.e. are incidental to) the entity’s ordinary activities, the
income may be disclosed net of the expense – since this still represents the substance of the sale.
5.7 Frequency of reporting (IAS 1.36 - .37)

Entities are required to produce financial statements at least annually. Entities are allowed, for
practical reasons, to report on a 52-week period rather than a 365-day period.
Sometimes, however, an entity may change its year-end, with the result that the reporting
period is either longer or shorter than a year. The entity must then disclose:
x The reason for using a longer or shorter period; and
x The fact that the current year figures are not entirely comparable with prior periods. See IAS 1.36
Interestingly, amounts in the current year’s statement of financial position would still be
entirely comparable with the prior year’s statement because this statement is merely a listing
of values on a specific day rather than over a period of time. On the other hand, the amounts
in the current year’s statement of comprehensive income would not be comparable with the
prior year since the amounts in each of these statements would reflect different periods.
5.8 Comparative information (IAS 1.38 - .44)

Comparative information comes in three forms:
x Minimum comparative information;
x Voluntary additional comparative information; and
x Compulsory additional comparative information.
5.8.1 Minimum comparative information (IAS 1.38 - .38B)

For all statements in a set of financial statements, a Minimum comparative info:
minimum of one year of comparative information is We must show prior year
required. Thus, there would be two columns of figures in, information (for numerical and
narrative information).
for example, a statement of financial position: one for the
Prior year info for narrative info
current year and one for the prior year. is only needed if relevant.
The need to present comparative information applies Comparisons may be needed in reverse....
equally to both numerical information (i.e. the amounts) and narrative information. However, in the
case of narrative information, comparative narrative information is only needed if it is relevant to
understanding the current period financial statements.
Comparative information can also be required in reverse! In other words, comparative information
doesn’t always refer to the need for prior period information to support current period information.
Current year information may be needed to support prior year information when prior year narrative
information continues to be relevant in the current year.
Worked example 2: Comparative information

If the prior year financial statements disclosed information regarding an unresolved court
case, then the current year information must include details regarding how this court case
was resolved in the current year or, if not yet resolved, the status of the unresolved dispute at the end of
the current year. This would enhance the usefulness of the financial statements.
5.8.2 Voluntary additional comparative information (IAS 1.38C - .38D)
If an entity wishes to provide extra comparative information (i.e. 2 or more years of

comparative information instead of just the minimum 1 prior year), it may do so on condition
that this extra comparative information is also prepared according to IFRSs.
Chapter 3 87
Interestingly, the comparative information need not be

provided for each and every statement. In other words, an Voluntary comparative
entity may give extra comparative information in its information:
statement of financial position but decide not to provide
x Extra comparative years can be given
comparatives in its statement of comprehensive income. if we wish e.g. 2 prior periods (2 PPs)
instead of just the minimum (1 PP).
If extra comparative information is presented in a statement
x We can give extra comparatives for:
(e.g. if a third column is included in the statement of financial
- just 1 statement if we wish, but
position to show the period prior to the prior period), then all
- the notes supporting this statement
the notes supporting that statement must also include the extra must include all PPs.
comparative information for that extra prior period.
x All PPs must comply with IFRS.
5.8.3 Compulsory additional comparative information (IAS 1.40A - .44)
An entity may need to make adjustments that change prior
year amounts. These are called retrospective adjustments. Compulsory comparative
information:
Retrospective adjustments can arise when:
x An extra comparative year must be
x retrospectively applying a new accounting policy; given if a ‘material retrospective
x retrospectively restating prior figures in order to adjustment’ is made.
correct an error that occurred in a prior year; or x This extra comparative year refers
x retrospectively reclassifying an item/s. to the opening balances of the PP
(i.e. the closing balances of the
If we find a material error in a prior year, we must correct period prior to the PP).
that prior year (i.e. retrospective adjustment). This extra comparative year:
x only applies to the SOFP; but
Similarly, retrospective adjustments are needed for x does not apply to the notes.
changes in accounting policy and reclassification of items.
These must be accounted for retrospectively because we need to maintain comparability
between the current and prior year figures:
x we may not simply change the accounting policy in the current year and leave the prior
year figures calculated using the old policy since this would prevent comparability; and
x we may not classify certain items in a certain way in the current year and use different
classifications in the prior year since this would prevent comparability.
If a retrospective adjustment is material, the statement of financial position must include an
extra column of comparatives to show the adjusted balances at the beginning of the prior year
(i.e. showing the prior year opening balances after being adjusted for any correction, new
policy or reclassification). Thus, there would be three columns in the statement of financial
position: current period, prior period (PP) and the period prior to the prior period (PPP).
Please note that this third column in the SOFP (i.e. the period prior to the prior period: PPP)
does not need to be supported by notes.
If the entity already voluntarily gives extra comparative periods, this third column would
already be provided. E.g. if the entity voluntarily gives two comparative periods, it will
automatically include both the minimum and compulsory comparatives (the PP and the PPP).
In addition to the third column, the following additional disclosure will also be required.
These additional disclosures depend on what the retrospective adjustment relates to. If the
retrospective adjustment is due to:
x a restatement to correct a prior error or the application of a changed accounting policy, then the
extra disclosure needed is in terms of IAS 8 Accounting policies, changes in accounting
estimates and errors; and
x a reclassification, then the extra disclosure needed is in terms of IAS 1 and includes:
the nature of the reclassification;
the amount of each item or class of items that is reclassified;
the reason for reclassification.
88 Chapter 3
If there is a reclassification but reclassifying the prior periods’ figures is impracticable, IAS 1
requires the following to be disclosed instead:
x the reason for not reclassifying; and
x the nature of the changes that would have been made had the figures been reclassified.
Example 5: Reclassification of assets
May Limited’s nature of business changed in 20X3 such that vehicles that were previously
held for use became stock-in-trade (i.e. inventory). The unadjusted property, plant and
equipment balances were:
x 20X1: C120 000 (C70 000 being machinery and C50 000 being vehicles)
x 20X2: C100 000 (C60 000 being machinery and C40 000 being vehicles)
x 20X3: C150 000 (C80 000 being machinery and C70 000 being vehicles).
Required: Show the statement of financial position and reclassification note at 31 December 20X3.
Solution 5: Reclassification of assets

May Limited
As at 31 December 20X3 (extract)
20X3 20X2 20X1
Notes C C C
Restated Restated
Property, plant and equipment 8 80 000 60 000 70 000
Inventory 8 70 000 40 000 50 000
May Limited
Notes to the financial statements
For the year ended 31 December 20X3 (extract)
20X2 20X1
8. Reclassification of assets C C
Previously vehicles were classified as part of property, plant and Restated Restated
equipment whereas it is now classified separately.
The reason for the change in classification is that the nature of the business
changed such that vehicles previously held for use are now held for trade.
IAS 2: Inventories requires inventories to be classified separately on the
face of the statement of financial position.
The amount of the item that has been reclassified is as follows:
x Inventory 40 000 50 000
Comment:
x The 20X1 and 20X2 columns are headed up ‘restated’ but the column for 20X3 is not. This is because the
20X3 column is published for the first time: we can’t restate something that has never been stated before.
x The note only gives detail for 20X3 and 20X2 as notes are not required for the third column (20X1).
5.9 Consistency of presentation (IAS 1.45 - .46)
Items should be presented and classified consistently (in Consistency refers to

the same way) from one period to the next unless: x presentation/classification of
x the current presentation/classification is no longer items being the same
the most appropriate (due either to a significant x from one period to the next.
change in the nature of the operations or due to a Thus, if presentation or classification must
review of its financial statements); or change, it is accounted for as a
x an IFRS requires a change in presentation; reclassification (see section 5.8.3 and 8.6).
and
x the revised presentation and classification is likely to continue; and
x the revised presentation and classification is reliable and more relevant to users.
Consistency is obviously necessary to ensure comparability. Thus, if the presentation in the

current year changes, the comparative information must be treated as a reclassification with
relevant disclosures provided (see section 5.8 on comparative information).
Chapter 3 89
6. Structure and Content: Financial Statements in General (IAS 1.47 - .53)
An annual report includes:

x the financial statements (including the five main statements listed under section 4); and
x a variety of other documents, which may or may not be required.
Other documents may be included in the annual report voluntarily (e.g. a value-added
statement), due to legal requirements (e.g. an audit report) or simply in response to
community concerns (e.g. an environmental report).
Since IFRSs only apply to financial statements, each statement (e.g. statement of financial
position) in the financial statements must be clearly identified from the other documents.
In addition to the identification of each statement,

other items must be prominently displayed:
x the name of the entity (and full disclosure of any Annual reports include:
change from a previous name); f/statements + other information.
x the fact that the financial statements apply to an IFRSs only apply to f/statements thus
individual entity or a group of entities; they must be clearly identified!
x relevant dates: we use the date of the end of the IAS 1 gives the structure & content for
reporting period for the statement of financial position all f/statements except the statement of
cash flows!
but refer to the period covered for other statements
(e.g. statement of cash flows);
x presentation currency (e.g. pounds, dollars, rands); and the
x level of rounding used (i.e. figures in a column that are rounded to the nearest thousand,
such as C100 000 shown as C100, should be headed up ‘C’000’).
These other items may need to be repeated (e.g. on the top of each page) to help make the
endless pages of financial statements easier to understand.
7. Structure and Content: Statement of Financial Position (IAS 1.54 - .80)
7.1 Overview Remember...
The statement of financial position summarises the entire The CF explained that an
entity’s financial position is
trial balance into the 3 elements of assets, liabilities and reflected by:
equity (remember that the income and expense items are
closed off to equity accounts, such as retained earnings). x its economic resources; and the
x claims against the entity.See CF 1.12
These three elements are presented under two headings:
x assets;
x liabilities and equity.
7.2 Current versus non-current (IAS 1.60 - .65) Current and non-current:
Distinguishing assets and liabilities between those that We can separate As and Ls into:
are current and non-current gives users an indication of x current and non-current; or
how long it will take x list them in order of liquidity instead
(if this is reliable & more relevant).
x for an asset to be used up or converted to cash and
x how long before a liability must be settled.
For this reason, assets and liabilities are then generally separated into two classifications:
x current; and
x non-current.
Instead of separating assets and liabilities into current and non-current, we could simply list
them in order of liquidity if this gives reliable and more relevant information.
90 Chapter 3
No matter whether your statement of financial position separates the assets and liabilities into
the classifications of current and non-current or simply lists them in order of liquidity, if the
item includes both a current and a non-current portion, then the non-current portion must be
separately disclosed somewhere in the financial statements. If preferred, this may be done in
the notes rather than on the face of the statement of financial position. (See example 7).
Where the assets and liabilities are monetary assets or liabilities (i.e. financial assets or liabilities,
such as accounts receivable and accounts payable) disclosure must be made of their maturity dates.
Examples of monetary items include:
x A monetary asset: an investment in a fixed deposit;
x A monetary liability: a lease liability.
Where the assets and liabilities are non-monetary assets or liabilities, disclosure of the
expected dates of realisation is not required unless these are considered useful in assessing
liquidity and solvency. For example:
x A non-monetary asset: inventory that is not expected to be sold within a year should be
identified separately from inventory that is expected to be sold within a year;
x A non-monetary liability: the expected date of settlement of a provision may be useful.
7.3 Assets (IAS 1.66 - .68)
7.3.1 Current assets versus non-current assets
An asset is classified as a current asset if any one of Non-current assets are those:
the following criteria are met: x that are not current assets.
x If it is expected to be realised within 12 months Current assets are those:
after the reporting date; x we expect to realise within 1yr of RD;
x If it is held mainly for the purpose of being traded; x we hold mainly to trade;
x we expect to use/realise/ sell within
x If it is expected to be sold, used or realised operating cycle; or
(converted into cash) as part of the normal x that are cash/ CE (unless restricted).
operating cycle (where ‘operating cycle’ means the RD: reporting date; CE: cash equivalents
period between purchasing the asset and converting
it into cash or a cash equivalent); or
x If it is cash or a cash equivalent, unless it is restricted from being used or exchanged
within the 12-month period after the reporting date. For example, cash received by way of
donation, a condition to which is that it must not be spent until 31 December 20X9, may
not be classified as a current asset until 31 December 20X8 (12 months before).
Non-current assets are simply defined as those assets that:
x are not current assets.
Example 6: Classification of assets
Era Limited has the following two assets at its financial year ended 31 December 20X4:
x Inventory: this is slow-moving and is expected to be sold during 20X6;
x Fixed deposit: this matures on 30 June 20X6.
Required: Explain whether these assets are current or non-current at year-end.
Solution 6: Classification of assets

Both assets are expected to be realised in 20X6 which is well after the 12-month period from reporting date of
31 December 20X4:
x However, the inventory is classified as current because inventory forms part of the operating cycle and thus
it meets one of the criteria to be classified as current.
x The fixed deposit is classified as non-current. Although it is cash it is a cash deposit that only matures in
20X6, and thus is restricted from being used within the 12-month period after reporting date. It is not
expected to be realised within 12 months of reporting date, it is not held mainly for the purpose of being
traded and is not held within the normal operating cycle. Thus, the deposit fails to meet any of the criteria
to be classified as current.
Chapter 3 91
7.4 Liabilities (IAS 1.69 - .76)

7.4.1 Current liabilities versus non-current liabilities (IAS 1.69-73)
A liability is classified as a current liability if any A non-current liability is one:

one of the following criteria are met: x that is not current.
x If it is due to be settled within 12 months after Current liabilities are those:
the reporting period; x we expect to settle within 1 yr of RD;
x If it is expected to be settled within the normal x we hold mainly to trade;
operating cycle (operating cycle: the period x we expect to settle within the OC; or
between purchasing materials and converting x we don’t have an unconditional right to
them into cash/ equivalent); NOTE 1 delay settlement beyond 1 yr from RD.
x If it is held mainly for trading purposes; or RD: reporting date; OC: operating cycle
x If the entity does not have an unconditional right to delay settlement beyond the 12-month
period after the reporting period. NOTE 2
Non-current liabilities are simply defined as liabilities that are not current liabilities.
Note 1 It is interesting to note that liabilities that are considered to be part of the normal operating cycle
(e.g. trade payables and the accrual of wages) are always be treated as current liabilities since they
are integral to the main business operations (even if payment is expected to be made more than 12
months after reporting date). Interestingly, deferred tax is always classified as non-current. See IAS 1.56
Examples of liabilities that are not part of the normal operating cycle include dividends payable,
income taxes, bank overdrafts and other interest-bearing liabilities. For these to be classified as
current liabilities, settlement thereof must be expected within 12 months after the reporting period.
Note 2 IAS 1 clarifies that if you have a liability, the terms of which allow the counterparty (i.e. the person
you owe) to choose that you pay by way of an issue of equity instruments (shares) instead of cash,
this will not have any effect on the classification as current or non-current.
Example: We receive cash from an issue of 10 000 debentures and must repay this cash after
20 years. However, the terms of this issue allow the debenture-holder to demand, at any time (i.e.
even now) that we issue ordinary shares to him, thus foregoing the future cash repayment. The fact
that he can demand shares now (giving up on receiving a redemption in cash) will not make this a
current liability: it remains non-current (expected settlement in 20 years). The fact that we may settle
by way of shares instead of cash will not influence whether a liability is current or non-current.
Example 7: Classification of liabilities

Pixi Limited has a bank loan of C500 000 at 31 December 20X3, payable in two
instalments of C250 000 (the first instalment is payable on 31 December 20X4).
Required: Present the loan in the statement of financial position and related notes at 31 December 20X3
(ignoring comparatives), assuming that Pixi presents its assets and liabilities:
A. In order of liquidity;
B. Using the classifications of current and non-current.
Solution 7A: Classification of liabilities in order of liquidity
Pixi Limited
Statement of financial position 20X3
As at 31 December 20X3 (extract) Notes C
LIABILITIES AND EQUITY
Bank loan Comment: This liquidity format means we must have a note to show the bank 8 500 000
split between current and non-current (see note 8 below)
Pixi Limited
Notes to the financial statements 20X3
For the year ended 31 December 20X3 (extract) C
8. Bank loan
Total loan 500 000
Portion repayable within 12 months 250 000
Portion repayable after 12 months 250 000
92 Chapter 3
Solution 7B: Classification of liabilities using current and non-current distinction

Pixi Limited
Statement of financial position Notes 20X3
As at 31 December 20X3 (extract) C
Non-current liabilities
Bank loan 250 000
Current liabilities
Current portion of bank loan 250 000
7.4.2 Refinancing of financial liabilities (IAS 1.72 - .76)

Refinancing a financial liability means postponing the due date for repayment.
When a liability that was once non-current (e.g. a 5-year bank loan) falls due for repayment
within 12 months after reporting period, it should now be classified as current. If it is possible
to refinance this liability resulting in the repayment being delayed beyond 12 months after the
end of the reporting period, then the liability could possibly remain classified as non-current.
There are, however, only two instances where the possibility of refinancing may be used to
avoid having to classify a financial liability as a current liability, being when:
x the existing loan agreement includes an option to refinance or roll-over the obligation (i.e.
to delay repayment of) where:
- the option enables a delay until at least 12 months after the reporting period, and
- the option is at the discretion of the entity (as opposed to the bank, for example), and
- the entity expects to refinance or roll over the obligation; See IAS 1.73
x an agreement is obtained before year-end that allows repayment of the loan to be delayed
beyond the 12-month period after the reporting period. By analogy from IAS 1.75
If an agreement allowing repayment to be delayed beyond 12 months from the reporting date
is obtained, but it is obtained after the reporting date but before approval of the financial
statements, this would be a ‘non-adjusting post-reporting period event’ and could not be used
as a reason to continue classifying the liability as non-current. Thus:
x details of agreement obtained after reporting date would be disclosed in the notes; but
x the liability would have to remain classified as current.
Example 8: Loan liability and a refinancing agreement
A loan of C100 000 is raised in 20X1. This loan is to be repaid in 2 instalments as follows:
x C40 000 in 20X5; and
x C60 000 in 20X6.
An agreement is reached, whereby payment of the C40 000 need only be made in 20X6.
Required: Present the loan, classified into current and non-current, in the statement of financial
position at 31 December 20X4 (year-end) assuming that:
A the agreement is signed on 5 January 20X5;
B the agreement is signed on 27 December 20X4.
Solution 8A: Loan liability not refinanced in time
Entity name
Statement of financial position 20X4 20X3
As at 31 December 20X4 C C
Non-current liabilities 60 000 100 000
Current liabilities 40 000 -
Comment: although the instalment of C40 000 has to be classified as current, a note should be included
to disclose the fact that the current liability of C40 000 has since been refinanced (during the post-
reporting period) and is now technically a non-current liability.
Chapter 3 93
Solution 8B: Loan liability is refinanced in time
Entity name
20X4 20X3
LIABILITIES AND EQUITY C C
Non-current liabilities 100 000 100 000
Example 9: Loan liability and the option to refinance

Needy Limited has a loan of C600 000, payable in 3 equal annual instalments.
The first instalment is due to be repaid on 30 June 20X4.
Required: Present the loan in Needy’s statement of financial position at 31 December 20X3 (year-end)
assuming that the existing loan agreement:
A. gives the entity the option to refinance the first instalment for a further 7 months and the entity
plans to utilise this facility;
B. gives the entity the option to refinance the first instalment for a further 4 months and the entity
plans to utilise this facility
C. gives the entity the option to refinance the first instalment for a further 7 months but the entity
does not plan to postpone the first instalment
D. gives the bank the option to allow the first instalment to be delayed for 7 months and the entity
plans to request the bank to allow this delay.
Solution 9: Loan liability and the option to refinance

Entity name
Part A Part B Part C Part D
20X3 20X3 20X3 20X3
LIABILITIES AND EQUITY C C C C
Non-current liabilities 600 000 400 000 400 000 400 000
Current liabilities 0 200 000 200 000 200 000
Comment:
x Part A: The entity has the option to delay payment of the first instalment to a date beyond 12 months from
reporting date and the entity intends to make use of this option, thus the liability is non-current.
x Part B: The entity has the option to delay payment of the first instalment, but this only extends the repayment
to 31 October 20X4 and not beyond 31 December 20X4, thus the liability remains current.
x Part C: The entity has the option to delay payment of the first instalment to a date that is beyond 12 months from
reporting date, but the entity does not intend to utilise this option, thus the liability remains current.
x Part D: The option to allow a delay in the payment of the first instalment is at the discretion of the bank and
thus the entity does not have control over this, and thus the liability remains current.
7.4.3 Breach of covenants and the effect on liabilities (IAS 1.74 - .76)
Covenants are sometimes included in loan agreements. A covenant in a loan agreement is essentially
a promise made by the borrower to the lender. Depending on the terms of the agreement, the
breaching of a covenant (breaking a promise) may enable the lender to demand repayment of part or
all of the loan. For example: a loan could be granted on condition that the borrower keeps his current
ratio above 2:1; and if it ever drops below 2:1, then the entire loan becomes repayable on demand.
If a covenant is breached and this breach makes all or part of a liability payable within 12
months, this portion must be classified as current unless:
x the lender agrees prior to the end of the reporting period to grant a period of grace to
allow the entity to rectify the breach;
x the period of grace lasts for at least 12 months after the reporting period; and
x the lender may not demand immediate repayment during this period.
94 Chapter 3
If such an agreement is signed after the end of the reporting period but before the financial
statements are authorised for issue, it would be a ‘non-adjusting post-reporting period event’:
x this information would be disclosed in the notes but
x the liability would have to remain classified as current.
Example 10: Loan liability and a breach of covenants

Whiny has a loan of C500 000, repayable in 20X9, on condition that total widgets sold by
31 December of any one year exceeds 12 000 units, failing which 40% of the loan becomes
payable immediately. At 31 December 20X3 unit sales were 9 200. Whiny reached an agreement
with the bank that the bank would grant a period of grace to boost sales.
Required: Present the loan in the statement of financial position at 31 December 20X3 assuming that the
financial statements are not yet authorised for issue and the agreement with the bank was signed on:
A. 31 December 20X3, giving the entity a 14-month period of grace during which the bank agreed not
to demand repayment;
B. 31 December 20X3, giving the entity a 14-month period of grace (although the bank reserved the
right to revoke this grace period at any time during this period and demand repayment);
C. 31 December 20X3, giving the entity a period of grace to 31 January 20X4 during which the bank
agreed not to demand repayment. At 31 January 20X4, the breach had been rectified;
D. 2 January 20X4, giving the entity a 14-month period of grace during which the bank agreed not to
demand repayment.
Solution 10: Loan liability and a breach of covenants

Entity name
Part A Part B Part C Part D
20X3 20X3 20X3 20X3
LIABILITIES AND EQUITY C C C C
Non-current liabilities 500 000 300 000 300 000 300 000
Current liabilities 0 200 000 200 000 200 000
Comment:
x Part C: Although the agreement was obtained on/before reporting date, the period of grace was not for a
minimum period of 12 months and thus the C200 000 must be classified as current. However, a supporting
note should state that agreement was obtained on/before reporting date, providing a short grace-period, and
that the breach was rectified during this period and thus, after reporting date, the loan became non-current.
x Part D: a note should be included to say that a period of grace had been granted after the end of the reporting
period that was more than 12 months from reporting date.
7.5 Disclosure: in the statement of financial position (IAS 1.54 - .55)
The following line items must be presented in the Minimum disclosure on the
SOFP face:
statement of financial position:
IAS1.54: lists line items that must
x property, plant and equipment; always appear on the SOFP face.
x investment property;
x intangible assets; Extra disclosure on the SOFP face:
x financial assets; IAS 1.55: judgement is needed to decide if
further line items, headings & totals are
x investments accounted for using the equity relevant to users understanding.
method (this is a financial asset but one that
requires separate disclosure);
x biological assets within IAS 41 (e.g. sheep);
x inventories;
x trade and other receivables (a financial asset but one that requires separate disclosure);
x cash and cash equivalents (a financial asset but one that requires disclosure separate to the
other financial assets);
x assets (including assets within disposal groups) that are held for sale in terms of
IFRS 5 Non-current Assets Held for Sale;
Chapter 3 95
x liabilities that are included in disposal groups classified as held for sale in terms of IFRS 5
Non-current Assets Held for Sale;
x financial liabilities;
x trade and other payables (a financial liability but one that requires separate disclosure);
x provisions (a financial liability but one that requires separate disclosure);
x tax liabilities (or assets) for current tax;
x deferred tax liabilities (or assets);
x minority interests (presented within equity);
x issued capital and reserves attributable to the owners of the parent. IAS 1.54 (reworded)
Whether or not to present extra line items, headings or subtotals on the face of the statement
of financial position requires judgement. In this regard consider:
x whether or not it is relevant to the user’s understanding; See IAS 1.55 and
x in the case of asset and liability line items, you should consider the following:
- Assets: the liquidity, nature and function of assets;
- Liabilities: the amounts, timing and nature of liabilities. See IAS 1.58
Example 11: Presenting line-items

The accountant of Logi Limited has presented you will the following list of items:
x cash in bank and a 15-month fixed deposit;
x property, plant and equipment and intangible assets;
x inventory and intangible assets;
x a long-term loan, 20% of which is repayable within 12 months of reporting date;
x provisions and tax payable.
Required: For each of the items listed above, indicate whether they need to be presented as separate
line items and the logic behind why separate presentation is relevant (i.e. refer only to IAS 1.58).
Solution 11: Presenting line-items
Items: Present as separate Reason:

line items?
Cash & the Fixed deposit Yes Different liquidity: 100% liquid versus delayed liquidity
PPE & Intangible assets Yes Different nature: tangible versus intangible
Inventory & Intangible assets Yes Different function: buy to sell versus buy to use
Loan: payable within 12m Yes Different timing of settlement: payable within 12m is
and payable after 12m current & payable after 12m is non-current
Provisions & tax payable Yes Different nature: a provision is a liability that involves
uncertainty and tax payable is a ‘definite’ liability
Note: the reasons why the items should be separately presented could be varied as there are sometimes more
than one reason why items should be separately presented.
7.6 Disclosure: either in the statement of financial position or notes (IAS 1.77 - .80)
7.6.1 Overview
Further disclosure requirements include:

x Disclosure of possible extra sub-classifications; and
x Disclosure of details regarding share capital and reserves.
These disclosures do not need to be made on the face of the SOFP.
7.6.2 Disclosure of possible extra sub-classifications (IAS 1.77 - .78 & 1.58)
More SOFP-related disclosure:
Line items in the statement of financial position may Extra sub-classifications may be
need to be separated into further sub-classifications. needed, which could be on the face/
in notes. These depend on:
These sub-classifications may either be shown as: x specific IFRS requirements;
x line items in the SOFP; or x materiality, liquidity, nature & function of
assets; and
x in the notes. See IAS 1.77
x materiality, timing & nature of liabilities.
96 Chapter 3
Whether further sub-classifications are needed depends on:

x whether an IFRS may contain disclosure requirements that requires sub-classifications;
x the materiality of the amounts, liquidity, nature and function of assets may suggest that a
sub-classification is relevant;
x the materiality of the amounts, timing and nature of liabilities may suggest that a sub-
classification is relevant. See IAS 1.78 & 1.58
Example 12: Presenting further sub-classifications

John has been given a list of line-items that his company wants sub-classified as follows:
x the ‘revenue’ line item: separate into revenue from contracts with customers and other revenue;
x the ‘property, plant and equipment’ line-item: separate into its two parts, being factory
equipment and the office equipment;
x the ‘cash’ line-item: separate into the amount held in cash and the amount held in the 6-
month fixed deposit;
x the ‘trade and other receivables’ line-item: separate into the trade receivable balance and
the rent prepaid balance.
Required: For each of the line-items listed above, explain to the assistant accountant why the
accountant has requested that certain sub-classifications be provided.
Solution 12: Presenting further sub-classifications
Items: Reason:
Revenue line-item The IFRS on revenue (IFRS 15) requires disclosure of each significant category of
revenue recognised from contracts with customers.
PPE line-item The IFRS on PPE (IAS 16) requires separate disclosure of each class of PPE.
Furthermore, office equipment and factory equipment have different in functions.
Cash line-item The cash and the fixed deposit have different liquidities.
Trade & other receivables The trade receivable and rent prepayment are different in nature.
Note: There may be more than one reason why these sub-classifications are required.
7.6.3 Further disclosures for share capital and reserves (IAS 1.79 - .80)
IAS 1 requires extra detail to be disclosed regarding More SOFP-related disclosure:

two items in the statement of financial position: Extra disclosure regarding share
x share capital; and capital and reserves is required.
x reserves. This disclosure may be given in the:
x SOFP,
If an entity has no share capital (e.g. a partnership), x SOCIE or
x the notes.
similar disclosure is required for each category of
equity interest instead.
For each class of share capital, the extra detail that must be disclosed includes: See IAS 1.79(a)
x the number of shares authorised;
x the number of shares issued and fully paid for;
x the number of shares issued but not yet fully paid for;
x the par value per share or that they have no par value;
x a reconciliation of the number of outstanding shares at the beginning and end of the year;
x rights, preferences and restrictions attaching to that class;
x shares in the entity held by the entity itself, or its subsidiaries or its associates; and
x shares reserved for issue under options and sales contracts, including terms and amounts.
For each class of reserve within equity, the extra detail that must be disclosed includes: See IAS 1.79(b)
x its nature; and
x its purpose.
The disclosures listed above may be provided in the statement of financial position, statement
of changes in equity or in the notes.
Chapter 3 97
7.7 A typical statement of financial position

An example of a statement of financial position appears below. However, the line items needed for
your entity might be fewer or more than those shown in this example: it depends entirely on what is
relevant to your entity (e.g. if an entity does not have goodwill, then it will not show this line-item).
Also, remember that if the ‘liquidity format’ provides more meaningful disclosure for your entity
than the ‘current versus non-current’ classification, then the statement of financial position will look
just the same but simply without the headings ‘current’ and ‘non-current’.
Sample presentation: statement of financial position of a simple entity (not a group)

ABC Ltd
20X2 20X1
C’000’s C’000’s
ASSETS X X
Non-current assets X X
Property, plant and equipment X X
Goodwill X X
Other intangible assets X X
Investment properties X X
Available-for-sale investments X X
Current assets X X
Inventories X X
Trade and other receivables X X
Non-current assets (disposal groups) held for disposal X X
Cash and cash equivalents X X
EQUITY AND LIABILITIES X X
Issued share capital and reserves Note 1 X X
Non-current liabilities X X
Long-term borrowings X X
Deferred tax X X
Provisions X X
Current liabilities X X
Trade and other payables X X
Current portion of long-term borrowings X X
Short-term borrowings X X
Current tax payable X X
Current provisions X X
Liabilities of a disposal group held for sale X X
Note 1 This amount would be the total in the statement of changes in equity (SOCIE)
Exam tip! Notice that the issued share capital and reserves on the face of the SOFP equals the
total equity on the face of the SOCIE. Thus, although it is not wrong to list each type of equity on
the face of the SOFP, it is unnecessary. Thus, if a question requires you to present both a SOFP
and a SOCIE, good exam technique might be to:
x start with the SOCIE and then,
x when preparing your SOFP, simply insert the total equity per your statement of changes in
equity in as the line-item ‘issued shares and reserves’.
8. Structure and Content: Statement of Comprehensive Income (IAS 1.10 & .81A - .105)
8.1 Total comprehensive income, profit or loss and other comprehensive income
The statement of comprehensive income gives information regarding the entity’s financial
performance. Overall financial performance is reflected by the total comprehensive income.
Total comprehensive income comprises two parts:
x profit or loss: income less expenses (excluding items of other comprehensive income); and
x other comprehensive income: income and expenses that are not recognised in profit or loss.
98 Chapter 3
Total comprehensive income = Profit or loss + Other comprehensive income

= P/L + OCI I – E (those that are not OCI) I – E (those that are OCI)
Definition of TCI :See IAS 1.7
Definition of P/L: See IAS 1.7 Definition of OCI: See IAS 1.7
x the change in equity x the total of x items of income and expense

x during a period x income less expenses, (including reclassification
x resulting from transactions and x excluding the components of other adjustments)
other events, comprehensive income. x that are either not required or not
x other than those changes resulting permitted to be recognised in profit
from transactions with owners in or loss by other IFRSs.
their capacity as owners.
Components of OCI:
There are ten components of OCI, which have been categorised into the six related IFRSs:
x IAS 16 Property, plant and equipment & IAS 38 Intangible assets: changes in revaluation surplus;
x IAS 19 Employee benefits: remeasurements of defined benefit plans;
x IAS 21 The effects of changes in foreign exchange rates: gains and losses arising from translating a foreign
operation’s financial statements;
x IFRS 17 Insurance contracts – insurance finance income and expenses from contracts excluded from profit or loss
x IFRS 9 Financial instruments:
- gains and losses from investments in equity instruments designated at fair value through OCI;
- gains and losses on financial assets measured at fair value through OCI;
- the effective portion of gains and losses on hedging instruments in a cash flow hedge, and
- the gains and losses on hedging instruments that hedge investments in equity instruments measured at fair
value through OCI;
- for certain liabilities designated as at fair value through profit or loss, the amount of the change in fair value
that is attributable to changes in the liability’s credit risk;
- changes in the value of the time value of options (when an option contract is separated into its intrinsic value
and time value and only the changes in this intrinsic value are designated as the hedging instrument);
- changes in the value of the forward elements of forward contracts (when the forward element is separated from
the spot element and only the changes in this spot element are designated as the hedging instrument, and
changes in the value of the foreign currency basis spread of a financial instrument (when excluding it from the
designation of that financial instrument as the hedging instrument). IAS 1.7 (slightly reworded)
8.2 Presentation: one statement or two statements (IAS 1.10 - .10A & 1.81A)
8.2.1 Overview
Entities may choose to present their total comprehensive income in:
x one single statement, or
x two statements. A single statement for TCI:
Could be called SOCI; SOPLAOCI; or
8.2.2 Single-statement layout any other appropriate name
An entity may choose to present its income using a single Includes two sections:
x 1st section: P/L &
statement. The single statement has two sections:
x 2nd section: OCI
x first the P/L section and
x then the OCI section, ending with the final total (TCI). Must include 3 totals:
x P/L
x OCI
This single statement must present the following 3 totals:
x TCI
x profit or loss (P/L) for the period;
x other comprehensive income (OCI) for the period;
x total comprehensive income for the period (being: P/L + OCI = TCI). IAS 1.81A (reworded)
As for all statements, the title used for this single statement is fairly flexible: IAS 1 suggests
that it be called the statement of comprehensive income (SOCI), or alternatively, the statement
of profit or loss and other comprehensive income (SOPLAOCI) but it allows you to use any
other appropriate title even if such a title does not appear in IAS 1 e.g. income statement.
This textbook uses:
x this single-statement approach and
x the title of: ‘statement of comprehensive income’.
Chapter 3 99
Sample presentation: single-statement approach

ABC Ltd
Statement of comprehensive income Note 1
For the year ended 31 December 20X2
20X2 20X1
C C
Income items X X
Expense items (X) (X)
Profit (or loss) for the period X X
Other comprehensive income X X
x Other comprehensive income - item 1 X X
x Other comprehensive income - item 2 X X
Total comprehensive income X X
8.2.3 Two-statement layout

An entity may choose to present its income using two statements, which involves:
x statement of profit or loss: this shows the profit or loss and must always be presented as
the first of the two statements (this statement could even be referred to as an income
statement – see IAS 1.IN6); and
x statement of comprehensive income: this shows the other comprehensive income and total
comprehensive income and must always start with the total profit or loss.
As with all statements, different titles may be used.
Sample presentation: two- statement approach

ABC Ltd
Statement of profit or loss
20X2 20X1
C C
Income items X X
Expense items (X) (X)
ABC Limited
20X2 20X1
C C
Other comprehensive income for the period X X
x Other comprehensive income – item 1 X X
x Other comprehensive income – item 2 X X
Total comprehensive income for the period X X
Example 13: Statement of comprehensive income: two layouts compared

The accountant of Orange Limited provides you with the following information:
Trial Balance Extracts at 31 December 20X1 Debit Credit
Revenue 1 000 000
Cost of sales 450 000
Cost of distribution 200 000
Interest expense 100 000
Tax expense 70 000
Other comprehensive income at 31 December 20X1 included one item:
x C170 000 on the revaluation of a machine (net of tax) which took place during 20X1.
Required: Prepare the following for Orange Limited’s year ended 31 December 20X1:
A. the statement of comprehensive income, using the single-statement layout;
B. the statement of comprehensive income, using the two-statement layout.
100 Chapter 3
Solution 13A: Statement of comprehensive income: single statement

Orange Limited
20X1 20X0
C C
Revenue 1 000 000 X
Cost of sales (450 000) (X)
Cost of distribution (200 000) (X)
Finance costs (100 000) (X)
Profit before tax 250 000 X
Tax expense (70 000) (X)
Profit for the year 180 000 X
Other comprehensive income for the year 170 000 (X)
x Items that may not be reclassified to profit or loss: Note 1
- Revaluation surplus, net of tax: machine 170 000 (X)
Total comprehensive income for the year 350 000 X
Note 1: Please note that this subheading is required disclosure and is explained in sections 8.3.3 and 8.6.
Solution 13B: Statement of comprehensive income: two statements

Orange Limited
Statement of profit or loss
20X1 20X0
C C
Revenue: sales 1 000 000 X
Cost of distribution (200 000) (X)
Finance costs (100 000) (X)
Orange Limited
20X1 20X0
C C
Other comprehensive income for the year 170 000 (X)
x Items that may not be reclassified to profit or loss: Note 1
- Revaluation surplus, net of tax: machine 170 000 (X)
Note 1: Please note that this subheading is compulsory disclosure and is explained in sections 8.3.3 and 8.6.
8.3 Line items, totals and sub-headings needed (IAS 1.81 - .87)
8.3.1 Overview
When presenting the statement/s that show profit or loss (P/L), other comprehensive income
(OCI) and total comprehensive income (TCI), IAS 1 requires that we present each of these
three totals together with certain minimum line items on the face of the statement/s.
Presentation of additional line items may also be necessary if:

x required by other IFRSs or if
x relevant to understanding the financial performance.
None of these line items may be classified as extraordinary.
Chapter 3 101
8.3.2 Minimum line items for: P/L (IAS 1.81A, 1.82, 1.85 & 1.87)
The minimum line items on the face of the statement that discloses profit or loss include:
x revenue (excluding interest revenue calculated using the effective interest rate method);
x revenue from interest (calculated using the effective interest rate method);
x gains and losses from the derecognition of financial assets measured at amortised cost; Note 1
x impairment losses (including impairment loss reversals/ gains) determined in accordance
with IFRS 9 Financial instruments; Note 1
x finance costs;
x share of profits and losses of equity-accounted associates and joint ventures; Note 2
x gains and losses on the reclassification of financial assets from measurement at amortised
cost to measurement at fair value through profit or loss; Note 1
x any cumulative gain or loss previously recognised in other comprehensive income that is
reclassified to profit or loss on reclassification of a financial asset from measurement at
fair value through other comprehensive income to fair value through profit or loss; Note 1
x tax expense;
x a single amount for the total relating to discontinued operations; Note 1
x profit or loss for the period. IAS 1.81A & 1.82 (reworded)
Note 1: These line items are specific to certain IFRSs and will thus be ignored in this chapter. Instead, these will
be covered in the chapters that explain those IFRSs.
Note 2: This line item is specific to certain IFRSs and is thus ignored in this chapter. Associates & Joint Ventures
are covered in a separate book entirely, called Gripping Groups.
8.3.3 Minimum line items for: OCI (IAS 1.81A, 1.82A, 1.85, 1.87, 1.90 - .96)
The minimum line items on the face of the statement that SOCI: line items, totals &
discloses other comprehensive income include: sub-headings:
x each item of other comprehensive income, classified Minimum line items: for
by nature; x P/L and
x total comprehensive income. See IAS 1.81A & 1.82A x OCI
Additional line items:
The other comprehensive income section must be x if IFRS requires or
grouped under the following sub-headings: x if relevant.
x Items that will not be reclassified* subsequently to Totals needed for:
profit or loss; and x P/L,
x OCI &
x Items that will be reclassified* subsequently to profit
x TCI.
or loss when specific conditions are met. See IAS 1.82A
No line item to be called extraordinary.
Line items specific to OCI:
Each item of OCI must be presented in the statement of
x Items on face:
comprehensive income:
- classified by nature, and
x after deducting tax; or - shown before or after tax.
x before tax, in which case it will be followed by a x Split between 2 sub-headings:
single amount for the tax effect of all the relevant - will be reclassified to P/L &
items per sub-heading (e.g. if there was only one - will not be reclassified to P/L
item of other comprehensive income, there would be x Tax effects on face or notes.
two single amounts whereas if there were two items x Reclassification adjustments:
of other comprehensive income, there would be - on face or
three amounts). See IAS 1.91 - notes.
The tax effect of each item of OCI (including

reclassification adjustments*) may be presented: A reclassification
x on the face of the statement; or adjustment is
x the transfer of an income
x in the notes. See IAS 1.90 or expense from OCI to P/L
In other words: the item was previously
Reclassification adjustments* may be presented either: recognised in OCI but must now be
x on the face of the statement; or recognised in P/L instead.
x in the notes. See IAS 1.94 Reclassifications are discussed in more
detail in section 8.6.
102 Chapter 3
Sample presentation: other comprehensive income section
Apple Limited
20X1 20X0
Profit or loss section: C C
....
Profit for the year X X
Other comprehensive income section: X X
x Items that may not be reclassified to profit or loss:
Revaluation surplus, net of tax X X
x Items that may be reclassified to profit or loss:
Gain on cash flow hedge, net of tax & reclassification adjustment X X
Total comprehensive income X X
8.4 Analysis of expenses
8.4.1 Overview (IAS 1.97 & .99)

Analysis of expenses:
Expenses used in the calculation of profit or loss must be Presented:
analysed based on either the: x On face; or
x nature of the expenses (nature method); or x In notes
x function of the expenses (function method). Two types of analysis:
x Function: allocate to functions
The choice between analysing expenses on the ‘nature x Nature: no allocation of expenses
method’ or ‘function method’ depends on which method
provides reliable and more relevant information. Exactly the same profit (or loss) will result
no matter which method is used.
This analysis could be included:

x as separate line items on the face of the statement of comprehensive income, or
x in the notes.
8.4.2 Nature method (IAS 1.102)
When using the nature method, expenses are presented based on their nature and are not
allocated to the various functions within the entity (such as sales, distribution, administration
etc). This method is simpler and thus suits smaller, less sophisticated businesses.
Sample presentation: Expenses analysed by nature (see section in white)
ABC Ltd
For the year ended 31 December 20X2 (nature method)
20X2
C
Revenue X
Other income X
Add/ (Less) Changes in inventories of finished goods and work-in-progress (X)
Raw materials and consumables used (X)
Employee benefit costs (X)
Depreciation (X)
Other expenses (X)
Total expenses (X)
Finance costs (X)
...
Chapter 3 103
8.4.3 Function method (IAS 1.103 – .105)
Generally, the four main functions (tasks) of a business include the:

x sales, Nature or function?
x distribution, x Choice depends on which
x administration, and gives reliable and more
x other operations. relevant information.
x Function method is normally
more relevant, but if cost
If one uses the function method, one has to allocate the allocations can only be done
expenses incurred to these different functions (use or arbitrarily, then the
purpose). The function method is therefore more information will not be
comprehensive than the nature method and is designed reliable.
for larger businesses that have the ability to allocate expenses to their functions on a
reasonable basis. It provides information that is more relevant, but there is a risk that arbitrary
allocations may lead to less reliable information.
The ‘function method’ gives more relevant information to the user than the ‘nature method’:
for instance, it is possible to calculate the gross profit percentage using the function method,
whereas this calculation isn’t possible if the nature method is used.
Information relating to the nature of expenses is crucial information to those users attempting
to predict future cash flows, therefore, if the function method is used, information regarding
the nature of the expense (e.g. depreciation and staff costs) is also given, but this additional
classification would then have to be provided by way of a separate note. See IAS 1.97
An example showing the statement of comprehensive income using the function method
follows. The highlighted section is the part of the statement of comprehensive income that
changes depending on whether the ‘function’ or ‘nature’ method is used.
Sample presentation: Expenses analysed by function (see section in white)
ABC Ltd
For the year ended 31 December 20X2 (function method)
20X2
C
Revenue X
Other income X
Cost of sales (X)
Distribution costs (X)
Administration costs (X)
Other costs (X)
Finance costs (X)
...
8.5 Material income and expenses (IAS 1. 97 - .98)
If an income or expense is material, we must separately

disclose it together with its: Material income/expenses:
x nature and
x amount. Should each be:
x disclosed separately,
This additional separate disclosure could be given either: x showing:
x as separate line items on the face of the statement of - nature and
- amount,
comprehensive income; or x either:
x in the notes. - on face of SOCI; or
- in notes.
104 Chapter 3
Examples of material income or expenses include those related to:

x write-downs of assets or reversals thereof;
x restructuring costs;
x disposals of property, plant and equipment and disposals of investments;
x discontinued operations;
x litigation settlements; and
x reversals of any provisions. IAS 1.98 (reworded)
8.6 Reclassification adjustments (IAS 1.92 - .96)
8.6.1 Explanation of reclassification adjustments

Reclassification adjustments
are defined as:
A reclassification adjustment refers to a journal entry
processed to recognise an income or expense in profit x amounts reclassified to P/L in the
or loss (P/L) where this income or expense had current period
previously been recognised in other comprehensive x that were recognised in OCI in the
income (OCI). current or previous periods. IAS 1.7
A reclassification adjustment refers to a

Thus, the one side of the journal entry recognises the journal that reverses an item out of OCI
item of income or expense in P/L while the contra entry and reclassifies it into P/L.
removes it from OCI. Reclassifications never occur with:
x Revaluation surpluses; or
The relevant IFRSs dictate when reclassifications from x Defined benefit plans.
OCI to P/L occur.
Reclassifications may be disallowed in
terms of IFRS 9 when accounting for:
However, the following two types of OCI may never be x certain cash flow hedges;
reclassified to P/L: x the time value of an option;
x changes in a revaluation surplus; x the forward element of a forward
x remeasurements of defined benefit plans. contract; and
x the foreign currency basis spread of a
financial instrument.
Worked example 3: Reclassification adjustments
Imagine that we made a gain of C200 on an investment of C1 000 and that this gain was
recognised as OCI in 20X1, and then in 20X2 it was reclassified to P/L.
x In 20X1, the other comprehensive income will include income of C200 (see jnl 1).
The ledger accounts will look as follows:
Investment (Asset) Gain on investment (OCI)
O/bal 1 000 Jnl 1 200
Jnl 1 200 C/bal 200
C/bal 1 200
Jnl 1 shows the income on the investment initially being recognised as OCI.
x In 20X2, the income of C200 is reclassified out of OCI and into profit or loss (see jnl 2).
Investment (Asset) Gain on investment (OCI)
O/bal 1 200 O/bal 200
Jnl 2 200
C/bal 0
Profit on investment (P/L)
Jnl 2 200
Jnl 2 shows the reclassification adjustment, which means that the income is now
recognised in P/L (credit) and taken out of OCI (debit).
Chapter 3 105
8.6.2 Disclosure of reclassification adjustments (IAS 1.90 & 1.94)
The reclassification adjusted must be presented:

x together with the related component of OCI
x in the period that the income or expense is reclassified from OCI to P/L
x may be presented in either:
- the statement of comprehensive income; or
- the notes. See IAS 1.93 - .94
Example 14: Statement of comprehensive income:

reclassification adjustments
Lemon Limited entered into a forward exchange contract (FEC) when it imported a plant.
This FEC is considered to be a cash flow hedge.
A gain of C100 000 (income) was recognised on this FEC at 31 December 20X1. Since the FEC is
considered to be a cash flow hedge, the gain was recognised in other comprehensive income (OCI) in
terms of the definition of OCI given in IAS 1.7 (the contra entry was debited to the FEC asset).
x The gain recognised in OCI is to be reclassified to profit or loss (P/L) over the life of the plant.
x The plant had a remaining useful life of 5 years as at 1 January 20X2.
The following was extracted before any journals related to this FEC had been processed:
Trial Balance Extracts at 31 December 20X1 Debit Credit
Revenue 1 000 000
Cost of administration 80 000
Tax expense 70 000
Required:
A. Journalise the gains and reclassifications (ignore tax on the gain) in 20X1 and 20X2;
B. Present the statement of comprehensive income for the period ended 31 December 20X2 (as a
single statement), with reclassification adjustments provided in the notes. Ignore tax on the gain.
Solution 14A: Journals

31 December 20X1 Debit Credit
FEC asset (A) Given 100 000
Gain on cash flow hedge (OCI) 100 000
Gain on cash flow hedge
31 December 20X2
Gain on cash flow hedge (OCI) 100 000 / 5 years x 1 year 20 000
Gain on cash flow hedge (P/L) 20 000
Reclassification of gain in OCI to P/L over the life of the plant
Solution 14B: Statement of comprehensive income

Orange Limited
20X2 20X1
C C
Revenue 1 000 000 X
Other income: gain on cash flow hedge 100 000 / 5 x 1 year 20 000 X
Administration costs (80 000) (X)
Other comprehensive income for the year 50. (20 000) 100 000
Gain on cash flow hedge, net of tax (N/A) & reclassification adjustment (20 000) 100 000
x Items that may not be reclassified to profit or loss (N/A in this question) 0 0
106 Chapter 3
Lemon Limited
20X2 20X1
50. Other comprehensive income: cash flow hedge C C
Gains on cash flow hedge arising during the year 0 100 000
Less reclassification adjustment: gain now in profit and loss (20 000) 0
(20 000) 100 000
Comment:
x The total gain on the cash flow hedge is C100 000. This will be recognised in P/L over the life of
the plant: 20 000 in 20X2 and 80 000 evenly over the remaining 4 years (20X3 to 20X6).
x The ‘gain on CFH: OCI’ account reflects a balance of C80 000 at the end of 20X2. This closing
balance will appear in both the SOCIE and the SOFP. However, the SOCI shows the movement in
this OCI account each year. Notice that since C20 000 (1/5) of the gain was recognised in P/L in
20X2, this C20 000 must be reversed from OCI in 20X2 otherwise, over the 2 years, the total
income recognised in TCI would be C120 000 and yet the total income to date is only C100 000.
[OCI: (recognise 100 000 – reclassify: 20 000) + P/L (recognise 20 000) = TCI: 100 000]
8.7 Adjustments to a prior year profit or loss (IAS 1.89)
Occasionally a prior year’s income or expense (i.e. P/L)

needs to be changed. This may occur when the entity: Adjusting a prior year P/L
x applies a new accounting policy;
x corrects a prior period error. May involve a:
x prospective adjustment (adjust the
Depending on the circumstances, the change may need current year P/L); or
to be made prospectively or retrospectively: x retrospective adjustment (adjust the
opening RE).
x A prospective adjustment means adjusting the prior
year’s income or expense (P/L) by processing a journal entry that adjusts the current
year’s income or expense (P/L) instead.
x A retrospective adjustment means adjusting a prior year’s income or expense (P/L) by
processing a journal that adjusts the prior year’s income or expense (P/L).
When making a retrospective adjustment, any adjustment to a prior year income or expense
will need to be journalised directly to the retained earnings account – and not to that income
or expense account. This is because the prior year’s income and expense accounts will have
already been closed off to that prior year’s profit or loss account and that prior year’s profit or
loss account will also have been closed off to retained earnings (only the current year’s
income and expense accounts will still be ‘open’).
The statement of comprehensive income will then show the prior year income and expenses
as being restated (assuming that the prior year being adjusted is presented as a comparative).
The statement of changes in equity will include a line item that shows the effect on retained
earnings of the retrospective adjustments to the prior year/s income and expenses.
For more information on these adjustments, please see the chapter on Accounting policies, estimates and errors.
8.8 A sample statement of comprehensive income
The following is an example of a statement of comprehensive income that might apply to a

single entity. It has also been simplified to show a very basic statement where there are no
associates or discontinued operations.
Please remember that the line items in your statement of comprehensive income might be
fewer or more than those shown below. It depends entirely on what line-items are relevant to
the entity (e.g. if the entity does not have a cash flow hedge, then one of the six components
of other comprehensive income would fall away).
Chapter 3 107
Sample presentation: Statement of comprehensive income for a single entity
ABC Ltd
20X2 20X1
C C
Revenue X X
Other income X X
Cost of sales (X) (X)
Distribution costs (X) (X)
Administration costs (X) (X)
Other costs (X) (X)
Finance costs (X) (X)
Profit (or loss) before tax X X
Taxation (X) (X)
Profit (or loss) for the year X X
Other comprehensive income for the year X X
Revaluation surplus, net of tax X X
Gain on cash flow hedge, net of tax & reclassification adjustment X X
Total comprehensive income for the year X X
8.9 A consolidated SOCI: the ‘allocation section’ (IAS 1.81B)
The following information relates to the consolidated

statement of comprehensive income produced for a Consolidated SOCI
group.
If the SOCI relates to a consolidated
If an entity owns part or all of a subsidiary, the entity is group that includes a partly-owned
subsidiary, the SOCI must show how
referred to as a parent and the two entities together are the:
referred to as a group of entities. x consolidated P/L and
x consolidated TCI
If the parent owns 100% of the subsidiary (called a will be allocated between:
wholly-owned subsidiary), then 100% of the subsidiary’s x the parent’s owners and
x the non-controlling interests.
income would belong to the parent. Groups are covered in the book ‘Gripping Groups’.
If, however, the parent owns less than 100% of the subsidiary (called a partly-owned
subsidiary), then less than 100% of the subsidiary’s income would belong to the parent - the
rest of it will belong to ‘the other owners’ (non-controlling interests).
Thus, if the group includes a partly-owned subsidiary, the group’s consolidated statement of
comprehensive income must show how much of the consolidated income belongs to the:
x owners of the parent; and
x non-controlling interests.
This sharing of the consolidated income between the owners of the parent and the non-
controlling interests is referred to as the allocation of income and is presented as a separate
section at the end of the SOCI (*) as follows:
x the portion of the profit or loss that is attributable to the *:
- owners of the parent;
- non-controlling interests; and
x the portion of total comprehensive income that is attributable to the:
- owners of the parent;
- non-controlling interests.
*: The allocation of profit or loss may be presented in the statement of profit or loss if this has
been provided as a separate statement (i.e. if a two-statement approach had been used).
108 Chapter 3
Sample presentation: Consolidated statement of comprehensive income: the ‘allocation section’
ABC Ltd Group

Consolidated statement of comprehensive income
20X2 20X1
... C C
Total comprehensive income for the year X X
Profit (or loss) for the year attributable to: X X
- owners of the parent X X
- non-controlling interest X X
Total comprehensive income for the year attributable to: X X
- owners of the parent X X
- non-controlling interest X X
9. Structure and Content: Statement of Changes in Equity (IAS 1.106 - .110)
9.1 Overview
Components of equity include:

x each class of contributed equity (e.g. ordinary shares and preference shares);
x retained earnings (which reflects the accumulated profit or loss);
x other comprehensive income, of which there are six possible components:
- changes in a revaluation surplus;
- actuarial gains and losses on defined benefit plans;
- gains and losses arising from translating the financial statements of a foreign operation;
- for particular liabilities designated as at fair value through profit or loss, the amount
of the change in fair value that is attributable to changes in the liability’s credit risk;
- the effective portion of gains and losses on hedging instruments in a cash flow hedge;
- gains and losses from investments in equity instruments measured at fair value through
other comprehensive income. See IAS 1.7 & 1.108
A statement of changes in equity is essentially a series of The SOCIE must

reconciliations between the opening and closing balances present:
for each component of equity.
x changes in equity; thus it needs
Bearing in mind that equity represents the net assets, x reconciliations for each component
(E = A – L), a change in equity simply means an increase of equity:
or decrease in the net assets (or a change in position). - each class of contributed equity
- retained earnings (P/L)
Changes in equity for the period are represented by: - each of the 6 items of OCI.
x total comprehensive income (P/L + OCI); and Change in E = Change in (A – L)
x transactions with owners (including related
transaction costs): such as the issue of shares or dividends declared to shareholders.
9.2 General presentation requirements (IAS 1.106 - .110)
The statement of changes in equity must present reconciliations between the opening and
closing balances for each component of equity (i.e. each class of contributed equity, retained
earnings and other comprehensive income). See IAS 1.106(d)
When presenting the reconciliations for each component of equity, we must be sure to
separately present the:
x Profit or loss for the period
x Other comprehensive income period (each component of OCI to be presented separately)
x Total comprehensive income for the period. See IAS 1.106 (a) & (d)
Chapter 3 109
If the reconciliation between the opening balance and closing balance of a component of
equity involves transactions with owners in their capacity as owners, these transactions must
be separately presented as being:
x contributions by owners (e.g. through the issue of shares); and
x distributions to owners (e.g. dividends declared). See IAS 1.106(d)(iii)
9.3 Dividend distributions (IAS 1.107; 1.137; IAS 10 & IFRIC 17)
The amount of the dividend distributions that have been The SOCIE: may also
recognised must be presented either: present:
x in the statement of changes in equity or x the amount of recognised dividend
x in the notes. distributions; and
x dividends per share (DPS).
The dividends per share (DPS) may also be disclosed either:
x in the statement of changes in equity or The dividend amount and DPS may be
shown in the notes instead.
x in the notes.
Not all dividends are recognised!
It is submitted that the amount of the dividend distributions would be best presented in the
statement of changes in equity while the dividends per share would be best presented in the
notes, preferably alongside the earnings per share note.
Dividends that are not recognised are explained in section 11.9.
9.4 Retrospective adjustments (IAS 1.109 - .110)
If there has been a retrospective change in accounting policy or correction of error, this
retrospective adjustment is presented in the statement of changes in equity as part of the
reconciliation between the opening and closing balances. However, retrospective adjustments
(RAs) are not considered to be ‘changes in equity’ as defined, but are simply adjustments to
the opening balances of the affected component of equity (e.g. retained earnings). See IAS 1.109
If the reconciliation between the opening balance and Retrospective adj’s are:
closing balance of a component of equity is affected by a x presented in the SOCIE,
retrospective adjustment/s, these adjustment/s must be
x not ‘changes in equity’!
separately identified and presented as relating to:
x a change in accounting policy; or Presentation of RAs must include:
x a correction of error. See IAS 1.110 x whether they relate to a:
- change in accounting policy; or
If there has been a retrospective adjustment, the effect - correction of error
thereof on the reconciliation of each component of equity x the effect on each item of equity
must be disclosed: - for each prior period; and the
x for each prior period; and - opening current period balances.
x the beginning of the current period. See IAS 1.110
9.5 A sample statement of changes in equity
The following example shows a statement of changes in equity. This statement has been
simplified to show a very basic spread of equity types (i.e. it does not show reserves other
than retained earnings and has only one class of share capital: ordinary shares).
The columns in the statement of changes in equity for your entity might be fewer or more
than those shown in the example. It depends on:
x what columns are relevant to the entity, for example:
contributed equity could need columns for ordinary shares and preference shares
other comprehensive income would need to include columns for each of the possible
six types of other comprehensive income relevant to the entity (e.g. if the entity does
not have foreign operations, then a translation reserve would not be necessary); and
x the materiality of the reserves.
110 Chapter 3
Sample presentation: Statement of changes in equity
ABC Ltd
Statement of changes in equity
Ordinary Retained Other Total
capital earnings compreh. equity
income
C C C C
Balance: 1 January 20X1 - restated X X X X
Balance: 1 January 20X1: as previously reported X
Change in accounting policy X
Correction of error X
Total comprehensive income X X X
Less dividends declared (X) (X)
Add issue of shares X X
Balance: 31 December 20X1 - restated X X X X
Balance: 31 December 20X2: as previously reported X
Change in accounting policy X
Correction of error X
Total comprehensive income X X X
Less dividends declared (X) (X)
Add issue of shares X X
Balance: 31 December 20X2 X X X X
9.6 A consolidated statement of changes in equity
If the statement of changes in equity involves a group of entities, extra columns are needed to
show the allocation of total comprehensive income between the:
x owners of the parent; and
x non-controlling interests.
Sample presentation: Consolidated statement of changes in equity
ABC Ltd
Consolidated statement of changes in equity
Attributable to owners of the parent Non- Total
Ord. Revaluation Retained Total controlling Equity of
capital surplus earnings equity interest the group
C C C C C C
Restated balance: 01/01/X1 X (X) X X X X
Balance: 1 Jan 20X1 - as X
previously reported
Change in accounting policy (X)
Total comprehensive income X X X X X
Less dividends (X) (X) (X) (X)
Add share issue X X X
Restated balance: 31/12/X1 X (X) X X X X
Balance: 31 Dec 20X1 - as X
previously reported
Change in accounting policy (X)
Total comprehensive income (X) X X X X
Transfer to retained earnings (X) X
Less dividends (X) (X) (X) (X)
Add share issue X X X
Balance: 31 Dec 20X2 X (X) X X X X
Chapter 3 111
10. Structure and Content: Statement of Cash Flows (IAS 1.111)
IAS 1 does not cover the statement of cash flows as it is dealt with in its own standard, IAS 7.
The statement of cash flows is explained in detail in chapter 27.
11. Structure and Content: Notes to the Financial Statements (IAS 1.112 - .138)
11.1 Overview
Notes are defined as:
x containing information in addition to that presented in the:
- SOFP: statement of financial position,
- SOCI: statement of comprehensive income,
- SOCIE: statement of changes in equity, and
- SOCF: statement of cash flows;
x narrative descriptions or disaggregations of:
- items recognised in those statements (i.e. supporting information); and about
- items not recognised in those statements (i.e. extra information). IAS 1.7 (reworded)
IAS 1 clarifies that notes give information about the following: See IAS 1.7; 1.112 & 1.117
x the basis of preparation;
x the significant accounting policies, including:
- the measurement basis or bases, and
- other relevant accounting policies;
x supporting information (i.e. regarding items recognised in the statements) which:
- is required by the IFRSs
- is not required by the IFRSs but is required because it’s relevant
x extra information (i.e. regarding items not recognised in the statements) which:
- is required by the IFRSs
- is not required by the IFRSs but is required because it’s relevant
IAS 1 also specifically refers to the requirements to provide notes that disclose details about:
x judgements made by management regarding:
- the application of accounting policies; See IAS 1.122
- making estimates; See IAS 1.125
x capital management; See IAS 1.134
x puttable financial instruments classified as equity; See IAS 1.136A
x dividends; See IAS 1.137
x various other details relating to the entity’s identity and description. See IAS 1.138
11.2 Structure of the notes (IAS 1.112 - .116)
The order of the notes must be:
x presented in a systematic (logical) manner, and
x cross-referenced when necessary. See IAS 1.113
Cross-referencing is necessary where the notes refer to information contained in the other
statements. In other words, the other four statements making up the financial statements must
be cross-referenced to the notes.
Notes must be listed in an order that is systematic. In other words, the order should be logical, bearing
in mind the effect that the order will have on understandability and comparability. For example, we
could provide the notes supporting the items in the other four components in the same order that each
line item and each financial statement is presented. However, a note may refer to more than one line-
item, in which case we would then simply have to try to be as systematic as possible.
112 Chapter 3
IAS 1 also suggests that the following order could be used:

x Statement of compliance Note 1
x Significant accounting policies
x Supporting notes (i.e. supporting information contained in the other statements) Note 2
x Other notes. Note 2 and Note 3 and See IAS 1.114
Note 1. It is submitted that the ‘statement of compliance’ be presented as part of the ‘basis of preparation’ note.
(Please see the discussion relating to basis of preparation, in sections 11.1 and 11.3).
Note 2. Both the supporting notes and other notes would contain information
- Required by IFRSs;
- Required because it is simply considered relevant to the users’ understanding. See IAS 1.112
Note 3. Other notes (i.e. those that do not support information contained in the other statements) could contain:
- Financial information, for example:
unrecognised contractual commitments, contingent liabilities and details of events that happened
after the reporting date but before the financial statements were authorised for issue;
- Non-financial information, for example:
the entity’s objectives and policies relating to its capital management. See IAS 1.114 (c)
11.3 Basis of preparation (IAS 1.112; 1.116 & 1.64)
The basis of preparation is not a defined term and as a result, there are many ways in which
this has been interpreted, two of which are explained below:
x Some interpret ‘basis of preparation’ as referring to ‘measurement bases’ (e.g. historical
cost, fair values etc), thus listing it under the ‘significant accounting policies’ (google:
Deloitte’s ‘Model financial statements for the year ended 31 December 2013’);
x Others interpret it to mean a number of things, such as whether the financial statements
comply with IFRSs or other national GAAP, whether the financial statements are separate
financial statements prepared for a single entity or are consolidated financial statements
prepared for a group of entities, judgements involved in applying accounting policies and
the sources of uncertainty that arose when making judgements involving estimates etc
(google: ‘KPMG’s guide to annual financial statements – illustrative disclosures’).
This textbook prefers aspects of KPMG’s interpretation above and thus submits that the ‘basis
of preparation’ should be presented separately to the ‘significant accounting policies’ and
should contain the following details, ideally under separate headings:
x Reporting entity: identifying whether the financial statements are prepared as separate
financial statements or consolidated financial statements;
x Statement of compliance: stating whether the financial statements have been prepared in
compliance with IFRSs, some other national GAAP or other set of principles;
x Other issues: such as whether the financial statements are prepared in a way that
presented assets in order of liquidity or under the headings of current and non-current.
Sample presentation: Basis of presentation
ABC Ltd
Notes to the Financial Statements
1. Basis of preparation...
1.1 The reporting entity:
The following financial statements have been prepared as consolidated financial statements
for ABC Limited and its subsidiary.
ABC Limited is a company that is both incorporated and domiciled in South Africa.
The address of its registered office and principal place of business is: 50 Ten Place,
Padfield, Johannesburg.
The group of companies are involved in properties held for the purpose of rental income as
well as the printing and distribution of textbooks.
1.2 Statement of compliance:
These financial statements have been prepared in accordance with IFRS.
Chapter 3 113
11.4 Significant accounting policies (IAS 1.117 – .124)
11.4.1 Overview
A summary of significant accounting policies can be presented as a separate statement, in

which case there would then be 6 statements to the set of financial statements.
The summary of significant policies includes:

x The measurement basis or bases used in preparing the financial statements; and
x Other accounting policies that are relevant to users (i.e. would help users understand the
financial statements). See IAS 1.117
Judgements that management makes in applying accounting policies could also be included in
the summary of significant accounting policies. See IAS 1.122 (see section 11.5)
Accounting policies are disclosed either because:
x an IFRS requires the accounting policy to be disclosed; or
x it is considered to be relevant to the user’s understanding of the performance and position.
11.4.2 Measurement bases
There are various methods (bases) of measuring items in the financial statements. Users
would be better able to understand the financial statements if they knew how these items were
measured and thus the measurement basis or bases used in preparing the financial statements
should be disclosed. Examples of the various measurement bases used include, for example:
x Historical cost
x Current cost
x Net realisable value
x Fair values
x Recoverable amounts.
11.4.3 Significant accounting policies are those that are relevant
Only the accounting policies that are significant to an entity need to be disclosed.
When deciding whether or not to disclose an accounting policy, one should consider if it
would assist the user in understanding the performance and position of the entity (i.e. consider
its relevance). See IAS 1.119
Whether or not an accounting policy is relevant to an entity depends largely on the nature of
its operations, (for example, if an entity is not taxed, then including accounting policies
relating to tax and deferred tax would be a silly idea!). It can thus happen that accounting
policies may be considered significant even if the amounts related thereto are immaterial.
Worked example 4: Significant accounting policy despite immaterial amount

Apple Limited’ core business activities include investing in property for rental income,
these properties thus being classified and accounted for as investment property.
Due to the receipt from a rich oil merchant of an unprecedented offer to purchase most of Apple’s
properties at highly inflated prices, Apple had very few investment properties at reporting date.
Despite this, users would want to see the entity’s accounting policies relating to its investment
properties in order to help them understand the investment property balance at reporting date.
Conclusion:
The accounting policy for investment properties is significant because it is considered relevant due to
the nature of the business even though the carrying amount of the investment properties is immaterial.
Accounting policies would be relevant where the IFRS allows a choice in accounting policies.
For example, IAS 16 Property, plant and equipment allows the assets to be measured using
the cost model or revaluation model. The accounting policy note should thus indicate which
model the entity chose to use.
114 Chapter 3
Here are a few more examples of accounting policies:

x whether property, plant and equipment is measured at fair value less subsequent
depreciation or at historical cost less depreciation;
x whether deferred tax assets are recognised;
x when revenue is recognised and how it is measured; and
x any accounting policy devised by management in the absence of an IFRS requirement.
Sample presentation: Significant accounting policies

ABC Ltd
2. Significant accounting policies
The following is a list of the significant accounting policies, including measurement bases, which
have been applied by ABC Limited. These accounting policies have all been consistently applied,
except for the changes in accounting policies described in note 50.
2.1 Inventories
Inventories are measured on the lower of cost or net realisable value. The cost of inventories is based
on the weighted average method. Finished goods and work-in-progress include a share of fixed
manufacturing overheads, calculated based on normal production capacity.
2.2 Property, plant and equipment...
11.5 Judgements made in applying accounting policies (IAS 1.122 - .124)
Judgements (except for those involving estimations) that are made by management when
applying accounting policies should be disclosed. However, not all such judgements need to
be disclosed. Instead, we need only disclose those judgements that have had the most
significant effect on the amounts recognised in the financial statements. See IAS 1.122
Example of a judgement involved in applying an accounting policy, rather than affecting the
estimation of an amount, is the criteria that the entity developed to decide whether a property
was an investment property (in which case accounting policies relating to investment property
would have applied) rather than a property held for sale in the ordinary course of business (in
which case accounting policies relating to inventory would have applied).
Judgements made in applying accounting policies could be disclosed anywhere in the notes or
could be included together with the related accounting policies (e.g. in the significant
accounting policies note). For example, the judgement referred to above could be included in
the investment property note and/ or the inventory note but could equally have been presented
in a separate significant accounting policy note relating to these line items. See IAS 1.122
Sample presentation: Judgements made in applying accounting policies

ABC Ltd
2. Significant accounting policies...
3. Judgements in applying accounting policies
The following are the judgements made by management that have had the most significant
effect of the amounts recognised in the financial statements:
3.1 XYZ Limited is accounted for as a subsidiary
Note 10 refers to XYZ Limited as a subsidiary despite ABC Limited owning only 40%
thereof. Management assessed whether ABC Limited has control over XYZ, thus making
XYZ a subsidiary, by assessing its practical ability to direct the relevant activities of XYZ.
In making its judgement, management took into account the absolute size of its own
shareholding (40%) together with the fact that the remaining shareholding (60%) is
dispersed among more than 1 000 remaining shareholders, none of whom have a
shareholding of more than 1% each.
3.2 ...
Chapter 3 115
A further example of judgements in applying an accounting policy: management’s reasoning

behind a difficult case involving whether an item of plant could continue to be accounted for
in terms of IAS 16 Property, plant and equipment, or whether it should be accounted for in
terms of IFRS 5 Non-current assets held for sale and Discontinued operations.
11.6 Judgements involving estimates: sources of estimation uncertainty (IAS 1.125–.133)

Preparing financial statements involves many estimates. These estimates involve professional
judgements, from estimating depreciation rates to estimating the amount of a provision. These
estimates involve assumptions regarding the future and other sources of uncertainty at
reporting date. If an estimate has been made that involves assumptions regarding the future or
other sources of uncertainty (e.g. the potential cost of rehabilitating land in 20 years’ time, the
discount rate to use when calculating a present value), that involve a high degree of subjective
and complex ‘guesswork’, there is, of course, a risk of the estimate being ‘wrong.’
Disclosure is required when the possibility of this estimate being wrong amounts to:
x a significant risk
x that a material adjustment to the carrying amount of an asset or liability
x may need to be made within the next financial year.
Sample presentation: Sources of estimation uncertainty
ABC Ltd
2. Significant accounting policies...
3. Judgements in applying accounting policies ...
4. Sources of estimation uncertainty
The following are the judgements made by management in the process of making estimates:
4.1 Impairment of plant
Note 15 includes plant, the carrying amount of which was impaired by C100 000 to its
recoverable amount of C800 000. This recoverable amount was estimated based on its
value in use, calculated as the present value of the future cash flows expected from the use
of the plant and present valued using a pre-tax discount rate of 7%.
The future cash flows were estimated based on management’s assumption that the company
secures a certain government contract. However, if the tender submitted for this
government contract is not awarded to ABC Limited, the carrying amount of plant would
be measured at C600 000 (i.e. its recoverable amount) and the impairment expense would
be measured at C300 000.
4.2 ...
Where disclosures are required regarding an estimate that required management to make
judgements involving ‘assumptions about the future and other major sources of estimation
uncertainty’ the disclosures should include, for instance:
x the nature and carrying amount of the assets and liabilities affected; See IAS 1.131
x the nature of the assumption or estimation uncertainty;
x the sensitivity of the carrying amounts to the methods, assumptions and estimates used in
their calculation;
x the reasons for the sensitivity;
x the range of reasonably possible carrying amounts within the next financial year and the
expected resolution of the uncertainty; and
x the changes made (if any) to past assumptions if the past uncertainty still exists. See IAS 1.129
If it is impracticable to provide the above disclosures, we must still disclose:

x the source/s of uncertainty;
x the nature and carrying amount of the assets and liabilities affected. See IAS 1.131
116 Chapter 3
Disclosures are not required, even if there is a significant risk of an item’s carrying amount
changing materially within the next year, if the asset or liability is measured at a fair value
that has been based on a quoted price in an active market for an identical asset or liability.
This is because the change in its carrying amount is caused by the market price changing and
is not caused by incorrect assumptions made by management. See IAS 1.128
IAS 1 does not indicate where the disclosures involving sources of estimation uncertainty
should be disclosed, but it is submitted that the required disclosures could also be useful if
they were presented in the actual note dealing with the affected estimate.
11.7 Capital management (IAS 1.134 - .136)
An entity must disclose its objectives, policies and processes for managing its capital. In so
doing, the disclosure must include:
x qualitative information, including at least the following information:
- a description of the capital that it manages (because the term capital is not defined);
- the nature of any externally imposed capital requirements;
- how externally imposed capital requirements (if any) have been incorporated into the
entity’s management of capital;
- how it is meeting its objectives for managing capital;
x quantitative information regarding the capital that it manages:
- some entities include some financial liabilities when talking about their capital (e.g.
the entity may manage its subordinated debt as part of its capital); while
- some entities exclude certain equity accounts from their idea of capital (e.g. the entity
may not consider its cash flow hedge reserves to be part of capital);
x changes to the information provided above from the prior year;
x whether it complied with the externally imposed capital requirements (if applicable); and
x the results of non-compliance with externally imposed capital requirements (if applicable).
Sample presentation: Capital management
ABC Ltd
1. Basis of preparation
3. Judgements in applying accounting policies
4. Sources of estimation uncertainty
5. Capital management
ABC Limited has a capital base that includes a combination of ordinary shares and non-
redeemable preference shares. The total capital at 31 December 20X2 is C1 000 000.
ABC Limited is not subjected to any externally imposed capital requirements. It does, however,
have an internal policy of maintaining a solid capital base in order to enable continued
development of the business and to ensure general confidence in the business.
The business manages its capital base by monitoring its debt to equity ratio. Its policy is to keep
this ratio from exceeding 3:1. The debt to equity ratio at 31 December 20X2 was 3.3:1 (20X1:
2.9:1). The increase in the debt to equity ratio in 20X2 was due to extra financing needed due to
the refurbishment of one of its uninsured properties following a devastating flood in March.
Management intends to issue 100 000 further ordinary shares in 20X4, which will bring the
debt: equity ratio back in line with the policy of 3: 1.
11.8 Puttable financial instruments classified as equity instruments (IAS 1.136A)

A puttable financial instrument is one that the holder may return to the issuer for an exchange
of cash. Puttable financial instruments that have been issued by the entity are thus normally
classified as liabilities, but some may need to be classified as equity (those that represent the
residual interest in the net assets of the entity). See IAS 32.16A-D
Chapter 3 117
If the entity issued puttable financial instruments classified as equity, the notes must include:
x A summary of the amounts classified as equity
x How the entity plans to manage its obligation to provide cash in exchange for a returned
instrument when required to do so by the holder of the instrument;
x The future cash outflow expected in relation to this instrument; and
x How the expected future cash outflow has been calculated. See IAS 1.136A
11.9 Unrecognised dividends (IAS 1.137; IFRIC 17.10 & IAS 10.13)
11.9.1 Disclosure of unrecognised dividends
IAS 1 requires that the notes include certain disclosures relating to unrecognised dividends.
x For dividends that have not been recognised, we must disclose the following in the notes:
- the amount in total; and
- the amount per share. See IAS 1.137
x For any cumulative preference dividends that, for whatever reason, have not been
recognised, we must disclose the following in the notes:
- the amount in total. See IAS 1.137
11.9.2 Why are some dividends not recognised?
A dividend distribution normally follows the following life-cycle:

x proposal; then
x declaration; then Dividends are recognised as
equity distributions when:
x payment.
x there is an obligation to pay.
Dividends are first proposed in a meeting. If the proposal is An obligation to pay arises when it
accepted, the entity will declare the dividend. Declaring a x has been appropriately authorised &
dividend means publicly announcing that the dividend will x is no longer at the entity's discretion
be paid on a specific date in the future. A dividend only The obligation date is normally the:
becomes an obligation once it is appropriately authorised x declaration date unless
and no longer at the discretion of the entity. See IAS 10.13 x the particular jurisdiction requires
further approval after the dividend
See IAS 10.13 & IFRIC 17.10
declaration.
In some jurisdictions, a declaration still needs to be
approved before an obligation arises (e.g. it may be declared by the board of directors, but
this declaration may still need to be approved by the shareholders). See IFRIC 17.10
It is only when an obligation arises to pay the dividend that a journal is processed:
Debit Credit
Dividends declared (distribution of equity) xxx
Dividends payable (liability) xxx
Dividend declared
Notice that the liability to pay a dividend is not recognised as an expense but rather as a
distribution of equity because a distribution of equity is expressly excluded from the
definition of an expense (read the expense definition again).
Certain dividends would not be recognised since there is not yet an obligation to pay them:
x proposed before or after the reporting date but are not yet declared or paid; and
x declared before reporting date but within a jurisdiction where further approval is required;
x declared after reporting date but before the financial statements are authorised for issue.
11.10 Other disclosure required in the notes (IAS 1.138)
Other information requiring disclosure includes:

x the domicile and legal form of the entity;
x which country it was incorporated in;
x the address of its registered office or principal place of business;
x a description of the nature of the entity’s operations and principal activities; and
x the name of the parent entity and the ultimate parent of the group (where applicable).
118 Chapter 3
12. Summary
IAS 1: Presentation of financial statements

x Objective of IAS 1:
prescribes the basis for presentation of general purpose f/ statements
to ensure comparability both with the entity’s prior periods and with other entities.
sets out overall requirements for the presentation of f/ statements, guidelines for their
structure and minimum requirements for their content
x Objective of f/statements
provide info about the:
financial position, performance & cash flows
that is useful to a wide range of users in making economic decisions; and
also shows the results of management’s stewardship of the resources entrusted to it.
x 5 Components of a set of f/statements
SOFP
SOCIE
SOCI
SOCF
Notes.
x 8 General features
Fair presentation and compliance with IFRSs
Going concern
Accrual basis
Materiality and aggregation
Offsetting
Reporting frequency
Comparative information
Consistency
x Structure and content of the five financial statements
Minimum disclosure requirements (both on the face of each component and in the notes)
SOFP:
o Current (C) vs Non-current (NCL)
o Effect of refinancing of liabilities and breach of covenants liabilities (CL or NCL)
SOCI:
o How to present expenses (function/ nature method)
o How to present P/L
o How to present OCI (and reclassification adjustments)
o How to present TCI (and if it is a consolidated group: how to allocate this between the owners and
the NCI’s)
SOCIE:
o How to present each component of equity: each type of contributed equity (e.g. ordinary
shares), retained earnings, each type of OCI (e.g. revaluation surplus) and TCI
o How to present within these components transactions with owners (contributions from
owners to be shown separately from distributions to owners, which must also be shown
as a dividend per share)
o How to present effects of changes in accounting policy and correction of errors
SOCF:
o How to separate cash flows into: operating, investing and financing activities
Notes:
o Compliance with IFRSs (if applicable)
o Basis of preparation and significant accounting policies
o Measurement bases
o Sources of estimation uncertainty
o How the entity manages its capital
o Items included in the other 4 statements that need supporting detail to be disclosed
o Items not included in the other 4 statements that do require disclosure
Chapter 3 119
The Financial Report =

Financial statements + Other statements and reports
Financial statements (must comply with IFRS)

x Statement of financial position:
Gives info about: Financial position
Presents: assets, liabilities, equity
x Statement of changes in equity
Gives info about: Changes in the financial position
Presents: Movement in equity (issued capital and reserves), showing separately the transactions
with owners
x Statement of comprehensive income
Gives info about: Financial performance
Presents: income and expenses = TCI, where TCI is split between:
o P/L and
o OCI
x Statement of cash flows
Gives info about: Cash generating ability
Presents: cash movements analysed into: operating, investing and financing activities
x Notes to the financial statements
Gives info about: line items that are in the other statements but also but items that have not been
recognised in the other statements but may still be relevant information to the users
Other statements and reports

x Index
x Directors’ report
x Audit report
x Any other relevant statements
Other information needed to make it understandable

x Name of entity
x Name of statement or report
x Financial statements for the group or the individual entity
x Date/ period of report
x Presentation currency
x Level of precision
Total comprehensive income =

Profit or loss + Other comprehensive income
P/L comprises income less expenses, being those income and expenses that are not OCI.
OCI comprises income and expenses that are not in P/L:
x changes in revaluation surplus
x remeasurements of defined benefit plans
x gains and losses from translating foreign operations
x gains and losses on financial assets measured at fair value through OCI
x gains and losses on investments in equity instruments designated at fair value through OCI
x effective portion of gains and losses on hedging instruments in a cash flow hedge &
gains and losses on hedging instruments that hedge investments in equity instruments measured at
fair value through OCI
x for certain liabilities designated as at fair value through profit or loss, the amount of the change in
fair value that is attributable to changes in the liability’s credit risk
x if not part of a designated hedging instrument:
- changes in the value of the time value of options;
- changes in the value of the forward elements of forward contracts, and
- changes in the value of the foreign currency basis spread of a financial instrument
x certain income and expenses, within the scope of insurance contracts, that are excluded from P/L. See IAS 1.7
120 Chapter 3
Gripping GAAP Revenue from contracts with customers
Chapter 4
Revenue from contracts with customers
Reference: IFRS 15 (including any amendments to 1 December 2018)

Contents: Page
1. Introduction 125
1.1 IFRS 15: The ‘new’ revenue standard 125
1.2 IFRS 15: The significant changes 125
1.3 IFRS 15: Transitional provisions 126
2. Scope 126
2.1 IFRS 15 only applies to contracts that involve customers 126
2.2 IFRS 15 does not apply to all contracts with customers 126
3. Income versus revenue 127
Diagram 1: Relationship between income and revenue, and the different types of revenue 127
4. IFRS 15 in a nutshell 127
4.1 Overview 127
4.2 The 5-step process to recognition and measurement 127
Diagram 2: the 5-step process for revenue recognition and measurement 127
4.3 Recognition 128
4.4 Measurement 129
4.5 Presentation 130
4.5.1 Overview 130
4.5.2 Rights are presented as assets 130
Example 1: Contract asset versus a receivable 131
4.5.3 Obligations are presented as liabilities 132
Example 2: When to recognise a contract liability 133
4.6 Disclosure 134
5. Identifying the contract (step 1) 134
5.1 Overview 134
5.2 The contract must meet certain criteria 135
5.3 The contract may be deemed not to exist 136
5.4 When the criteria are not met at inception 136
Example 3: Criteria not met at inception 136
5.5 When the criteria are met at inception but are subsequently not met 137
Example 4: Criteria met an inception but subsequently not met 137
5.6 Combining contracts 138
5.7 Modifying contracts 138
5.7.1 What is a contract modification? 138
5.7.2 Accounting for a modification 138
5.7.3 Modification accounted for as a separate contract 139
5.7.4 Modification accounted for as a termination plus creation of a new contract 139
5.7.5 Modification accounted for as part of the existing contract 139
6. Identifying the performance obligation (step 2) 140
6.1 Performance obligations are promises 140
6.2 Revenue is recognised when performance obligations are satisfied 140
6.3 Performance obligations could be explicitly stated or be implicit 140
Example 5: Explicit and implicit promises 141
6.4 The promised transfer must be distinct 141
6.4.1 Overview 141
6.4.2 The goods or services must be capable of being distinct 141
6.4.3 The good or service must be distinct in the context of the contract 142
6.5 Bundling indistinct goods or services 142
Example 6: Distinct goods and services 143
Chapter 4 121
Contents continued …: Page

7. Determining the transaction price (step 3) 143
7.1 Overview 143
Example 7: Transaction price, collectability and the loss allowance 144
Example 8: Transaction price: collectability versus implied price concession 145
7.2 Variable consideration 146
7.2.1 Overview 146
7.2.2 When is consideration considered to be variable? 147
Example 9: Variable consideration – discounts 147
7.2.3 Estimating the variable consideration 148
Example 10: Estimating variable consideration – the two methods of estimation 149
Estimating when the distribution is continuous
Example 11: Estimating variable consideration – the two methods of estimation 149
Estimating when the distribution is discontinuous
7.2.4 Constraining the estimate 150
Example 12: Estimating variable consideration – constraining the estimate 151
Example 13: Estimating variable consideration – determining the constraint 152
Example 14: Estimating variable consideration – effect of a constrained estimate 153
on the transaction price
7.2.5 Refund liabilities 154
Example 15: Receipts exceed constrained estimate of variable consideration 155
7.2.6 Specific transactions involving variable consideration 155
7.2.6.1 Overview 155
7.2.6.2 Contracts involving a volume rebate 155
Example 16: Variable consideration – volume rebate 155
7.2.6.3 Contracts involving a sale with a right of return 156
Example 17: Variable consideration – sale with right of return 157
7.2.7 Reassessment of variable consideration 158
7.2.8 Exception to estimating and constraining variable consideration 158
7.3 Significant financing component 158
7.3.1 Overview 158
Example 18: Significant financing component – arrears versus advance 159
Example 19: Significant financing component – arrears journals 159
Example 20: Significant financing component – advance journals 160
7.3.2 When would we adjust for the effects of financing? 161
Example 21: Significant financing component exists – adjust or not 161
7.3.3 How do we decide whether a financing component is significant or not? 163
7.3.4 What discount rate should we use? 164
Example 22: Significant financing component – discount rate 164
7.3.5 How do we present interest from the significant financing component? 165
7.4 Non-cash consideration 165
7.4.1 Overview 165
7.4.2 Whether to include non-cash items in the transaction price 166
7.4.3 How to measure non-cash consideration 166
Example 23: Non-cash consideration 166
7.5 Consideration payable to the customer 168
7.5.1 Overview 168
Worked example 1: Consideration payable is not for distinct goods or services 168
Worked example 2: Consideration payable is for distinct goods or services 169
Worked example 3: Consideration payable is for distinct goods or services but 169
exceeds their fair value
Worked example 4: Consideration payable – coupons for customer’s customers 169
Worked example 5: Consideration payable – coupons for customer’s customers 170
8. Allocating the transaction price to the performance obligations (step 4) 170
8.1 Overview 170
122 Chapter 4

8.2 Allocating the transaction price based on stand-alone selling prices 171
Example 24: Allocating the transaction price based on stand-alone selling prices 171
Example 25: Allocating a transaction price based on estimated stand-alone selling prices 172
Example 26: Allocating a transaction price based on estimated stand-alone selling prices 173
(where one was estimated based on the residual approach)
8.3 Allocating a discount 174
8.3.1 Overview 174
8.3.2 Identifying a discount 174
8.3.3 Allocating a discount proportionately to all performance obligations 175
8.3.4 Allocating a discount to one or some of the performance obligations 175
Example 27: Allocating a discount to only one / some performance obligations 175
Example 28: Allocating discount – the regular discount ≠ contract discount 177
Example 29: Allocating discount before applying the residual approach 178
8.4 Allocating variable consideration 178
Example 30: Allocating variable consideration to all/some of the perf. obligations 180
Example 31: Allocating variable consideration 181
8.5 Allocating a change in the transaction price to performance obligations 182
9. Satisfying performance obligations (step 5) 182
9.1 Overview 182
9.2 How do we assess when a performance obligation has been satisfied? 183
9.3 How do we assess when control has passed? 183
9.4 Classifying performance obligations as satisfied over time or at a point in time 183
9.4.1 Overview 183
Diagram 3: Overview of the classification of performance obligations 183
9.4.2 Performance obligations satisfied over time 184
Diagram 4: The 3 core criteria used to classify performance obligations 184
9.4.2.1 Criterion 1: Does the customer receive the asset and consume its benefits 184
as the entity performs?
Diagram 5: Classifying performance obligations – using criterion 1 185
Example 32: Classifying performance obligations: the first criterion 185
9.4.2.2 Criterion 2: Does customer get control as the asset is being created or 186
enhanced?
Example 33: Classifying performance obligations: the second criterion 188
9.4.2.3 Criterion 3: Does the entity have no alternative use for the asset and an 188
enforceable right to payment?
9.4.2.3.1 No alternative use 189
9.4.2.3.2 Enforceable right to payment 190
Example 34: Classifying performance obligations: the first and third 191
criterion
9.5 Measuring progress of performance obligations satisfied over time 191
9.5.1 Overview 191
9.5.2 Input methods 192
Example 35: Measure of progress – input methods – straight-lining 192
Example 36: Measure of progress – input methods 192
Example 37: Measure of progress – input methods: total cost changes 193
Example 38: Measure of progress – input method: input does not contribute to progress 195
Example 39: Measure of progress – input methods: input is not proportionate to 195
the entity’s progress
9.5.3 Output methods 196
Example 40: Measure of progress – output method: work surveys 196
9.5.4 If a reasonable measure of progress is not available 197
9.5.5 If a reasonable measure of the outcome is not available 197
Example 41: Outcome not reasonably measured 197
Chapter 4 123

9.6 Repurchase agreements 198
9.6.1 Overview 198
9.6.2 Where a repurchase agreement means the customer does not obtain control 198
9.6.3 Where a repurchase agreement means the customer does obtain control 198
10. Contract costs 199
10.1 Overview 199
10.2 Costs of obtaining a contract 199
Example 42: Costs of obtaining a contract 200
10.3 Costs to fulfil a contract 200
Example 43: Costs of fulfilling a contract 201
10.4 Capitalised costs are amortised 201
10.5 Capitalised costs are tested for impairments 201
11. Specific revenue transactions 202
11.1 Overview 202
11.2 Sale with a warranty 202
Example 44: Sale with a warranty 202
11.3 Sale with a right of return 203
11.4 Transactions involving principal – agent relationship 203
11.4.1 Overview 203
11.4.2 Where the entity is the principal 203
11.4.3 Where the entity is the agent 203
11.5 Sale on consignment 204
Example 45: Sale on consignment 204
11.6 Sale on a bill-and-hold basis 204
Example 46: Bill-and-hold sale 205
11.7 Customer options for additional goods and services 206
Worked example 6: Customer receives a material right 206
Worked example 7: Customer does not receive a material right 206
Example 47: Option accounted for as a separate performance obligation 206
Example 48: Option involves similar goods or services (e.g. contract renewal) 207
Example 49: Option involves customer loyalty programme (entity = principal) 208
12. Presentation 210
12.1 Overview 210
12.2 Sample presentation involving revenue 210
13. Disclosure 210
13.1 Overview 210
13.2 Contracts with customers 211
13.2.1 Disclosure of related revenue and impairment losses to be separate 211
13.2.2 Disclosure of disaggregated revenue 211
13.2.3 Disclosure relating to contract balances 211
13.2.4 Disclosure relating to performance obligations 21
13.2.5 Disclosure of the remaining unsatisfied performance obligations and how 212
much of the transaction price has been allocated to these
13.2.6 Sample disclosure relating to the line-item ‘revenue from customer contracts’ 213
13.3 Significant judgements 213
13.3.1 Judgements (and changes therein) that significantly affect the timing of revenue 213
13.3.2 Judgements (and changes therein) that significantly affect the amount of revenue 214
13.4 Contract costs recognised as assets 214
13.4.1 Quantitative information 214
13.4.2 Qualitative information 214
14. Summary 215
124 Chapter 4
1. Introduction
1.1 IFRS 15: The ‘new’ revenue standard

IFRS 15 Revenue from contracts with customers was released in May 2014, but only effective for
financial years beginning on or after 1 January 2018 (although entities could apply it earlier, if preferred).
Thus, for those preparing financial statements in 2019, IFRS 15 is now fully effective. This new standard
replaces the two previous revenue-related standards and their interpretations:
x IAS 18 Revenue;
x IAS 11 Construction contracts;
x All interpretations relating to revenue, including:
IFRIC 13 Customer loyalty programmes;
IFRIC 15 Agreements for the construction of real estate;
IFRIC 18 Transfer of assets from customers; and
SIC 31 Revenue - barter transactions involving advertising services.
1.2 IFRS 15: The significant changes
There are many changes arising from IFRS 15. These include when to recognise revenue, how to
measure it, how to present revenue-related transactions and balances in the financial statements, and how
to disclose revenue-related information, and where these disclosure requirements are far more onerous
than before. The following is simply a list of some of the significant changes:
x The previous standard, IAS 18 Revenue, provided overarching general principles on how to
recognise and measure revenue and then explained how these principles applied to five main
types of revenue: sales, services, interest, royalties and dividends. In other words, each of these
different types of revenue had their own specific recognition and measurement issues to consider.
By contrast, the new IFRS 15 does not have principles for different types of revenue. Instead, it
provides a five-step approach to recognising and measuring all types of revenue within its scope.
x Previously, revenue from construction contracts was covered in a separate standard,
IAS 11 Construction contracts, and was thus accounted for using different principles to the
principles applied to revenue from other sources, such as sales. Thus, revenue from construction
contracts will now be accounted for in the same way as all other revenue (e.g. revenue from sales).
x Revenue used to be recognised when the ‘risks and rewards’ transferred to the customer, but revenue
is now recognised when ‘control’ has passed to the customer.
x The previous revenue standards provided little guidance on when to recognise revenue and how to
measure it when a contract involved more than one task. IFRS 15, on the other hand, explains this in
detail. IFRS 15 refers to these tasks as performance obligations and requires us to first ‘unpack’ a
contract into the separate performance obligations that are considered ‘distinct’, and then allocate the
transaction price to each of these ‘distinct performance obligations’. This new guidance may have a
significant impact on certain industries where contracts often include multiple obligations, such as:
the construction industry: a contract to construct a building may involve the supply of materials
and the completion of many tasks (e.g. building walls, plumbing, electrical etc);
the telecommunications industry: a cell phone contract may involve the supply of the phone and
also the supply of airtime. See section 5 for a detailed discussion on performance obligations.
x IFRS 15 clarifies that we must consider the time value of money, which is effectively the financing
component within a contract. Under certain circumstances it may be ignored, but if we must
account for it, we may need to recognise not only interest income on an entity’s receivables, but also
interest expense on amounts received in advance. Incidentally, depending on circumstances, interest
income from the time-value of money should be presented as ‘revenue’, but it is never presented as
part of the ‘revenue from contracts with customers’.
x IFRS 15 does not only explain how to account for revenue, but also how to account for the
incremental costs incurred in obtaining and fulfilling a contract (to the extent that these costs are not
within the scope of another standard, such as IAS 2 Inventories). The effect of the IFRS 15 guidance
on how to account for costs is that the decision to capitalise contracts costs will be reached more
often than under the previous standards of IAS 18 and IAS 11.
Chapter 4 125
1.3 IFRS 15: Transitional provisions

When applying IFRS 15 for the first time, we must follow a detailed transitional provision, the essence
of which is that, when applying IFRS 15 for the first time, we must apply it retrospectively, but may
make the necessary adjustments using one of the following two methods:
x to each prior period presented (i.e. as a change in accounting policy in terms of IAS 8 Accounting
policies, changes in accounting estimates and errors); or
x as one cumulative adjustment in the period in which it is first applied, in which case, an entity must:
recognise the cumulative effects of initial application of IFRS 15 as an adjustment to retained
earnings
for all periods that include the date of initial application, the amount that each line item is
affected by applying IFRS 15 compared to previous standards, as well as the reason for
significant changes. See IFRS 15.C3(a) and (b), C7-8
2. Scope
2.1 IFRS 15 only applies to contracts that involve

customers A contract is defined as:
x An agreement between two or
As its name suggests, IFRS 15 only deals with contracts and more parties
only those contracts that involve customers. Both these terms x that creates enforceable rights
are defined in IFRS 15 (see grey boxes on the right): and obligations. IFRS 15 Appendix A
x A contract is any agreement resulting in the parties to the

agreement having rights and obligations that are enforceable. It does not need to be in writing – it
can be verbal or simply implied by the way in which the entity normally conducts its business.
What is important is that it is enforceable by law.
x A customer is simply a party (e.g. a person) who has come A customer is defined as:
to an agreement with the entity, promising to give some x a party that has contracted with an
form of consideration (e.g. cash) in exchange for goods or entity
services (e.g. widgets) that the entity promises to provide as x to obtain goods or services
part of its ordinary activities. Thus, a party that agrees to x that are an output of the entity’s
ordinary activities
pay the entity for goods or services that are not part of the
x in exchange for consideration.
entity’s ordinary activities, would not be a customer. Thus, IFRS 15 Appendix A
this contract would not be accounted for under IFRS 15.
2.2 IFRS 15 does not apply to all contracts with customers Scope exclusions:
Although IFRS 15 applies to many contracts with customers, IFRS 15 does not apply to:
some contracts are not covered by IFRS 15. x contracts that do not involve customers
as defined
x IFRS 15 does not apply to contracts that fall within the x contracts with customers that are
scope of another standard. In other words, we first decide covered by other standards
whether other standards would apply to the contract: if - lease contracts under IFRS 16
other standards apply, then IFRS 15 will not apply; but if - insurance contracts under IFRS 4
no other standards apply, then IFRS 15 will apply. For - financial instruments and ‘other
contractual rights or obligations’
example, lease contracts (IFRS 16), insurance contracts covered by IFRS 9, IFRS 10, IFRS 11,
(IFRS 4) and financial instruments (IFRS 9) are scoped IAS 27 or IAS 28
out of IFRS 15 if these standards are found to apply. x exchanges of non-monetary items
between entities in the same line of
x IFRS 15 does not apply to contracts involving the business to facilitate sales to
exchange of non-monetary items between entities that are customers or potential customers.
See IFRS 15.5-6
involved in the same type of business and where the
contract is entered into in order to assist each other to secure sales to existing or possible future
customers. For example: Entities A and B are both involved in milk distribution. Each entity
operates in a different geographic area. IFRS 15 will not apply to a contract between A and B if it
was an agreement:
to provide each other with milk if one entity has a surplus and the other has a shortage.
to assist each other by providing milk to each other’s customers if the other entity is closer to
that customer (e.g. B will provide milk to one of A’s customers, since B is closer to that
customer, and A will provide milk to one of B’s customers, since A is closer to that customer).
126 Chapter 4
3. Income versus revenue
‘Income’ and ‘revenue’ are not the same: ‘income’ is an umbrella term that includes ‘revenue’. Revenue
is defined as ‘income that arises in the entity’s ordinary activities’. IFRS 15 defines both terms.
Income is defined in IFRS 15 as Revenue is defined in IFRS 15 as

x increases in economic benefits during the x income
accounting period x arising in the course of
IFRS 15. Appendix A
x in the form of inflows or enhancements of x an entity’s ordinary activities.
assets or decreases of liabilities
x that result in an increase in equity, other
than those relating to contributions from
See IFRS 15 App A
equity participants.
Note: The ‘income definition’ per IFRS 15 and 2018 Conceptual Framework differ, although the effects are identical.
This difference can be explained as follows. A retailer may earn interest on surplus cash. Since this
interest income falls outside its ordinary activities of buying and selling, this entity would not present
this interest income as revenue. On the other hand, a financier (e.g. a bank) that charges interest on
loans as one of its core business activities would present its interest income as revenue. See IFRS 15.BC247
It is also important to remember that, although IFRS 15 deals with revenue, it does not apply to all
types of revenue – it only applies to revenue arising from ‘contracts with customers’ and it only
applies to contracts with customers that do not fall within the scope of certain other standards (e.g.
IFRS 16 Leases – see section 2). This relationship is shown in the diagram below:
Diagram 1: Relationship between income and revenue, and the different types of revenue
Income
Income from ordinary activities: Income not from ordinary activities:

Revenue 1 Other income
x Revenue from contracts with customers Income that is not revenue
covered by IFRS 15 E.g. income earned in the following way is not revenue:
Revenue from contracts with customers x incidental rent,
x
covered by other IFRSs (e.g. IFRS 16 Leases) x interest by charging interest on overdue accounts,
x a gain on an occasional sale of property, plant and
x Other revenue equipment)
revenue not covered by any specific IFRS
Note 1: revenue from contracts with customers is disclosed separately from other revenue. See IFRS 15.113(a)
4. IFRS 15 in a nutshell
4.1 Overview
IFRS 15 explains a 5-step process to decide when to recognise revenue and how to measure it.
It also gives guidance regarding how to present revenue and how to disclose the related detail.
4.2 The 5-step process to recognition and measurement
The 5-step process is the process followed when recognising and measuring revenue. These
steps are inter-related. This means that the process of considering step 3, for example, may
require us to simultaneously consider step 5, or vice versa.
Diagram 2: the 5-step process for revenue recognition and measurement See IFRS 15.2/IN7
Step 1 Step 2 Step 3 Step 4 Step 5

Identify the Identify the Determine the Allocate the Recognise
contract/s with a performance transaction price transaction price revenue when/ as
customer obligations in the to the the entity
contract performance satisfies a
obligations in the performance
contract obligation
Recognition Recognition Measurement Measurement Recognition
Chapter 4 127
IFRS 15 gives detailed guidance to help us decide if and when each of these 5 steps have been
completed. Each of these steps is covered in detail under sections 5 to 9, but first let us look at
the ‘big picture’ of the recognition, measurement, presentation and disclosure requirements.
4.3 Recognition (IFRS 15.9 - .45)
Revenue is recognised
When deciding if revenue should be recognised (i.e. if we when:
should process a journal for revenue), we consider three steps: x we have identified the contract
step 1, step 2 and step 5. In other words, revenue should be with a customer (step 1);
recognised when we have a legally enforceable contract, we x we have identified the
performance obligations (step 2);
can identify our obligations in this contract and will be able and
identify as and when we have satisfied these obligations. x the performance obligations are
satisfied (step 5).
Now let’s look at these three steps in a little more detail. See IFRS 15.9; 15.22 & 15.31
x We must be able to identify a contract with a customer:

(IFRS 15 describes this as step 1):
The contract need not be in writing or even be verbal, it can simply be implied. What is
important is that it is enforceable by law. If we conclude that we do not have a contract with a
customer, then it falls outside of the scope of IFRS 15 and thus we do not recognise revenue
from contracts with customers.
x We must be able to identify the performance obligations in this contract:
Performance obligations include promises to supply distinct Performance obligations
goods or services or a combination of distinct goods or services. (POs) are promises to
transfer:
For a good or service, or bundle of goods or services, to be x goods or services/ bundles thereof
considered distinct, it must be: x that are ‘distinct’
x capable of being distinct – which means the good or (A PO could include a promise to
service must be able to benefit the customer, whether transfer a series of the above) See IFRS 15 App A
this is achievable on its own or by combining it with

other resources available to the customer (either by being owned by the customer or
simply being readily available on the market); and
x distinct in the context of the contract – which means A good or service is
that the promise to transfer the good or service must be distinct, if it is:
able to be separately identifiable from the other x capable of being be distinct:
promises within the contract (e.g. a contract that - can benefit the customer; &
promises a fridge motor and a fridge body where the x distinct in context of the contract:
fridge motor can only be used with that specific fridge - it is separately identifiable from
body and the fridge body cannot be used without the other G/S in the contract.
See IFRS 15.27
fridge motor are considered to be promises that are so
highly inter-related that they would not be separately identifiable).
The concept of ‘distinct’ is explained in more detail in section 6.4.
x We must be able to identify when/as the performance obligations are satisfied:
This step is important since the related revenue will be recognised
as and when the entity completes its performance obligations. Note this change!
The entity has satisfied its obligations when it has transferred x Previously, risks & rewards of
the goods and/ or services to its customer in a way that gives the ownership had to be transferred
before revenue was recognised.
customer control. This could happen at a point in time
x Now, IFRS 15 requires that
(instantly) or over a period of time (gradually). control passes to the customer
before revenue is recognised.
If, after these three steps, we decide revenue needs to be
The transfer of risks and rewards is
recognised, we will need to process a journal. Obviously, to now just one of the factors that may
process a journal, we need to know the amount of the journal. suggest that control has passed.
This is called measurement (see section 4.4).
128 Chapter 4
4.4 Measurement (IFRS 15.46 - .90)

Revenue is measured:
When measuring revenue (i.e. how much the revenue
journal should be), we consider two steps: step 3 and step 4. x based on the transaction price;
which must then be
Revenue is measured by first deciding the transaction price, x allocated to each performance
obligation based on the relative
which is the total amount we expect to be entitled to, and then stand-alone selling prices of the
allocating this to each of our performance obligations. underlying goods or services.
See IFRS 15.73 - .90
Let’s look at these two steps in more detail:
x Determine the transaction price:

The transaction price is the amount of consideration that the entity expects to be entitled to for
the transfer of the goods and/ or services to the customer.
The transaction price must exclude any amounts that the entity will be collecting on behalf of
a third party (e.g. the transaction price would not include VAT since this would be an amount
collected on behalf of, and thus owed to, the tax authorities).
x Allocate the transaction price to each performance obligation:

If the contract involves only one single performance obligation, the contract’s entire
transaction price will apply to that single obligation.
However, if a contract involves more than one performance obligation, the transaction price
will need to be allocated to each separate performance obligation.
The reason we take the trouble to allocate the transaction price to each of these obligations is because
revenue is recognised separately for each separate obligation as and when that performance
obligation is satisfied (i.e. completed). At any one time, the revenue recognised should reflect the
effort the entity has put into satisfying each individual performance obligation.
For example: a contract requiring us to supply and install a ‘complex computer network’,
involves two performance obligations: the supply of the hardware and the installation of the
hardware. It is possible that these two obligations could be satisfied at different times, in which
case the revenue from each obligation would need to be recognised at different times.
The allocation of the transaction price to each performance obligation is done in proportion to the
stand-alone transaction prices of the ‘distinct’ goods or services identified in the contract.
The portion of the transaction price that is allocated to a performance obligation is only
recognised as revenue once that obligation has been satisfied (i.e. completed).
With this in mind, we need to understand that some performance obligations are satisfied:
x at a point in time (i.e. in an instant); and others are satisfied
x over time (i.e. gradually).
If the performance obligation will be completed in an instant (i.e. at a point in time) the
related revenue will be recognised at that point in time. If it will be completed gradually (i.e.
over time), the revenue from this obligation will also be recognised gradually.
For example: If we consider our ‘complex computer network’ example referred to above, the
supply of the hardware would be a performance obligation that is completed at a point in time
(at which point, revenue from this obligation would be recognised immediately), whereas the
installation would probably be a performance obligation that would be completed over time
(revenue from this obligation would be recognised gradually).
Chapter 4 129
When recognising revenue over time, the amount of revenue to be recognised will need to be
measured based on the progress towards complete satisfaction of the performance obligation.
This progress is measured using either an input method or an output method.
4.5 Presentation (IAS 1.82(a) and IFRS 15.105 - .109)
4.5.1 Overview
Revenue must be presented as a line-item in profit or loss (profit or loss can be presented within the
statement of comprehensive income or as a separate statement of profit or loss). See IAS 1.82 (a)
In addition to the presentation in the statement of comprehensive income, revenue also affects
the presentation of our financial position (SOFP). In this regard, a customer contract may lead
to the presentation in our statement of financial position (SOFP) of the following line-items:
x a contract asset or contract liability; and/or
x a receivable (receivables are to be presented separately from contract assets).
Assets = our rights Liabilities = our obligations
A contract asset is defined as: A contract liability is defined as:
x an entity’s right to consideration x an entity’s obligation to transfer goods or
x in exchange for goods or services that the services to a customer
entity has transferred to a customer x for which:
x when that right is conditional on something - the entity has received consideration
other than the passage of time from the customer; or
(e.g. the entity’s future performance). - the amount of consideration is due from
IFRS 15 App A
the customer.
IFRS 15 App A (slightly reworded)
A receivable is defined as:
x an entity’s right to consideration
IFRS 15.108 (extract)
x that is unconditional.
A right to consideration is unconditional if:
x all we have to do is wait for time to pass
x before payment falls due.
See IFRS 15.108 (reworded)
In order to understand the use of these line-items, we need to understand that when we enter
into a contract with a customer, we accept certain rights and certain obligations:
x the right to receive the promised consideration; and
x the obligation to transfer promised goods or services to the customer (i.e. the obligation to
satisfy certain specified performance obligations – in other words, to complete our
obligations; or basically to perform our side of the contract).
The relationship between these rights and obligations will determine whether we have:
x a contract asset: if our remaining rights are greater than our remaining obligations; or
x a contract liability: if our remaining rights are less than our remaining obligations. See IFRS 15.BC18
When measuring the contract asset (our conditional rights), we must exclude the amounts to be
included in the receivable (our unconditional rights). In other words, our contract asset and
receivable asset are different assets: our contract asset represents our right to receive consideration
but where there is still a condition attached. A receivable refers to our right to receive consideration
where we have satisfied all our obligations and are now simply waiting for the customer to pay.
4.5.2 Rights are presented as assets (IFRS 15.107-.108) Rights are assets:
As mentioned above, an entity’s right to consideration is A contract asset is a:
recognised as an asset. However, as we can see, there are x conditional right
two types of assets: a contract asset and a receivable. A receivable is an:
x unconditional right.
When recognising revenue (a credit entry) that is received in * The need to simply wait for time
cash, the asset we recognise is cash in bank (a debit entry). to pass is not considered to be a
condition. See IFRS 15.107-.108
130 Chapter 4
However, if the revenue is not received in cash, we would need to decide whether to debit the
contract asset or the receivable asset.
Deciding which asset to debit depends on whether the right is conditional or not. If the
entity’s right to consideration:
x is conditional upon something happening, other than the passing of time* (e.g. conditional
upon the future performance of the entity), then we debit the contract asset;
x is unconditional (i.e. there are no conditions other than the possible requirement to simply
wait for the passing of time*), then we debit the receivable.
* Note: a condition that requires us to simply wait for the passage of time is not considered to
be a condition for purposes of IFRS 15 (because ‘time is an inevitability’)
In other words, a receivable represents a right that is unconditional (i.e. at most, all we have
to do is wait for time to pass) whereas a contract asset represents a right that is conditional.
Example 1: Contract asset versus a receivable Adaptation of IFRS 15.IE38 & 39
Home Fires signed a contract with Deluxe Renovations (the customer) on 1 March 20X2, the
terms of which included the following:
x Home Fires would supply and install a designer fireplace on 1 April 20X2 after which it would be
required to supply and install a fire-door.
x Deluxe Renovations (the customer) promised consideration of C20 000, payable one month after
both the fireplace and the door have been supplied and installed.
x The contract is cancellable in the event of non-performance.
The stand-alone selling prices for the supplied and fitted products are as follows:
x fireplace: C15 000; and
x fire-door: C5 000.
Home Fires supplies and installs the fireplace on 1 April 20X2 and supplies and installs the door on
5 May 20X2. The customer obtains control of each product on the date of its installation.
The customer pays the promised consideration on 25 July 20X2.
Required: Prepare all journals for the information given, using the general journal of Home Fires.
Solution 1: Contract asset versus a receivable

Comment:
x This example shows when the recognition of revenue:
- requires a debit to a contract asset (i.e. when the right to the consideration is conditional) and
- requires a debit to a receivable (i.e. when the right to the consideration is unconditional)
x This example also shows the transfer of a contract asset to a receivable when a conditional right to
consideration becomes an unconditional right.
x This contract involves the supply and fitment of a fireplace and the supply and fitment of a door,
which are clearly distinct from one another.
Thus, we conclude that the contract has two performance obligations (POs): to supply and install both
a fireplace and a door.
x Journal on 1 April 20X2:
When the fireplace is installed (1 April 20X2), the entity (Home Fires) has performed one of its POs
and thus the consideration relating to this PO must be recognised as revenue.
However, this consideration is not yet unconditionally receivable. This is because Home Fires must
supply and fit both a fireplace and a door and the contract is cancellable if this does not happen. Thus,
this consideration will only become unconditionally receivable when the second PO is satisfied.
Thus, when we recognise revenue in respect of this PO (credit revenue) we may not yet recognise the
receivable and must therefore recognise a contract asset instead (debit contract asset).
x Journals on 5 May 20X2:
When the door is installed (5 May 20X2), the entity has performed its second PO and thus the
consideration relating to this PO must be recognised as revenue.
Chapter 4 131
At this point, the consideration from both POs becomes unconditionally receivable (only the passage
of time remains to the due date of 5 June 20X2, calculated as one month from the satisfaction of the
last PO) and thus all consideration receivable must be recognised as a receivable.
Thus, when we recognise revenue in respect of this second PO (credit revenue), we must recognise a
receivable (debit receivable).
Since the contract could have been cancelled if the second PO was not completed, the revenue from
the first PO had been recognised as a contract asset (1 April 20X2). Since this second PO is now
complete, it means that the contract asset that was recognised on 1 April 20X2 must now be
recognised as a receivable (debit receivable and credit contract asset).
x Journal on 25 July 20X2:
The receipt of cash is recorded. Please note that the date on which the customer was meant to have
paid was 5 June 20X2, in terms of the contract (being 1 month after both POs were satisfied).
However, this date is of no relevance to our journals.
1 April 20X2 Debit Credit
Contract asset (A) Given 15 000
Revenue from customer contract (I) 15 000
Recognising revenue on supply & installation of fireplace (satisfaction of PO
#1), recognised as a contract asset since the right to the consideration is not
yet unconditional (we still need to satisfy PO#2)
5 May 20X2
Accounts receivable (A) Given 5 000
Recognising revenue on supply & installation of fire-door (satisfaction of
PO #2), recognised as a receivable since the right to this consideration is
unconditional (we have satisfied both POs)
Contract asset (A) 15 000
Transferring the contract asset to the receivable asset since the right to
the consideration for PO#1 is now unconditional (both POs are satisfied)
25 July 20X2
Bank Given 20 000
Accounts receivable (A) 20 000
Receipt of payment from customer (also referred to as consideration)
Note that, although IFRS 15 refers to contract assets and receivables, both are actually measured in terms
of IFRS 9 Financial instruments. This will also mean applying the impairment requirements of IFRS 9,
which involves the use of the expected credit loss model (a forward-looking model), instead of the
‘allowance for doubtful debt’ model (an incurred-loss model) that was previously applied under the old
revenue standard. See section 7 in this chapter, as well as section 4 of chapter 21 for further details.
4.5.3 Obligations are presented as liabilities (IFRS 15.106)
If we have not yet satisfied our performance obligations, we cannot recognise revenue (see step 5).
However, although we may not yet recognise revenue, we may need to recognise a contract liability
instead, if we either:
x have already received the consideration from the customer (i.e. we have debited bank but
cannot yet credit revenue since the performance obligation has not yet been satisfied); or
x have an unconditional right to this consideration (i.e. we have debited accounts receivable but
cannot yet credit revenue since the performance obligation has not yet been satisfied).
This contract liability is recognised when the entity either receives the consideration or obtains
the unconditional right to this consideration, whichever happens first.
Thus, a contract liability reflects our obligation to either return any amounts received to our
customer, or to satisfy our performance obligations (i.e. do what we promised to do).
Normally, an unconditional right to consideration arises only when we have satisfied our performance
obligations (see previous example where we were only able to recognise a receivable once both
performance obligations were satisfied). However, an unconditional right to consideration can arise
before we have satisfied our performance obligations (i.e. before we are able to recognise revenue).
This happens if, for example, the contract is non-cancellable.
132 Chapter 4
If we sign a non-cancellable contract, the date on which our customer is required to make payment is
the date on which we obtain an unconditional right to the consideration, even if we have not
performed our obligations.
The due date for payment in a contract is normally irrelevant when accounting for revenue from
contracts with customers. However, the date is very important if the contract is non-cancellable, because
it becomes the date on which the entity obtains an unconditional right to receive the consideration.
Example 2: When to recognise a contract liability

Home Fires signed a contract with Deluxe Renovations on 1 March 20X2, the terms of which
included the following:
x Home Fires agreed to supply and install a designer fireplace before 30 May 20X2.
x Deluxe Renovations agreed to pay C15 000 in advance, on 1 April 20X2.
Home Fires installed the fireplace on 10 May 20X2, on which date the customer obtained control.
The customer paid the promised consideration on 30 April 20X2 (i.e. before installation but after the due date).
Required: Prepare all journals in the general journal of Home Fires assuming that:
a) the contract is non-cancellable.
Adaptation of IFRS 15.IE38 & 39
b) the contract is cancellable in the event of non-performance.
Solution 2: When to recognise a contract liability

Comment in general: In both (a) and (b) of the example, the due date for receipt of the consideration
(1 April) occurs before the cash is received (30 April). However:
x In part (a), the contract is non-cancellable and thus the due date (1 April) is the date on which the entity
obtains an unconditional right to consideration. Since the unconditional right arises before the cash is
received (30 April), we need to debit the receivables account before we get to debit bank.
Thus, on 1 April, because we have not satisfied our performance obligations, we cannot credit revenue and
thus we will need to recognise the contract liability.
Debit Accounts Receivable and Credit Contract Liability.
x In part (b), the contract is cancellable and thus the due date (1 April) does not lead to the entity having an
unconditional right to consideration before the performance obligations are satisfied (i.e. the due date is
irrelevant to our journals).
Thus, when the cash is received (30 April), we must recognise a contract liability: this is because we cannot
yet recognise revenue since the performance obligations have not yet been satisfied.
Debit Bank and Credit Contract Liability.
Solution 2A: Contract liability – recognised when recognising the receivable

Comment on Part A:
x Since the contract is non-cancellable, Home Fires obtains an unconditional right to consideration on
1 April 20X2, being the due date for payment stipulated in the contract (this date occurs before the
cash was received). An unconditional right to consideration must be recognised as a receivable.
x Since the installation had not yet occurred on this date (1 April), the debit to the receivable account
will require a contra entry of a credit to the contract liability account (i.e. showing that the entity still
needs to perform i.e. its obligation to perform) and not a credit to the revenue account.
x On the date that the fireplace is installed (10 May), the contract liability is reversed and recognised as
revenue instead (because the PO has been satisfied).
Contract liability (L) 15 000
Recognising the unconditional right to receive consideration (the
receivable) and the obligation to install the fireplace (contract liability)
Chapter 4 133

Bank (A) Given 15 000
Recognising the receipt of cash as a decrease to the related receivable
(the unconditional right to receive consideration no longer exists)
10 May 20X2
Contract liability (L) Given 15 000
Reversing the contract liability and recognising it as revenue instead
since the PO is now satisfied.
Solution 2B: Contract liability – recognised when recognising the receipt

Comment:
x Notice that this solution does not process a journal entry on 1 April. This is because, since the
contract is cancellable, the due date for payment stipulated in the contract (1 April) does not give
Home Fires an unconditional right to consideration. Thus, we do not recognise a receivable.
In other words, the due date is irrelevant.
x We wait for the receipt of the consideration before processing our first journal. The receipt occurs on
30 April. Since the installation had not yet occurred on this date, the debit to the bank account will
require a contra entry of a credit to the contract liability account (i.e. reflecting the fact that the entity
still needs to perform) and not a credit to the revenue account.
x On the date that the fireplace is installed (10 May), the contract liability is reversed and recognised as
revenue instead (because the PO has been satisfied).
Recognising the receipt of cash and the obligation to install the fireplace
(contract liability)
10 May 20X2
Contract liability (L) Given 15 000
Reversing the contract liability and recognising it as revenue instead
since the PO is now satisfied.
4.6 Disclosure (IFRS 15.110 - .129)

IFRS 15 includes copious disclosure requirements. The disclosure requirements are
summarised in section 12. The basic requirement is that there must be enough disclosure that
a user of the financial statements can assess the ‘nature, amount, timing and uncertainty’ of
both the revenue and the cash flows that stem from the entity’s customer contracts. See IFRS 15.110
IFRS 15 contains significant changes in disclosure requirements from IAS 18:

One of the significant changes is that the previous IAS 18 used to require that revenue be
disclosed based on the categories of sales, services, interest, royalties or dividends.
Now revenue may be disclosed based on a variety of categories (e.g. revenue from different geographical
areas, revenue from different products, revenue from long-term contracts versus short-term contracts,
revenue from shop sales versus from online sales - as well as sales, services etc.).
5. Identifying the contract (step 1)
5.1 Overview (IFRS 15.10)

IFRS 15 only applies if it involves a contract with a customer. However, this contract need
not be in writing nor does it even need to be verbal. Instead, it could simply be implied by
virtue of the entity’s common business practice. What is important is that the rights and
obligations contained in the contract are enforceable by law. See IFRS 15.10
134 Chapter 4
5.2 The contract must meet certain criteria (IFRS 15.9)

A contract is said to exist if it meets all of the following five criteria:
a) If it is approved by all parties, who are also committed to fulfilling their obligations;
b) If each party’s rights to the goods and/or services are identifiable;
c) If the payment terms are identifiable;
d) If the contract has commercial substance (i.e. the risk, timing and amount of future cash
flows is expected to change); and
e) It is probable that the entity will collect the consideration to which it expects to be entitled. See IFRS 15.9
A contract will not exist if any one of the above five criteria are not met.
These criteria make it clear that the contract must specify both rights and obligations of all
parties to the contract. However, IFRS 15 clarifies that what Please note:
is important is that these rights and obligations must be Even if all criteria are met,
legally enforceable. As already mentioned, to be legally the contract may be
enforceable does not mean the contract must be in writing. deemed not to exist
(see section 5.3).
The concept of legal enforceability is interesting. Depending on where you are in the world
(i.e. in which geographical area you are doing business), contracts could be considered legally
binding if they are verbal or could even be considered legally binding based purely on the
entity’s ‘customary business practices’. Furthermore, it is not only which geographical area
in which you are doing business that may affect whether an agreement is legally binding: it is
also feasible for contracts within the same entity to take different forms depending on which
customer it is dealing with.
For example, an entity may insist on written contracts with certain customers but may be
happy to accept a handshake when contracting with other long-standing customers. Another
example of a customary business practice might be where a car dealership provides a
‘courtesy valet service’ at every ‘maintenance service’, where this courtesy valet service’ is
not specified in the maintenance contract. Thus, when deciding whether an entity has entered
into a legally enforceable contract, we must consider that particular entity’s ‘practices and
processes’. See IFRS 15.10
Goods and services promised in a contract are generally easily identifiable. However,
identification of goods and services can appear complex if the contract has no fixed duration:
some contracts are able to be terminated at any time or are able to be renewed continuously (e.g. a
contract to provide electricity to a customer on a monthly basis) or even renewed automatically on
certain dates (e.g. a cell phone contract to provide air-time for two-year periods and where the
contract automatically renews at the end of each two-year period). In such cases, we simply
account for the rights and obligations that are presently enforceable (e.g. the obligation to provide
electricity for a month or the promise to provide air-time for two years).
The payment terms refer to both the amount of consideration and the timing of the payments.
Revenue should not be recognised if the contract has no commercial substance. The exchange of
non-monetary items where the exchange has no commercial substance is an example of a contract
from which we would not be allowed to recognise revenue. These exchanges were specifically
excluded from IFRS 15 because entities would otherwise have been able to artificially inflate their
revenues by continually exchanging equal-valued non-monetary items with one another. An
example might be Entity A agreeing to deliver crude oil to Entity B’s customer, and Entity B
agreeing to deliver crude oil to Entity A’s customer. See IFRS 15.9(d) and BC40 and 41
A contract has commercial substance if we expect the contract to change the risk, timing or
amount of the entity’s future cash flows. To assess a transaction’s commercial substance, we
calculate the present value of the future cash flows from the contract. A present value
calculation takes into account the cash flows (amount), the effects of when payments will
occur (timing) and a discount rate that reflects the related risks (risk). See IFRS 15.9(d)
Chapter 4 135
When considering whether it is probable that the entity will collect the consideration, we
consider the customer’s ability to pay and intention to pay, but only when payment falls due.
In other words, a customer may currently not have the ability to pay but may be expected to
have the ability to pay when payment falls due.
It is also important to note that the consideration we are referring to is the consideration that
we expect to be entitled to – this may not necessarily be the price quoted in the contract. For
example, a contract could quote a price of C100 000 but if we offer a volume discount of
C10 000 to the customer on condition that he buys further goods within the month, and if we
expect that he will buy further goods within the month, then we only need to consider whether
the customer has the ability and intention to pay C90 000.
5.3 The contract may be deemed not to exist (IFRS 15.12)

A contract will not exist if any one of the above five
criteria are not met (see section 5.2). However, even if all Contracts are deemed
criteria are met, the contract will be deemed not to exist if: not to exist if:
x each and every party to the contract
all parties are equally entitled to
x has a ‘unilateral enforceable right to terminate’ terminate a contract that is wholly
x a ‘wholly unperformed contract’, unperformed, without compensating
x without providing any compensation to the other party/ies. the others.
A wholly unperformed contract is
A wholly unperformed contract is a contract where the one where the entity:
entity has not yet transferred any of the promised goods or x has not yet done anything
services, has not yet received any consideration and is not x has not yet been paid; and
yet entitled to any consideration. x is not yet owed anything. See IFRS 15.12
5.4 When the criteria are not met at inception (IFRS

15.14-.16)
It can happen that a contract does not meet these five criteria at inception. If this happens, the
entity must continually re-examine the contract in the light of changing circumstances in
order to establish whether these criteria are subsequently met. See IFRS 15.14
While these criteria are not met, any consideration received by the entity must not be
recognised as revenue. This is because we technically do not have a contract. This means that
any amounts received will need to be recognised as a liability. The reasoning behind
recognising amounts received as a liability is that it represents the entity’s obligation to either:
x provide the goods or services that it has promised to provide; or
x refund the amounts received. See IFRS 15.15-16 If criteria are not met,
receipts must be
The liability is simply measured at the amount of the recognised as a liability.
consideration received. See IFRS 15.16 The liability is transferred to
revenue when either the:
These receipts that are recognised as a liability will then either x 5 criteria are eventually met;
be recognised as revenue (i.e. debit liability and credit revenue) x entity has no further
or will be refunded (i.e. debit liability and credit bank). obligations and the receipts
are non-refundable; or the
However, the entity may not recognise the contract liability as
x contract is terminated and the
revenue until: receipts are non-refundable
x all five criteria (in para 9) are subsequently met; or
x it has no further obligations in terms of the contract ‘and all, or substantially all,’ of the
promised consideration has been received and is non-refundable; or
x The contract is terminated, and the consideration received is non-refundable. See IFRS 15.15-16
x
Example 3: Criteria not met at inception

On 5 November, a customer requested Publications Limited to print a large quantity of
magazines. The customer is not yet able to identify exactly how many magazines it will need
to have printed but insists that they will have to be printed during December.
136 Chapter 4
Publications agreed to these terms but, since December is an exceedingly busy month for the printers, it
requires the customer to pay a C5 000 deposit to secure this printing time.
This deposit will be set-off against the contract price but is non-refundable in the event that the contract
is cancelled. The deposit was paid on 12 November. The contract was cancelled on 28 November.
Required: Explain how to account for this contract.
Solution 3: Criteria not met at inception

A contract was entered into on 5 November. However, since the customer is unable to confirm how
many magazines will need to be printed, the rights and obligations cannot yet be identified. Thus at
least one of the 5 criteria to support the existence of a contract is not met. All 5 criteria must be met and
thus we conclude that a contract for purposes of IFRS 15 does not exist.
During the period that all criteria for a contract to exist are not met, any receipts must be recognised as
a liability. Thus, the deposit on 12 November must be recognised as a liability. This liability is then
recognised as revenue on 28 November since the contract is terminated and the deposit was non-
refundable. Thus, the receipt and forfeiture of the deposit are journalised as follows:
12 November Debit Credit
Refund liability (L) 5 000
Recording the receipt of a non-refundable deposit
28 November
Refund liability (L) Given 5 000
Revenue (I) 5 000
Recognising the non-refundable deposit as revenue
Comment: Although, collecting penalties is not Publication’s ordinary activities, the non-refundable
nature of the deposit is an industry norm and as such revenue in terms of IFRS 15 can still be recognised.
5.5 When the criteria are met at inception but are subsequently not met (IFRS 15.13)
Unlike the situation when the contract does not meet the criteria at inception, if a contract does meet
the criteria at inception, we do not continually reassess whether the criteria continue to be met. We
only need to reassess the situation when there is a ‘significant change in facts and circumstances’
(e.g. if we become aware that one of our customers is experiencing significant cash flow problems).
If a reassessment of the facts and circumstances leads us to believe, for example, that it is no longer
probable that that we will receive payment from the customer, it means that all 5 criteria for the
existence of a contract are no longer met. In other words, in terms of IFRS 15, we have no contract.
Since revenue from contracts with customers may only be recognised if a contract exists, we
must immediately stop recognising revenue from this contract. Furthermore, any related
receivables account that may have arisen from this contract will need to be checked for
impairment losses in terms of IFRS 9 Financial instruments. These impairment losses will
need to be presented separately. The issue of impairments is discussed in more detail when
we discuss step 3: determining the transaction price (see section 7).
Example 4: Criteria met at inception but subsequently not met
On 2 January, an entity entered into a contract with a customer. All criteria for the existence
of a contract were met on this date. The entity began to perform its obligations and duly
invoiced the customer each month for C1 000, which was deemed appropriate in terms of the contract.
On 5 May, the entity received a letter from the customer’s lawyer to say that the customer was
disputing the terms of the contract. The entity continued performing its obligations in May.
Required: Explain how the above situation should be accounted for.
Solution 4: Criteria met at inception but subsequently not met

On 2 January, all criteria for the existence of a contract were met. Thus, revenue from the contract at
C1 000 per month would have been recognised until ‘significant changes in facts and circumstances’
suggested otherwise: Debit Receivable and Credit Revenue. (See the first journal below.)
Chapter 4 137
On 5 May, a lawyer’s letter was received indicating that there was a ‘significant change in facts and
circumstances’ and which suggested that the criteria for the existence of a contract were no longer met
(the terms of the contract were under dispute).
The entity continued to perform its obligations during May, but since the contract criteria are no longer
met, the revenue may not be recognised. Instead, the entity must recognise this as a liability: Debit
Receivable and Credit Liability (it is submitted that this liability should not be called a contract liability
since the definition thereof is not met and we technically do not have a contract but could be called a
refund liability instead). (See the second journal below.)
The receivable balance would be measured in terms of IFRS 9 Financial instruments. This would mean
recognising a loss allowance to reflect the expected credit losses. No information has been given
regarding the estimation of these losses and thus the following journals do not reflect the journal
relating to the loss allowance.
Total of the journals from January to end April Debit Credit
Receivable (A) C1 000 x 4 4 000
Revenue (I) 4 000
Recording the receipt of a non-refundable deposit
May
Receivable (A) C1 000 x 1 1 000
Refund liability (L) 1 000
Recognising the non-refundable deposit as revenue
5.6 Combining contracts (IFRS 15.17)
We would account for two or more contracts as if they were a single contract:
a) if they were entered into at the same time – or nearly the same time; and
b) if they involved the same customer – or the customer’s related parties; and
c) if:
- they were ‘negotiated as a package with a single commercial objective’; or
- the amount to be paid in terms of one of the contracts ‘depends on the price or
performance of’ one of the other contract/s; or
- all or some of the goods or services that are promised in these contracts are, together,
considered to form ‘a single performance obligation’ (see section 6). IFRS 15.17 reworded
5.7 Modifying contracts (IFRS 15.18-.21)
5.7.1 What is a contract modification? (IFRS 15.18-.19)

A modification exists if:
A modification to a contract is when either the scope of work or x all parties agree
the price (or both) is subsequently changed. Modifications are x to a change in the:
also known by other terms, such as a variations or amendments. - scope; and/ or
See IFRS 15.18
- price.
Just as was the case when identifying the original contract,
a modification to a contract need not be in writing or even be verbal – it can simply be
implied. What is of importance is that it is approved by all parties in a way that makes the
changes legally enforceable.
5.7.2 Accounting for a modification (IFRS 15.19-.21) Modifications are

accounted for only if
they are enforceable.
We would account for a change to the contract only if it has See IFRS 15.18
been approved by all parties to the contract. However, this
does not mean that everything has to be agreed upon – it can happen that all parties have agreed
to a change in the scope of work, but have not yet agreed to the revised price. In this case, we
would need to estimate the new price. Estimating a new price involves ‘estimating variable
consideration’ and taking into account the ‘constraining estimates of variable consideration’
(see section 7 on ‘determining the transaction price’).
138 Chapter 4
Before we account for a change, we must consider all terms and Modifications may be
conditions to be sure that the change is enforceable. accounted for as:
Modifications that are not considered enforceable are ignored.
1 an extra separate contract
Depending on the circumstances, if the extra goods or 2 a termination of the old and
creation of a new contract
services are considered to be distinct from the original
3 part of the existing contract.
goods or services, the modification is either accounted for: See IFRS 15.20 & 21
x as an additional separate contract; or
x as a termination of the old contract and the creation of a new contract. IFRS 15.20 & .21 (a)
If the extra goods or services are not distinct, the modification will be accounted for:
x as part of the existing contract. IFRS 15.21 (b)
5.7.3 Modification accounted for as a separate contract (IFRS 15.20)
The modification is accounted for as a separate contract if the following criteria are met:
x the scope increases due to extra goods or services that are distinct; and
x the contract price increases by an amount that reflects the ‘stand-alone selling prices’ of
these extra goods or services. See IFRS 15.20
The contract price does not need to increase by an amount representing the usual stand-alone
selling prices for these extra goods or services. For example, if a contract is modified to include
extra goods or services the contract price is generally increased. It may be increased by an amount
that is less than the related stand-alone selling prices for these extra goods or services (i.e. the
contract price is increased by ‘discounted stand-alone selling prices’). This is often because the
entity may not need to incur additional costs it would have incurred to secure another customer
(e.g. selling costs that are now avoidable etc). See IFRS 15.20(b)
5.7.4 Modification accounted for as a termination plus creation of a new contract
If the modification does not meet the criteria to be accounted for as a separate contract (see
section 5.7.3), then it would be accounted for as if it were a termination of the old contract
and a creation of a completely new revised contract if, on date of modification:
x the remaining goods or services still to be transferred are distinct from
x the goods or services already transferred. See IFRS 15.21 (a)
The amount of the consideration to be allocated to this deemed new contract is the total of:
x the portion of the original transaction price that has not yet been recognised as revenue;
x plus: the extra consideration promised as a result of the modification. See IFRS 15.21 (a)
5.7.5 Modification accounted for as part of the existing contract (IFRS 15.21(b))
If the modification does not meet the criteria to be accounted for as a separate contract (see
section 5.7.3), then it would be accounted for as an adjustment to the existing contract, if on
date of modification:
x the remaining goods or services still to be transferred are not distinct from
x the goods or services already transferred. See IFRS 15.21 (a)
Accounting for the modification as if it were an adjustment to the original contract means:
x Adding the extra consideration from the modification to the original transaction price;
x Adding the extra obligation/s from the modification to the original performance
obligations that are still unsatisfied.
Since our total obligation has changed and the total transaction price has changed, we must reassess
our estimated progress towards completion of the performance obligation and make an adjustment to
the revenue recognised to date. This method of adjusting revenue is referred to as the cumulative
catch-up method and is accounted for as a change in estimate (per IAS 8, see chapter 26).
Chapter 4 139
6. Identifying the performance obligations (step 2)
6.1 Performance obligations are promises (IFRS 15.22-.23 & .25)
A performance obligation is simply a promise made by an entity to a customer, where the promise
is made within a contract, and involves the transfer certain goods or services to that customer.
This contract may include one or more performance obligations (promises).

A performance obligation is defined as:
x a promise contained in a contract,
x to transfer to a customer either:
- a distinct good or service or bundle of goods or services; or
- to transfer a series of distinct goods or services that are:
- substantially the same; and
- have the same pattern of transfer to the customer. IFRS 15 Appendix A reworded
This definition of a performance obligation refers only to goods or services that are distinct
(what makes something distinct is explained in section 6.4). Goods or services that are
indistinct will need to be bundled together until we find ourselves with a distinct bundle,
which will thus represent a single performance obligation (this is explained in section 6.5).
Where the promise involves providing a series of goods or services (e.g. a contract that
promises to mow the lawn every week for 2 years), the series will be considered distinct if the
goods or services in the series are largely the same and have the same pattern of transfer.
This is defined below:
Goods or services within a series have the same pattern of transfer if:
x the obligation to transfer each good or service in the series:
- will be satisfied over time; and
x the progress towards completion of the transfer of each good or service in the series will be:
- assessed using the same measurement method. IFRS 15.23 reworded
Not all activities necessary to complete a contract are activities necessary to complete a performance
obligation. In other words, activities that are necessary in terms of the contract but yet do not result in
the actual transfer of goods or services to the customer, would not be part of the performance
obligation (e.g. initial administrative tasks necessary in setting up a contract). See IFRS 15.25
6.2 Revenue is recognised when performance obligations are satisfied (IFRS 15.31)
It is important to identify each performance obligation (promise) contained in a customer
contract because we will be recognising the related revenue when these performance
obligations are satisfied. Some of these performance obligations will be satisfied at a single
point in time and others may be satisfied gradually over time.
6.3 Performance obligations could be explicitly stated or be implicit (IFRS 15.24)
Interestingly, the various promises could be explicitly stated in the contract or could be
implicit. An implicit promise is one that emanates from the:
x ‘entity’s customary business practice, published policies or specific statements
x if, at the time of entering into the contract,
x those promises result in the customer having a valid expectation
x that the entity will transfer a good or service to the customer’. IFRS 15.24 reworded
It is important to note that IFRS 15 only considers implicit promises that resulted in valid
expectations arising at contract inception. Any implied promises that arise after inception are
not accounted for as performance obligations under IFRS 15. Instead, any further implied
promises would need to be accounted for in terms of IAS 37 Provisions, contingent liabilities
and contingent assets.
140 Chapter 4
Example 5: Explicit and implicit promises

A car dealership signed a contract with a customer agreeing to the sale of a car for C100 000.
The dealership has been in business for 5 years.
Consider the following scenarios and explain whether the additional term is explicit or implicit and
whether this fact would affect how the transaction price is allocated:
A: The contract specifically mentions that a 3-year maintenance plan will be ‘thrown in for free’.
This maintenance plan is currently valued at C10 000.
B: During the past 5 years, all customers concluding sale agreements have been given a maintenance plan
for free. This is not stated in the contract. Similar maintenance plans are currently valued at C10 000.
C: After signing the contract with the customer, and in order to encourage the customer to purchase a
second car for her son, the dealership phoned the customer to announce that it would be giving her
a free maintenance plan with her car. The maintenance plan is valued at C10 000.
Solution 5: Explicit and implicit promises

A: Since the contract explicitly promises both a car and a maintenance plan, the transaction price of
C100 000 will have to be allocated between these two performance obligations.
B: The contract only explicitly promises the car. However, the past practice of providing a
maintenance plan to all customers who purchase a car from the dealership gives the customer a
valid expectation at contract inception. Thus, the maintenance plan is an implied promise that
existed contract inception.
The transaction price of C100 000 must be allocated between these two performance obligations
(explicit and implicit).
C: The contract does not mention a maintenance plan (i.e. no explicit promise) and, at contract
inception, past practice does not give the customer an expectation of a maintenance plan (i.e. no
implicit promise).
Thus, the transaction price is allocated entirely to the only promise (the explicit promise): the car.
Since the subsequent promise of a maintenance plan is an implied promise, it would need to be
accounted for in terms of IAS 37 Provisions, contingent liabilities and contingent assets (because it
it is an implied promise that arose after inception of the contract).
6.4 The promised transfer must be distinct (IFRS 15.26-.29)
6.4.1 Overview
The definition of a performance obligation refers to the transfer of goods or services (or a
bundle thereof) that is distinct. A good or service transferred to a customer is distinct if it is
both capable of being distinct and is distinct in the context of the contract.
Distinct: A good or service transferred to a customer is distinct if the following 2

criteria are met:
a) The good or service is capable of being distinct
This means it must be able to generate economic benefits for the customer either:
- on its own; or
- together with other resources that are readily available to the customer; and
b) the good or service is distinct in the context of the contract
This means that the promise to transfer the good or service is:
IFRS 15.27 reworded slightly
- separately identifiable from other promises in the contract.
6.4.2 The goods or services must be capable of being distinct (IFRS 15.28)
For a good or service to be capable of being distinct, the customer must be able to benefit
from it (i.e. the customer must be able to obtain economic benefits from it). Goods or services
are considered capable of generating economic benefits for the customer in any number of
ways, for example, by the customer being able to use or consume the goods or services or
being able to sell them for a price greater than scrap value.
Chapter 4 141
We consider the goods or services capable of generating economic benefits for the customer
even if these benefits will only be possible in conjunction with other readily available
resources (i.e. with other readily available goods or services). It is worth emphasising that the
customer need not already own these other necessary resources – they need only to be
resources that are readily available. These other resources (i.e. other goods or services) would
be considered readily available if they are sold separately by the entity (or any other entity).
We could also deem that the promised good or service to be capable of generating economic
benefits for the customer under certain circumstances. An example of such circumstances is
if the entity regularly sells such goods or services separately.
6.4.3 The good or service must be distinct in the context of the contract (IFRS 15.29)
For a good or service to be distinct in the context of the contract means that the promise to
transfer it must be separately identifiable from other promises made in the contract.
As a guideline, IFRS 15 mentions certain factors to be considered in deciding if a specific promise to

transfer goods or services is separately identifiable from other promises in the contract.
The following are examples of goods or services promised in terms of a contract which would
not be considered separately identifiable and would thus not be distinct in the context of a
contract. Goods or services that are:
x used as an input to create an output within the same contract: if the entity is using the
goods or services as an input to create some other promised item for the customer within
the same contract, then that good or service being used is considered to be part of this
other promised item (i.e. it is merely an input to create an output).
For example, a construction company that signs a contract agreeing to construct a
building for a customer may include a ‘contract management’ service (a service involving
a contract manager whose task it will be to ensure that all aspects of the construction will
comply with all contract specifications);
x used as an input to modify an output within the same contract: if the entity is using the
goods or services to significantly customise another good or service promised within the
same contract, then that good or service is considered to be part of the customised good or
service (i.e. it is merely an input to modify an output).
For example, a software company sells standard software to a customer but since this
software will need significant modification in order to run on the customer’s server, the
software company agrees to modify this software. In this case, the modification service is
simply an input to modify the output (the software);
x highly dependent on another good or service promised within the same contract: for
example, if it is not possible for the customer to buy the one without the other, then these
goods or services are so interdependent that they cannot be considered separately
identifiable from one another.
For example, an entity promises to create an experimental design from which it will then
manufacture 10 prototypes that will need constant re-work, after which a final workable
design will be produced. The design and manufacture performance obligations are
considered highly dependent. See IFRS 15.29 and BC107-BC112
6.5 Bundling indistinct goods or services (IFRS 15.30)
If our contract promises a good or service that is not considered to be distinct from other
goods or services promised in the contract, we will need to combine it with the other
indistinct goods or services that have been promised until we find ourselves with a bundle of
goods or services that is considered distinct.
Obviously, this process of bundling indistinct goods or services until we find ourselves with a
distinct bundle (i.e. a performance obligation) may result in all the promises contained in the
contract being considered to be a single performance obligation.
142 Chapter 4
Example 6: Distinct goods and services

Rad Building has signed a contract to construct an additional bathroom for a customer and
promises to provide all building materials, sanitary ware, electrical supplies and labour.
Required:
a) Explain whether the goods and services contained in the contract are capable of being distinct.
b) Explain whether the goods and services promised are distinct in the context of the contract.
c) Explain whether the contract contains one or more performance obligations.
d) Explain whether the goods and services contained in the contract would be considered distinct (and
thus whether the contract contains more than one performance obligation) if the contract also
includes a promise to repair the existing gutters of the customer’s house.
Solution 6: Distinct goods and services

a) Each of the individual goods (the building materials, the sanitary ware and electrical supplies) and services
(the labour involved in constructing the building, installing the sanitary ware and electrical supplies) are
capable of being distinct. This is because the customer is able to benefit from each of them separately:
- each good and service is of a type that is sold and provided to customers on a separate basis
(e.g. we can buy a bath separately from the building materials);
- the customer can generate economic benefits from each of the goods or services: it could sell
them onwards, or it could use them.
b) Each of the goods and services are not considered distinct in the context of the contract. This is
because the promises to transfer them are not separately identifiable from one another. This is
evidenced by the fact that a significant aspect to this contract is the promise to combine the goods
and services in a way that produces a bathroom (i.e. to use them as an input to create an output).
c) Although the individual goods and services promised in the contract are capable of being distinct,
they are not considered to be distinct in the context of the contract. Since both these criteria were
not met, the individual goods and services promised in the contract are not individually distinct.
However, by grouping them together they form one distinct bundle: the bathroom. The contract
thus has one performance obligation: to construct the bathroom.
d) The construction of the bathroom and the repair to the gutters of the pre-existing house are highly
independent promises: the customer could have contracted with the entity to provide the one
without the other. Since they are highly independent, these two promises are separately
identifiable. The contract thus has two performance obligations: the promise to construct a
bathroom and the promise to repair the gutters.
7. Determining the transaction price (step 3)
7.1 Overview
The transaction price is
defined as:
The transaction price is not necessarily the total price
quoted in a contract. In other words, the contract price x the amount of consideration
does not necessarily equal the transaction price. x to which an entity expects to be
entitled
x in exchange for transferring
Instead, the transaction price is the amount of consideration goods/ services to a customer,
to which the entity expects to be entitled for satisfying the x excluding amounts collected on
performance obligations contained in the contract. behalf of third parties.
IFRS 15.App A (reworded slightly)
Since the ‘transaction price’ is the total amount we expect to The transaction price is:
recognise as ‘revenue’ from the completed contract, we must the amount we expect to be
exclude from this ‘transaction price’ any amounts that are entitled to – not the amount
we expect to collect!
included in the ‘contract price’, but which are effectively
amounts to be received on behalf of third parties (e.g. if the total ‘contract price’ includes VAT, this
VAT portion must be excluded when we calculate the ‘transaction price’).
When determining this transaction price, we look only at the existing contract. In other words,
we must ignore, for example, any renewals of the contract or modifications to the contract
that may possibly be expected. See IFRS 15.49
Chapter 4 143
Factors that must be

Furthermore, the collectability of the consideration (i.e. the considered in the
possibility the entity may end up not receiving all amounts determination of the
owed to it) is not considered when we determine the transaction transaction price:
price. This is because collectability was considered as part of x variable consideration (we need to
step 1, when determining if a contract exists: the probability of estimate it and constrain it)
x significant financing components
collecting the transaction price is one of the 5 criteria that must
x non-cash consideration
be met when we decide if a contract exists (step 1).
x consideration payable to the
customer. See IFRS 15.48
However, where credit risk exists, there is always a possibility
Collectability:
that the full transaction price might not get collected. Since
x is not a factor when determining
revenue is measured at the full transaction price, any losses TP (thus it does not affect
expected due to selling on credit must be taken into account measurement of revenue), but
when measuring the related receivable or contract asset. x is a factor when measuring the
receivable.
In this regard, when we recognise the receivable (or
contract asset), we will recognise a loss allowance, reflecting the expected credit losses (debit
‘impairment expense’; credit ‘loss allowance’). The loss allowance is an ‘asset measurement
account’ (i.e. the receivable is presented net of its loss allowance in the statement of financial
position). Receivables, contract assets, and their related loss allowances, are measured
separately from revenue, and in terms of IFRS 9 Financial instruments. See example 7,
below, and also chapter 21, example 15-16.
The loss allowance relating to receivables and contract assets: covered by IFRS 9 (see chapter 21).
IFRS 9 requires us to recognise a loss allowance, measured using an ‘expected credit loss model’.
This is a forward-looking model that requires us to estimate and recognise credit losses before they occur (i.e.
before a ‘credit event’).
This differs from the previous approach where we used to recognise doubtful debts (debit ‘doubtful debt
expense’, credit ‘doubtful debt allowance’) only when evidence existed that the debtor was going bad (i.e. when
a ‘credit event’ had already occurred).
See chapter 21, section 4.5 and example 15-16 for more detail.
Example 7: Transaction price, collectability and the loss allowance

We sign a contract with a customer on 1 June 20X1. The contract price is C100 000. Collectability is
considered probable. However, based on an assessment of the credit risk of similar customers, we
expect to incur a loss of C10 000 (i.e. we expect to receive only 90%). We satisfy our performance obligation
on 20 June 20X1. At 31 December 20X1, reporting date, the expected credit loss is reassessed to be C15 000.
Required: Show the journals:
A) for 20X1 to account for the information provided above.
B) for 20X2 if the customer pays, on 15 January 20X2, an amount of C85 000, in full and final settlement.
C) for 20X2 if the customer pays, on 15 January 20X2, an amount of C100 000, in full and final settlement.
D) for 20X2 if the customer pays, on 15 January 20X2, an amount of C80 000, in full and final settlement.
Solution 7A: Transaction price, collectability and the loss allowance

Comment: Notice that
x Revenue is measured at the full transaction price, being the amount to which we expect to be entitled, not
the amount we expect to collect. Expected credit losses do not affect the measurement of revenue.
x The receivable, on the other hand, is measured in terms of IFRS 9 Financial instruments. This requires us
to recognise a separate loss allowance, showing the related ‘expected credit losses’, and a corresponding
impairment loss expense.
x The receivable at 31 December 20X1 will be presented at C85 000, which is the gross carrying amount
(C100 000) less the loss allowance (C15 000).
1 June 20X1 Debit Credit
Receivable (A) TP: Given 100 000
Revenue (I) 100 000
Impairment - credit losses (E) Given (ECLs on transaction date) 10 000
Receivable: loss allowance (-A) 10 000
Recognising the revenue when customer obtains control, and recognising
a separate loss allowance for expected credit losses
144 Chapter 4

Impairment - credit losses (E) LA to reflect ECLs at reporting date: 5 000
Receivable: loss allowance (-A) C15 000 – balance in this a/c: 10 000 5 000
Remeasuring the loss allowance at reporting date to reflect the latest
estimate of the expected credit losses
Solution 7B: Receipt from customer – no further loss allowance adjustment

Comment: Notice that, when we receive payment of C85 000 from the customer, there is no adjustment to the
loss allowance required. We had predicted the losses accurately.
15 January 20X2 Debit Credit
Bank Given 85 000
Receivable (A) 100 000
Receipt from the customer: recognise the cash received and derecognise
the receivable and the related loss allowance
Solution 7C: Receipt from customer – reversal of prior impairment loss

Comment: Notice that, when we receive payment of C100 000 from the customer, we reverse the entire prior
impairment loss (we had recognised an expected loss of C15 000 in 20X1, but actually do not incur a loss).
Impairment loss reversed (I) 15 000
Remeasuring the loss allowance to nil on date of full and final receipt
from the customer
Bank Given 100 000
the receivable (there is no balance in the loss allowance)
Solution 7D: Receipt from customer – recognising a further impairment loss

Comment: Notice that, when we receive payment of C80 000 from the customer, we recognise a further
impairment loss (we had recognised an expected loss of C15 000 in 20X1, but actually incur a loss of C20 000).
Impairment - credit losses (E) 5 000
Remeasuring the loss allowance to C20 000 on date of full and final
receipt from the customer
Bank Given 80 000
the receivable and the loss allowance
Please note that, if we entered into a contract knowing that a part of it may not be collectable,
it may be evidence of an implied price concession, which is taken into account when
determining the transaction price (see example 8).
Example 8: Transaction price: collectability versus implied price concession

An entity signs a contract on 1 January 20X1 with a new customer in a new region. The contract
price is C100 000. When the contract was signed, the entity was aware the customer had significant
cash flow problems. However, the entity believed that the customer’s financial situation would improve and
that it would probably be able to pay C60 000 when the amount falls due for payment. The entity also believed
that transacting with this new customer would possibly result in further potential customers in this region. The
entity satisfied its performance obligation on 20 January 20X1.
Required:
Discuss how this information should be considered.
Chapter 4 145
Solution 8: Transaction price: collectability versus implied price concession

Since, at contract inception, the entity believes that at least part of the contract price is recoverable, it
means there is a contract (step 1). We then need to determine the TP (step 3).
When determining the TP, we need to decide whether, by entering into this contract, the entity is either
implicitly agreeing to a price concession of C40 000 (implied price concession) or whether the C40 000
reflects a collectability problem due to the customer’s credit risk and that the entity is dealing with an
impairment of the receivable. All facts and circumstances would need to be considered in detail.
If it is found to be a price concession, then the transaction price would be C60 000 (revenue of
C60 000 will be recognised when the performance obligation is satisfied).
Receivable (A) TP: Given 60 000
Revenue (I) TP: see IFRS 15.51 60 000
Recognising revenue: transaction price adjusted since it was an
implied price concession
If it is found to be an issue of collectability, then the transaction price is the full C100 000. When the
performance obligation is satisfied, we recognise revenue of C100 000 (debit receivable; credit revenue) and
an impairment loss of C40 000 (debit loss expense; credit loss allowance). See the journals in example 7.
Comment:
x When price concessions (i.e. a reduction in the price: a discount) are offered or are possible, we are
dealing with ‘variable consideration’ (see section 7.2).
x To convert the contract price into the transaction price, we take into account the fact that we are
dealing with variable consideration (e.g. CP – potential price concession = TP).
x Only after we have determined the TP, do we consider the collectability i.e. we consider the
collectability of the TP – not the collectability of the CP.
When determining the transaction price, we also need to consider a number of other factors:
a) Whether the contract includes any variable consideration:
b) Whether the contract includes a significant financing component
c) Whether the contract includes non-cash consideration
d) Whether the contract includes consideration payable to the customer.
Each of these issues will now be discussed in more detail in sections 7.2 to 7.5.
7.2 Variable consideration (IFRS 15.50-.59) A contract may include

consideration that is
7.2.1 Overview fixed/ variable / both.
The total contract consideration could be fixed, variable or a combination thereof. Since the
transaction price must reflect the amount of consideration to which the entity expects to be entitled,
all consideration is considered for inclusion in the transaction price whether it is fixed or variable.
When dealing with fixed consideration, we simply have to estimate how much of it the entity
expects to be entitled to. However, when dealing with variable consideration, there are two
estimates: we first estimate the amount of the variable Variable consideration
consideration and then estimate how much of this the entity is included in the
expects to be entitled to. transaction price
measured by:
Since variable consideration involves significant estimation, x estimating the amount to which
there is an increased risk that we might overstate revenue. In the entity believes it will be
order to avoid this, we are further required to constrain (limit) entitled; and
our estimate of the variable consideration. x constraining (limiting) the
estimate to an amount that has a
Thus, we will need to decide how much of this variable high probability of there being
consideration to include in the transaction price by: no significant reversal of
revenue in the future.
x estimating the amount to which we think we will be
entitled; and then
x constraining (i.e. limiting) this estimate to the amount that has a high probability of not
resulting in a significant reversal of revenue in the future.
146 Chapter 4
7.2.2 When is consideration considered to be variable? Consideration may be

considered variable due
Variations in the consideration can come in many forms. to:
Examples include discounts, rebates, refunds, performance x contractual terms; or
bonuses (or even penalties), price concessions and other x the customer having a valid
incentives. See IFRS 15.51 expectation of a price concession;
or
Consideration is considered variable if any one of the x the entity having the intention, at
following criteria are met: inception, to give a price
x the contractual terms explicitly state how the concession.
See IFRS 15.52
consideration may vary;
x the ‘entity’s customary business practice, published policies or specific statements’ have
given the customer a valid expectation that the entity will give a price concession; or
x other facts and circumstances suggesting that the entity intended, at contract inception, to
provide a price concession. See IFRS 15.52
A price concession (see section 7) is often called a discount, rebate or credit.
Example 9: Variable consideration - discounts

Anastasia Limited sold inventory to a customer for C100 000, on credit. This customer
qualified for a trade discount of 10% off this price. The customer obtained control of the
inventory on 1 February 20X2. A further discount of 5% is offered off the contract price to those
customers who pay within 30 days. Based on experience, Anastasia expects most of its customers to
pay within this time frame. This customer paid within 20 days (on 20 February 20X2).
Required: Provide the necessary journals to account for the above information.
Solution 9: Variable consideration - discounts

The contract price is C100 000, but we first consider all discounts in determining the transaction price.
x Trade discount: The trade discount is not variable as we know the customer qualifies for this
discount. Thus, we know that we will not be entitled to C10 000 of the contract price (C100 000 x
10%) – thus our transaction price is reduced by the trade discount.
x Settlement discount: It is not certain that the customer will qualify for the settlement discount and
thus the further discount of C5 000 is variable consideration.
The existence of the potential settlement discount effectively means that our contract price includes:
x variable consideration: C5 000 (C100 000 x 5%) and
x fixed consideration: C85 000 (Contract price C100 000 – Trade discount: C10 000 – variable
consideration: C5 000).
Since the entity expects the settlement discount to be granted, the transaction price is based on the
reduced contract price.
1 February 20X2 Debit Credit
Receivable (A) 100 000 – Trade discount: 10 000 90 000
Receivable: settlement discount allowance (-A) C100 000 x 5% 5 000
Revenue (I) Balancing 85 000
Recognising the revenue when customer obtains control, net of discount
Bank (A) 100 000 – trade discount: 10 000 – settlement discount: 5 000 85 000
Receivable: settlement discount allowance (-A) 5 000
Recognising the receipt from the customer
Note: If the customer did not pay on time, the allowance account would then be transferred to revenue
(debit bank C90 000, credit receivable C90 000 and debit receivable: settlement discount C5 000, credit
revenue C5 000).
Comment: This example did not involve constraining the estimate. This is because we reduced the
transaction price by the full settlement discount offered. In other words, the variable consideration was
excluded entirely from the transaction price (TP).
Chapter 4 147
Variable discounts (e.g. the amount of C5 000 in the above example), are accounted for by reducing
the revenue recognised. However, we do not reduce the specific customer’s receivables account with
this discount until the customer successfully qualifies for the discount. Hence, a settlement discount
allowance account (a ‘negative asset’; being an asset account with a credit balance) is created as an
interim measure until the entity knows if the customer will qualify for the discount.
x In so doing, the statement of account sent to the customer will show the full balance
owing, but the statement of financial position will reflect a net receivables balance
(receivables account – settlement discount allowance account).
x If the customer does not pay in time to qualify for the discount, the settlement discount
allowance account is reversed and recognised as revenue.
7.2.3 Estimating the variable consideration (IFRS 15.53 - .54)
There are two methods that are available for estimating the variable consideration:
x the ‘expected value’ method; and
x the single ‘most likely amount’ method.
Which method to use is not a free choice: we must choose the method that is expected to be the
best predictor of the consideration to which the entity will be entitled. IFRS 15 states that:
x The ‘expected value method’ is probably ideal for situations where there are many
similar contracts on which to base the estimates of the possible outcomes; whereas
x The ‘most likely amount’ method would probably be best suited to a contract wherein
there are only two possible outcomes. See IFRS 15.53
The two measurement methods for variable consideration
The expected value method entails: The most-likely amount method entails:
x identifying the various possible x identifying the various possible amounts
amounts of consideration; of consideration; and
x multiplying each of these by its x selecting the single amount that is that
relative probability of occurring; and contract’s most likely outcome.
x adding together each ‘probability-
See IFRS 15.53 (a) See IFRS 15.53 (b)
weighted amount’.
When using the ‘expected value’ method, although we are required to consider all ‘historical,
current and forecast’ information that is reasonably available to us, we are not required to
include in the calculation each and every consideration amount that is possible. Instead, we
need only include a ‘reasonable number’ of possible consideration amounts.
For example,
If we estimate that there may be anything up to 100 or so different amounts possible, we do not
need to calculate and assess the probability of each and every one of these possibilities when
calculating our expected value, but may base our expected value calculation on just a selection of
possible amounts that we feel will give us a reasonable estimate of the outcome (i.e. ‘a reasonable
estimate of the distribution of possible outcomes’ IFRS 15.BC201). So if, for example, 80 of the 100
outcomes are considered to be highly unlikely, we could base our expected value calculation on
only the remaining 20 outcomes that we feel are more likely to occur – or we could base our
calculation on only those outcomes we feel are most likely to occur. The decision as to what is
considered a ‘reasonable number’ of possible outcomes will need our professional judgement.
Once we decide which method to use when estimating the variable consideration, we must
apply it consistently throughout the period of the contract. However, a contract may include
different types of variable consideration, in which case different methods may be used to
estimate each of these different type. See IFRS 15.BC202
At the end of each reporting period, we must reassess the estimates of variable consideration
and if necessary, account for a change in the estimated transaction price. See IFRS 15.59
148 Chapter 4
Example 10: Estimating variable consideration – the two methods of estimation

Estimating when the distribution is continuous
Fundraising For All (FFA) provides its clients with various initiatives to help raise funds to
support that client’s cause, for example, hosting music festivals, corporate fundraising events, school
book fairs etc. It entered into a contract with Desperate Dan, who was trying to raise funding for the
rescue and housing of donkeys that had been mistreated.
In this contract, FFA agreed to arrange and market a series of children’s plays to be held over the
months of September to December. The plays would take place in tents erected in and around the
province and all money collected would go towards funding Desperate Dan’s ‘Donkeys in Distress’. In
exchange for this, FFA would be paid a sum of C100 000 and would receive a performance bonus of
anything between C0 and C300 000 depending on the number of plays presented during the period.
When preparing the following schedule of expected performance bonuses from this contract, FFA
considered previous contracts that were similar to this one, current economic trends relating to
fundraising events and its projections for other similar projects.
Performance bonus: Probability:
C %
10 000 15%
80 000 20%
180 000 25%
240 000 40%
100%
Required:
a) Explain which method should be used to estimate the variable consideration.
b) Calculate the estimated variable consideration using your chosen method, but do not attempt to
constrain the estimate.
c) Assuming that the process of constraining of the estimate was not a limiting factor in any way (i.e.
the estimated variable consideration is an amount that is highly probable of not resulting in a
significant reversal of revenue in the future), calculate the estimated transaction price.
Solution 10: Estimating variable consideration – continuous distribution

a) Since the range of possible outcomes is constituted by a continuous range of anything between C0 and
C300 000 (i.e. not constituted by individual amounts, one of which is the most likely), the ‘most likely
amount’ method may not be used. Thus, the ‘expected value’ method is the most appropriate.
b) The estimated variable consideration is measured at its expected value of C158 500.
The measurement of its expected value is as follows:
Performance bonus: Probability: Expected value
C % C
10 000 15% 1 500
80 000 20% 16 000
180 000 25% 45 000
240 000 40% 96 000
100% 158 500
c) Assuming the constraint was not a limiting factor, the estimated transaction price would be
C258 500 (fixed consideration: C100 000 + variable consideration: C158 500).
Example 11: Estimating variable consideration – the two methods of estimation
Estimating when the distribution is discontinuous (i.e. the
distribution includes a limited number of ‘discrete amounts’)
This example uses the same information given in the previous example, except that the performance
bonuses are not simply anything between C0 to C300 000, but instead are discrete amounts as follows:
Performance bonus: If number of plays presented is
C between:
0 0 – 24
100 000 25 – 48
200 000 49 – 60
300 000 61 – or more
Chapter 4 149
FFA prepared the following schedule of expected performance bonuses:

C %
0 30%
100 000 30%
200 000 35%
300 000 5%
100%
Required:
a) Calculate the estimated variable consideration using the ‘expected value’ method – but before
considering the effects of constraining the estimate.
b) Calculate the estimated variable consideration using the ‘most likely amount’ method – but before
considering the effects of constraining the estimate.
c) Explain why we cannot yet calculate the estimated transaction price.
Solution 11: Estimating variable consideration – discontinuous distribution
a) Using the ‘expected value’ method, the estimated variable consideration is C115 000. However,
this estimate is before considering the required ‘constraining of the estimate’.
The measurement of the expected value is as follows:
Performance bonus: Probability: Expected value
C % C
0 30% 0
100 000 30% 30 000
200 000 35% 70 000
300 000 5% 15 000
100% 115 000
b) Using the ‘most likely amount’ method, the estimated variable consideration is C200 000. This
is because C200 000 reflected the highest probability of occurring (35%). However, this estimate
of C200 000 is before considering the required ‘constraining of the estimate’.
c) We cannot yet calculate the transaction price because, although we have the fixed consideration
and have an estimated variable consideration, this estimated variable consideration is not yet
final since we have not yet applied the principle of constraining the estimate.
The process of
7.2.4 Constraining the estimate (IFRS 15.56) constraining the
estimated variable
When calculating the amount of estimated variable consideration:
consideration to include in the transaction price, we may be The transaction price may only
include the estimated variable
faced with significant uncertainties. These uncertainties consideration to the extent that:
increase the risk that we may misinterpret something, and a x ‘it is highly probable
misinterpretation may result in revenue being overstated or x that a significant reversal
understated. Since the revenue line-item is critical to many x in the amount of cumulative
users of financial statements, we must be sure that our revenue recognised
estimates are as robust as possible. Furthermore, when dealing x will not occur
with revenue, the risk of overstatement is a particular concern. x when the uncertainty associated
with the variable consideration is
subsequently resolved’.
Thus, in order to limit volatility in our revenue estimates, IFRS 15.56
and also to avoid significant overstatement of our revenue,
we apply the principle of including only that portion of the estimated variable consideration
that we believe has a ‘high probability’ of not resulting in a ‘significant reversal’ in the future
of the ‘cumulative revenue recognised’ to date.
In other words, we only recognise variable consideration to the extent that we can reliably
measure it without there being a high probability of an excessive reduction in our estimated
revenue in the future. See IFRS 15.56
Applying this principle is referred to as the process of constraining (limiting) the estimate.
150 Chapter 4
Example 12: Estimating variable consideration – constraining the estimate

An entity has entered into a contract, which has a fixed consideration of C400 000 and a
variable consideration estimated at C300 000 (estimation based on its expected value).
The amount of variable consideration that would be highly probable of not resulting in a significant
reversal of the cumulative revenue recognised to the date that the uncertainty is resolved, is C250 000.
Required: Explain the calculation of the final estimated transaction price.
Solution 12: Estimating variable consideration – constraining the estimate

The contract includes both fixed and variable consideration, both of which must be considered for
inclusion in the transaction price.
The variable consideration was first estimated at C300 000 based on the ‘expected value’ method.
However, in order to prevent overstatement of revenue, we must constrain this estimate to an amount
that is not expected to result in a significant reversal of cumulative revenue recognised to the date that
the uncertainty is expected to eventually be resolved. This amount is estimated to be C250 000.
Thus, the total transaction price that we plan to recognise as revenue is C650 000 (fixed consideration:
C400 000 + constrained estimated variable consideration: C250 000).
If we look carefully at the wording of paragraph 56 (see Highly probable = likely

pop-up explaining the process to constraining variable to occur
consideration on the previous page), the calculation of the See IFRS 15.BC211
constraint (i.e. the amount to which the estimated variable

consideration must be limited) involves assessing both:
x the probability of a revenue reversal (i.e. is it highly probable?); and
x the amount of the possible revenue reversal (i.e. is it significant?). See IFRS 15.57
There are no criteria to determine either whether a potential The significance of a
reversal is considered highly probable to occur or whether the potential reversal of
amount of a particular reversal would be considered significant. revenue is determined by:
Thus, professional judgment is required for both these aspects. x considering the reversal in relation to
x the total consideration recognised
A reversal is considered to be probable of occurring if it is to the date of this reversal.
See IFRS 15.56
more likely than not to occur (using the definition of
‘probable’ from IFRS 5 Non-current Assets Held for Sale & Discontinued Operations).
The significance of the amount of a potential reversal of Highly probable
revenue on the date that the uncertainty clears up must be
x highly probable = not defined, but
considered in relation to the entire contract revenue
x it seems to suggest ‘likely’
recognised (i.e. including both the fixed and variable
consideration recognised). What is considered to be Reasons:
significant to one entity will not necessarily be significant x probable = defined in IFRS 5 as:
to another entity. Thus, professional judgement will be more likely than not, and thus
needed in deciding what is significant. x highly probable =
more likely than ‘more likely than not’ =
Although there are no criteria to determine whether a which roughly equates to ‘likely’.
potential reversal is highly probable to occur, there may be See IFRS 15.BC211
indicators that there is an increased risk that a reversal is Deciding whether a

highly probable of occurring or that it may be significant. significant reversal is
highly probable, entails
Examples of such indicators (given in IFRS 15) include: considering:
x the amount of the variable consideration will be highly x the entity’s ability to estimate
affected by external factors (i.e. factors that the entity (e.g. due to lack of experience on
similar contracts or the complexity
cannot influence, such as the weather, economic state of the contract) and
of the country, market price of shares, actions of third
x whether factors beyond the
parties, technological advancements by competitors); entity’s control may affect the
x the amount of the variable consideration will only be variable consideration.
decided after a long time;
Chapter 4 151
x the entity is unable to reasonably predict the variable consideration because it has limited
experience with similar contracts;
x the entity is unable to reasonably predict the variable consideration because, although it
has had experience with other similar contracts, the various outcomes have been so varied
that they have not provided a pattern on which predictions may be made (i.e. the
experience does not provide predictive value);
x the contract has a large number of outcomes and these outcomes represent a broad range
of possible consideration amounts. See IFRS 15.57
Example 13: Estimating variable consideration – determining the constraint

An entity signed a contract in which the promised consideration includes fixed consideration of
C100 000 and variable consideration, estimated using the expected value method, of C90 000.
The entity has estimated that the amount of the variable consideration that is highly probable of not
resulting in any future reversal of revenue is C80 000 but the accountant is unsure whether this means
that going ahead and recognising the variable consideration of C90 000 would mean that the potential
reversal of C10 000 would be considered significant in terms of IFRS 15.
The accountant has determined that, when the entity finally knows the amount of variable consideration
that it will receive, the entity will have already recognised revenue to the extent of 10% of the fixed
consideration and 100% of the estimated variable consideration.
The entity considers amounts equal to or greater than 7% of revenue to be significant.
Required: Explain whether the estimated variable consideration should be constrained and calculate
the estimated transaction price.
Solution 13: Estimating variable consideration – determining the constraint

Answer: Transaction price = C180 000 (fixed consideration: C100 000 + variable consideration: C80 000).
Discussion:
Variable consideration (VC) should only be included in the transaction price (TP) to the extent that it is
highly probable that a reversal of revenue, which is significant relative to the cumulative revenue
recognised to date, will not be necessary in the future when the uncertainty is resolved.
We are told that if we include VC at C80 000, it is highly probable that a future reversal of revenue will
not be necessary. However, the future reversal that we are trying to avoid (C10 000) must also be
significant before we consider constraining the VC (i.e. if the amount of the possible reversal is not
significant, we would include the full VC of C90 000). When deciding whether this possible future
reversal is significant, we must consider whether it is significant relative to the cumulative revenue that
will have been recognised by the time we expect the uncertainty to be resolved.
If we included the full VC of C90 000, the cumulative revenue that would have been recognised by the
time the uncertainty was resolved, would be C100 000, calculated as follows:
C
Fixed consideration C100 000 x 10% (% given) 10 000
Variable consideration C90 000 x 100% (% given) 90 000
Cumulative revenue recognised to date 100 000
If we included the full VC of C90 000 and the reversal of C10 000 then became necessary, it would
represent 10% of the cumulative revenue recognised to date (Reversal: C10 000 / Cumulative revenue:
C100 000). Since this is greater than the 7% threshold applied by this entity (given), this potential
reversal of C10 000 is considered significant.
Since we are told that C80 000 is the amount that is highly probable of not leading to a reversal and we
have since proved that this potential reversal (C10 000) that we are trying to avoid would be considered
significant relative to the cumulative revenue recognised to the date when the uncertainty is expected to
resolve itself, the estimated variable consideration of C90 000 should be constrained to C80 000.
Constraining estimated variable consideration differs from one situation to another. Let us now
look again at a prior example (example 11) in which we estimated the variable consideration but
stopped short of constraining the estimate. Notice that, in this example, the method of estimating
variable consideration where it involves a range of outcomes that is discontinuous (i.e. the range
is constituted by a specific number of distinct amounts rather than a continuous range of
possibilities) will also have an impact on how the estimate is constrained.
152 Chapter 4
Example 14: Estimating variable consideration – effect of a constrained estimate

on the transaction price
This example uses the same information given in example 11 except that we now consider the
effects of constraining the estimate. The information is repeated here for your convenience.
A fixed sum of C100 000 is payable plus a performance bonus, dependent on how many plays are
presented. The performance bonuses are discrete amounts as follows:
Performance bonus: If number of plays presented is
C between:
0 0 – 24
100 000 25 – 48
200 000 49 – 60
300 000 61 – or more
FFA prepared the following schedule of expected performance bonuses:
C %
0 30%
100 000 30%
200 000 35%
300 000 5%
100%
Required:
a) Calculate the estimated variable consideration using the ‘expected value’ method and apply the
principle of constraining the estimate and then calculate the final estimated transaction price.
b) Calculate the estimated variable consideration using the ‘most likely amount’ method and apply the
principle of constraining the estimate and then calculate the final estimated transaction price.
Solution 14: Estimating variable consideration – effect of a constrained estimate on the

transaction price
a) Using the ‘expected value’ method, the estimated variable consideration is C115 000 (see
calculation in part (a) of example 11). However, this estimate is before considering the required
‘constraining of the estimate’.
When constraining the estimate, we must limit the estimated variable consideration to an amount
that is highly probable of not resulting in a significant reversal of revenue in future.
When calculating the expected value of a discontinuous range (i.e. a range made up of distinct
amounts), we will often end up calculating an amount that is technically not possible.
This is exactly what has occurred in this example: our expected value is C115 000 and yet we
know that this is not one of the possible bonuses. Thus, in this situation, the principle of
constraining the estimate requires us to limit the variable consideration to an amount that is one of
the distinct amounts possible. Thus, we would constrain the estimate of C115 000 to C100 000.
The reason we cannot leave it at C115 000, is because to receive C115 000 will require us, in reality,
to achieve a bonus of C200 000 or more and, looking at the probabilities, we only have a 40% chance
of achieving this i.e. we will need to present 49 or more plays (5% + 35%). In other words, we have a
high probability (100% - 40% = 60%) of not achieving a bonus of at least C200 000. Since it is
currently highly probable (i.e. likely) that we will not achieve a bonus of C200 000, the extra C15
000 will be highly probable of needing to be reversed out of revenue in future.
Thus, the estimate of C115 000 (based on the ‘expected value’) must be constrained to C100 000
since it is highly probable (30% + 30% = 60%) the latter will be received and thus it is highly
probable that there will not be a significant reversal of revenue.
The total estimated consideration will thus be C200 000 (fixed consideration: C100 000 + variable
Note: this solution assumes that the potential reversal of C15 000 is considered to be significant in
relation to the total potential consideration recognised of C215 000 (fixed consideration: C100 000
+ variable consideration: C115 000).
Chapter 4 153
b) Using the ‘most likely amount’ method, the estimated variable consideration is C200 000. This is
because C200 000 is the outcome that has the highest probability of occurring (35%). However,
this estimate of C200 000 is before considering the required ‘constraining of the estimate’.
When constraining the estimate, we must limit the estimated variable consideration to an amount
that is highly probable of not resulting in a significant reversal of revenue in future.
To include variable consideration of C200 000 in the transaction price, we must believe that it is
highly probable that this amount will not result in a significant reversal in the future. However,
when we look at the probabilities, we can see that, given that this would require us to present 49 or
more plays, there is actually only a 40% chance (5% + 35%) of achieving a bonus of C200 000.
This means that there is a high probability (60%) of a significant reversal of revenue in the future.
In contrast, there is a 70% chance (5% + 35% + 30%) of achieving the next best bonus of
C100 000. Thus, recognising as revenue the estimate of C200 000, while being aware that,
currently, the highly probable bonus is C100 000, means that we would be facing a highly probable
reversal of C100 000 (C200 000 – C100 000).
Thus, the estimate of C200 000 (based on the ‘most likely amount’) must be constrained to
C100 000 since it is highly probable the latter will be received and thus it is highly probable that
there will not be a significant reversal of revenue.
The total estimated consideration will thus be C200 000 (fixed consideration: C100 000 + variable
Note: this solution assumes that the potential reversal of C100 000 is considered to be significant in
relation to the total potential consideration recognised of C300 000 (fixed consideration: C100 000
+ variable consideration: C200 000).
7.2.5 Refund liabilities (IFRS 15.55)

A refund liability is
As you have no doubt gathered, the uncertainties affecting measured as:
variable consideration mean that we tend to err on the side x the amount received (or
of caution: we carefully estimate the variable consideration receivable)
and then we constrain this estimate. x less: the amount the entity
expects to be entitled to (i.e.
the amount included in the
Thus, the variable consideration that gets included in the transaction price).
transaction price (i.e. the constrained estimate) is often See IFRS 15.55
lower than the amounts of consideration actually received.
Until such time as the uncertainty resolves itself (i.e. and the variable consideration becomes
fixed), if our customer happens to pay us more than the variable consideration that we have
included in the transaction price (i.e. more than we are currently prepared to recognise as
revenue), this excess must be recognised as a refund liability.
This refund liability represents our obligation to refund this excess amount received if our
estimates are proved correct.
We do not have to have received any consideration before we recognise a refund liability. It is
possible, for instance, to be owed an amount before we are prepared to recognise it as revenue.
For example, a contract could require a customer to pay the entity part of the consideration as
a deposit (say C10 000), part of which may be refunded depending on future events.
Assuming the deposit owed by the customer (variable consideration), is constrained to nil (i.e.
on the expectation that the full C10 000 will be refunded), the entity would recognise a
receivable of C10 000 and a refund liability of C10 000.
Refund liabilities can also arise in relation to the sale of goods that are sold with the ‘right of
return’. How to account for goods that are sold with the ‘right of return’ are explained in
detail in section 7.2.6.3.
Please note, however, that refund liabilities only reflect obligations to refund the customer –
they do not include obligations under warranties. Warranties are explained in section 11.
154 Chapter 4
Example 15: Receipts exceeds constrained estimate of variable consideration

An entity has signed a contract with customer X in which the promised consideration is
entirely represented by variable consideration estimated at C90 000 (based on its expected value) and
which was constrained to C80 000.
By the end of the reporting period, the entity had recognised C64 000 (80%) of this variable
consideration based on the performance obligations completed to date. The customer made its first
payment a few days before reporting date. The amount received from this customer was C70 000.
Required: Prepare the journal entry to reflect the information provided.
Solution 15: Receipts exceeds constrained estimate of variable consideration

Debit Credit
Revenue from customer contracts (I) 64 000
Recording the revenue from the contract with customer X – this is based
on 80 % of the constrained estimate of C80 000
Accounts receivable (A) The balance in this account 64 000
Refund liability (L) Balancing: 70 000 – 64 000 6 000
Recording the receipt from the customer
7.2.6 Specific transactions involving variable consideration (IFRS 15.50-.51)
7.2.6.1 Overview
There are many different types of transactions that involve the issue of variable consideration.
However, it may be helpful if we look at a few specific and fairly common transactions:
x contracts involving a volume rebate;
x contracts involving a sale with a right to return; and
x contracts involving royalties earned from licensed intellectual property that are calculated
based on either sales or usage.
7.2.6.2 Contracts involving a volume rebate (IFRS 15.51 & .55 & B20 – B27)
When a contract includes the offer of a reduced price (e.g. a volume rebate) based on, for
example, a threshold sales volume, we need to take this into consideration when determining
the transaction price. This is variable consideration because we do not know whether the
threshold will be reached. We thus estimate the transaction price based on the amount to
which we expect to be entitled and ensure that this estimate is constrained where necessary.
Any portion of the contract price that is not included in the transaction price and will not be
recognised as revenue will thus be recognised as a refund liability.
This refund liability will need to be reassessed at each reporting date and any adjustments will
be accounted for in revenue.
Example 16: Variable consideration – volume rebate

An entity sold 500 tennis racquets to a customer for C100 each on 1 June 20X8.
The entity offers a volume rebate of 10% off the contracted price if a customer purchases more than
2 000 racquets before 31 December of a year. This rebate is offered retrospectively.
At the time of the sale, it was expected that this customer would qualify for the rebate. However, by
31 December, the customer had not purchased any further racquets due to being forced to close a
number of shops.
Chapter 4 155
Solution 16: Variable consideration – volume rebate

Accounts receivable (A) 500 x C100 5 000
Refund liability (L) 500 x C100 x 10% 500
Revenue from customer contracts (I) 5 000 x (100% - 10%) 4 500
Recognise revenue (amount we expect to be entitled to) and refund
liability (amount we expect to refund by way of a rebate)
31 December 20X8
Refund liability (L) 500 x C100 x 10% 500
Revenue from customer contracts (I) 500
Adjustment to refund liability and revenue when uncertainty is resolved
7.2.6.3 Contracts involving a sale with a right of return (IFRS 15.51 & .55 & B20 – B27)
A sale of goods with a right of return occurs when the A sale with the right of
customer has the right to return the goods to the entity. As return involves variable
consideration:
such, it involves variable consideration because we can’t be
certain how much of the consideration we will get to keep x consideration for the products we
and how much we may have to refund in the event that expect will be returned is not
included in the TP (i.e. it must be
goods are returned. recognised as a refund liability –
not revenue);
When accounting for a right to return, we only consider the x consideration for the products
possible return of goods that would have commercial that we expect won’t be returned
substance. In other words, a sale of goods to a customer is included in the TP (i.e. it will be
who may exchange goods purchased for a different size or recognised as revenue) – we must
estimate this variable
colour is not a right of return that would be accounted for
consideration & constrain it with
because this exchange would have no effect on our net reference to the expected
assets or profit (i.e. no adjustment is made for these returns.
exchanges).
The ability to return defective goods is not considered to be a ‘sale with a right of return’.
Instead, the return of defective goods is accounted for as a ‘return under warranty’ (see
section 11.2).
A sale with the right of
If we sell an item to a customer and, at the same time, we return does not refer to:
offer the customer a right to return it, we must exclude the x exchanges that have no commercial
consideration for these items from the transaction price if substance (changing a shirt for a
the entity expects them to be returned. This should make different colour/ size);
sense because, if you recall, the transaction price reflects x A return of defective goods (these
the amount of consideration to which the entity expects to are returns under warranty).
be entitled. Thus, if an entity expects that certain goods
may be returned, it cannot say that it expects to be entitled The refund resulting from
a return need not be in full
to the consideration for these goods. Since the consideration or be in the form of cash:
for these goods is thus excluded from the transaction price,
it means it cannot be recognised as revenue and would thus x it could be a full or partial refund
be recognised as a refund liability instead. x a refund could come in the form
of cash or credits that the
customer could use or as an
The remaining promised consideration (i.e. the entirely different product. .
consideration to which the entity expects to be entitled – or,
in other words, the consideration for the goods or services that the entity does not expect to be
returned), is variable consideration since we cannot be certain as to what will or will not be
returned. Thus, for the purpose of including it in the transaction price (and ultimately in
revenue), we estimate how much of the consideration is variable and then constrain this
estimate, based on the products that we expect will be returned. This constrained variable
consideration (i.e. reflecting the sale of goods that we do not expect will be returned) is
included in the transaction price and will thus be recognised as revenue.
156 Chapter 4
In addition to splitting the contract price between what will be included in the transaction price
(revenue) and what will be excluded from the transaction price (refund liability), we must also
recognise an asset that reflects the right to recover the goods that the customers must physically
return in exchange for the refund.
This right to recover goods (an asset) is measured in the same way that we measure the amount that
would be expensed if it was sold (i.e. cost of sales expense, in the case of inventory sold). However,
this measurement must then be adjusted for any costs that the entity expects it will have to incur in
recovering these goods. These adjustments would also include any decreases in the value of the
goods, (e.g. due to the fact that they are no longer new or are missing their packaging).
At each reporting period, we would then have to reassess our estimation of the:
x refund liability – any adjustment will be recognised in revenue; and
x refund asset (right to recover the goods) – any adjustment will be recognised in cost of sales expense.
Summary: The accounts to be recognised when accounting for a right of return
Goods not expected to be returned Revenue

And
Contract price Cost of sales expense
Goods expected to be returned Refund liability

And
Refund asset (the right to
recover the goods)
Example 17: Variable consideration – sale with right of return

An entity sold 500 vests to a long-standing customer for C10 each (each cost C7). The
customer intends giving these vests to people attending an environmental event.
x Surplus vests may be returned if they are returned in good condition before 15 January 20X1.
x Using expected values, the entity estimates the customer will return 100 vests. This estimate was not
constrained as it is highly probable it will not lead to a significant reversal of revenue in the future.
x The customer took delivery of the 500 vests on 5 January 20X1.
x On 12 January 20X1, the customer returned 80 vests and paid for the 420 vests used.
Solution 17: Variable consideration – sale with right of return

Accounts receivable (A) 500 x C10 5 000
Refund liability (L) 100 x C10 1 000
Revenue from customer contracts (I) (500 – 100) x C10 4 000
Recognise revenue (amount we expect to be entitled to) and refund
liability (amount we expect to refund)
Cost of sales (E) (500 – 100) x C7 2 800
Right of return asset (A) 100 x C7 700
Inventory (A) 500 x C7 3 500
Recognising the cost of the sale and the right of return asset (cost of the
inventories we expect to recover when the customer returns his vests)
12 January 20X1
Refund liability (L) 100 x C10 1 000
Revenue from customer contracts (I) 20 x C10 (not returned) 200
Accounts receivable (A) 80 x C10 (returned) 800
Bank (A) 420 x C10 4 200
Adjusting the refund liability by adjusting revenue for the goods that
were not returned, reduce the receivable by the remaining refund liability
being the goods that were returned & recognising the cash received
Chapter 4 157
12 January 20X1 continued … Debit Credit

Cost of sales (E) 20 x C7 140
Inventory (A) 80 x C7 560
Right of return asset (A) 700
Reverse right of return asset: uncertainty is resolved: partly expensed (20
shirts not returned) and partly re-capitalised to inventory (80 shirts returned)
7.2.7 Reassessment of variable consideration (IFRS 15.59 and .87-.89)
The transaction price, which is estimated at contract inception, must be re-estimated at every
reporting date to reflect the circumstances at this date and the change in circumstances during
the reporting period.
Any change in the transaction price must be allocated to performance obligations on the same
basis that the original transaction price was allocated at contract inception. If one or more of
these performance obligations have already been satisfied, the related revenue from this
performance obligation will have already been recognised. Thus, if the transaction price
increases (or decreases), the portion of the increase (or decrease) that relates to this satisfied
performance obligation will be recognised as an increase (or decrease) in revenue.
7.2.8 Exception to estimating and constraining variable consideration (IFRS 15.58)
An entity may sign a contract with a customer wherein the entity will earn royalties from
allowing the customer to use certain licensed intellectual property. The promised
consideration may be calculated in many ways but if it is calculated based on how many items
under licence the customer sells or uses, the promised consideration is clearly variable
consideration (because we won’t know how many items the customer will sell or use).
However, although it is variable consideration, we would not apply the usual principle of
estimating the variable consideration and then constraining this estimate. Instead, royalty
consideration from licensed intellectual property that is calculated based on sales or usage
will only be recognised as revenue when the customer sells or uses the items under licence.
Thus, at this point, there would be no variability to account for.
7.3 Significant financing component (IFRS 15.60-.65)
7.3.1 Overview A financing component

exists if there is a
If a contract includes a significant financing component, we difference between:
must exclude the effects thereof from the transaction price. x the timing of the payment &
x the timing of the performance.
In other words, the transaction price should reflect the cash See IFRS 15.61
selling price when (or as) the customer obtains control.

Another way of putting this is that the transaction price must be adjusted for the time value of
money - we need to remove the effects of the financing from the promised consideration in
order to calculate the contract’s true transaction price.
The related interest is then recognised separately using an appropriate discount rate over the
period of the financing using the effective interest rate method in terms of IFRS 9 Financial
instruments. See IFRS 15.IE140
The reason why we need to separate the effects of financing is because the economic
characteristics of a transaction that involves providing goods or services and a transaction that
involves financing are different. See IFRS 15.BC246
The fact that financing is being provided need not be explicitly stated in the contract – it can
simply be implied by the payment terms. This means that, whether or not the contract states
that it includes an element of financing, a financing component is deemed to exist if the
timing of the payment differs from the timing of the transfer of the good/ service. See IFRS 15.60
158 Chapter 4
We also need to realise that it could be either the entity or the customer providing financing:
x If the customer pays in advance (i.e. before he receives control over the goods or services), then
the customer is providing finance and
the entity is receiving the benefit of the financing.
Thus, the entity may need to recognise a finance expense. See IFRS 15.62
x If the customer pays in arrears (i.e. after he receives control over the goods or services), then
the entity is providing finance and
the customer is receiving the benefit of the financing.
Thus, the entity may need to recognise finance income (in terms of IFRS 9 - not IFRS 15).
For practical purposes (referred to as a practical expedient), IFRS 15 allows us to ignore the
time value of money if, at inception of the contract, this financing component is not considered
significant to the contract as a whole, and the period between the customer obtaining control
and the receipt of the consideration is expected to be 12 months or less. See IFRS 15.63
Example 18: Significant financing component – arrears versus advance

An entity signed a contract with a customer to transfer goods to the customer in exchange for
promised consideration of C100 000.
The timing of the transfer and the timing of the payment differ.
After considering this time-difference, and all other facts and circumstances, the accountant correctly
concluded that the contract includes a significant financing component.
The difference between the promised consideration and the cash selling price on the expected date of
transfer is C10 000.
Required: Identify the party that obtains the benefit of the financing and then calculate the transaction
price and the effect of the financing that the entity will have to account for:
A) the customer pays in arrears (i.e. after the transfer of goods);
B) the customer pays in advance (i.e. before the transfer of goods).
Solution 18: Significant financing component – arrears versus advance

a) The customer obtains the benefit of the financing.
The entity will have to account for the following:
x Transaction price = cash selling price = C90 000 (contract revenue)
Calculation: Promised consideration 100 000 – Difference (Financing income) 10 000
x Finance income = C10 000 (amount given) (a separate income, i.e. separate from contract revenue,
and which will be recognised in profit or loss using the effective interest rate method)
b) The entity obtains the benefit of the financing.
The entity will have to account for the following:
x Transaction price = cash selling price = C110 000 (revenue from the contract)
Calculation: Promised consideration: 100 000 + Difference (Financing expense): 10 000
x Finance expense = C10 000 (amount given) (separate expense i.e. not set-off against contract revenue)
Example 19: Significant financing component – arrears journals

Pink Limited signed a contract with a customer on 1 January 20X1 to transfer goods to the
customer (transfer takes place on 1 January 20X1) in exchange for promised consideration of
C121 000, payable on 31 December 20X2.
After careful consideration of the facts, it was decided:
x that the payment terms constitute a significant financing component in terms of IFRS 15.
x the implicit interest rate of 10% is an appropriate discount rate in terms of IFRS 15.
Required: Prepare all related journals for Pink Limited, using its general journal.
Chapter 4 159
Solution 19: Significant financing component – arrears journals

Comment:
x The payment occurs 2 years after transfer takes place (i.e. the customer pays in arrears) and thus
the entity is providing financing to the customer over this 2-year period and will need to recognise
interest income.
x The transaction price for the contract to transfer goods must be measured at the cash sales price on
date of transfer. We are not given this, but we can work this out by calculating the present value of
the payment to the date that the goods are transferred to the customer (i.e. when the customer
obtains control).
x The interest rate implied by the payment terms was given as 10% but could have been calculated
using your calculator if you had been given a cash selling price. In this situation, the implicit
interest rate was considered an appropriate discount rate to use in the calculation of the present
value of C121 000. Using a financial calculator, we calculate the cash selling price of C100 000.
We recognise this as revenue on the date that the goods are transferred (i.e. as our PO is satisfied).
x The interest is recognised on this receivable over the 2 years that financing is provided, using the
effective interest rate method.
Revenue from contracts with customers (I) 100 000
Recognising the revenue from the contract on transfer of the goods
31 December 20X1
Accounts receivable (A) 100 000 x 10% x 12/12 10 000
Revenue from interest (I) 10 000
Recognising the interest income on the significant financing component
31 December 20X2
Accounts receivable (A) (100 000 + 10 000) x 10% x 11 000
Revenue from interest (I) 12/12 11 000
Recognising the interest income on the significant financing component
Bank (A) 100 000 + 10 000 + 11 000 121 000
Recognising the receipt of the promised consideration from the customer
Example 20: Significant financing component – advance journals

Blue Limited signed a contract with a customer on 1 January 20X1 to transfer goods to the
customer (transfer takes place on 31 December 20X2) in exchange for consideration of
C100 000, payable on 1 January 20X1, or C121 000 on 31 December 20X2. The customer chooses to
make a payment of C100 000 on 1 January 20X1.
The payment terms are considered to constitute a significant financing component in terms of IFRS 15.
The implicit interest rate of 10% is considered to be an appropriate discount rate in terms of IFRS 15.
Required:
Prepare all related journals for Blue Limited, using its General Journal.
Solution 20: Significant financing component – advance journals

Comment:
x The customer chooses to pay 2 years before transfer takes place (i.e. the customer pays in advance)
and thus the customer is providing financing to the entity over this 2-year period and thus the
entity will need to recognise an interest expense.
date of transfer. Although the customer pays C100 000, the future value on date of transfer of the
goods is given as C121 000. The future amount (C121 000) is more than the amount actually
received (C100 000) because the amount actually received is effectively a net amount of the
amount the customer owes us for the goods (C121 000) less the amount we owe the customer for
the interest (C21 000).
160 Chapter 4
x The interest rate implied by the payment terms was given as 10% but could have been calculated
using your calculator (FV C121 000; PV C100 000; Period 2 years). In this situation, the implicit
interest rate was considered an appropriate discount rate to use in the calculation of the interest.
x The interest is recognised on this liability over the 2 years that financing is provided, using the
effective interest rate method.
Cash (A) Given 100 000
Recognising the cash received in advance from the customer as a liability
31 December 20X1
Interest expense 100 000 x 10% x 12/12 10 000
Recognising the interest expense on the significant financing component
31 December 20X2
Interest expense (100 000 + 10 000) x 10% x 11 000
Contract liability (L) 12/12 11 000
Contract liability (L) 100 000 + 10 000 + 11 000 121 000
Revenue from contracts with customers 121 000
7.3.2 When would we adjust for the effects of financing? The transaction price
excludes the effect of
Although a financing component may exist, the only time financing if:
we would adjust the transaction price for the existence of x the timing difference is > 1yr &
the financing component is if:
x the benefit is significant to the
x the difference between the timing of the payment and contract. See IFRS 15.61 & .63
the timing of the transfer of goods or services is more

than one year; and
the financing benefit provided (to the entity or its customer) is considered significant to
the contract. See IFRS 15.61 & .63
Example 21: Significant financing component exists – adjust or not

Both Blipper and its customer Ben signed a contract on 1 April 20X2 in which the contractual
terms include the following:
x the entity will transfer the promised goods to the customer at inception of the contract;
x the customer will pay the promised consideration of C484 on 31 March 20X4; and
x no interest will be charged.
The cash selling price for these goods on date of transfer (i.e. 1 April 20X2) is C400. The customer
made the required payment on the date stipulated in the contract.
The benefit from any financing is considered to be significant. The appropriate discount rate is
considered to be 10%.
Required:
A. Prepare all related journal entries to reflect the information provided above.
B. Show how your answer would change if the terms of the contract required the customer to pay the
promised consideration on 31 December 20X2 (i.e. not 31 March 20X4).
C. Explain how your answer would change if the benefit of the financing component was considered
to be insignificant.
Solution 21A: Transaction price adjusted for significant financing

Comment:
x The timing of the transfer of the goods differs from the timing of the payment and thus there is a
financing component to this contract.
Chapter 4 161
x The difference in the timing is more than one year (it is 2 years) and the benefit from the financing
is significant (we are told to assume this). Since both criteria are met, we must adjust the
transaction price for the existence of the financing.
x Although the promised consideration is C484, we must separate out the financing component from
the transfer of goods and services and measure the related transaction price at the notional cash
selling price of C400 and account for this in terms of the five-step approach in IFRS 15.
x The financing component of C84 (promised consideration: C484 – transaction price: C400) is
measured over the period of the financing using the effective interest rate method in IFRS 9.
x In this case, the entity is providing finance and thus earns interest. The interest earned is credited to
‘interest income’. When presenting the SOCI, the effects of the financing component must be
presented separately from the revenue from contracts with customers. If earning this interest was
considered part of the entity’s ordinary activities, then the interest would be recognised as interest
revenue (instead of interest income), but it would still be presented separately from the revenue
from customer contracts.
Accounts receivable (A) 400
Revenue from contracts with customers (I) 400
Recording the revenue from the contract with customer Ben
31 December 20X2
Accounts receivable (A) 400 x 10% x 9/12 30
Revenue from interest (I) 30
Recording the revenue from interest on the contract with the customer
31 December 20X3
Accounts receivable (A) (400 x 10% x 3/12) + (400 x 43
Revenue from interest (I) 1.1 x 10% x 9/12) 43
31 March 20X4
Accounts receivable (A) 400 x 1.1 x 10% x 3/12 11
Revenue from interest (I) 11
Bank (A) 400 + 30 + 43 + 11 484
Recording the receipt of the promised consideration from the customer
Solution 21B: Transaction price not adjusted for significant financing

Comment:
x The timing of the transfer of the goods and the payment differs and thus there is a financing
component to this contract.
x The difference in the timings is less than one year (it is 9 months) and although the benefit from the
financing is significant (we are told to assume this), we do not remove the effects of the financing
when calculating the transaction price (i.e. we are using the practical expedient in IFRS 15).
x The transaction price is thus measured at the promised consideration of C484.
31 December 20X2
Bank (A) 484
162 Chapter 4
Solution 21C: Transaction price not adjusted for financing

Comment:
x The timing of the transfer of the goods and the payment differs and thus there is a financing
component to this contract.
x The difference in the timings is more than one year (it is 2 years) but the benefit from the financing
is insignificant (we are told to assume this) and thus we do not adjust the transaction price.
x The transaction price is thus measured at the promised consideration of C484.

31 March 20X4
Bank (A) 484
7.3.3 How do we decide whether a financing component is significant or not?
When assessing if a financing component is significant, we

assess it in relation to the contract – not to the individual The significance of a
financing component is
performance obligation/s which may be financed. determined:
Whether or not the benefit of a financing component is x relative to the contract as a
significant to the contract requires us to consider all ‘facts whole; &
and circumstances’ including: x involves assessing all facts &
circumstances.
x any difference between the promised consideration and See IFRS 15.61
the cash selling price; and

x the ‘combined effect’ of the following:
- the expected time period between the transfer of the good/ service and the receipt of
the consideration; and
- the prevailing market interest rates. See IFRS 15.61 (reworded slightly)
Normally, if there is a significant difference between the amount of the promised consideration
and the cash selling price and the period between the date of payment and the date of transfer of
the goods or services is more than one year, a significant financing component is said to exist and
we must remove the effects of the financing when calculating the transaction price. However, a
significant financing component will be deemed not to exist in some situations. In each of these
situations, the reason for deeming that a significant financing component does not exist is because
the primary purpose of the payment terms in these situations is not to provide financing. In other
words, the payment terms are for a reason other than financing:
a) A significant financing component would not be considered to exist if the transfer of
goods or services is delayed at the customer’s request (i.e. the customer has paid in
advance but has requested/ chosen to delay the transfer of goods).
Examples of this situation include sales on a bill and hold basis, prepaid electricity and the
sale of customer loyalty points.
b) A significant financing component would not be considered to exist if a ‘substantial
amount’ of the promised consideration is variable and this variability (of the amount of
the payments or timing thereof) is dependent on future events over which neither the
customer nor the entity has control.
Examples of this situation include royalty contracts where, for example, the contractual
terms may allow a delay in the payment of the promised consideration, the purpose of
which is merely to provide the parties with the necessary comfort where significant
uncertainty exists as to the value of the royalty.
Chapter 4 163
c) A significant financing component would not be considered to exist if ‘the difference

between the promised consideration and the cash selling price’ is to satisfy a purpose
other than financing.
Examples of this situation include a customer paying in arrears in order to ensure
successful completion of a project or a customer paying in advance in order to secure
goods that are in limited supply. See IFRS 15.62 & .BC233
Allocation of a significant financing component to more than one PO appears unclear

As already mentioned, when we consider whether or not the benefit of a financing component is
significant, we consider it in context of the entire contract – not on the basis of a specific performance
obligation that may be financed.
However, it appears unclear, in the case of a contract that has more than one performance obligation, how a
financing benefit that is considered to be significant in the context of the contract would be allocated to the
specific performance obligations.
Would they, for example, be allocated:
x to only those performance obligations that are being financed, or
x to all the performance obligations in the contract?
The wording in this regard appears vague and thus it is expected that further guidance from the IASB may be
needed. See IFRS 15.61 & .BC234
7.3.4 What discount rate should we use? (IFRS 15.64)
The discount rate that we should use is the rate that the
entity and the customer would have agreed upon if they had The discount rate to
use is:
entered into a separate financing agreement on inception of
the contract. This discount rate is based on the relevant x the rate the entity & customer
circumstances on the date of inception of the contracts and would have agreed upon
must not be updated for any changes in circumstances. x if they had entered into a
separate financing agreement on
date of contract inception.
This discount rate takes into account the credit risk of the See IFRS 15.64
borrower at contract inception and other related factors

such as any security provided by the borrower.
In other words, when deciding on an appropriate discount rate, we would not use a market-
related interest rate, a risk-free interest rate or the interest rate in the contract (whether it is
explicitly stated or whether it is the implicit rate) unless it reflects the interest rate that the
entity and the customer would have agreed upon had they entered into a separate financing
agreement at contract inception.
After contract inception the discount rate may not be changed under any circumstances (e.g. interest
rates change or there is an increase or decrease in the customer’s credit risk). See IFRS 15.64
Example 22: Significant financing component – discount rate

The following example is a continuation of the previous example 20 (i.e. the previous
example involving Blue Limited), except that the interest rate implicit in the contract is now not
considered to be an appropriate discount rate for purposes of IFRS 15.
Blue Limited signed a contract with a customer on 1 January 20X1 to transfer goods to the customer
(transfer takes place on 31 December 20X2) in exchange for consideration of:
x C100 000, if paid on 1 January 20X1, or
x C121 000, if paid on 31 December 20X2.
The customer chooses to make a payment of C100 000 on 1 January 20X1.
The payment terms are considered to constitute a significant financing component in terms of IFRS 15.
The implicit interest rate in the contract is 10% but the rate that the customer and entity would have
agreed to had they entered into a separate financing agreement on date of contract inception is 8%.
Required: Prepare all related journals for Blue Limited, using its general journal.
164 Chapter 4
Solution 22: Significant financing component – discount rate

Comment:
x The customer chooses to pay 2 years before transfer takes place (i.e. the customer pays in advance)
and thus the customer is providing financing to the entity over this 2-year period and thus the
entity will need to recognise an interest expense.
date of transfer. Although the future value on date of transfer of the goods is given as C121 000,
this is based on the implicit interest rate of 10% when an appropriate discount rate for this contract
is 8%. Thus, the contract liability is increased by interest of only 8%, with the result that the
revenue recognised on date of transfer will only be C116 640 (i.e. its notional cash selling price).
Cash (A) Given 100 000
Recognising the cash received in advance from the customer as a liability
31 December 20X1
Interest expense 100 000 x 8% x 12/12 8 000
31 December 20X2
Interest expense (100 000 + 8 000) x 8% x 12/12 8 640
Contract liability (L) 100 000 + 8 000 + 8 640 116 640
7.3.5 How do we present interest from the significant financing component? (IFRS 15.65)
When accounting for the interest relating to a significant Interest contained in a

financing component that is found to exist in a contract contract is presented
with a customer, we would either recognise that we have separately from revenue
earned interest (income) or incurred interest (expense), from contracts with customers .
See IFRS 15.65
depending on whether we provided the financing to the
customer or received the financing from the customer.
x Interest income is presented as interest revenue only if it was earned as part of the entity’s
ordinary activities. However, this interest income, whether presented as part of revenue or
not, is not considered part of the revenue from the contract with the customer and thus it
must be presented separately from the line-item ‘revenue from contracts with customers’.
x Interest expense is presented separately from the line-item ‘revenue from contracts with
customers’ (i.e. a related ‘interest expense’ may not be offset against the ‘revenue from
contracts with customers’). See IFRS 15.65 & .BC247
7.4 Non-cash consideration (IFRS 15.66-.69)
7.4.1 Overview
Non-cash consideration
If the contract price includes non-cash consideration, this
will need to be included in the transaction price – unless the x is included in the TP if the entity
gets control of the non-cash items,
entity does not obtain control over the non-cash items. This
non-cash consideration should be measured at its fair value x is measured at its FV.
See IFRS 15.66
(per IFRS 13) assuming this is able to be reasonably
estimated. If a reasonable estimate is not possible, it is measured based on the stand-alone
prices of the goods or services to be transferred to the customer (i.e. it is measured on the
basis of the goods or services given up).
Chapter 4 165
7.4.2 Whether to include non-cash items in the transaction price

A contract price may include non-cash consideration. Non-cash consideration arises in contracts
that require customers to pay the promised consideration, either partly or entirely, using something
other than cash. For example, the customer could be required to pay the consideration by
providing the entity with services or with some other non-cash item (e.g. a vehicle).
If the entity obtains control over these non-cash items, they are considered to be non-cash
consideration and must be included in the transaction price. If the entity does not obtain
control over these non-cash items (e.g. goods or services), these non-cash items are not
considered to be non-cash consideration and are thus not included in the transaction price.
For example, if the customer provides the entity with a machine to be used by the entity in
completing its obligations but over which the entity does not obtain control, then the
transaction price must not include the value of the machine because the machine is not
considered to be ‘non-cash consideration’. Conversely, if the customer provides the entity
with a machine to be used by the entity in completing its obligations, and the entity obtains
control over this asset, then the machine is considered to be ‘non-cash consideration’ and thus
the transaction price must include the value of the machine.
7.4.3 How to measure non-cash consideration

When including non-cash consideration in the transaction price, we measure it at its fair
value. However, if a reasonable estimate of the fair value is not possible, we measure it
indirectly based on the stand-alone selling prices of the goods or services transferred (i.e. the
goods or services given up).
When trying to estimate the fair value of the non-cash consideration, we may find that the fair
value is variable. There are two reasons why the fair value could vary:
x it could vary due to the form of the consideration (e.g. if the non-cash consideration is a
share that the customer will give to the entity, the price of which changes daily on the
stock exchange, it may be difficult to estimate what this fair value will be); or
x it could vary due to reasons other than form (e.g. uncertainties regarding the future and
thus what or how much non-cash consideration will be received, if any).
If the variability of the fair value is due to reasons other than the form of the non-cash
consideration (e.g. it is due to uncertainty regarding whether or not it will be received), then
we must measure the non-cash consideration as variable consideration. Thus, we will need to
ensure that the estimate of its fair value is constrained (i.e. limited) to an amount that has a
high probability of not resulting in a significant revenue reversal in the future. See IFRS 15.BC252
Once the non-cash consideration is recognised as having been received, it is accounted for in
terms of the IFRS that is relevant to that item. For example, if we receive an asset that we
intend to use in our business, we would account for that asset in terms of IAS 16 Property,
plant and equipment, whereas if we receive an asset that we intend to sell as part of our
normal activities, then we would account for it in terms of IAS 2 Inventory.
Once the fair value of the non-cash consideration has been recognised, changes to that fair
value are not recognised within revenue. See IFRS 15.IE158
Example 23: Non-cash consideration
Yellow Limited signed a contract with a customer, Mauve Limited, on 1 January 20X1.
Required: Briefly explain what Yellow’s transaction price would be in the following instances:
a) The contract requires Yellow to provide services to Mauve over a period of 3 months and requires
Mauve to pay C100 000 in cash and to provide a machine that Yellow will use in the performance
of the services. Yellow will return the machine at the end of the contract. The fair value of the
machine is C50 000.
166 Chapter 4
b) The contract requires Yellow to transfer goods to the customer on 1 January 20X1 and requires
Mauve to pay C100 000 in cash and to issue Yellow with 1 000 shares in Mauve on 30 June 20X1,
the date on which Mauve will be issuing these shares. The fair value of these shares could be
anything between C40 and C60 per share on date of issue, but is expected to be C50 per share. The
cash selling price of the goods being transferred is C160 000.
Solution 23: Non-cash consideration

a) The contract refers to the promise of both cash (C100 000) and a machine (C50 000). However,
Yellow must return the machine and thus it does not obtain control of the machine. Thus, the
machine is not considered to be non-cash consideration. Consequently, the value of the machine is
not included in the transaction price.
The transaction price is thus C100 000 (i.e. the cash consideration only).
b) Yellow will obtain control over the shares and thus the contract is said to include both cash
consideration (C100 000) and non-cash consideration (shares).
We are not sure what the fair value of the shares will be. However, the variability of the fair value
is due entirely to the form of the non-cash consideration and thus it is not considered to be ‘variable
consideration’ for purposes of IFRS 15. In other words, when measuring the fair value of the
shares, we do not apply the requirements for measuring variable consideration (we do not need to
estimate it using one of the two methods and then constrain this estimate).
x If the estimate of C50 per share is a reliable estimate, then the transaction price will be
C150 000 (cash consideration: C100 000 + non-cash consideration: C50 x 1000 shares).

Recognising revenue from the customer contract when the
performance obligation is satisfied (transaction price includes
non-cash consideration measured at its FV)
x If the estimate of C50 per share is not a reliable estimate, then non-cash consideration will be
measured indirectly based on the stand-alone prices of the goods transferred.
The stand-alone price of the goods transferred is given as C160 000.
The transaction price is thus C160 000 (the stand-alone selling price of the goods transferred).
The non-cash consideration is measured indirectly using this stand-alone price, (i.e. we
balance back to the non-cash consideration):
Since part of the consideration is cash of C100 000, the non-cash consideration is measured at
C60 000 (total consideration: C160 000 – cash: C100 000).

Recognising revenue from customer contract when
performance obligation satisfied (transaction price includes
non-cash consideration measured indirectly based on the
stand-alone price of the goods transferred)
Note:
x If the actual fair value per share is, for example, C70 on the date that we receive the shares, the
increase of C20 in the share’s fair value (C70 – C50) is recognised as an adjustment to revenue.
x In other words, revenue recognised will be C170 000 (cash consideration: C100 000 + non-
cash consideration C70 x 1 000 shares).
x Any subsequent changes to the fair value of the shares will be recognised in terms of
IFRS 9 Financial instruments and not as an adjustment to revenue.
Chapter 4 167
7.5 Consideration payable to the customer (IFRS 15.70-.72)
7.5.1 Overview The transaction price is

reduced by the
consideration payable to
Sometimes a contract includes not only consideration the customer (or the customer’s
payable by the customer to the entity, but also consideration customers), unless it is for the
payable by the entity to the customer. If this happens, the transfer of distinct goods or
transaction price must be reduced by: services for which FVs can be
x the consideration (1) reliably estimated.
See IFRS 15.70
x that the entity expects to pay the customer (2)
x unless the payment by the entity is for the transfer of distinct goods or services from the
customer (and the fair value of these goods or services is able to be reasonably estimated and
the cash payable does not exceed this fair value).
Note 1: Consideration could come in the form of:
x a cash amount that the entity pays, or expects to pay, the customer (or the customer’s
customers); or
x credits, coupons, vouchers or other items that may be used to reduce the amount owed to
the entity. See IFRS 15.70
Note 2: If a contract requires the entity to pay consideration to Consideration payable
‘parties that purchase the entity’s goods or services to a customer includes:
from the customer’ (e.g. our customer’s customers), x cash; and
we would account for this payment as if it was x other items that may be used to
consideration payable to the customer. reduce the amount owed to the
entity (e.g. coupons) and
A reduction in the transaction price means a reduction in x includes consideration payable to
the amount recognised as revenue. customers and also the
customer’s customers.
See IFRS 15.70
The reduction in revenue is recognised on the later of the
following two dates:
x the date on which the revenue is recognised; and
x the date on which the entity pays or promises to pay the consideration. See IFRS 15.72
Worked example 1: Consideration payable is not for distinct goods or services

(we reduce the TP)
If we expect a customer to pay us C100 000 in return for goods and we expect to pay the customer
C20 000, but we are not effectively purchasing something for C20 000, we would net the two amounts
off and account for the transaction price at the reduced C80 000. Assume that we first paid the customer
and then transferred 40% of the goods:
Debit Credit
Contract asset: prepayment (A) Given 20 000
Bank 20 000
Recognising payment to customer
Receivable (A) 100 000 x 40% 40 000
Revenue from customer contracts (I) (100 000 – 20 000) x 40% 32 000
Contract asset: prepayment (A) 20 000 x 40% 8 000
Recognising 40% of the receivable and 40% of the revenue based
on the reduced transaction price
This can happen where, for example, our customer requires the construction of a store-room (cost
C20 000) in order to house the goods he is buying from us. Since we do not obtain control of the store-
room, we are not effectively acquiring control of a distinct good or service.
If the consideration payable is for the transfer of distinct goods or services, this must simply
be recognised as a separate transaction and would not affect the transaction price.
168 Chapter 4
Worked example 2: Consideration payable is for distinct goods or services

(we do not reduce the TP)
If we expect the customer to pay us C100 000 and we expect to pay the customer C20 000, but we are
effectively purchasing inventory for C20 000, we would not net the two amounts off. We would
account for the C100 000 as the transaction price for revenue (IFRS 15) – we would not reduce it by
the consideration payable. The C20 000 payable would be accounted for as the cost of purchasing
inventory (IAS 2). Assume that we first paid the customer and then transferred 40% of the goods:
Debit Credit
Inventory (A) Given 20 000
Bank 20 000
Receivable (A) 100 000 x 40% 40 000
Revenue from customer contracts (I) 100 000 x 40% 40 000
Recognising 40% of the receivable and 40% of the revenue
based on the unadjusted transaction price
If the consideration payable is for a distinct good or service but the fair value thereof is not
able to be reasonably estimated, then the entire consideration payable to the customer is
accounted for as a reduction in the transaction price. Similarly, if the consideration payable is
for a distinct good or service but the consideration payable exceeds the fair value thereof, then
the excess will be accounted for as a reduction of the transaction price.
Worked example 3: Consideration payable is for distinct goods or services but

exceeds their fair value (we reduce the TP – by the excess)
If we expect the customer to pay us C100 000 and we expect to pay the customer C20 000, but we are
effectively purchasing inventory with a fair value of C15 000, the consideration payable exceeds the
fair value of the distinct good purchased.
The transaction price must be reduced by this excess of C5 000.
Assume that we first paid the customer and then transferred 40% of the goods:
Debit Credit
Inventory (A) FV 15 000
Contract asset: prepayment (A) 20 000 – 15 000 5 000
Bank Given 20 000
Accounts receivable (A) 100 000 x 40% 40 000
Contract asset: prepayment (A) 5 000 x 40% 2 000
Revenue from customer contracts (I) (100 000 – 5 000) x 40% 38 000
Recognising 40% of the receivable and 40% of the revenue
based on the adjusted transaction price
The consideration payable does not need to be in the form of cash – it could for example be in
the form of coupons. Similarly, the consideration need not be payable to the customer – it
could be payable to the customer’s customers.
Worked example 4: Consideration payable – coupons for customer’s customers

A manufacturer of shampoo (the entity) enters into a contract with a retailer (the customer) in
which the manufacturer agrees to sell 100 000 bottles of shampoo to the retailer in exchange for
consideration of C1 000 000 and the manufacturer further agrees to provide coupons – not for use by
the retailer, but for use by the retailer’s customers (the shoppers).
A coupon is then attached to each bottle offering the customer a refund of C1 on presentation of the
coupon. This refund of C1 per bottle may be offset by the retailer in determining the amount payable to
the manufacturer. Continued …
Chapter 4 169
In this case, the consideration payable is in the form of coupons that the customer’s customers can
utilise when purchasing shampoo from the customer (i.e. the retailer). However, the retailer may then
utilise the coupons to reduce the amount owing to the manufacturer. Thus, when the manufacturer
determines the transaction price, it must deduct the potential consideration payable. Thus the
transaction would be determined at C900 000.
Calculation: Consideration payable by the customer: (100 000 bottles x C10 each) – Consideration payable by the
entity: (100 000 bottles x C1 each).
Worked example 5: Consideration payable – coupons for customer’s customers

This example follows on from the previous worked example (worked example 4), where the
manufacturer of the shampoo (the entity) agreed to provide coupons offering a discount of C1 per
bottle and which are for use by the retailer’s customers (the shoppers).
If the coupon is available for use immediately (i.e. if the shopper can get the C1 discount immediately),
then the manufacturer (i.e. the entity) would recognise the reduction in the revenue on the date that it
recognised the revenue from the sale of shampoo to the retailer (i.e. on the date that the manufacturer
transferred the shampoo bottles to the retailer).
If the coupon will only be available for use by the retailer’s customers at some future date (e.g. against
the purchase of another product that is not yet available upon the shelves), then the manufacturer (i.e.
the entity) would recognise the reduction in the revenue on the date that it sold these new products to
the retailer. See the pop-up on the apparent contradiction!
Contradiction relating to the recognition of a reduction in the transaction price

The delayed timing of the recognition of the potential reduction in revenue (e.g. the potential
discounts that may arise due to the potential use of coupons) required in the section on ‘consideration payable
to customers’ appears to contradict the section on ‘variable consideration’.
x Variable consideration is described in IFRS 15 as including, for example, discounts, credits, incentives
and other price concessions. This description is thus wide enough to include the offer of coupons.
However, IFRS 15 requires that we estimate the variable consideration (using either the expected value
method or the most likely outcome method) and then constrain the estimate and that this variable
consideration needs to be taken into account in determining the transaction price at inception of the
contract – not at a later date.
x Consideration payable to customers, on the other hand, the definition of which would encompass the
offer of coupons, is only required to be accounted for as a reduction in revenue at the later of two
dates: the date on which revenue is recognised and the date on which the entity pays or promises to pay
the customer. It thus appears that consideration payable is not required to be estimated and taken into
account at inception of the contract.
8. Allocating the transaction price to the performance obligations (step 4)
The objective when

8.1 Overview allocating the transaction
price (TP) is:
A contract frequently involves more than one performance
x for an entity to allocate the TP
obligation (PO) and yet the transaction price (TP) is
x to each PO (or distinct
determined for the contract as a whole. good/service)
x by an amount that depicts
The transaction price represents the revenue that will be x the amount of consideration
earned from the whole contract and thus, since revenue is x to which the entity expects to be
recognised when (or as) the performance obligation is entitled
satisfied, we will need to allocate the transaction price x in exchange for transferring the
(revenue) to each of these performance obligations. promised goods or services to the
customer.
IFRS 15.73
The transaction price is allocated to each of the
performance obligations based on their relative stand-alone selling prices.
Exceptions to this approach may arise if the transaction price includes:

x a discount; or
x variable consideration.
170 Chapter 4
We will first discuss the allocation of a transaction price where no discount is involved, then
discuss the allocation of a transaction price that does involve discount and then finally will
discuss the allocation of a transaction price that involves variable consideration.
8.2 Allocating the transaction price based on stand-alone selling prices (IFRS 15.76-.80)
To be able to allocate a transaction price to the various Stand-alone selling prices

performance obligations, we will need the relative stand- are defined as
alone selling prices for each of the distinct goods and x ‘the price at which
services that make up these obligations. x an entity would sell
x a promised good or service
A stand-alone selling price is the price at which the distinct x separately to a customer’.
good or service would be sold if it was sold separately on IFRS 15.77
the date of inception of the contract. See IFRS 15.76-.77 The stand-alone selling price is
determined at:
See IFRS 15.76
The best evidence of the stand-alone selling price is an x contract inception.
observable price.
An observable price is the price at which the good or

service is sold separately to a ‘similar customer’ under Stand-alone selling prices
‘similar circumstances’. can be:
x directly observable (ideal); or
See IFRS 15.77-8
It may happen, however, that an entity does not have access x estimated.
to an observable price because, for example, the entity may
have never sold this good or service before or may not have sold the good or service on a
separate basis before. If a separately observable price is not available, then the entity must
estimate it.
Example 24: Allocating a transaction price based on stand-alone selling prices

Bright Blue Limited signed a contract with a customer, Deep Purple Limited, to supply and
install a manufacturing plant and to provide maintenance over this plant for a two-year period. The
total contract price is C200 000.
The installation is not considered to be a service that is distinct from the supply of the plant and thus
the entity concludes that the contract contains two performance obligations, for which the stand-alone
selling prices are as follows:
Supply and installation of plant C180 000
Maintenance over 2 years C40 000
Required: Briefly explain, together with calculations, how the transaction price is to be allocated.
Solution 24: Allocating a transaction price based on stand-alone selling prices

The transaction price must be allocated to each performance obligation in the contract based on the
stand-alone selling prices.
Two performance obligations are identified in the contract and the stand-alone selling prices for each
(whether observed or estimated) were given to us. The transaction price is thus allocated as follows:
Stand-alone Allocation of
selling prices transaction price
Supply and installation of plant C180 000 TP: C200 000 x 180 000 / 220 000 C163 636
Maintenance over 2 years C40 000 TP: C200 000 x 40 000 / 220 000 C36 364
C220 000 C200 000
TP: Transaction price
Thus, Bright Blue would recognise revenue of:
x C163 636 when the plant is installed (satisfied at a point in time); Note 1 and
x C36 364 over the two-year period that the maintenance is provided (satisfied over time). Note 1
Note 1: How to decide whether a PO is satisfied at a point in time or over time is explained in section 9.
Chapter 4 171
The standard does not stipulate how we should estimate a stand-alone selling price, but it does
suggest three possible approaches that may be helpful – a combination of which could be used
if necessary (the entity may also use any other approach that it may prefer):
x adjusted market assessment approach: this approach assesses the market and estimates
what the customer might be prepared to pay in this market (e.g. the entity could consider
what others in the market are selling the good or service for and could then make
appropriate adjustments for its own entity-specific costs and required margins);
x expected cost plus margin approach: this approach involves the entity first estimating the
costs it expects to incur in the process of satisfying the PO and then adding its required
margin to get to a suitable selling price;
x residual approach: this approach is suitable when the entity knows the stand-alone selling
prices for some of its goods or services, (i.e. it does not know all of the stand-alone selling
prices), in which case the unknown stand-alone selling price/s is determined as a
balancing amount as follows:
Transaction price - the sum of the observable stand-alone selling prices. See IFRS 15.79
Although the residual approach is suggested as one of the ways in which we could estimate
the stand-alone selling prices, it may only be used if one of the following criteria is met:
a) the entity sells the same goods or services to different customers but for such a broad
range of amounts that the price is considered to be highly variable; or
b) the entity has not previously sold that good or service on a stand-alone basis and has not
yet set a price for it and thus the price is uncertain. See IFRS 15.79 reworded.
Although the standard does not stipulate how we should estimate stand-alone selling prices, it
does state that, irrespective of what method is used, the method used:
x must result in an allocation that meets the allocation objective (IFRS 15.77 – see pop-up
under the overview) – in other words, the portion of the transaction price that is allocated
to a performance obligation must depict the price to which the entity expects to be entitled
for transferring the related underlying goods or services;
x must consider all the information that is reasonably available to the entity (e.g. factors
relating to the customer, the entity and the market);
x must maximise the use of observable inputs; and
x must be applied consistently to other similar circumstances. See IFRS 15.78
Example 25: Allocating a transaction price

x based on estimated stand-alone selling prices
Green Limited signed a contract with a customer, Yellow Limited, to supply 3 products: X, Y, and Z,
each of which is considered to be a separate performance obligation. The total consideration promised
in the contract is C200 000.
Green regularly sells product X – the stand-alone selling price for X is C100 000.
Products Y and Z have never been sold before but Green estimates that the cost of producing Y will be
C100 000 and costs of producing Z will be C50 000. A suitable profit margin is 10% on cost.
Required: Briefly explain, together with calculations, how Green should allocate the transaction price.
Solution 25: Allocating the transaction price

The transaction price must be allocated to each performance obligation in the contract based on the
stand-alone selling prices.
Product X is the only product that has a stand-alone selling price based on a directly observable price.
The stand-alone selling price (SASP) for products Y and Z must be estimated.
172 Chapter 4
Since Purple has estimated the cost of production for products X and Y and is able to suggest a suitable
margin, the ‘expected cost-plus margin approach’ may be used to estimate these SASPs.
The stand-alone selling prices are as follows:
Stand-alone
selling prices
Product X C100 000 Directly observable price: given
Product Y C110 000 Estimated cost + margin approach:
Estimated costs: C100 000 + required margin: C100 000 x 10%
Product Z C55 000 Estimated cost + margin approach:
C265 000
The transaction price (TP) of C200 000 (which, incidentally, includes an inherent discount of C65 000) must
now be allocated to the POs based on their relative stand-alone selling prices (2 of which were estimated):
Product X C100 000 TP: C200 000 x 100 000 / 265 000 C75 472
Product Y C110 000 TP: C200 000 x 110 000 / 265 000 C83 019
Product Z C55 000 TP: C200 000 x 55 000 / 265 000 C41 509
C265 000 C200 000
Example 26: Allocating a transaction price

x based on estimated stand-alone selling prices (where one was
estimated based on the residual approach)
Purple Limited signed a contract with a customer, Red Limited, to supply 3 products: A, B, and C, each
of which is considered to be a separate performance obligation. The total consideration promised in the
contract is C200 000.
Purple regularly sells product A and B. Product A sells for C100 000 but product B sells for anything
between C20 000 and C70 000, depending on a variety of factors.
Product C has never been sold before, but Purple estimates that the cost of production will be C50 000
and a suitable profit margin is 10% on cost.
Required: Briefly explain, together with calculations, how Purple should allocate the transaction price.
Solution 26: Allocating the transaction price

The transaction price (TP) must be allocated to each performance obligation in the contract based on
the stand-alone selling prices (SASPs).
Product A is the only product that has a stand-alone selling price based on a directly observable price.
The stand-alone selling price for products B and C must be estimated.
Since Purple has estimated the cost of production for product C and is able to suggest a suitable margin, it is
suggested that the ‘expected cost-plus margin approach’ be used to estimate C’s stand-alone selling price.
Since insufficient detail is provided as to how to estimate the stand-alone selling price for product B, it
is suggested that the ‘residual approach’ may be appropriate for this product (we are assuming that the
criteria that must be met before using the residual approach, are indeed met).
The stand-alone selling prices are as follows:
Stand-alone
selling prices
Product A C100 000 Directly observable price: given
Product B C45 000 Residual approach:
TP: C200 000 – C100 000 (A) – C55 000 (C)
Product C C55 000 Estimated cost + margin approach:
C200 000
Chapter 4 173
When using the residual approach to estimate the SASP for one of the products, the sum of the SASPs
(C200 000) equals the transaction price (C200 000) and thus no further calculations are necessary.
However, before we accept the resultant allocation of the transaction price based on SASPs, we need to
check that, where we have estimated the SASPs for a PO (i.e. in the case of B and C), the transaction
price allocated to that particular PO meets the allocation objective. The allocation objective is that the
price allocated to the PO reflects the amount to which the entity expects to be entitled for the transfer of
the underlying goods or services.
x In the case of product B, we are told that the normal price is anything between C20 000 and
C70 000 and thus the allocation of C45 000, being within this range, is acceptable.
x We are not given a range for product C and thus we assume that the allocation of C55 000 is an
amount to which the entity would expect to be entitled.
Note: If we had been told that the normal price range for product B was anything between, for example,
C50 000 and C70 000 we would not have been able to accept the allocation of C45 000 since it is
outside of the expected range. In this case, we would have to come up with another method of
estimating the stand-alone price for product B (e.g. looking at competitor prices and making
appropriate adjustments for the entity’s own cost structure and expected margins) or we would need to
use a different method to estimate the stand-alone price for product C, such that, when using the
residual approach to estimate product B, it results in an allocation that falls within the expected range.
Comment: This example involves the estimation of one of the stand-alone selling prices using the
residual approach. Note how this approach requires extra care when checking that it meets the
allocation objective (i.e. it is essential we check the reasonableness of this estimate).
It is probably also wise to remind you at this point that we are allocating the transaction price
based on the stand-alone prices that exist at contract inception. It can happen that these stand-
alone prices, whether based on observable prices or based on estimates, may change after
contract inception (e.g. through inflation, annual increases, changes in the market, improved
estimation). However, any changes in the stand-alone selling prices after date of contract
inception will not result in the re-allocation of the transaction price. See IFRS 15.88
8.3 Allocating a discount (IFRS 15.81-.83)
8.3.1 Overview
If the transaction price includes a discount (i.e. if the transaction price is net of a discount),
the process of allocating this discounted transaction price to the performance obligations in
the contract based on the relative stand-alone selling prices will mean that we will have
automatically allocated the discount proportionally to each of the performance obligations.
However, we need to be careful here, because there are instances where a discount does not
apply to all the performance obligations in the contract.
8.3.2 Identifying a discount
The fact that a discount has been given to a customer is not

A discount exists if:
always stipulated in the contract. Conversely, a contract x the promised
could state that the contract price is calculated after consideration
deducting discounts on certain goods or services when in x Is less than
fact the goods or services are not truly discounted and the x The sum of the SASPs.
See IFRS 15.81
statement to this effect is essentially a marketing ploy.
To identify whether the promised transfer of goods or services are truly discounted, we
simply calculate the sum of the stand-alone selling prices of these goods or services and
compare this with the consideration promised in the contract: if the promised consideration is
less than the sum of the stand-alone selling prices, we conclude that the consideration is
discounted. For example, if we look at example 24, we see that the sum of the stand-alone
prices is C220 000 when the total transaction price in the contract was C200 000. This means
that the transaction price was discounted by C20 000.
174 Chapter 4
8.3.3 Allocating a discount proportionately to all performance obligations
If we find that a discount exists, it will be automatically A discount is normally

allocated proportionately across all performance obligations allocated proportionately
when we use the underlying stand-alone selling prices. For to all POs in the contract.
example, if we look at example 24, we see that there was no This happens automatically when
specific treatment of the C20 000 discount inherent in the allocating the TP to the POs based
contract – it was simply allocated when allocating the on their relative stand-alone selling
See IFRS 15.81
prices.
discounted transaction price.
Although no information was provided in example 24 to suggest otherwise, it is possible that

this discount applied only to one of the performance obligations. In this case, the allocation of
the transaction price would have been incorrect. See example 27 for how to allocate a
transaction price when a discount does not apply to all performance obligations in the contract.
8.3.4 Allocating a discount to one or some of the performance obligations

A discount is allocated
Discounts are allocated proportionately to all the to only one/ some of the
performance obligations unless there is observable evidence POs in the contract if
to suggest that the discount does not apply to all x there is sufficient observable
performance obligations in the contract. evidence (that meets all 3
criteria in para 82) that
If this observable evidence exists, we must not allocate the x it relates to only one/some of
See IFRS 15.81 -82
the POs.
discount proportionately to all performance obligations in the
contract: instead, we allocate it to only the specific performance obligations to which the discount
relates. However, before we take the observable evidence into account, we must make sure all three
criteria listed in IFRS 15.82 are met (see grey box below).
The following three criteria must be met before a discount may be allocated to specific
POs:
a) the entity regularly sells each distinct good or service (or each bundle of distinct goods or services)
in the contract on a stand-alone basis;
b) the entity also regularly sells, on a stand-alone basis, a bundle (or bundles) of some of those
distinct goods or services at a discount to the individual stand-alone selling prices of the goods or
services in each bundle; and
c) the discount attributable to each bundle of goods or services described in paragraph 82(b) is
substantially the same as the discount in the contract and
an analysis of the goods or services in each bundle provides observable evidence of the performance
IFRS 15.82
obligation/s to which the entire discount in the contract belongs.
If any of these three criteria are not met, the evidence suggesting that the discount should not be
allocated to all of the performance obligations is not considered to be sufficiently observable.
Example 27: Allocating a discount to only one / some performance obligations
Snack Limited signed a contract with a customer, Meal Limited, involving three performance
obligations:
x the supply of a manufacturing plant,
x the installation of this plant and
x the maintenance of this plant over a three-year period.
The consideration promised in the contract is C300 000.
Snack Limited regularly sells this type of plant, regularly provides installation services and regularly
provides maintenance services. Snack also regularly sells the plant as a package deal together with the
installation thereof at a combined, discounted price of C220 000.
The following are the normal prices for each:
Supply of plant C200 000
Installation of plant C50 000
Maintenance of plant (3 yrs) C80 000
Required: Briefly explain, together with calculations, how the transaction price is to be allocated.
Chapter 4 175
Solution 27: Allocating a discount to only one / some performance obligations

The transaction price must be allocated to each performance obligation in the contract. The entity has
identified 3 performance obligations in the contract and given the stand-alone selling prices for each.
The sum of the 3 stand-alone prices is C330 000 (C200 000 + C50 000 + C80 000) whereas the total
promised consideration is only C300 000. Thus, a discount of C30 000 exists in the contract.
In the case of this contract, we do not allocate the discount proportionately to all 3 performance
obligations because there is observable evidence, which meets all three criteria, that suggests that the
entire discount relates to only one or some of the performance obligations.
Each of the three criteria and how they are met follows:
a) The entity must regularly sell each of the distinct goods or services (or bundle thereof) in the
contract on a stand-alone basis.
Snack regularly sells, as separate items, all three of the distinct goods and services that are
contained in the contract. (i.e. the plant, installation services and maintenance services).
b) The entity must regularly sell some of these distinct goods or services as a stand-alone bundle and
at a discounted price for this bundle.
Snack regularly sells the plant together with the installation thereof as a stand-alone bundle and at
a discounted price of C220 000 (i.e. instead of C200 000 + C50 000 = C250 000).
c) The discount for the abovementioned bundle of goods or services must be substantially the same as
the discount offered in the contract; and
An analysis of the goods or services in each of the abovementioned bundles must provide observable
evidence of the performance obligation(s) to which the entire discount in the contract belongs.
Snack normally sells the abovementioned bundle (i.e. a plant together with installation thereof) for
C220 000, which represents a discount of C30 000 against the sum of the stand-alone selling price
for each item in the bundle (C200 000 + C50 000 = C250 000) and this discount is substantially
the same (in this case, it is exactly the same) as the C30 000 discount in the contract.
An analysis of the goods and services contained in the stand-alone bundle reveals a plant and the
installation thereof where this plant and installation provides observable evidence of the
performance obligation to which the entire discount in the contract relates (in fact, in this case, the
plant and installation regularly sold as a bundle are identical to the plant to be supplied and
installed in terms of the contract).
Thus, it is clear that the C30 000 discount relates purely to the supply and installation of the plant (i.e. only 2 of
the performance obligations). Since the discount does not apply to all 3 of the performance obligations
contained in the contract, the transaction price is not allocated based on the stand-alone selling prices of each of
the performance obligations. Instead, the entire discount is first allocated to the 2 performance obligations that
are identified as being the discounted obligations: the supply of the plant and the installation of the plant.
We do this by allocating C220 000 of the transaction price (i.e. the discounted price for the stand-alone bundle)
to these 2 obligations and allocating the remaining C80 000 to the 3rd obligation, the maintenance of the plant.
If the performance obligations relating to the supply of the plant and the maintenance of the plant will
be satisfied at different times, then the C220 000 transaction price will then need to be allocated
between these two performance obligations.
This allocation will be done based on their relative stand-alone selling prices:
Stand-alone Allocation of Allocation of
selling prices TP discount
Supply & installation of plant Stand-alone price for the bundle C220 000
x supply of plant C200 000 TP for the bundle: C220 000 x C176 000 24 000
200 000 / (200 000 + 50 000)
x installation of plant C50 000 TP for the bundle: C220 000 x C44 000 6 000
50 000 / (200 000 + 50 000)
Maintenance of plant (3yrs) C80 000 Stand-alone price for the stand- C80 000 0
alone service
C330 000 C300 000 30 000
176 Chapter 4
In the above example, the discount offered when regularly selling stand-alone bundles was
exactly the same as the discount offered in the contract (C30 000). However, if the discount
regularly offered on a stand-alone basis is substantially the same as the discount offered in the
contract, this full contract discount of C30 000 would still be allocated to the performance
obligations making up that bundle.
Example 28: Allocating discount - the regular discount ≠ contract discount
Lunch Limited signed a contract with a customer, Dinner Limited, involving 4 performance
obligations: the supply of A, B, C and D.
The consideration promised in the contract is C300 000.
Lunch Limited regularly sells A, B, C and D at the following prices:
A C200 000
B C50 000
C C60 000
D C20 000
C330 000
Lunch Limited regularly sells A and B as a bundle, at a discounted price of C230 000. There is
observable evidence (which meets all 3 criteria in IFRS 15.82) that the contract discount should be
allocated to A and B only.
Required: Briefly explain, together with calculations, how Lunch should allocate the transaction price.
Solution 28: Allocating discount - the regular discount ≠ contract discount

The transaction price must be allocated to each performance obligation in the contract. The entity has
identified 4 performance obligations in the contract and given the stand-alone selling prices for each.
The sum of the 4 stand-alone prices is C330 000 (C200 000 + C50 000 + C60 000 + C20 000) whereas
the total promised consideration is only C300 000. Thus, a discount of C30 000 exists in the contract.
In the case of this contract, we do not allocate the discount proportionately to all 4 performance
obligations because there is observable evidence, which meets all three criteria, that suggests that the
entire discount relates to only A and B.
As mentioned above, the contract discount is C30 000. However, the regular discount offered when selling
A and B as a bundle is only C20 000 (sum of the stand-alone prices for A and B: C250 000 - stand-alone
prices for the bundle: C230 000). Although the contract discount (C30 000) and the regular discount for the
bundle of A and B (C20 000) are not the same, the fact that the 3 criteria were all met means that the entity
considers them to be substantially the same (i.e. the difference of C10 000 is immaterial).
As such, the full contract discount of C30 000 is allocated to A and B even though they are normally
sold as a bundle at a discount of only C20 000. The transaction price is thus allocated as follows:
Stand-alone Stand-alone Allocation of Allocation of
selling prices: selling prices: transaction price discount
individual bundles (balancing)
A C200 000 TP for the bundle: C220 000 calc 1 x 200 000 / C176 000 C24 000
C230 000 (200 000 + 50 000)
B C50 000 (discount of TP for the bundle: C220 000 calc 1 x 50 000 / C44 000 C6 000
C20 000) (200 000 + 50 000)
C C60 000 Individual stand-alone price C60 000 0
D C20 000 Individual stand-alone price C20 000 0
C330 000 C300 000 C30 000
Calculation 1:
The TP for the bundle = C220 000; calculated in a number of ways, as follows:
- Stand-alone price for a bundle: C230 000 – Extra discount contained in the contract: C10 000 = C220 000
- Stand-alone price for A: C200 000 + Stand-alone price for B: C50 000 – Total contract discount: C30 000= C220 000
- Transaction price: C300 000 – Stand-alone price for individual C & D: (C60 000 + 20 000) = C220 000
Comment: Notice that when we allocate the TP (and related discount) to A and B, we allocated what we referred
to as the transaction price for the bundle of C220 000 (i.e. after deducting the discount per the contract) – we did
not allocate the normal stand-alone price for the bundle of C230 000.
Chapter 4 177
If we decide we need to allocate a discount to only one or some of the performance obligations (i.e.
not to all of them), and we also need to estimate the stand-alone selling prices of one or more of the
other performance obligations using the residual approach, then we must allocate the discount first
before we calculate the estimated stand-alone selling price using the residual approach.
Example 29: Allocating discount before applying the residual approach
Tea signed a contract with a customer, Cake, involving 3 performance obligations: the supply
of A, B and C.
The contract price is C280 000, which is considered to be a discounted price.
Tea regularly sells A and B:
x on an individual basis for C200 000 and C50 000, respectively
x as a bundle for C230 000 (i.e. at a discount of C20 000).
C is a one-of-a-kind product that Tea has never sold before. It has no reliable measure of the costs and
has no idea what the market price for C might be.
There is observable evidence (which meets all 3 criteria in IFRS 15.82) that the contract discount
should be allocated to A and B only.
Required: Briefly explain, together with calculations, how Tea should allocate the transaction price.
Solution 29: Allocating discount – the regular discount ≠ contract discount

This contract involves 3 performance obligations (POs): the supply of A, B and C. The transaction price must
be allocated to each of these POs based on their relative stand-alone selling prices (SASPs). We have the
SASPs for A and B but not for C. There is no way of estimating the SASP for C other than using the residual
approach. However, the contract price is considered to be discounted, and since Tea regularly sells A and B on
both an individual basis as well as on a discounted bundle-basis, we must consider the possibility that the entire
contract discount, if any, might apply only to these specific POs. In other words, it is possible that the contract
price of C280 000 was determined by including products A and B at their discounted bundle price of C230 000
rather than at the total of their undiscounted individual prices of C250 000 (C200 000 + C50 000).
In this regard, we are told that there is observable evidence that any discount in the contract is attributable solely
to products A and B. Thus, when applying the residual approach to estimate the SASP for product C, our first
step must be to allocate the discount to these specific products. This means the estimated SASP for product C,
using the residual approach, is C50 000 (CP: 280 000 – discounted bundle price for A&B: 230 000).
The second step is to allocate the portion of the transaction price representing the ‘discounted bundle price’ of
C230 000 to the individual POs making up the bundle: the supply of product A and the supply of product B.
We do this based on their relative undiscounted individual SASPs.
Stand-alone Stand-alone Allocation of Allocation of
selling prices: selling prices: transaction price discount
individual bundles (balancing)
A C200 000 C230 000 230 000 x 200 000 / (200 000 + 50 000) C184 000 C16 000
B C50 000 (discount of 230 000 x 50 000 / (200 000 + 50 000) C46 000 C4 000
C20 000)
C ? TP: 280 000 – Discounted SASP for the C50 000 0
bundle of A&B: 230 000
? C280 000 C20 000
Comment:
x This example involved a situation where there was a discount that did not apply to all POs and where one of
the SASPs was estimated using the residual approach.
x This situation requires that we allocate the discount to the specific POs before estimating the residual SASP.
8.4 Allocating variable consideration (IFRS 15.84-.86) Notice that there is a

difference between:
As we know, the transaction price is normally allocated to the x a discount inherent in a contract
various performance obligations based on their relative stand- (due to the fact that the contract
alone selling prices. price is less than the sum of the
stand-alone selling prices) – see
section 8.3; and
However, if the transaction price includes variable x an unsecured discount, being one
consideration, the total transaction price may not always be that has not yet been secured –
this discount is treated as variable
allocated in this way. consideration (e.g. an early
settlement discount)
178 Chapter 4
A transaction price that includes variable consideration is constituted as follows:

TP = fixed consideration + variable consideration.
This variable consideration may apply ‘across the board’ to all the performance obligations in
the contract, in which case there will be no change in how we allocate our transaction price.
In other words, the total transaction price (fixed + variable) will be allocated based on relative
stand-alone prices.
Variable consideration
However, it can happen that the variable consideration is allocated to only one/
applies to only one/some of the performance obligations or some of the POs (or to a
may even apply to only part of a single performance part of a PO) in the contract if:
obligation. In this case, the variable consideration will be x the discount is specifically
allocated to these certain specific performance obligations, connected to this PO/s (or to part
but only on condition that certain criteria are met, and the of a PO) and
remaining fixed consideration would be allocated based on x both criteria in para 85 are met,
stand-alone selling prices. indicating that it is appropriate
under the circumstances to
allocate it to this specific PO/s (or
For example: A contract includes the supply of product A part thereof) .
(PO 1), the supply of product B (PO 2) and the supply of a See IFRS 15.85
service (PO 3). The transaction price includes fixed

consideration in relation to the supply of the products PO 1 and PO 2 but includes variable
consideration relating to the service.
x the fixed consideration would be allocated in the normal way, based on the stand-alone
prices for the two products (PO 1 and 2), but
x the variable consideration may need to be allocated exclusively to the service (PO 3).
Where the transaction price includes variable consideration that does not apply to all the
performance obligations, this variable consideration must be separated out from the
transaction price and allocated to the specific performance obligation/s (or parts thereof) to
which the variable consideration relates, but this is done only if both criteria in IFRS 15.85
are met (see grey box above).
If the variable consideration does not meet both these criteria, then it may not be separated out and
allocated to the specific performance obligation/s. In other words, the sum of the ‘fixed
consideration’ and the ‘variable consideration that does not meet the criteria in IFRS 15.85’ will
be allocated to all the performance obligations based on their relative stand-alone selling prices.
The following two criteria must be met before variable consideration may be allocated
to specific POs (or to parts of certain POs):
a) the terms of a variable payment relate specifically to either:
x the entity’s efforts to satisfy the performance obligation or transfer the distinct good/ service, or
x a specific outcome from satisfying the performance obligation or transferring the distinct good/
service; and
b) allocating the variable amount of consideration entirely to the performance obligation (or to the distinct
good or service) is consistent with the allocation objective (para 73) when considering all of the
performance obligations and payment terms in the contract (i.e. the result of the allocation must depict
the amount of consideration to which the entity would expect to be entitled in exchange for each
promised transfer). IFRS 15.85 (reworded)
These two criteria essentially require that the variable

Variable consideration
consideration must be specifically related to that that does not meet
performance obligation (criterion a), and that the variable both criteria in para 85
consideration allocation accurately reflects what the entity is:
believes it should receive for rendering that specific x added to the fixed consideration
performance obligation (criterion b). and
x allocated based on relative stand-
The next example illustrates the allocation of variable alone selling prices.
See IFRS 15.86
consideration to all or some of the performance obligations.
Chapter 4 179
Example 30: Allocating variable consideration to all/some of the performance

obligations
Coffee Limited signed a contract for C200 000 with a customer, Milk Limited, involving 2
performance obligations: the construction of a building (A) and the supply of unrelated globes (B).
The stand-alone selling prices of each of these performance obligations are as follows:
A C160 000
B C30 000
C190 000
In addition to the contract price of C200 000, the entity will be paid a bonus of C10 000 if it meets
certain criteria.
Based on past experience, the entity believes that it is most likely that it will qualify for this bonus and
highly probable that including the bonus in the transaction price will not lead to a significant reversal of
revenue in future.
Required:
Briefly explain, together with calculations, how Coffee must allocate the transaction price if:
a) the criterion to qualify for the bonus is for the contract to be completed within a certain time period.
b) the criterion to qualify for the bonus is for the building to be completed within a certain time period.
Solution 30 A: Allocating variable consideration to all the POs

The bonus is ‘variable consideration’ since it is not certain the entity can comply with the terms thereof.
Since the terms of the bonus apply to the entire contract, the bonus clearly applies to both performance
obligations (POs), and thus the bonus must be allocated to both POs. (i.e. applying criterion (a) of IFRS 15.85)
Since no information is given to the contrary, we assume the final allocation of C210 000 depicts the amounts to
which the entity expects to be entitled for each PO. (i.e. criterion (b) of IFRS 15.85)
(including the bonus)
A C160 000 210 000 x 160 000 / (160 000 + 30 000) C176 842
B C30 000 210 000 x 30 000 / (160 000 + 30 000) C33 158
Note 1
C190 000 200 000 + Bonus 10 000 C210 000
Note 1: notice that the transaction price including the variable consideration was allocated (200 000 + 10 000).
Solution 30 B: Allocating variable consideration to some of the POs

The bonus is variable consideration since it is not certain the entity can comply with the terms thereof.
Since the terms of the bonus apply only to the construction of the building i.e. only one of the performance
obligations (POs), the bonus must only be allocated to this specific PO. (i.e. applying criterion (b) of IFRS 15.85)
Since no information is given to the contrary, we assume the final allocation of C210 000 depicts the amounts to
which the entity expects to be entitled for each PO. (i.e. being criteria (b) of IFRS 15.85)
Stand-alone Allocation of Allocation of Allocation of
selling prices transaction price variable transaction price
excluding the bonus consideration including bonus
A C160 000 200 000 x 160 000 / (160 000 + 30 000) C168 421 C10 000 C178 421
B C30 000 200 000 x 30 000 / (160 000 + 30 000) C31 579 0 C31 579
C190 000 C200 000 C10 000 C210 000
The following example shows that, even if the variable consideration applies to only certain
specific performance obligations, it may be necessary to allocate the variable consideration to
all the performance obligations. This is done when the allocation to a specific obligation
results in an allocation that is not representative of the consideration that the entity expects to
be entitled to (i.e. if criteria (b) of IFRS 15.85 is not met).
180 Chapter 4
Example 31: Allocating variable consideration

Supper Limited signed a contract with a customer, Pudding Limited, involving two
performance obligations (POs): the transfer of a machine (PO 1) and the construction of a factory
building (PO 2). The consideration promised in the contract includes a fixed consideration for the
machine of C20 000 and variable consideration for the construction of the factory building. The
variable consideration is as follows:
x C500 000 if the building takes one month or less to complete;
x C400 000 if the building takes more than one month but less than two months to complete; or
x C150 000 if the building takes two months or more to complete.
Supper estimates that it will complete the building in just under two months and thus that C400 000
will be received. This estimate is what the entity expects to be the most likely amount and it is
considered highly probable that, if it is included in the transaction price, a significant reversal of
revenue will not occur in the future.
The entity determines the transaction price to be C420 000:
PO 1: Machine: Fixed C20 000
PO 2: Building: Variable (i.e. estimated) C400 000
C420 000
The stand-alone selling prices at contract inception for each performance obligation are as follows:
PO 1: Machine C100 000
PO 2: Building C350 000
C450 000
Required:
Briefly explain, together with calculations, how Supper Limited should allocate the transaction price.
Solution 31: Allocating variable consideration

The transaction price (TP) must be allocated to each performance obligation (PO) in the contract. The
entity has identified 2 POs in the contract and has the stand-alone selling prices (SASPs) for each.
The promised consideration contains both fixed consideration (stated in the contract at C20 000 for
PO 1) and variable consideration (the estimated amount to which the entity expects to be entitled is
C400 000 for PO 2).
Although the contract states that the variable consideration relates purely to PO 2, before we may
allocate it entirely to PO 2 we must decide whether or not this would be appropriate by first assessing
whether it meets the two criteria listed in IFRS 15.85:
a) the terms of the variable consideration must relate to either the entity’s efforts to satisfy the PO or
to a specific outcome resulting from the PO; and
b) by allocating the variable consideration to just certain POs (i.e. not all of them), we must be sure the
allocation objective is met for all the POs. (i.e. the portion of the TP allocated to each of the POs must
reflect the amount to which the entity expects to be entitled for the transfer of the related good or service).
Discussion of the criteria:
a) In this case, the variable consideration depends entirely on the efforts by the entity to meet the
required deadlines. Thus criteria (a) is met.
b) If we allocate the entire variable consideration of C400 000 to PO 2, it means that PO 1 will be
allocated just the fixed consideration of C20 000. However, since the C20 000 is significantly
lower than PO 1’s SASP of C100 000, it is suggested that the allocation objective would not be
met. Thus, criteria (b) would not be met if the variable consideration of C400 000 was allocated
entirely to the building.
Since only one of the criteria are met, the C400 000 cannot be allocated to the building only.
Instead, we must combine the expected variable consideration of C400 000 and the fixed consideration
of C20 000 (C400 000 + C20 000 = C420 000) and then allocate this total consideration of C420 000 in
the usual way:
Chapter 4 181
A C100 000 TP: C420 000 x 100 000 / 450 000 C93 333
B C350 000 TP: C420 000 x 350 000 / 450 000 C326 667
C450 000 C420 000
Comment: This example depicts a scenario where, although the contract states that the variable
consideration relates to only one PO, allocating it entirely to that PO is not always appropriate (i.e. it may not
always meet the allocation objective). In this situation, the variable consideration is allocated to all POs.
8.5 Allocating a change in the transaction price to performance obligations (IFRS 15.87-.90)
It is possible for a transaction price to change after initial recognition. A transaction price
could change for a number of different reasons including, for example, the resolution of
previously uncertain events (e.g. it is possible that some consideration that was previously
considered to be variable consideration is now fixed).
If the transaction price changes, any change must be allocated to the performance obligations
using the same allocation that was used at contract inception (e.g. if we used observable
stand-alone selling prices as the basis for the allocation at contract inception, we would
allocate the increase or decrease in the transaction price using these same observable stand-
alone selling prices – even if these have subsequently changed).
If the transaction price changes after some performance obligations have been satisfied, it
would mean that the revenue for these performance obligations would have already been
recognised. Thus, an increase or decrease in the transaction price allocated to these satisfied
performance obligations is recognised immediately as an adjustment to revenue.
Note: a change in the transaction price (TP) as envisaged in this section is not a contract modification.
x A contract modification entails a change in the scope or the price of a contract, (creating new or
changing existing enforceable rights and obligations).
x In this section, the change in the TP is due to the resolution of a prior uncertainty and thus is not a
contract modification (see section 5.7).
9. Satisfying performance obligations (step 5) (IFRS 15.31-.45)
9.1 Overview
Identifying the date on which (or periods over which) we Knowing when a
satisfy our performance obligations (i.e. identifying when performance obligation
we have completed doing what we promised to do) is very is satisfied is important
important because this is the date when (or period in which) because:
we recognise the revenue from that performance obligation. x Revenue can only be recognised
x as/when we have satisfied our
Some obligations will take time to complete (i.e. satisfied performance obligations.
over time) and some will be completed in an instant (i.e. See IFRS 15.31
satisfied at a point in time).
We need to decide, at the inception of a contract, how each of the performance obligations in
a contract will be satisfied (i.e. will it be satisfied over time or in an instant).
To decide this, we have to ascertain if it meets the criteria that would classify it as a
performance obligation satisfied over time. If it does not meet these criteria, then it is
classified as a performance obligation satisfied at a point in time.
If we believe that our performance obligation will be satisfied over time, we will need to
decide how to measure our progress towards complete satisfaction of the performance
obligation since we will have to recognise this revenue gradually over this period of time.
182 Chapter 4
9.2 How do we assess when a performance obligation has been satisfied? (IFRS 15.31-.33)
A performance obligation is considered to be completely
A performance
satisfied when the goods or services have been transferred to obligation is satisfied
the customer. See IFRS 15.31 when:
This transfer of goods or services occurs when the customer has x the goods or services have
transferred
obtained control over the goods or services. See IFRS 15.31
x which is when control has passed.
See IFRS 15.31
We assess whether control has passed to the customer by
referring to our understanding of the control over an asset. Interestingly, the standard clarifies that
all goods – and even services – are considered to be assets, ‘even if only momentarily’. See IFRS 15.33
9.3 How do we assess when control has passed? (IFRS 15.33)
Control over assets is evidenced by the ability to dictate how Control over an asset is
the asset will be used and the ability to obtain most of its evidenced by the ability
remaining benefits. Control can also be proved by the ability to to:
prevent others from obtaining most of its remaining benefits. x direct how the asset will be used;
and the ability to
Benefits refer to direct or indirect: x obtain substantially all of its
x cash inflows; or remaining benefits.
IFRS 15.33 reworded
x reductions in cash outflows.
A customer could obtain these benefits in many different ways, such as by using the goods or
services or selling them onwards or pledging them as security in order to obtain a loan.
When we assess whether control over the asset has passed to a customer, we must be careful
to consider any possible repurchase agreements (e.g. where we have sold goods to a customer
but have agreed to buy them back after a period of time – or have the option to do so under
certain circumstances). Although it may look like control has passed to a customer, the
existence of a repurchase agreement may prove that control has not actually passed.
Repurchase agreements are explained in section 9.6. See IFRS 15.34
9.4 Classifying performance obligations as satisfied over time or at a point in time
9.4.1 Overview
Performance obligations
As already explained, revenue relating to a performance are classified (at
contract inception) as:
obligation is recognised when the obligation is satisfied –
and this occurs when control over the promised goods or x satisfied over time; or
services is transferred to the customer. x satisfied at a point in time.
See IFRS 15.32
At contract inception, we first assess if the performance obligation is satisfied over time. If it is not a
performance obligation satisfied over time, we conclude that it must be a performance obligation
satisfied at a point in time. In assessing if a performance obligation is satisfied over time, we
consider whether the performance obligation meets any one of the three core criteria. If it fails to
meet any of these criteria, then we conclude that it must be a performance obligation that will be
‘satisfied at a point in time’. This process is shown diagrammatically below: See IFRS 15.32
Diagram 3: Overview of the classification of performance obligations

Classification of a
performance obligation (PO)
PO satisfied at a No Does the PO meet any of the Yes PO satisfied

point in time 3 criteria to be classified as over time
a PO satisfied over time?
Chapter 4 183
9.4.2 Performance obligations satisfied over time (IFRS 15.35-.37)
A performance obligation is classified as ‘satisfied over time’ if any one of the three core
criteria given in paragraph 35 is met. These three criteria are presented diagrammatically
below. Each of these 3 criteria are then discussed in more detail in the 3 separate diagrams
that follow thereafter.
Diagram 4: The 3 core criteria used to classify performance obligations
Classification of a
performance obligation (PO)
Does the PO meet any one of the 3 criteria to be classified as a Yes

PO satisfied over time?
See IFRS 15.35 & B3-B13
No Criterion 1
Does the customer receive the asset & consume its benefits at the
same time that the entity performs its obligations?
See IFRS 15.35(a) & .B3-B4
PO satisfied
Or
over time
Criterion 2
If the entity is creating or enhancing an asset, does the customer
obtain control of the asset as it is being created or enhanced?
See IFRS 15.35(b) & .B5
Or
Criterion 3
If the entity is creating an asset, does:
x the asset have no alternative use for the entity; and does
x the entity have an enforceable right to payment for
performance completed to date?
See IFRS 15.35(c) & .B6-B8 & .B9-B13
PO satisfied
at a point in time
As has been explained, if any one of the three criteria is met, then the performance obligation
is classified as ‘satisfied over time’. Each of these criteria are now explained in more detail.
9.4.2.1 Criterion 1: Does the customer receive the asset and consume its benefits as the
entity performs? (IFRS 15.35 (a))
The essence of the criteria given in paragraph 35 (a) is that, if the customer receives the asset
and consumes its benefits as the entity is in the process of performing its obligation, then we
conclude that the obligation is being satisfied over time.
Sometimes this is straight-forward such as in the case of an entity providing a customer with
cleaning services. However, it may not always be as straight-forward in which case the
diagram overleaf shows the logic to apply in assessing whether this criterion is met or not.
184 Chapter 4
Diagram 5: Classifying performance obligations – using criterion 1
Using criterion 1 to classify a performance obligation (PO)
Criterion 1: Yes
Does the customer receive & consume benefits at the same time
that the entity performs its obligations?
See IFRS 15.35(a)
If it is difficult to answer this, ask yourself the following:

Hypothetically, if another entity were to complete our outstanding performance
obligations, would it need to ‘substantially re-perform’ the work we have already
done? If the answer to this is:
x Yes, then the answer to criterion (1) is:
No, the customer does not receive & consume the benefits as the entity
performs its obligations = thus, we must also consider criteria (2) and (3)
x No, then the answer to criterion (1) is:
Yes, the customer does receive & consume the benefits as the entity
performs its obligations = PO satisfied over time
PO satisfied
over time
In other words: if that other entity would not have to re-perform the work we
have already done, then we conclude that the customer was receiving and
consuming the benefits as we were performing our obligations.
Tip: Typically, the provision of services that are routine would not need re-
performance whereas specialised services probably would. However, the specific
circumstances would have to be considered carefully.
In answering this:
x ignore any contractual restrictions or practical limitations that might
prevent us from getting some other entity to complete our PO; and
x assume that any asset we have created so far in the performance of
our PO would remain in our control and would not be of benefit to the
other entity.
In other words: we ignore any facts that would contractually or physically

prevent us from actually transferring the remaining obligations to another
entity and assume that any asset we have created to date would not be
available to the entity that takes over the remaining obligations.
See IFRS 15.B3-4
No
Consider criteria 2 and 3 before concluding that the PO is satisfied

at a point in time
Example 32: Classifying performance obligations:

x considering the first criterion
Admin & Legal Services provides various services to customers on a contract basis. During
June, it signs contracts with two customers:
a) Contract 1 involves providing a customer with the services of a telephonist for six months.
b) Contract 2 involves providing a customer with legal advice and representation leading up to a court
case in which this customer is being sued.
Required:
For each contract, classify the performance obligation by assessing whether or not the customer
receives an asset & consumes its benefits as the entity performs its obligation.
Chapter 4 185
Solution 32: Classifying performance obligations: the first criterion

a) The nature of the receptionist’s tasks is routine, which typically suggests that ‘substantial re-
performance’ of these tasks is unnecessary or even impossible.
Assuming, for example, we provided the customer with only four months of the promised services, and
another entity was to complete our obligation and provide a receptionist for the remaining two months,
this other entity would not be required to ‘substantively re-perform’ the work we had done in the first
four months.
Since the new entity would not (and, in this case, could not) be required to re-perform any work, we
would conclude that the customer received and consumed the related benefits of the telephonist services
at the same time that they were provided.
Conclusion:
This performance obligation would be considered to be ‘satisfied over time’.
b) The nature of the legal advice and representation is not routine, which typically suggests that ‘substantial
re-performance’ of these tasks would be necessary.
Assuming, for example, we provided the customer with only four months of legal advice and
representation and, for some reason, another entity was to take over this obligation (e.g. perhaps the
customer was unhappy with the service we had provided), this new entity would need to ‘substantively
re-perform’ the work we had done.
This is because all the work done by us, (for example, the meetings to discuss legal issues plus the
ensuing legal paperwork), is assumed to be our asset that would not be available to the new replacement
entity. Furthermore, if another entity were to take over our obligation of legal advice and representation,
it would need to start from scratch in order to understand the case against the customer and prepare its
own legal advice.
Since a replacement entity would need to ‘substantively re-perform’ the work we had done, we conclude
that the customer would not receive and consume the related benefits as we perform our obligation.
Conclusion:
This criterion is not met and thus, unless it meets one of the remaining two criteria, this performance
obligation would not be considered to be ‘satisfied over time’.
9.4.2.2 Criterion 2: Does the customer get control as the asset is being created or enhanced?
(IFRS 15.35 (b))
The essence of the criterion given in paragraph 35 (b) is that we will conclude that the
obligation is being satisfied over time, if:
x the customer gets control over an asset that the entity is either creating or enhancing, but
x the customer gets this control during the process of creation or enhancement (i.e. as
opposed to the customer only getting control once the creation or enhancement of the
asset has been completed).
This criterion obviously needs us to thoroughly understand when control passes. The
customer is said to have control over an asset when either:
x the customer is:
able to direct the use of the asset (i.e. able to decide how it will be used); and
obtain most of the benefits from that asset; or
x the customer has the ability to prevent others from doing so. see IFRS 15.33
In deciding when control is expected to pass, we must consider all indicators of control (see
the diagram below for some examples of indications of control passing, per IFRS 15.38).
186 Chapter 4

Criterion 2: Yes
If the entity is creating or enhancing an asset, does the customer get
control during the period that this asset is being created or enhanced?
See IFRS 15.35(b) & .B5
We assess when the customer is expected to obtain control by:

x asking ourselves when we expect the criteria for control to be met and
x considering all indicators of control (examples of which are given in IFRS 15.38),
Important: be aware that the existence of a repurchase agreement may negate these
criteria (see section 9.6 and IFRS 15.33 and .34).
Remember the control criteria, per IFRS 15.33/4:

The customer is considered to have control if it is able:
x to direct the use of the asset &
x obtain substantially all of its benefits
PO satisfied
over time
If we assess that these control criteria will be met during the period that the
asset is being created or enhanced, then criterion 2 is met and thus the PO is
classified as ‘satisfied over time’.
If, however, we assess that these control criteria will not be met during the
period of creation or enhancement (e.g. the criteria will only be met after the
asset has been created or enhanced), then criterion 2 is not met and thus it
suggests that the PO may be satisfied at a point in time – but before we conclude
this, we would need to consider criteria 1 and 3.
Indicators of control, per IFRS 15.38:

The following are indicators (given as examples in IFRS 15.38) which may or may
not be relevant to assessing when control is expected to pass to the customer:
Note 1
a) When the customer will become obliged to pay for the asset
Note 2
b) When the customer will obtain legal title over the asset
c) When the customer will obtain physical possession of the asset Note 3
d) When the customer will obtain the significant risks and rewards of
ownership Note 4
e) When customer acceptance will occur. Note 5
Professional judgement is essential when assessing these indicators.
No
at a point in time
Notes: There are a number of important points that we need to bear in mind when assessing the
indicators of control (given as examples in paragraph 38 of IFRS 15):
1. If our assessment is that the customer will be obliged to pay for the asset after completion of the
asset, this may suggest that the obligation is satisfied at a point in time whereas, if our
assessment is that the customer will be obliged to gradually pay for the asset during completion of
the asset, this may suggest that the obligation is satisfied over time.
2. If the passing of legal title is relevant to the asset in question, we must bear in mind that, if we
plan to retain legal title purely to force our customer to pay, this fact would be ignored when
assessing when our customer obtains control. In other words, the possibility that we may end up
retaining the legal title over the asset to force the customer to pay, would not stop us from
concluding that the customer has obtained control and thus this retention would not stop us from
recognising the related revenue. See IFRS 15.38 (b)
Chapter 4 187
3. If physical possession is relevant to the asset in question, we must bear in mind that:
- physical possession may not always indicate control e.g. in the case of certain repurchase
agreements and consignment sales; and
- control can exist without physical possession e.g. in some bill-and-hold agreements. See IFRS 15.38 (c)
4. If the transfer of risks and rewards is relevant to the asset in question, we must be careful when
the risks and rewards are expected to transfer on a piecemeal basis! See IFRS 15.38 (d)
This is because the risks & rewards that remain un-transferred for a time may actually relate to a
separate performance obligation.
E.g. a contract involving the obligation to provide a customer with a car plus future maintenance
normally results in the risks and rewards over the car transferring before the risks and rewards
over the maintenance services would transfer, in which case the customer would probably have
control of the car even though not all risks and rewards in the contract have transferred.
5. If customer acceptance is relevant to the asset in question, we must consider whether the
contract includes a customer acceptance clause/s. If so, clauses that can be objectively assessed
by the entity (e.g. the goods must meet certain dimensions) could be used to determine when the
customer acceptance is expected to occur without the need for formal customer acceptance. On
the other hand, clauses that are not able to be objectively assessed would still need the customer’s
See IFRS 15.38 (e)
formal acceptance before concluding that the customer has obtained control.

x considering the second criterion
Consider the following two contracts:
a) Contract 1 involves providing a customer with onsite developers who will be tasked
with enhancing the customer’s existing live accounting system.
b) Contract 2 involves manufacturing 30 000 widgets over a period of 3 months, with
delivery and full payment expected to take place at the end of the 3-month period.
Required: For each contract, classify the performance obligation by assessing whether or not the
customer gains control during the creation or enhancement of the asset.
Solution 33: Classifying performance obligations: considering the second criterion
a) Since the enhanced accounting system is being developed onsite and is being developed live, the
customer has physical possession of the asset and will be able to direct the use thereof and obtain
substantially all of its benefits (i.e. be able to control it) while it is being enhanced.
Conclusion: There are indications to suggest that the customer obtains control during the creation
of this asset (i.e. that criterion 2 is met) and thus the performance obligation will be classified as
‘satisfied over time’.
b) The customer is only obliged to pay at the end of the three-month period at which point the
customer would be considered able to direct the use of the widgets and be able to obtain
substantially all their benefits. Similarly, the customer will only obtain physical possession at the
end of the three-month period at which point the risks and rewards of ownership will also
transfer. Physical possession, in this case, enables the customer to not only direct the use of the
widgets and obtain substantially all their benefits, but also enables the customer to prevent others
from doing so.
Conclusion: The indicators suggest that the customer obtains control after the widgets are created
(i.e. at the end of the three-month period), not during their creation and thus this second criterion
is not met. Thus, unless the obligation meets one of the other two criteria, this performance
obligation will be classified as ‘satisfied at a point in time’.
9.4.2.3 Criterion 3: Does the entity have no alternative use for the asset and an enforceable
right to payment? (IFRS 15.35 (c))
The essence of the criteria in paragraph 35 (c) is that, where a performance obligation requires
an entity to create an asset, this obligation is classified as satisfied over time if the entity:
x has no alternative use for this asset (i.e. all it can do with the asset is give it to the customer in
terms of the contract), and
x has an enforceable right to payment for performance to date throughout its creation.
188 Chapter 4
The idea behind these two requirements is that if, for example, an entity is required to create a highly
specialised asset for a customer, the entity would probably need to incur significant extra costs or
would need to sell it at a significant discount if it was forced to find another purpose for this asset.
Thus, if the entity has no other use for the asset other than for the purpose stated in the contract,
we must deem that the customer controls this asset over the period of the contract. However,
since we are only deeming the customer to have control, we must also be able to prove that, at
all times during the contract period we will have a right to be paid for the work completed to
date (i.e. in the event that the contract is terminated by the customer or some other entity for
reasons other than the entity failing to perform as promised). Having a right to receive payment
for work completed to date gives us added confidence that the customer is obtaining benefits as
the entity is performing its obligations (i.e. that they are being satisfied over time).
An entity will have no alternative use for an asset if it is prevented from being able to readily
use it for some purpose other than the purpose in terms of the contract, and where the entity is
prevented through either contractual restrictions that are substantive (section 9.4.2.3.1 explains
how to decide if a contractual restriction is ‘substantive’) or practical limitations,. The
enforceable right to payment must exist throughout the contract term and must be expected to
be sufficient compensation for any performance completed to the date of termination.
Criterion 3:
Yes
If the entity is creating an asset,
See IFRS 15.35 (c)
does the entity have:
No alternative use An enforceable right to payment

for the asset AND for performance completed to
date
This is evidenced by either: This right to payment must:
PO satisfied
x Substantive contractual x exist continually throughout over time
restrictions preventing the the period of the contract; and
entity from being able to x be sufficient compensation for
readily use the incomplete asset any performance completed to
for something else; or date.
x Practical limitations preventing
the entity from being able to
readily use the complete asset
for something else.
See IFRS 15.B6-B8 See IFRS 15.B9-B13
No

at a point in time
9.4.2.3.1 No alternative use (IFRS 15.36 and .B6-B8)

Having an alternative use for an asset means being readily able to use it for some other
purpose (i.e. other than the purpose envisaged by the contract).
An entity is considered to have no alternative use for the asset if it is either:
x contractually restricted from readily using the asset during its creation/ enhancement –
and if these contractual restrictions are substantive; or
x practically limited from readily using the asset after its completion. See IFRS 15.36
Chapter 4 189
Notice that:
x The requirements for contractual restrictions:
- refer only to the use of the incomplete asset. (i.e. during its creation or enhancement).
Thus, a contractual restriction that prevents the entity from using the incomplete asset
fulfils this requirement but a contractual restriction that only prevents the entity from
using the completed asset would not fulfil this requirement (because it would then be
possible for this asset, while incomplete, to have an alternative use).
- refer only to contractual restrictions that are substantive:
A contractual restriction is substantive ‘if a customer can enforce its rights to the
promised asset’ in the event that the entity used it for some other purpose.
Thus, the contractual restriction would be substantive if, by using the asset for some other
purpose, the entity would breach the contract and incur significant extra contract costs.
x The requirement for the practical limitation refers only to the completed asset.
Thus, a practical limitation that prevents the entity from using the completed asset fulfils
this requirement but a practical limitation that only prevents the entity from using the
incomplete asset would not fulfil this requirement (because it would then be possible for
this asset, while complete, to have an alternative use).
We decide whether the entity has no alternative use for the asset at the inception of the
contract and we do not re-assess this decision unless a contract modification is approved that
causes the performance obligation to be substantively changed (see section 5.7 for more about
contract modifications). See IFRS 15.36
9.4.2.3.2 Enforceable right to payment (IFRS 15.37 and IFRS 15.B9-B13)
We conclude that the entity has a right to payment that is enforceable if:
x the entity is entitled at all times throughout the contract
x to a payment that would be sufficient to compensate for performance completed to date
x in the event of a contract termination, for reasons other than a breach by the entity, and
x this entitlement is enforceable by either contractual terms and/or any laws that apply.
When we talk about the right to payment, we are not referring to a present right but rather to
the right to be able to demand such payment (or retain payments) if the contract were to be
terminated by another party.
A payment would be considered sufficient to compensate for performance completed to date

if this payment is at least close to the selling price of the goods or services transferred to date:
x This selling price is calculated as cost plus a reasonable profit margin; and
x The reasonable profit margin is calculated as the lower of:
- the portion of the total expected profit on this specific contract, calculated based on
the performance completed to date of termination; or
- the return that the entity usually earns from similar contracts (e.g. based either on the
entity’s normal expected return on cost of capital or its normal operating margins).
In the event that the customer attempts to terminate the contract without having the right to
terminate, we (the entity) may have the legal right to continue completing our performance
obligations in terms of the contract in which case we would have the right to expect the
customer to complete their obligations (i.e. we would have a right to payment in full).
When assessing whether our right to payment is enforceable, we would not only look at the
contractual terms, but would also need to look at all other laws and/ or legal precedents that
may support the contractual terms or negate the contractual terms – or even create a right that
is not referred to at all within the contractual terms.
190 Chapter 4

x considering the first and third criterion
This example follows on from example 32.
Admin & Legal Services provides a customer with legal advice and representation leading up to a court
case in which this customer is being sued for defamation.
The contract includes a clause that, in the event of a termination that is not a result of a breach by
Admin & Legal Services, the customer will be required to compensate Admin & Legal Services for the
performance completed to date, calculated as the costs incurred to date plus a 20% profit.
Admin & Legal Services had calculated the contract price as costs plus a 30% profit margin whereas it
normally applied a profit margin of 10% on costs when quoting on similar contracts.
Required: Classify the performance obligation as either performed over time or at a point in time.
Solution 34: Classifying performance obligations: the first and third criterion
In order to decide whether the PO is satisfied over time or at a point in time, we need to assess whether
one of the three criteria are met.
Criterion 1 (IFRS 15.35(a)) and criterion 3 (IFRS 15.35(c)) would be relevant to this contract.
Assessment of criterion 1:
The nature of the legal advice and representation is not routine and would require substantial re-performance of
the work by another entity in the event of an early termination of the contract. Thus we conclude that the
customer does not receive the asset & consume its benefits at the same time that the entity performs its
obligations. This first criterion is thus not met. (For a full discussion, please see the solution to example 32).
Assessment of criterion 3:
Since the contract involves defending a customer against a case of defamation, the legal advice and
representation is customer-specific and there would thus be no alternative use for the asset created.
Furthermore, the contract entitles the entity to expect payment for work completed to date. Since this
entitlement is stipulated in the contract, and there is no evidence to suggest that there are laws that
would negate this clause, we can assume that it makes the right to payment enforceable.
Since the compensation will be calculated based on cost plus a 20% profit, we conclude that the
payment will be sufficient compensation since it roughly equates the selling price, where selling price
is considered to be cost plus a reasonable profit and where a reasonable profit is considered to be the
lower of the contract-specific profit (30%) and the normal profit applied to similar contracts (10%).
In other words, the lower of the contract-specific profit and the normal profit is 10% and since the
required 20% payment is higher than this, it is considered to be sufficient compensation.
Note: had the contract profit been calculated at 20% on costs and a normal profit on similar contracts
was 10% on costs but the contract required the customer to pay costs plus 5% profit, then the expected
payment would not be considered to be sufficient compensation.
Conclusion:
The third criterion is met and thus the performance obligation is considered ‘satisfied over time’.
9.5 Measuring progress of performance obligations satisfied over time (IFRS 15.39-.45)
9.5.1 Overview
Where a performance obligation is satisfied at a point in time (PIT), the revenue is recognised
immediately. If we have a performance obligation that is satisfied over time (SOT), we
recognise revenue gradually as this obligation is satisfied.
This means that, in the case of a performance obligation that is satisfied over time (SOT), we
will continually need to assess the progress towards complete satisfaction of this performance
obligation.
Chapter 4 191
The methods that may be used to measure this progress towards complete satisfaction of the
performance obligation are categorised as:
x input methods; and
x output methods.
When deciding which method is most appropriate, we will need to consider the nature of the
underlying good or service. Output methods are normally considered to be superior, but using
an output method may not always be possible and/ or may be too costly.
We may only use one method per performance obligation but whichever method is used, it
must be used consistently for all similar performance obligations.
If circumstances change and a different method of measuring progress needs to be adopted,

this must be accounted for as a change in accounting estimate in terms of IAS 8 Accounting
policies, changes in accounting estimates and errors.
When measuring the progress, irrespective of the method chosen, we must only ever include
in our calculations the goods or services over which the customer has obtained control.
9.5.2 Input methods (IFRS 15.B18-.B19)
The input method means calculating progress based on the entity’s efforts towards complete
satisfaction of a performance obligation. We look at the effort the entity has put in relative to
the total effort required in order to complete the performance obligation. This effort can be
measured in a number of ways. We could measure the entity’s efforts using costs incurred,
labour hours, machine hours or time elapsed. See example 36.
If the entity’s efforts are considered to be evenly expended over the performance period, then
we could simply use the straight-line method to recognise revenue. See example 35.
Example 35: Measure of progress – input methods – straight-lining

Lit-amuse is a business that offers customers access to a private library. It sells ‘any-time
access for a year’ for an annual membership fee of C1 200.
Required: Explain how Lit-amuse should measure the progress relating to the performance obligation.
Solution 35: Measure of progress – input methods – straight-lining

The performance obligation involves Lit-amuse providing access to the library for a period of a year.
The performance obligation is classified as satisfied over time because the customer would receive and
consume the benefits as Lit-amuse performs the obligation of providing access (criterion 1). IFRS 15.35(a)
The entity’s efforts are the same throughout the year – access simply has to be granted. Since the
entity’s efforts are evenly expended over the year, the best measure of progress would be time-based on
the straight-line method. In other words, Lit-amuse would recognise the revenue at C100 per month.
Example 36: Measure of progress – input methods

Scrubbers Limited signed an agreement whereby it is to scrape and re-plaster 50 old
buildings. The total contract price is C80 000. The expected contract cost is C50 000.
The following details were available as at year-end, 31 December 20X3:
x according to Scrubbers Limited, 30 buildings had been scraped and re-plastered;
x costs of C35 000 have been incurred to date (the total expected cost remains C50 000).
The following details are available as at year-end, 31 December 20X4:
x according to Scrubbers Limited, 20 buildings were scraped and re-plastered during 20X4;
x costs of C15 000 had been incurred during 20X4 (the total expected cost remains C50 000).
Required: Show the revenue journals for 20X3 and 20X4 for each of the following input methods of
measuring progress:
A. tasks already performed as a percentage of total tasks to be performed;
B. costs incurred to date as a percentage of total expected costs.
192 Chapter 4
Solution 36A: Measure of progress – input method: number of tasks completed

20X3 Debit Credit
Receivable (A) W2 48 000
Revenue from PO satisfied over time: input method: tasks complete
20X4
Revenue from PO satisfied over time: input method: tasks complete
Workings:
W1. Estimated progress: input method: tasks completed 20X3 20X4
Tasks performed to date 20X3: Given and 20X4: (30 + 20) 30 50
Total tasks to be performed Given 50 50
Percentage progress to date (30 / 50); (50 / 50) 60% 100%
W2. Revenue to be recognised based on estimated progress 20X3 20X4
Revenue recognised to date (80 000 x 60%) (80 000 x 100%) 48 000 80 000
Less revenue recognised in prior years (0) (48 000)
Revenue recognised in current year 48 000 32 000
Solution 36B: Measure of progress – input method: costs incurred

20X3 Debit Credit
Revenue from services satisfied over time: input method: costs
20X4
Workings:
W1. Estimated progress: input method: costs 20X3 20X4
Costs incurred to date 20X3: Given; 20X4: (35 000 + 15 000) 35 000 50 000
Total expected costs Given 50 000 50 000
Percentage progress to date (35 000 / 50 000); (50 000 / 50 000) 70% 100%
Revenue recognised to date (80 000 x 70%) (80 000 x 100%) 56 000 80 000
Revenue from performance obligations satisfied over time: general comment

x Notice that the amount of the revenue recognised changes depending on the method chosen to
measure the estimated progress.
x It is essential that we measure the estimated progress on a cumulative basis since the total revenue and/
or total expected contract costs may change over the period that the PO is satisfied (see ex 37)
Example 37: Measure of progress – input method: total costs changes

Use the same information from example 36 with the following additional information:
x the total expected contract costs changed to C60 000 during 20X4.
Required:
Show the journals for 20X3 and 20X4 assuming that the measure of progress is an input method using
costs incurred to date as a percentage of total expected costs.
Chapter 4 193
Solution 37: Measure of progress – input method: total costs changes

Journals: Debit Credit
20X3
20X4
W1. Estimated progress: input method: costs 20X3 20X4
Costs incurred to date 20X3: Given; 20X4: (35 000 + 15 000) 35 000 50 000
Total expected costs Given 50 000 60 000
Percentage progress to date (35 000 / 50 000); (50 000 / 60 000) 70% 83,3%
Revenue recognised to date (70% x 80 000) and (83.3% x 80 000) 56 000 66 667
Comment:
x It is essential that you calculate the measure of progress on a cumulative basis since the total
revenue and/ or total expected contract costs may change over the period that the PO is satisfied.
This example involves the situation where the total expected costs change.
x If you had not calculated the measure of progress on a cumulative basis (i.e. you had used the costs
incurred in 20X4 as a percentage of total expected costs: 15 000 / 60 000 = 25%), you would have
calculated an incorrect measure of progress for 20X4 as follows:
- 20X3: 70% (35 000 / 50 000): 70% x 80 000 = 56 000 revenue (there is nothing wrong YET)
- 20X4: 25% (15 000 / 60 000): 25% x 80 000 = 20 000 revenue (Here is where you would have
gone wrong: this should have been 10 667! Always remember to calculate the measure of
progress using cumulative figures: cumulative costs to date/ latest total estimated costs).
When measuring progress, we must remember to only consider goods or services over which
the customer has obtained control. A downside to the use of the input method is that it can
happen that there is not always a direct relationship between the inputs and the transfer of
control. Thus, care must be taken when using the input method to make appropriate
adjustments to the inputs when measuring progress. For example:
x if an input does not contribute to an entity’s progress in satisfying a PO (a wasted cost),
we exclude these inputs when calculating the measure of progress – see example 38; and
x if an input is not proportionate to the entity’s progress in satisfying a PO (i.e. it
exaggerates the entity’s progress), the best approach may be to limit the measurement of
the revenue related to that input to the extent of the cost of that input and to then exclude
the cost of that input when calculating the measure of progress – see example 39.
An input would not be considered proportionate to the entity’s progress in satisfying a PO if it

distorted the true measure of progress. This happens if a good was needed to satisfy a
performance obligation but, at inception of the contract, the entity expects that all the
following conditions will be met:
x the good is not distinct from the rest of the PO;
x the customer is expected to obtain control over the good significantly before receiving the
related services;
x the cost of the transferred good is significant relative to the total expected costs to
completely satisfy the performance obligation; and
x the entity buys the good from a third party and is not significantly involved in the design
or manufacture thereof (but the entity is acting as a principal). IFRS 15.B19 (reworded)
194 Chapter 4
Example 38: Measure of progress – input method

– input does not contribute to entity’s progress
An entity signed a contract for C5 000 000 with a wealthy private individual. The contract
requires the entity to conduct research into an unusual and rare disease.
The performance obligation is considered to be satisfied over time (because the entity has no
alternative use for the research results and the entity has an enforceable right to payment).
The entity decided that an input method based on costs incurred would be the best measure of progress.
The expected cost of this project is C3 000 000.
During the first year, 20X1, costs of C800 000 were incurred. Included in these costs is an amount of
C200 000, being the cost of inventory damaged during a wild-cat strike by the entity’s factory staff.
Required: Explain how the entity should measure the progress relating to the performance obligation.
Solution 38: Measure of progress – input methods – straight-lining

Although costs of C800 000 were incurred, C200 000 of these costs were wasted costs. In other words,
these costs did not contribute to the entity satisfying the performance obligation.
Thus, the progress at the end of 20X1 is measured as:
(Total costs incurred: C800 000 – Wasted costs: C200 000) ÷ Total expected costs: C3 000 000 = 20%
Thus, revenue of C1 000 000 will be recognised (20% x C5 000 000) in 20X1.
Example 39: Measure of progress – input method

– input is not proportionate to the entity’s progress
An entity signed a contract for C10 000 000 with a customer. The contract requires the
entity to construct a building to house a specialised plant.
The performance obligation is considered to be a single performance obligation satisfied over time.
The entity decided that an input method based on costs incurred would be the best measure of progress.
The expected cost of this project is C5 000 000. An analysis of these costs reflected one specific input,
being the acquisition of plant (expected cost C2 000 000) that, on date of contract inception, met the
criteria to be considered an input that would distort ‘the entity’s progress in satisfying a PO’.
During the first year, 20X1, costs of C3 000 000 were incurred. Included in these costs was the amount
of C2 000 000, being the cost of purchasing the plant. The plant will still need to be installed as part of
this performance obligation. At reporting date, this plant had not yet been installed but it had been
delivered to the customer’s premises and the customer now has full control thereof.
Required: Explain how the entity should measure the progress relating to the performance obligation.
Solution 39: Measure of progress – input methods

– input is not proportionate to the entity’s progress
We are told that all the necessary criteria were met, at contract inception, for us to conclude that the
input of the plant acquisition would distort the measure of progress. We thus need to make appropriate
adjustments when measuring the entity’s progress.
We were told that these criteria were met, but, for interest sake, the reasoning behind this is as follows:
x The building is being designed specifically to house this plant, and thus the building and plant do
not represent 2 distinct obligations.
x The customer was expected to obtain control over the plant significantly before the completion of
the building.
x The cost is a significant portion of the total expected costs relating to the complete obligation.
x The entity was not involved in the design or manufacture of the plant but was simply required to
purchase it from a third party.
The adjustments we should make for this disproportionate input is explained below:
Although costs of C3 000 000 are incurred, C2 000 000 thereof reflects the cost of purchasing the plant,
being the disproportionate input. Thus, the C2 000 000 cost of purchasing the plant should be excluded
from the estimation of the measure of progress because it would otherwise distort the true measure of
progress. The revenue recognised relating to the plant will thus be measured at the cost of the plant.
Chapter 4 195
The progress at the end of 20X1 is thus measured as:

(Costs incurred: C3 000 000 – Significant cost incurred unrelated to true progress: C2 000 000)
÷ (Total expected costs: C5 000 000 – Significant cost unrelated to true progress: C2 000 000) = 33,3%
The revenue recognised to date will include the revenue relating to the plant, but measured at the cost
to acquire the plant, plus 33,3% of the transaction price, reduced by the cost of this plant.
Revenue (I) Calculation 1 C4 666 667
Less contract costs (E) Given (Plant and all other costs) (3 000 000)
Profit C1 666 667
Calculations:
(1) Adjusted TP: (TP: 10 000 000 – Plant cost: 2 000 000) x 33,3% + Plant revenue (at cost): 2 000 000 =
C4 666 667
9.5.3 Output methods (IFRS 15.B15-.B17)
The output method means calculating progress based on the value that the customer has
obtained to date. To do this we calculate the value of the goods or services transferred to date
relative to the value of the total goods or services promised. This value can be measured in a
number of ways (see example 40). We could use:
x surveys of performance completed,
x appraisals of results achieved,
x time passed,
x units produced, or
x units delivered.
Irrespective of which output method we use, we must always bear in mind that our ultimate
objective is to ‘faithfully depict the entity’s performance towards complete satisfaction of the
performance obligation’. Thus, we need to be sure that the output method chosen achieves
this objective.
For example, an output method based on units delivered may not be a faithful depiction of the
entity’s performance if the entity has also produced units of finished goods (or even units that
are still a work-in-progress) that the entity has not yet delivered but over which the customer
has already obtained control.
As a practical expedient, if the contract gives the entity the right to consideration (i.e. the right
to invoice the customer) for an amount that exactly equals the value of the entity’s
performance to date, (e.g. the contract allows the entity to invoice the customer based on a
rate per hour of work done for the customer), then the entity may simply recognise the
revenue as it invoices the customer (i.e. debit receivable and credit revenue). In other words,
it need not go through the process of estimating the measure of progress.
The disadvantages of output methods include the fact that the relevant outputs are not always
directly observable and may not be easily available without undue cost. Thus, although
output methods are normally considered superior, the use of an input method may be
necessary.
Example 40: Measure of progress – output method: work surveys

Scrubbers Limited signed an agreement in which it agreed to scrape and re-plaster 50 old
buildings. The total contract price is C80 000. The expected contract cost is C50 000.
According to the results produced by the independent surveyor:
x work performed to 31 December 20X3 is valued at C50 000;
x work performed to 31 December 20X4 is valued at C80 000.
Required: Show the revenue journals for 20X3 and 20X4 using an output method based on the surveys
of work performed to date.
196 Chapter 4
Solution 40: Measure of progress – output method: work surveys

20X3 Debit Credit
Receivable (A) Given – or W2 50 000
Revenue from services satisfied over time: output method
20X4
Revenue from services satisfied over time: output method
W1. Estimated progress: output method: surveys performed 20X3 20X4
Work surveyed (to date!) Given: surveys normally ‘to date’ 50 000 80 000
Total contract revenue Given 80 000 80 000
Percentage progress to date (50 000/ 80 000); (80 000/ 80 000) 62,5% 100%
Revenue recognised to date (80 000 x 62.5%) (80 000 x 100%) 50 000 80 000
Note: work surveyed is normally provided on a cumulative basis: the surveyor would say that the work
certified for invoicing is C80 000 in 20X4, not the extra C30 000 that still needs to be invoiced in 20X4.
9.5.4 If a reasonable measure of progress is not available (IFRS 15.44)
If we do not have a reasonable measure of progress, then no revenue at all may be recognised
until a reasonable measure becomes available. In this case, if we receive payments from our
customer, we will have to recognise them as a liability instead. See IFRS 15.B44
9.5.5 If a reasonable measure of the outcome is not available (IFRS 15.45)
If the outcome of the performance obligation is not able to be reliably measured (this often
happens in the early stages of a contract), but the entity believes it will recover the costs that it
has incurred, then revenue may be recognised but only to the extent of these incurred costs.
If the customer happens to have paid us more than the costs that we have incurred, this excess
would be recognised as a liability until such time that the outcome is reasonably measurable.
See IFRS 15.B44
Example 41: Outcome not reasonably measured

An entity has signed a contract with customer X in which the promised consideration is
C100 000 and the related performance obligation is satisfied over time.
At reporting date, the entity had received C40 000 from the customer and, in terms of the contract, this
customer still owes a further C10 000.
The entity has incurred costs of C20 000 to date. However, given that this is a new contract upon which
the entity has no historic evidence to estimate its total costs, the entity concludes that it cannot measure
the expected outcome of this contract.
Required: Prepare the journal/s to reflect the information provided.
Solution 41: Outcome not reasonably measured

Debit Credit
Bank Given 40 000
Receivable Given 10 000
Revenue from customer contract (I) Max = costs incurred 20 000
Contract liability (L) Balancing: 40 000 + 10 000 – 20 000 30 000
Recording the receipt and receivable from the customer: partly revenue (limited
to costs incurred) and partly contract liability: because outcome is unknown
Chapter 4 197
9.6 Repurchase agreements (IFRS 15.B64-.B76)
9.6.1 Overview
When we assess whether control over the asset has passed to a customer, we must be careful
to consider any possible repurchase agreements (e.g. where we have sold goods to a customer
but have agreed to buy them back after a period of time – or have the option to do so under
certain circumstances). Although it may look like control has passed to a customer, the
existence of a repurchase agreement may prove that control has not actually passed.
A repurchase agreement does not only refer to an agreement where we have committed
ourselves to buying the asset back after a period of time (a forward), but also to an agreement
where we may choose to buy the asset back (a call option) – or where the customer may
choose to force us to buy the asset back (a put option).
IFRS 15 classifies repurchase agreements into those in which:

x the customer obtains control; and where
x the customer does not obtain control.
9.6.2 Where a repurchase agreement means the customer does not obtain control
If an entity has an obligation to repurchase an asset (referred to as a ‘forward contract’) or has

a right to repurchase an asset (referred to as a ‘call option’), we conclude that the customer
does not obtain control. This is because the entity can insist that the customer return the asset.
Thus the customer is limited in its ability to direct the use of and to obtain substantially all the
remaining benefits from the asset. See IFRS 15.B66
In cases such as these, the repurchase agreement will either be accounted for as a:
x Lease agreement in terms of IFRS 16 Leases
This happens if the entity can or must repurchase the asset for an amount that is less than
the original selling price of the asset; or
x Financing arrangement in terms of IFRS 15 (para B86)
This happens if the entity can or must repurchase the asset for an amount that is more than
or equal to the original selling price of the asset. See IFRS 15.B66
If the repurchase agreement is a financing arrangement, then the asset that has been sold (and
which we are to repurchase at a later date) is not removed from our books.
The amount we receive from the customer will be recognised as a liability (because we are
effectively using our asset as security in order to borrow money). The excess of the
repurchase price that we will be expected to pay over the original selling price will be
recognised as interest (we will need to build in to this calculation the effects of the time value
of money – thus we would work with a present valued repurchase price). See IFRS 15.B67-B68
If the repurchase agreement was based on a call option (rather than a forward), and if this
option lapses without the entity choosing to repurchase the asset, then the liability will be
derecognised and recognised as revenue instead. See IFRS 15.B69
9.6.3 Where a repurchase agreement means the customer does obtain control
Where the customer may choose to force the entity to buy the asset back (i.e. a put option), we
conclude that the customer does obtain control. This is because the customer can choose
whether or not to force the entity to buy the asset back. Thus, the customer is not limited in its
ability to direct the use of and to obtain substantially all the remaining benefits from the asset.
See IFRS 15.B66
In such cases, we would need to assess, at contract inception, whether:

x the repurchase price is lower or higher than the original selling price; and whether
x the customer has a significant economic incentive to force us to buy back the asset.
198 Chapter 4
If the repurchase price is lower than the original selling price and:
x the customer has a significant economic incentive to force us to buy the asset back, this
agreement would be accounted for as a lease agreement in terms of IFRS 16 Leases. This
is because the customer will have effectively paid for the right to use the asset from the
time the entity ‘sells’ it to the customer to the time the customer forces the entity to buy it
back. See IFRS 15.B70
x the customer does not have a significant economic incentive to force us to buy the asset
back, this agreement would be accounted for as a sale with a right of return (see
section 7.2.6.3). See IFRS 15.B72
If the repurchase price is equal to or greater than the original selling price and
x is more than the expected market price of the asset, we would account for the agreement
as a financing arrangement (see section 9.6.2). See IFRS 15.B73
x is less than or equal to the expected market price of the asset (and yet the customer has a
significant economic incentive to exercise its right), we would account for the agreement
as a sale of a product with a right of return (see section 7.2.6.3). See IFRS 15.B74
If this put option lapses without the customer forcing the entity to repurchase the asset, then
the liability will be derecognised and recognised as revenue instead. See IFRS 15.B7
10. Contract costs (IFRS 15.91-.104)
10.1 Overview
Entities incur costs in connection with their contracts with customers. These costs can be split
into two types:
x Costs to obtain the contract; and
x Costs to fulfil the contract.
These costs may need to be recognised as an asset (i.e. capitalised) if they meet certain
criteria. If the criteria are not met, they would be expensed.
If costs are recognised as an asset, this asset will need to be amortised and checked for
impairments.
10.2 Costs of obtaining a contract (IFRS 15.91-.94)
The costs incurred to obtain a contract with a customer could include aspects of
administration, marketing, legal costs, commissions and the costs of preparing tenders.
A cost of obtaining a contract would be recognised as an asset (i.e. capitalised) if the cost:
x is incremental and if the entity expects to recover the cost; and
x is not incremental but the cost is explicitly chargeable to the customer even if the entity is not
awarded the contract (i.e. the entity will recover these costs from the customer). See IFRS 15.91 & .93
Incremental costs mean extra costs. Thus, the incremental costs of obtaining a contract refer
to the extra costs that relate to having obtained a contract.
A commission paid on successfully securing a contract would be considered an incremental
cost (since it would not have been incurred if we had not secured the contract). Thus, a
commission paid on the successful securing of the contract would be capitalised if the entity
expected these costs to be recoverable. Conversely, the cost of preparing a tender would not
be an incremental cost of obtaining a contract since this is a cost that is incurred whether or
not the contract is obtained. Since these tender costs are not incremental costs, they would not
normally be capitalised. However, it is possible to capitalise these if the customer agreed to
refund these even if the contract was not granted to the entity. See IFRS 15.92-93
As a practical expedient, if the asset created would be completely amortised in a year or less,
then the entity may expense the costs instead. See IFRS 15.94
Chapter 4 199
Example 42: Costs of obtaining a contract

An entity incurred the following costs in successfully tendering for a 5-year contract:
Fees paid to lawyers for preparation of relevant contracts C10 000
Travel and accommodation fees for 2 staff members to attend and present the proposal C25 000
Commissions paid to sales manager for securing the contract C5 000
Discretionary bonus paid to sales manager for individual performance evaluation C30 000
C70 000
The customer had agreed to pay for the travel and accommodation fees even if the contract had not
been awarded to the entity.
Required: Explain which costs should be capitalised in terms of IFRS 15.
Solution 42: Costs of obtaining a contract

x The lawyers’ fees would have been paid even if the contract had not been awarded and are thus not
incremental costs of obtaining the contract. Since these costs were not chargeable to the customer,
they must be expensed.
x The travel and accommodation fees would have been paid even if the contract had not been
awarded and are thus not incremental costs of obtaining the contract. However, since these costs
were chargeable to the customer, they must be capitalised.
x The commissions paid to the sale manager for securing the contract is an incremental cost of
obtaining the contract and it is assumed that the entity expects to recover these through the
contract. Thus, these costs must be capitalised.
x The discretionary bonus paid to the sales manager pursuant to his individual performance
evaluation is not directly linked to the contract but is based on a variety of other factors. This cost
is thus not an incremental cost of obtaining the contract and must thus be expensed.
The costs capitalised will be amortised over the 5-year period of the contract.
10.3 Costs to fulfil a contract (IFRS 15.95-.98)
Costs that an entity incurs to fulfil (complete) a contract must be recognised:

x in terms of the relevant standards; or
x in terms of this standard (IFRS 15) if there is no other relevant standard.
For example, if the cost to complete a contract involved the sale of goods to a customer, then
the cost of the sale would be accounted for in terms of IAS 2 Inventories.
If a cost is to be recognised in terms of IFRS 15, it will be recognised as an asset if the

following criteria are met:
x the costs are directly related to a contract (or an expected contract) and are able to be
specifically identified;
x the costs will ‘generate or enhance’ the entity’s resources that will be, or are being, used
to complete the contract; and
x the entity expects to recover these costs. See IFRS 15.95
If the cost does not meet these criteria, it will be expensed.
Irrespective of the above criteria, the following costs are always immediately expensed:
x general and administrative costs – unless the contract enables these costs to be charged to
the customer;
x costs of abnormal wastage
x costs that have been incurred in relation to a satisfied or partially satisfied performance
obligation (i.e. costs relating to past performance);
x costs where the entity is unsure of whether or not it relates to an unsatisfied performance
obligation (i.e. we are cautious and assume it relates to a satisfied performance
obligation).
200 Chapter 4
Example 43: Costs of fulfilling a contract

An entity incurred the following set-up costs relating to a 5-year contract to manufacture a
patented product, renewable for a year:
Licence to manufacture patented products C10 000
Purchase of a machine to be used to manufacture the product C40 000
Costs of liaising with the customer to ensure suitable quality of output C20 000
Wages of employees who will be allocated full-time to this contract C30 000
C100 000
Required: Explain which costs should be capitalised in terms of IFRS 15.
Solution 43: Costs of obtaining a contract

x The cost of the licence must be accounted for in terms of IAS 38 Intangible assets.
x The cost of the machine must be accounted for in terms of IAS 16 Property, plant and equipment.
x The costs of assessing the required quality levels of the output would be accounted for in terms of
IFRS 15 – we would need to ascertain whether these costs meet the criteria laid out in IFRS 15.95.
If the costs meet the criteria, they will be capitalised.
x The wages to the employees allocated to the contract would be accounted for in terms of IFRS 15
– we would need to ascertain whether these costs meet the criteria laid out in IFRS 15.95. These
costs would, however, be expensed since they will fail the criteria on the basis that they do not
‘generate or enhance’ the entity’s resources.
The costs capitalised in terms of IFRS 15 will be amortised over 6 years (being the period of the
contract plus any periods of renewal – see section 10.4 below)
10.4 Capitalised costs are amortised (IFRS 15.99-.100)
Costs that are recognised as an asset (i.e. capitalised) will need to be amortised (i.e. expensed
over a period of time) using a method that reflects the transfer of the related goods or services
to the customer. Costs would typically be amortised over the period of the related contract –
and if that contract is expected to be renewed, then the amortisation would be over the period
of the contract, including the expected renewal period/s. See IFRS 15.IE195
If there is a significant change in the expected timing of the transfer of these goods or services, the
amortisation method will need to change. A change in amortisation method is accounted for as a change
in accounting estimate (i.e. per IAS 8 Accounting policies, estimates and errors; see chapter 26).
10.5 Capitalised costs are tested for impairments (IFRS 15.101-.104)
Costs that are recognised as an asset will need to be tested for impairment. The asset will be
considered impaired if its carrying amount is greater than the net remaining consideration that
the entity expects to receive. Impairment losses are recognised as an expense in profit or loss.
This net remaining consideration is calculated as:

x The remaining amount of consideration that the entity expects to receive in exchange for
the goods or services to which the asset relates;
x Less: the directly related costs that have not been expensed. See IFRS 15.101
If the transaction price does not include variable consideration (i.e. the consideration is fixed), the
consideration is simply calculated using the same principles that we used when calculating the
transaction price, but it must then be adjusted to reflect the credit risk specific to that customer.
If the transaction price includes variable consideration, the consideration must be calculated
using the same principles that we used when calculating the transaction price and adjusted to
reflect the credit risk specific to that customer (i.e. as above), but we must ignore the
principles relating to constraining estimates of variable consideration.
If, at a later stage, the circumstances that led to the impairment loss reverse or improve, then
the impairment expense may be reversed (i.e. recognised as income in profit or loss). When
reversing an impairment loss, we must be sure that the reversal does not increase the asset’s
carrying amount above the carrying amount that it would have had had it never been impaired.
Chapter 4 201
11. Specific revenue transactions
11.1 Overview
The 5-step approach to revenue recognition requires a holistic and integrated approach when
considering each of the steps. It is probably helpful if we now consider a few interesting and
fairly common revenue-related transactions in the context of the 5-step approach.
11.2 Sale with a warranty (IFRS 15.B28-.B33)
Goods are often sold with warranties. There are two types:
assurance-type warranties and service-type warranties.
Warranties come in two
x An assurance-type warranty is a warranty that assures forms:
the customer than the product will function as intended
or that it meets the agreed-upon specifications. x assurance-type: account for it in
terms of IAS 37
x A service-type warranty offers the customer a service x service-type: account for it in
in addition to the mere assurance that the product will terms of IFRS 15, as a separate
function as intended. PO
An assurance-type warranty is simply a confirmation that the product is what it purports to

be. In other words, an assurance-type warranty does not promise anything in addition to the
product. Thus, the transaction price is allocated entirely to the product. However, the fact that
the assurance-type warranty exists will need to be accounted for in terms of
IAS 37 Provisions, contingent liabilities and contingent assets.
A service-type warranty involves the promise of a service (should the need arise), and is thus
a separate promise - a distinct performance obligation. Thus, if the sale of a product includes a
service-type warranty, the transaction price will have to be allocated between the two
performance obligations: the transfer of a good and a service. If and when this service is
provided, it will result in the recognition of revenue.
If a customer is able to purchase a warranty separately, this would indicate that it is a service-
type warranty and should be accounted for as a separate performance obligation. In cases
where the customer is not able to purchase a warranty separately, we will need to carefully
assess which type of warranty we are dealing with. IFRS 15 provides a list of factors that may
need consideration.
Two of the factors are explained overleaf:

x the warranty may be a legal requirement – this suggests that it exists as protection for the
customer, in which case it is an assurance-type warranty;
x the warranty may cover a short period – this suggests it is an assurance-type warranty (the
longer the warranty period the more likely it is that a service will need to be provided in
which case it is a service-type warranty).
Sometimes a warranty involves both an assurance-type warranty and a service-type warranty,

each of which would need to be accounted for separately. An assurance-type warranty that
cannot be separated from a service-type warranty is accounted for as a service-type warranty
(i.e. as a single performance obligation).
Example 44: Sale with a warranty

An entity sells a product for C100 000. Included in the sales contract is a warranty that the
product will function as intended for up to one year. Included in the contract price is a further
extended warranty covering the next two years, during which period the entity promises to repair the
product if necessary. The extended warranty is available for sale separately for C10 000.
Required: Briefly explain how the information should be accounted for.
202 Chapter 4
Solution 44: Sale with a warranty

The first warranty covering the first year simply assures the customer that the product will function as
intended for this first year and thus is considered to be an assurance-type warranty.
The second extended warranty covering the next 2 years offers the customer a service in the event that
the product malfunctions during this period. This warranty is also available for sale separately. Both
factors indicate that it is a service-type warranty.
Thus, the transaction price of C100 000 must be allocated to the two POs: the extended warranty
(C10 000) and the product (C90 000, the balancing amount). As soon as control of the product is
transferred to the customer, the following journal will be processed:
Debit Credit
Accounts receivable (A) W1 100 000
Contract liability 10 000
Revenue: sales (I) 90 000
Recording the sale of goods and service-type warranty
11.3 Sale with a right of return (IFRS 15.51 &.55 & B20-B27)
A contract involving a transfer of goods with a right of return is covered in section 7.2.6.3.
11.4 Transactions involving principal – agent relationship (IFRS 15. B34-B38)
11.4.1 Overview
Sometimes contracts are complicated by the involvement of a third party. In such cases, we
must take care in deciding whether the entity is acting as a principal or an agent. The entity:
x is a principal if the entity transfers the goods or services to the customer
x is an agent if the entity is simply connecting a principal with a customer. See IFRS 15.B34
11.4.2 Where the entity is the principal
For the entity to be a principal it must be the party transferring the goods or services to the
customer. This means it must have had control of the goods or services immediately before it
was transferred. Control is assessed on many levels, such as who has the risks and rewards of
ownership, who has physical control, who has legal title etc. However, IFRS 15 clarifies that,
in the case of legal title, we must be aware that, if an entity simply obtained legal title on a
temporary basis for the purpose of being able to then transfer this legal title to the customer
soon after, this would not necessarily prove the entity had control and was acting as a
principal. All facts and circumstances must be carefully considered in deciding if the entity
had full control prior to transferring the item to the customer. See IFRS 15.B35
The entity would still be the principal in situations where it used a third party to complete part or
all of a performance obligation, for example, when the entity used a subcontractor to do the work.
Where the entity is acting as a principal, it recognises revenue at the gross amount of
consideration to which it expects to be entitled – any commissions payable to the agent would
be recognised as a separate expense.
11.4.3 Where the entity is the agent
The entity would be an agent if it did not have control of the good or service prior to the
transfer to the customer. In other words, the entity is an agent if its performance obligation is
satisfied once it has simply arranged for another party (i.e. the principal) to provide goods or
services to the customer.
Facts and circumstances that suggest that an entity is acting as an agent include, for example:
x the entity cannot decide the selling price of the good or service;
x the entity’s consideration will be in the form of commission;
x the entity is not exposed to credit risk in the event that the customer defaults on payment;
x the entity does not have the risk related to inventory either before or after the goods have
been ordered or during shipping. See IFRS 15.B37
Chapter 4 203
Where the entity is acting as an agent, it recognises revenue being the fee or commission
receivable from the principal. See IFRS 15.B36
11.5 Sale on consignment (IFRS 15.51 &.55 & B77-B78)
When an entity sells goods on consignment, it is using an agent who will sell the goods to the
customer.
An agent acts on behalf of the principal (the entity) thus, although the agent obtains physical
possession of the goods while holding them on consignment, the agent never actually obtains control
of the asset. Since IFRS 15 only allows the recognition of revenue when control passes from an entity
to a customer, revenue may not be recognised until the agent has sold the consignment goods to the
final customer. Indications that a sale is a sale on consignment include:
x the product is controlled by the entity until a specified event occurs (e.g. the sale of the
product to a customer of a dealer or until a specified period expires);
x the entity is able to insist upon the return of the product or can insist that it be transferred
to a third party (e.g. another dealer); and
x the dealer does not have an unconditional obligation to pay for the product (although it
may be required to pay a deposit)
x the entity continues to insure the product while being held by the dealer. See IFRS 15.B78
Revenue may be recognised when a performance obligation is satisfied. Since a performance
obligation is satisfied when control has passed to a customer, it means that if a good is sold on
consignment, no revenue would be recognised (however, a journal would be processed to
reflect the movement of inventory from the warehouse to the dealer on consignment – e.g.
debit inventory on consignment and credit inventory). Revenue will be recognised when the
dealer has, as agent, transferred control from the entity (the principal) to the customer. The
revenue recognised must be the gross amount – not net of any commissions owed to the agent.
Example 45: Sale on consignment
Vital-Drive sells a vehicle on consignment to a dealer, Multi-Car, for C100 000 on 5 January
20X1. The cost of the vehicle is C70 000.
If the dealer succeeds in selling the vehicle to a customer, the dealer retains 10% as a sales commission
and pays Vital-Drive the difference.
Multi-Car sold the vehicle to a customer on 20 January 20X1.
Required: Show all related journals.
Solution 45: Sale on consignment

Inventory on consignment with Multi-Car (A) Given 70 000
Inventory (A) 70 000
Recording the transfer of inventory to Multi-Car, on consignment
20 January 20X1
Cost of sales Given 70 000
Inventory on consignment with Multi-Car (A) 70 000
Recognising the cost of goods sold
Receivable 100 000 x 90% 90 000
Revenue from customer contract 100 000 x 100% 100 000
Sales commission (E) 100 000 x 10% 10 000
Recognising revenue and sales commission resulting from the sale
11.6 Sale on a bill-and-hold basis (IFRS 15.B79-B82)

A bill-and-hold sale is one where the entity has invoiced the customer for a product, but the
entity still has physical possession of this product. However, the usual principle applies – if
control has passed to the customer, then the entity may recognise the revenue even though the
entity still has physical possession (remember: physical possession is only one aspect of
control). Thus, in all bill-and-hold situations, we must assess if control has passed.
204 Chapter 4
Control has passed to the customer if the customer is able to direct the use of the product and
obtain substantially all of the remaining benefits from the product. For control to have passed
in a bill-and-hold situation, we must also ensure that the following additional criteria are met:
x the reason for the bill-and-hold arrangement must be substantive (e.g. the customer must
have requested it);
x the product must be identified separately as belonging to the customer;
x the product must be ready for physical transfer to the customer; and
x the entity must not have the ability to use the product or to direct it to another customer.
If all these criteria are met, then control is said to have passed to the customer and revenue
must then be recognised. However, since the entity is effectively providing storage for the
customer, the entity must assess whether the provision of storage is another separate
performance obligation, in which case the transaction price would need to be allocated
between the performance obligation to transfer the product (PO1) and the performance
obligation to provide storage services (PO2).
Example 46: Bill-and-hold sale

Lemon-Drop manufactures a specialised vehicle for Rondil, for C100 000. The vehicle is
complete and ready for delivery on 5 January 20X1. On this date, Rondil inspected the vehicle and
accepted that it meets all specifications, and immediately paid in full. Rondil has signed all paperwork
giving it legal title over the vehicle but requested that Lemon-Drop retain the vehicle for a further 6
months until the construction of Rondil’s garage had been completed. Lemon-Drop has agreed to this
arrangement and has stored the vehicle in the company warehouse and identified it as a vehicle that had
already been sold to Rondil. They agreed that Lemon-Drop would ensure that no-one would use the
vehicle during the period of storage.
Required: Explain how this should be accounted for.
Solution 46: Bill-and-hold sale

The sale of the vehicle is a bill-and-hold sale since Lemon-Drop has invoiced Rondil and yet still has
physical possession of the vehicle. For revenue to be recognised from this sale, we must prove that
control has passed to Rondil (by referring to the indications of the transfer of control provided in
IFRS 15.38) and decide whether all the additional criteria provided in IFRS 15.B81 have been met.
It is submitted that control over the vehicle has passed to Rondil because (using some of the indicators
in IFRS 15.38):
x Rondil was obliged to pay for the vehicle;
x Rondil has obtained legal title over the vehicle;
x Rondil has inspected the vehicle and accepted that it meets all required specification.
Furthermore, all criteria in IFRS 15.B81 are met:

x Rondil requested that Lemon-Drop retain possession (i.e. the reason for the bill-and-hold
arrangement is substantive);
x the vehicle is separately identified as having been sold to Rondil;
x the vehicle was ready for delivery on 5 January 20X1;
x the vehicle is specialised and thus it is practically not possible for it to be redirected to another
customer. There is also a verbal agreement (legal restriction) preventing Lemon-Drop from using
the vehicle during the period of storage.
Conclusion:
Since control passed to Rondil on 5 January 20X1 (in terms of IFRS 15.38) and all further criteria
relevant to a bill-and-hold arrangement (in terms of IFRS 15.B81) have been met, Lemon-Drop must
recognise the revenue from the sale of the vehicle.
However, before recognising the revenue, Lemon-Drop must assess whether the request for storage
results in a separate performance obligation, in which case the transaction price would first have to be
allocated between the two performance obligations. However, the fact that the requested storage is for
such a short period suggests that the provision of storage facilities is incidental to the contract and may
be ignored. The following journal would be processed:
Chapter 4 205

Recording the receipt from the customer and the related revenue from
the bill-and-hold sale
11.7 Customer options for additional goods and services (IFRS 15.B39-B47)
Sometimes a contract provides a customer with the option to acquire additional goods and services –
these may be offered for free or at a discount. They are often called sales incentives, loyalty points or
award credits, contract renewal options or other discounts on future goods or services.
An option for additional goods or services must be accounted for as a separate performance
obligation only if it provides the customer with a ‘material right that it would not receive
without entering into that contract’. See IFRS 15.B40
An option to acquire further goods or services at a price that would reflect the normal relevant
stand-alone selling prices would not be a material right – even if this option can only be
exercised by entering into the first contract.
Worked example 6: Customer receives a material right
A contract for the sale of 100 000 units at C3 each could include a clause to the effect that, if
this customer entered into a further contract for a further 100 000 units, then these further
units would be sold at a discounted price of C2 each. Since these further units are at a discounted price,
the customer has received a material right that it would not receive without entering into that contract
and thus this option must be accounted for as a separate performance obligation.
Worked example 7: Customer does not receive a material right

A contract for the sale of 100 000 units of product X could include a clause to the effect that
since this customer has purchased a quantity of product X, the customer is now entitled to
purchase product Y. Since there is no discount being offered on product Y, the customer has not been
given a material right. Instead, the entity has simply marketed product Y. Thus, this contract does not
include an option that would be accounted for as a separate performance obligation.
In cases where we conclude that the customer is being given a material right that it would not receive
without entering into that contract, we account for the right as a separate performance obligation.
In this case, the transaction price would need to be allocated between the obligation to transfer the
goods or services per the contract and the obligation to provide the future goods or services at a
discount (or for free). In other words, we will be accounting for the first contract as if the customer
is paying a portion of the consideration, in advance, for the future goods or services. The revenue
from the future goods or services is recognised as revenue when they are transferred (i.e. when the
customer orders the free or discounted goods or services) or when the option expires (i.e. if the
customer does not order the free or discounted goods or services).
The transaction price is allocated based on the relative stand-alone selling prices. Please note
that it is the stand-alone selling price of the option and not the stand-alone selling price of
future goods or services that we use for this allocation. For example, if the contract includes a
clause that stipulates that a customer can purchase further goods, which normally sell for
C100 000, at C80 000 instead, the stand-alone selling price that we would use for the purpose
of allocating the transaction price is the net stand-alone selling price of the option: C20 000.
Example 47: Option accounted for as a separate performance obligation
An entity signed a contract selling a vehicle for C800 000. This contract includes a clause stating that,
if this customer entered into a further contract to buy a trailer, the trailer’s selling price would be
C100 000. The option expires on 28 February 20X1. The entity normally sells trailers for C250 000 but, as part
of a marketing campaign, it is offering trailers to the public for C180 000 during this period.
The customer paid and obtained control of the vehicle on 5 January 20X1 and then purchased the trailer
on 20 February 20X1 for cash.
Required: Show the journal entries for the above.
206 Chapter 4
Solution 47: Option accounted for as a separate performance obligation

The contract offers the customer the option of purchasing a trailer at a discounted price. This option
gives the customer a ‘material right that it would not receive without entering into that contract’ and so
this option must be accounted for as a separate performance obligation. The transaction price must be
allocated based on the relative stand-alone selling prices as follows:
Vehicle C800 000 TP: C800 000 x 800 000 / 880 000 C727 272
Option C80 000 (calculated below)
TP: C800 000 x 80 000 / 880 000 C72 727
C880 000 C800 000
Calculation of the stand-alone selling price of the option:
Price to the public: C180 000 – Price to the customer in terms of the option: C100 000 = C80 000

Revenue from customer contract (I) See allocation of TP above 727 272
Contract liability (L) See allocation of TP above 72 727
Recording the receipt from the customer and the related revenue from
the sale of the vehicle and the contract liability reflecting the obligation
in terms of the option offered
20 February 20X1
Contract liability (L) See allocation of TP above 72 727
Bank (A) Discounted price per the contract 100 000
Recording the receipt from the customer for the trailer at the discounted
price per the contract and reversing the contract liability to revenue
Comment: If the customer had not purchased the trailer by 28 February 20X1 (when the option expired), we
would have processed a journal (on 28 Feb. 20X1), reversing the liability and recognising revenue of C72 727.
As a practical expedient, if the material right provided to the customer involves goods or
services that are the same or similar to those in the original contract (e.g. in the case of a
renewal of a contract), then the entity can choose not to bother estimating the stand-alone
selling price of the option for purposes of allocating the initial contract’s transaction price.
Instead, the entity can account for the initial contract and the potential renewal contracts as if
it were one contract. It would then calculate the total expected transaction price for the
combined contracts and then allocate across the total expected goods and services offered
under the combined contract (i.e. allocating it between the goods and services offered under
the existing contract and the future goods and services offered under the renewal contracts).
As mentioned above, this would apply in the case of contract renewals but would also apply if
the option simply involved offering the same product at a discounted price. The practical
expedient would also be available if, in the previous example, the option was to purchase
another vehicle of the same type rather than a trailer.
Example 48: Option involves similar goods or services (e.g. contract renewal)
An entity sells annual contracts for the provision of weekly home maintenance services at C10 000
each. The contracts include a clause stating that, if a customer renews the contract for a further year,
the second annual contract would cost C12 000 instead of C15 000, being the standard price for customers
entering into a new contract rather than renewing an old contract. This option expires on 31 December 20X1
(i.e. the customer must renew the contract by 31 December 20X1 to qualify for the discount).
The entity sells 20 contracts during January 20X1 and expects that 80% of these customers will renew their
contracts. All customers paid for the first year of their contracts in 20X1 and 80% of these customers, as
expected, renewed their contracts.
The entity chooses to measure progress towards complete satisfaction based on time elapsed.
Required: Show the journal entries for the above using the practical expedient if available to the entity.
Chapter 4 207
Solution 48: Option involves similar goods or services (e.g. contract renewal)
Since the second annual contract involves the same or similar services to those in the first-year
contract, the entity can choose the practical expedient. The practical expedient allows the entity to
choose not to estimate the stand-alone selling price of the option for purposes of allocating the
transaction price (i.e. it may choose not to allocate the transaction price between the first-year contract
and the option). Instead, the entity can choose to calculate the total expected consideration and allocate
it to the total goods or services that it expects to provide.
W1: At contract inception, the entity expects 80% of its customers to renew their contracts and thus:
x the total expected consideration = 20 x C10 000 + 20 x 80% x C12 000 = C392 000
x the total services to be provided will be provided over time and thus we will need to estimate the
measure of progress. The entity measures its progress based on time: 24 months.
Total expected Allocation of total Allocation based on
consideration expected consideration measure of progress:
Year 1 C200 000 20 x C10 000 C196 000 C392 000 x 12/24 months
Year 2 C192 000 20 x 80% x C12 000 C196 000 C392 000 x 12/24 months
C392 000 W1 C392 000
Year 1 Debit Credit

Bank (A) Transaction price: 20 x C10 000 200 000
Contract liability (L) Balancing 4 000
st
Receipt from customers; related revenue from the sale of the contracts for the 1 year (based on
total expected consideration allocated using a time-based measure of progress) and resultant
contract liability reflecting the obligation to renew the contract at a discounted price
Year 2
Contract liability (L) See above 4 000
Bank (A) 20 x 80% x C12 000 192 000
Receipts from customers; related revenue from the sale of contracts for the 2nd year and reversal of
the contract liability since the option no longer exists
Comment: If more or less than the 80% of the customers renewed their contracts, then the transaction
price would be adjusted and the adjustments would be accounted for directly in revenue.
Exactly the same principles apply in the case of customer loyalty programmes. We must first
assess whether the entity is acting as a principal or an agent in the transaction. This is because
an entity can provide customer loyalty schemes that allow the customer to claim discounted or
free goods or services either:
x from the entity, in which case the entity is acting as a principal; or
x from another third party, in which case the entity is acting as an agent.
Example 49: Option involves customer loyalty programme (entity = principal)

An entity offers a customer loyalty programme (CLP) in which customers earn 1 loyalty point
for every C50 spent in the store. Each point may be redeemed for a C10 discount on future purchases at
the store. Sales during 20X1 by customers who had registered for the CLP totalled C500 000. The
entity estimates that 90% of these points will be redeemed.
Required:
Show the journal entries:
a) for 20X1 assuming that, by the end of 20X1, 2 000 of these points had been redeemed and that the
estimation that 90% of the points would be redeemed remained the same
b) for 20X2 assuming that, by the end of 20X2, a further 3 000 of these points had been redeemed
and that the estimation that 90% of the points would be redeemed remained the same
c) for 20X2 assuming that, by the end of 20X2, a further 3 000 of these points had been redeemed
and that the estimation that 90% of the points would be redeemed had changed to 95%.
208 Chapter 4
Solution 49A: Customer loyalty programme (entity is a principal) – first year

The CLP offers a discount on future goods or services and gives the customers a ‘material right that it
would not receive without entering into that contract’. Thus, the CLP must be accounted for as a
separate performance obligation and thus the transaction price must be allocated between the PO to
transfer goods and the PO to provide the discount in terms of the CLP.
At contract inception, the entity expects 90% of the customer loyalty points to be redeemed:
selling price transaction price
Goods C500 000 TP: C500 000 x 500 000 ÷ C590 000 C423 729
CLP: Future discount C90 000 TP: C500 000 x 90 000 ÷ C590 000 C76 271
C590 000 C500 000
Calculation of the stand-alone selling price of the future discount under the CLP:
C500 000 / C50 x 1 point x C10 x 90% (expected redemption) = C90 000
During 20X1 (sum of the journals recorded as the sales occurred) Debit Credit
Bank (A) TP: total sales 500 000
Contract liability: CLP (L) See allocation of TP above 76 271
Receipt from customers allocated between sale of goods and future
discount on the expected redemption of CLP points
End 20X1
Contract liability: CLP (L) C76 271 x (C20 000 ÷ C90 000) 16 949
Redemption of 2 000 points at C10 per point means we gave customers a
C20 000 discount off the estimated total discount of C90 000
Or: 10 000 points were granted, 90% or 9 000 are expected to be redeemed – at
year-end, 2 000 of these 9 000 points have been redeemed: thus 2/9 x C76 271
Solution 49B: Customer loyalty programme (entity is a principal) – second year

Comment: When we recognise the revenue from the customer loyalty programme, we must remember
to first calculate the revenue to be recognised on a cumulative basis and work backwards to how much
revenue should be recognised in the current year. This is in case there is a subsequent change in our
estimate of how many points will be redeemed.
End 20X2 Debit Credit
Contract liability: CLP (L) C76 271 x (C70 000 ÷ C90 000) – 42 373
Revenue from customer contract (I) revenue already recognised: 16 949 42 373
Redemption of a further 5 000 points at C10 per point means we have
given a further C50 000 discount off the estimated total discount of
C90 000: total discount to date = C20 000 in 20X1 and C50 000 in 20X2
= C70 000
Solution 49C: Customer loyalty programme (entity is a principal) – second year and
estimated changes
Comment: When we recognise the revenue from the customer loyalty programme, we must remember
to first calculate the revenue to be recognised on a cumulative basis and work backwards to how much
revenue should be recognised in the current year. This is in case there is a subsequent change in our
estimate of how many points will be redeemed.
End 20X2 Debit Credit
Contract liability: CLP (L) C76 271 x (C70 000 ÷ C95 000) – 39 251
Revenue from customer contract (I) revenue already recognised: 16 949 39 251
Redemption of a further 5 000 points at C10 per point means we have
given a further C50 000 discount - however our estimated total discount
has now increased to C95 000: total discount to date = C20 000 in 20X1
and C50 000 in 20X2 = C70 000
Chapter 4 209
12. Presentation (IAS 1.82 and IFRS 15.105-.109)
12.1 Overview
Revenue must be presented as a line-item in the statement of comprehensive income (as part
of profit or loss). See IAS 1.82
Revenue also affects the presentation of our financial position (SOFP). In this regard, a
customer contract may lead to the presentation in our statement of financial position (SOFP)
of the following line-items:
x a contract asset or contract liability; and/or
x a receivable (receivables are to be presented separately from contract assets).
More detail regarding presentation is provided in section 4.5.
12.2 Sample presentation involving revenue
Company name
Statement of comprehensive income (extracts)
For the year ending 31 December 20X2
20X2 20X1
Note C C
Revenue See IAS 1.82 15 150 000 80 000
Other income xxx xxx
Cost of sales (xxx) (xxx)
... (xxx) (xxx)
Profit before tax 22 xxx xxx
Company name
Statement of financial position (extracts)
20X2 20X1
ASSETS C C
Contract assets See IFRS 15.105 xxx xxx
Receivables See IFRS 15.105 (unconditional rights) xxx xxx
LIABILITIES
Contract liabilities See IFRS 15.105 xxx xxx
13. Disclosure (IFRS 15.110-.129)
13.1 Overview
IFRS 15 includes copious disclosure requirements. However, the objective is that there must
be enough disclosure that a user can assess the ‘nature, amount, timing and uncertainty’ of
both the revenue and cash flows stemming from the entity’s customer contracts. See IFRS 15.110
To achieve this, we must disclose both qualitative and quantitative information regarding:
x Contracts with customers
x Significant judgements (and any changes therein) made when applying IFRS 15
x Assets recognised relating to costs to obtain and costs to fulfil a contract.
The level of detail required in presenting the above disclosure requirements is not prescribed
by IFRS 15. Instead, IFRS 15 requires us to use our professional judgement in deciding how
much detail is needed in order to meet the basic objective (i.e. of enabling a user to assess the
‘nature, amount, timing and uncertainty’ of both the revenue and cash flows).
210 Chapter 4
13.2 Contracts with customers (IFRS 15.110(a) and .113-.122)
Contracts with customers result in revenue, contract balances (contract assets/ liability and
receivables) and possibly impairment losses, all of which will require certain disclosures. The
revenue and impairment losses that relate to customer contracts must be disclosed separately
from those that relate to other kinds of contracts. Revenue from customer contracts will need
to be disaggregated. Revenue that is recognised depends on when performance obligations are
satisfied and therefore information relating to these performance obligations is required.
Revenue may not be recognised until the performance obligation is satisfied and thus information
relating to the remaining unsatisfied performance obligations at reporting date is also required.
This is explained in more detail in the table below. A very brief example of how the revenue
amounts from customer contracts would be disclosed is presented after this table.
13.2.1 Disclosure of related revenue and impairment losses to be separate:

x Revenue: Revenue from customer contracts must be disclosed separately from revenue
from other sources. See IFRS 15.113 (a)
x Impairment losses: Impairment losses relating to customer contracts (receivables and
contract assets) must be disclosed separately from impairment losses on other types of
contracts. See IFRS 15.113 (b)
13.2.2 Disclosure of disaggregated revenue:

x Revenue must be disaggregated to enable users to assess how economic factors may
affect the ‘nature, amount, timing and uncertainty’ of the customer contract revenue and
related cash flows. See IFRS 15.114
x Disaggregation simply means to separate into categories that are relevant to the entity. To
determine the categories that are relevant to the entity, we must consider the ‘facts and
circumstances’ relating to the entity’s customer contracts. See IFRS 15.B87 and see .B88
x Thus IFRS 15 is not specific but simply provides guidance by way of examples. We
could, for example, disaggregate our revenue into categories based on:
- Type of good or service (e.g. major product lines: sale of hosepipes and sale of toys)
- Geographical region (e.g. sales in South Africa and sales in Europe)
- Market or type of customer (e.g. government and non-government customers)
- Contract type (e.g. fixed price contracts and variable price contracts)
- Contract duration (e.g. contracts of less than a year and contracts longer than a year)
- Timing of transfer of goods or services (e.g. transfers that occur at a point in time and
transfers that occur over time)
- Sales channels (e.g. wholesale customers and retail customers). See IFRS 15.B89
x In order to meet the objective of revenue disclosure, entities may need to disclose the
revenue disaggregated into more than one type of category. See IFRS 15.B87
13.2.3 Disclosure relating to contract balances:

x We must disclose the:
- opening and closing balances of the following, if they relate to customer contracts:
- receivables
- contract assets
- contract liabilities;
- revenue recognised in the current year:
- that was included in the contract liability opening balance;
- relating to performance obligations that were satisfied in prior periods (e.g. due to
a change in the estimated transaction price). See IFRS 15.116
Chapter 4 211
x We must provide a reconciliation showing the significant changes making up the movement
between the contract asset opening and closing balance and the contract liability opening and
closing balance.
This reconciliation needs to provide both quantitative and qualitative information.
Examples of the movements in these balances include:
- a decrease in the contract asset caused by an impairment of the contract asset;
- an increase in the contract asset due to an increase in revenue caused by a change in
how we estimated the measure of progress towards satisfaction of the performance
obligation (i.e. a change in estimate resulting in a cumulative catch-up adjustment);
- a decrease in the contract liability due to a transfer to revenue, caused by a change in
time frame that resulted in a performance obligation becoming considered satisfied;
- a decrease in the contract asset caused by a transfer from the contract asset to the
receivable, caused by a change in time frame that resulted in the expected
consideration now becoming regarded as unconditional. See IFRS 15.118
x We must explain how the timing of the satisfaction of performance obligations compares with
the typical timing of payments and how this affects the contract asset/ liability balances.
13.2.4 Disclosure relating to performance obligations:

We must disclose a description of each of the following:
x when the performance obligations are normally satisfied (e.g. upon delivery or as services
are being rendered or when services are complete);
x significant payment terms (e.g. whether a significant financing component exists, when
payment is due, whether the consideration is variable).
x the nature of the goods or services that the entity is obliged to transfer and highlighting
any obligation that the entity will be performing as an agent;
x any obligation for returns, refunds or similar items;
x warranty obligations. See IFRS 15.119
13.2.5 Disclosure of the remaining unsatisfied performance obligations and how much of
the transaction price has been allocated to these
x For performance obligations that are totally or partially unsatisfied at reporting date, we
will need to disclose:
- the aggregate amount of the transaction price that has been allocated to these
unsatisfied performance obligations (i.e. we are effectively disclosing the amount of
revenue that we have not yet been able to recognise); and
- whether any consideration was excluded from the transaction price and thus not
included in the aggregate amount disclosed (e.g. variable consideration that was
constrained);
- when we expect to be able to recognise this remaining revenue – this information can
either be given quantitatively, using time bands considered appropriate to the
remaining period of the contract, or can be given qualitatively. See IFRS 15.120 and 122
x Practical expedients: As a practical expedient, we can ignore the requirement to provide
the information above if:
- the total expected duration of the related contract is one year or less; or
- the revenue from this performance obligation is to be recognised based on the right to
invoice (this aspect is not covered in this chapter, but is explained in IFRS 15.B16).
If we opt for this practical expedient, we must disclose this fact.
212 Chapter 4
13.2.6 Sample disclosure relating to the line-item ‘revenue from customer contracts’
The following example uses hypothetical amounts.
Company name
20X2 20X1
C C
15 Revenue
Revenue comprises 150 000 80 000
x Revenue from customer contracts – see note 16 See IFRS 113 (a) 120 000 60 000
x Revenue from other sources See IFRS 113 (a) 30 000 20 000
16 Revenue from contracts with customers – disaggregation See IFRS 15.114

Revenue from customer contracts has been disaggregated based on geographical areas because this is how
the company evaluates the performance of its segments. It has also been disaggregated based on product
lines since this was the focus of our presentation to investors when raising financing earlier in the year.
Geographical region: See IFRS 15.B89 120 000 60 000

x South Africa 85 000 42 000
x Asia 35 000 18 000
Product lines: See IFRS 15.B89 120 000 60 000
x Sales of hose pipes 51 000 28 000
x Sales of toys 69 000 32 000
22 Profit before tax

Profit before tax is calculated after taking into account the following separately disclosable income/
(expense) items
x Impairment loss on customer contract: receivables * See IFRS 113 (b)
x Impairments losses on customer contract: contract assets* See IFRS 113 (b)
x Impairments losses on other contract assets See IFRS 113 (b)
* Please note: The wording of IFRS 113 (b) suggests that impairment losses relating to contracts with
customers, (whether on a customer receivable or on a contract asset) could be combined into one line-item.
13.3 Significant judgements (IFRS 15.110(b) and .123-.126)
Disclosure must be made of the significant judgements (and any changes therein) that were
made when applying IFRS 15. IFRS 15 specifically refers to the judgements (and any changes
that significantly affect the timing of revenue and the amount of revenue. This is explained in
more detail in the table below:
13.3.1 Judgements (and changes therein) that significantly affect the timing of revenue
We will need to explain the judgements (and changes therein) that we used when deciding
when performance obligations (POs) were satisfied. See IFRS 15.123 (a)
x When POs are satisfied (and thus revenue recognised) over time, we must:
- Disclose the method used (e.g. input method), describe the method (e.g. costs
incurred as a % of total expected contract costs) and how it was applied.
- Provide an explanation as to why this method used is considered to be ‘a faithful
depiction of the transfer of goods or services’. See IFRS 15.124
x When POs are satisfied (and thus revenue recognised) at a point in time, we must:
- Disclose the significant judgements used in deciding when control over the goods or
services passes to the customer. See IFRS 15.125
Chapter 4 213
13.3.2 Judgements (and changes therein) that significantly affect the amount of revenue
x We will need to explain the judgements (and changes therein) that we used when:
- determining the transaction price (TP); and
- determining how much of the TP should be allocated to each PO. See IFRS 15.123 (b)
x As part of the explanation, we must disclose the methods, inputs and assumptions used to:
- determine the TP: including how we estimated variable consideration, how we
adjusted for the time value of money, how we measured non-cash consideration and
how we assessed whether an estimate of variable consideration was limited;
- allocate the TP: including how we estimated the stand-alone selling prices, how we
allocated any discounts and how we allocated any variable consideration;
- measure any obligations, such as returns and refund obligations. See IFRS 15.126
x Practical expedients: If the entity chose not to account for a significant financing
component, this fact must be disclosed. See IFRS 15.129
13.4 Contract costs recognised as assets (IFRS 15.110(c) and .127-.128)
Where costs related to a customer contract have been recognised as an asset (i.e. costs to
obtain or costs to fulfil a contract), certain qualitative and quantitative information needs to be
disclosed. This is explained in detail in the table below.
13.4.1 Quantitative information

x We will need to disclose the:
- amount of the closing balances for each main category of asset (e.g. costs to obtain a
contract and costs to fulfil a contract);
- amount of amortisation and impairment losses. See IFRS 15.128
13.4.2 Qualitative information

x We will need to describe the:
- judgments made in calculating the costs incurred to obtain and to fulfil a contract;
- amortisation method. See IFRS 15.127
x Practical expedients: If the entity chose to expense the costs to obtain a contract (this
option exists if the amortisation period for this asset would have been one year or less),
this fact must be disclosed. See IFRS 15.129
214 Chapter 4
14. Summary
Revenue recognition and measurement – the 5-step model
Step 1 Identify if we have a contract with a customer

x We must have a contract that involves a customer as defined and the contract must be enforceable.
x 5 criteria must be met
- all parties have approved & are committed to the contract
- each party’s rights & obligations are identifiable
- the payment terms identifiable
- the contract has commercial substance
- it is probable that the entity will collect the consideration to which it expects to be entitled.
x If 5 criteria are not met at inception, keep reassessing to see if they are subsequently met (in
the meantime, recognise any receipts as a refund liability).
x If 5 criteria are met at inception, but subsequently fail to be met, stop recognising revenue
and recognise as a refund liability from that point onwards.
x Can be deemed not to exist if it is wholly unperformed and all parties can terminate without
compensating the other party/ies.
x Contracts may need to be combined and accounted for as a single contract if certain criteria
are met (see IFRS 15.17).
x Contract modifications may need to be accounted for as a:
- separate contract (if scope increases due to extra goods or services (G/S) that are
distinct and the price increases by an amount that reflects the stand-alone selling price
(SASP) of these extra G/S); or
- termination of the old contract and creation of a new contract (if it is not a single contract
and the G/S are distinct); or
- adjustment to the existing contract (if it is not a single contract and the G/S are not distinct).
Step 2 Identify the performance obligations (PO)

x POs are the distinct promises in the contract.
x The promise can either refer to the transfer of:
- distinct G/S or bundles of G/S
- a series of distinct G/S that are substantially the same and have the same pattern of transfer.
x Revenue will be recognised for each PO that is satisfied.
x PO can be explicitly stated in the contract or could be implied (e.g. through published policies).
x Promises are distinct if the G/S:
- can generate economic benefits for the customer (i.e. is capable of being distinct)
- is separately identifiable from other promises (i.e. is distinct in the context of the contract).
Step 3 Determine the transaction price (TP)

x The TP is the amount of consideration to which the entity expects to be entitled in exchange
for the transfer of G/S, excluding amounts collected on behalf of 3rd parties
x Could include variable consideration (VC) –VC could be explicitly stated in the contract or be implied
- Eg: bonus (may/ may not increase the TP) and early settlement discount (may/may not decrease TP)
- We include only the ‘constrained estimate of the VC’ in the TP – this requires us to:
- estimate the VC (using either most likely amount or expected values); and then
- constrain the estimate (i.e. limit the estimate to an amount that has a high probability
of not causing a significant reversal of revenue in the future).
- The VC in excess of the constrained estimate of VC won’t be recognised as revenue
Amounts received from the customer in excess of the ‘constrained estimate of VC’ in the
TP are recognised as refund liabilities (i.e. debit bank and credit refund liability) until the
uncertainty is resolved (goes away), at which point, we reverse the refund liability and
either repay the amount or recognise it as revenue.
Chapter 4 215
x A sale with a right of return is an example involving VC because we don’t know if the goods will
be returned or not. Thus, we should only recognise revenue that we expect to be entitled to
(i.e. products that will not be returned within the return period), which could be a variable
amount, as it depends on our estimates (which may change).
But this is slightly different to other forms of VC because we must not only remember to
constrain our estimate of the VC when determining the TP (and thus revenue) and recognise a
refund liability for the goods that are expected to be returned (e.g. debit bank/receivable &
credit refund liability), but we must also recognise a right of return asset (for the cost of the
goods sold that we think will be returned e.g. debit right of return asset & credit inventory).
Could include significant financing component
- the principle to apply here is that the TP should reflect the cash selling price
- the difference between the cash selling price and the consideration receivable is recognised as:
- interest income (if the customer gets the financing benefit)
- interest expense (if the entity gets the financing benefit)
- practical expedient: if the period between payment and transfer of the G/S is less than 1
year, don’t bother to separate out the interest (leave the TP unadjusted).
x Could include non-cash consideration
- only include this in the TP if the entity gets control of the item, in which case measure it at
fair value (FV).
x Could include consideration payable to customer (or to the customer’s customers!)
- reduce the TP by this consideration payable unless it is actually an amount we are paying to
the customer for distinct G/S that the customer is transferring to us and for which FVs
can be reliably determined.
x We must reassess the VC every year – if it changes:
- we allocate the change in VC on the same basis that the original TP was allocated to the POs
- and the PO has already been satisfied, we recognise the change in VC immediately as an
increase/decrease in revenue.
Step 4 Allocate the TP to the POs

x We must allocate the TP to the POs in such a way that the amount of the TP that gets
allocated to each PO reflects the amount of consideration that the entity would have
expected to be entitled to in exchange for that PO’s underlying transfer of G/S.
x The TP is allocated to the POs based on the relative (SASP) of the G/S in each PO.
x The SASP are either based on observable prices (if available) or must be estimated.
x SASPs may be estimated using any reasonable method, but IFRS 15 suggests using:
- adjusted market price
- expected cost plus an appropriate margin
- residual approach.
x Allocating a TP that contains an inherent discount:
- a contract has an inherent discount if the sum of the SASP > promised consideration)
- the discount can be allocated to all the POs by simply allocating the discounted TP to all
the POs in the normal way (i.e. based on the relative SASPs of the POs) if the discount
relates to all POs
- the discount can be allocated to a specific PO/s if it relates to certain specific PO/s (and
the required criteria are met – see IFRS 15.82)
- if we have a discounted TP and the discount relates to a specific PO/s and we also have to
estimate the SASP of one of the POs using the residual approach, it is important to
allocate the discount to the specific PO/s first before balancing to the estimated SASP
(i.e. before we estimate the SASP using the residual approach).
216 Chapter 4
x Allocating a TP that contains VC:
- the VC can be allocated to all the POs by simply allocating the total TP (fixed consideration
+ variable consideration) to all the POs in the normal way (i.e. based on the relative SASPs
of the POs) if the VC relates to all POs
- the VC can be allocated to a specific PO/s if it relates to certain specific PO/s (and the
required criteria are met – see IFRS 15.85), in which case:
- the TP excluding the VC is allocated on SASP and then
- VC is allocated to the specific PO/s.
x If the TP has changed, we allocate the change in TP to the POs

- using the same allocation basis that was used at contract inception (i.e. using the same
SASP, even if these have subsequently changed)
- if a PO has already been satisfied, then the change relating to the PO will be immediately
recognised as an increase/ decrease in revenue.
Step 5 Recognise revenue when POs are satisfied
x POs are satisfied when control over the G/S has passed to the customer.
x Control has passed to the customer when

- the customer can direct the use of the G/S; and
- obtain substantially all its remaining benefits (see IFRS 15.33/4).
IFRS 15 provides example indicators that may suggest control has passed (see IFRS 15.38).
x Control either passes:

- over time (gradually); or
- at a point in time (in an instant).
x POs are classified based on how control over the G/Ss transfers:
- PO satisfied over time (SOT)
- PO satisfied at a point in time (SAPIT).
x A PO is classified as satisfied over time (SOT) if any of the 3 criteria in IFRS 15.35 are met:
- if customer receives and consumes benefits as the PO is satisfied; or
- if customer gets control of the asset while the entity creates/ enhances the asset; or
- if the entity has no alternative use for the asset and also has an enforceable right to
payment for performance completed to date (See IFRS 15.35).
x A PO is classified as satisfied at a point in time (SAPIT) if none of the 3 criteria in
IFRS 15.35 are met i.e. if it is not satisfied over time (SOT).
x If a PO is classified as satisfied over time (SOT), measurement of revenue requires us to be

able to measure progress towards complete satisfaction.
x Methods of measuring progress towards complete satisfaction include:
- input methods:
- measures the entity’s efforts (e.g. costs to date ÷ total expected costs to complete the PO)
- can use the straight-line method if the entity’s efforts will be expended evenly over
the period that the PO will be satisfied.
- output methods:
- considered superior to input methods, but may be impossible or too costly to use
- measures the value received by the customer (e.g. work certified to date ÷ total transaction
price allocated to the PO – referred to as the surveys or work certified method).
Chapter 4 217
Contract costs
Contract costs may need to be capitalised

x Contract costs my need to be capitalised in terms of IFRS 15 – if so, they will also need to be:
- amortised; and
- tested for impairment.
x There are two types of contract costs
- costs of obtaining the contract
- costs to fulfil the contract.
x Costs of obtaining a contract are capitalised if they are:
- incremental costs and the entity expects them to be recoverable
- not incremental costs but the entity can recover them from the customer (or potential customer).
Practical expedient: if the asset created would be amortised within a year or less, then costs
are not capitalised.
x Costs of fulfilling a contract:
- apply other IFRSs first
- if other IFRSs do not apply, then capitalise the costs in terms of IFRS 15 if all the
- costs relate directly to the contract and can be specifically identified
- costs will generate/enhance the resources that the entity will be/is using on the contract
- the entity expects to recover these costs. (See IFRS 15.95)
Presentation and disclosure
SOCI – presentation
x Revenue must be presented on the face of the SOCI (IAS 1 requirement).
x Revenue from customer contracts must be presented separately from other revenue.
x The revenue from customer contracts on the face of the SOCI must be disaggregated (either
on the face or in the notes).
SOFP – presentation
x Contract asset (represents the entity’s conditional rights): must be presented on the face of
the SOFP
- this is recognised when we have earned revenue because the PO is complete but our right
to consideration is still conditional
- e.g. debit contract asset and credit revenue.
x Receivable (represents the entity’s unconditional rights): must be presented on the face of
the SOFP
- this is normally recognised when we have earned revenue since the PO is complete and our
right to consideration is unconditional i.e. at most, all we have to do is wait for time to pass
e.g. debit receivable and credit revenue
- this can also arise when we the terms of the contract make a sum receivable, but we still
have to satisfy the PO (e.g. when the contract is non-cancellable)
e.g. debit receivable and credit contract liability.
x Contract liability (represents our obligation to perform or return the cash received): must be
presented on the face of the SOFP
- this is recognised when we have not yet completed our POs and thus cannot recognise the
revenue yet, but we either:
- have an unconditional right to receive consideration (i.e. a receivable) (e.g. our
contract is non-cancellable)
e.g. debit receivable and credit contract liability
- have received the cash already
e.g. debit bank and credit contract liability.
218 Chapter 4
Gripping GAAP Taxation: various types and current income taxation
Chapter 5
Taxation: Various Types and Current Income Tax
Reference: IAS 12 and IAS 1 (including amendments to 10 December 2018)
CHAPTER SPLIT:
This entire chapter revolves around tax. However, it is a long chapter which is easier to manage if you
split it into two parts, one of which deals with the various different types of taxes and the second focuses
purely on the intricacies of income tax.
The chapter has thus been split into two separate parts as follows:
PARTS: Page
PART A: Various types of tax 221
PART B: Income tax (current only) 230
PART A:
Various Types of Tax
Contents: Page
A: 1 Introduction 221
A: 2 Transaction tax (VAT) 221
2.1 Overview 221
2.2 The sale of goods 222
Example 1: VAT on sale of goods 223
Example 2: VAT on sale of goods 223
2.3 The purchase of goods 224
Example 3: VAT on purchase of goods 224
Example 4: VAT on purchase of goods 225
A: 3 Employees’ taxation 226
Example 5: Employees’ tax 226
A: 4 Income tax 227
A: 5 Dividends tax 227
5.1 Overview 227
5.2 Measuring dividends tax 228
5.3 Recognition of dividends tax 228
Example 6: Income tax and dividends tax 228
PART B:
Income Tax (Current Only)
Contents: Page
B: 1 Introduction 230
B: 2 Recognition of income tax 230
2.1 Overview 230
2.2 Tax recognised in profit or loss 230
2.3 Presentation of tax recognised in profit or loss 231
2.4 Tax recognised in other comprehensive income 231
2.5 Presentation of tax recognised in other comprehensive income 231
B: 3 Measurement of income tax (current only) 231
3.1 Overview 231
3.2 Enacted and substantively enacted tax rates 232
Example 7: Enacted and substantively enacted tax rates 232
Chapter 5 219

3.3 Taxable profits versus accounting profits 233
3.4 Permanent differences 234
3.4.1 Exempt income and non-deductible expenses – a general overview 234
Example 8: Permanent differences: exempt income and non-deductible expense 235
3.4.2 Capital profits versus taxable capital gains 236
3.4.2.1 General 236
3.4.2.2 IFRSs: capital profits 236
3.4.2.3 Tax legislation: taxable capital gains 236
3.4.2.4 Difference: exempt capital profit 237
Example 9: Capital profits and taxable capital gains 237
Example 10: Exempt income and non-deductible expenses 238
3.5 Temporary differences 239
3.5.1 Overview 239
3.5.2 Temporary differences caused by the system of accrual 240
Example 11: Income that is receivable 241
Example 12: Income that is received in advance 242
Example 13: Expenses that are payable 242
Example 14: Expenses that relate to provisions 243
Example 15: Expenses that are prepaid 244
3.5.3 Temporary differences caused by depreciable assets 245
3.5.3.1 Depreciation expense versus tax deduction 245
Example 16: Depreciation versus tax deductions 245
3.5.3.2 Carrying amount versus tax base 246
Example 17: Depreciable assets - carrying amount versus tax base 246
3.5.3.3 The effect of selling the asset - at below the original cost 247
Example 18: Profit/loss on sale versus recoupment/ scrapping allowance on sale 247
3.5.3.4 The effect of selling the asset - at above the original cost 248
Example 19: Capital profit vs. capital gains on sale (proceeds > original cost) 250
3.5.4 Temporary differences caused by tax losses (also known as assessed losses) 251
Example 20: Tax losses (assessed losses) 251
3.6 Permanent differences and temporary differences 252
Example 21: Temporary differences and permanent differences 252
B: 4 Payment of income tax 254
4.1 Overview 254
4.2 Income tax: provisional payments and estimates 254
4.3 The first provisional payment 255
4.4 The second provisional payment 256
4.5 The final estimate of current income taxation 256
Example 22: The provisional payments and tax estimate 256
4.6 The formal tax assessment and resulting under / over provision of current tax 257
4.7 The formal tax assessment and resulting under / over payment of current tax 258
Example 23A: First provisional tax payment in 20X1 258
Example 23B: Second provisional tax payment in 20X1 259
Example 23C: Current tax expense estimated for 20X1 259
Example 23D: Under/over provisions of 20X1 income tax 260
Example 23E: Income tax transactions in 20X2 260
Example 24: Under / over-payments and under/ over-provisions of tax 261
B: 5 Disclosure of income tax – a brief introduction 262
5.1 Overview 262
5.2 Statement of financial position disclosure 262
Example 25: Disclosure of current tax assets and liabilities (set off) 262
5.3 Statement of comprehensive income disclosure 263
Example 26: Disclosure involving exempt income and non-deductible expenses 264
Example 27: Disclosure involving an under-provision 265
Example 28: Disclosure involving other comprehensive income 266
Summary 268
220 Chapter 5
PART A:
Various Types of Tax
A: 1 Introduction
Many different taxes are levied around the world. The following are some of the common taxes
in South Africa:
x VAT (value-added taxation): see Section A: 2
Many types of tax, for
This is a tax on goods bought: the purchaser of the goods example:
will pay the VAT and the seller, being the one to receive
the payment, pays the tax over to the tax authority. x VAT
x Employees tax
x Employees’ tax: see Section A: 3 x Income tax
x Dividends tax
This is a tax on an employee’s salary: the entity deducts x Property tax
the tax from the employee’s salary and pays it to the tax x Vehicle licences
authority; the employee is paid his salary net of tax. x Fuel levies & toll fees.
x Income tax on companies: see Sections A: 4 and Part B

This is a tax on a company’s taxable profits. Taxable capital gains (which is a term
calculated in accordance with Capital Gains Tax legislation) are included in these taxable
profits. Income tax is paid to the tax authority using a provisional tax payment system. The
corporate income tax rate in South Africa is 28%.
x Dividends tax: see Section A: 5
Dividends tax is levied on the shareholder receiving the dividends. It is a withholding tax,
meaning the dividend is paid net of tax and the entity declaring the dividend is responsible
for paying the tax to the revenue authorities. (Dividends tax has replaced Secondary tax on
Companies, which was an additional tax levied on the entity that declared the dividend).
South Africa has recently increased its dividends tax rate from 15% to 20%.
x Other taxes
Countries often have many other hidden taxes, such as property rates, postage stamps,
petrol, unemployment insurance funds, regional levies and many more.
We will concentrate on some of the main taxes affecting a business entity: VAT, employees’
taxes, income tax on profits and dividend withholding tax.
What tax rates should we use?
For consistency and simplicity, the following tax rates will be used throughout this text unless
indicated otherwise:
x VAT at 15%;
x Income tax on companies at 30% of taxable profit; and
x Dividends tax at 20% on the receipt of dividends.
Remember: in an exam, you must obviously use the tax rates given in the question. If none are given, it is
generally advisable to use the latest known rates: VAT is currently 15%, income tax on companies vary widely,
but is generally taken to be 28% and dividends tax is currently 20%.
A: 2 Transaction Tax (VAT)
A: 2.1 Overview
A transaction tax is simply a tax levied on a transaction. 3 categories of supplies
Some countries choose to use General Sales Tax (GST) as (goods/services):
their transaction tax whereas others choose to use value x Vatable supplies;
added tax (VAT) instead. We will focus only on VAT. x Zero-rated supplies; and
x Exempt supplies.
VAT is a levied on the supply of certain goods or services.
Goods and services supplied are generally categorised into vatable supplies, zero-rated supplies
and exempt supplies.
Chapter 5 221
Zero-rated and exempt supplies are similar in that there is effectively no VAT paid on these
goods (or services), however, there is a practical difference in that zero-rated supplies
technically have VAT levied on them, but at 0%, whereas exempt supplies do not have VAT
levied on them at all. The reason for this is beyond the scope of this chapter.
What makes VAT unique from other forms of transaction taxes, such as General Sales Tax
(GST), is that, where VAT applies to the supply of a good (or service), VAT will be levied on
every transaction in the supply chain related to that good (or service), and not just on the final
transaction with the final customer. This means that every purchaser in the supply chain who is
a registered VAT vendor (in terms of the relevant tax legislation) must pay VAT and then claim
it back. If the purchaser is not registered as a VAT vendor, then he will not be allowed to claim
the VAT back and is therefore considered to be the ‘final customer’ for tax purposes.
Worked example: The VAT process

1. A (manufacturer & VAT vendor) sells goods to B (retailer) for C115 (the goods are a vatable supply and thus
this price includes 15% VAT).
2. B pays C115 to A.
3. A pays the C15 VAT to the tax authority.
4. B is a VAT vendor so he claims and receives the C15 VAT back from the tax authorities.
5. B (the retailer) sells the goods to C (the man in the street) for C230 (including C30 VAT).
6. C pays B C230.
7. B pays the C30 VAT to the tax authorities.
8. C is not classified as a vendor for VAT purposes and may therefore not claim the C30 back.
9. The tax authority gets to keep the final C30.
The following picture shows the flow of cash above. Can you see that it is Mr C (the one who is not smiling!) who
is the only one in the chain of transactions who actually ends up paying the VAT. Mr. C is normally the man in the
street and not a business. Can you see that this system is quite an onerous system in terms of the paperwork
that has to be sent to the tax authorities supporting amounts owing and claimed.
A B C
1&2: 115 5&6: 230
3: 4: 7:
15 15 30
Tax authority
A: 2.2 The sale of goods

VAT Vendors who sell
Businesses that are registered as VAT vendors in terms of the vatable supplies must:
tax legislation must charge VAT on the sale of all the goods and x Charge VAT (this is
services supplied (assuming that the supplies are classified as called output VAT)
‘vatable supplies’). The law requires that the goods and services
that are vatable should be marked at a price that includes the VAT (i.e. marked price = selling
price + VAT, if any). Where the goods and services are either zero-rated or exempt, no
additional VAT will be included in the marked price (since MP = SP + VAT, if the VAT is
zero, the MP = SP). It is the selling price that we recognise as revenue. The VAT charged is
referred to as ‘output VAT’.
Some useful equations:
Marked price = Selling price + VAT; Thus: MP = SP + SP x 15%

Or: MP = SP + VAT MP = SP x 100% + SP x 15%
VAT = SP x 15% (assuming the VAT rate is 15%); MP = SP x (100% + 15%)
Thus: MP = SP x 115%
MP = SP + VAT Thus: SP = MP ÷ 115%
115% = 100% + 15% Thus: VAT = MP ÷ 115% x 15%
222 Chapter 5
Example 1: VAT on sale of goods (output VAT)

Mr. Seller is a VAT vendor and the inventory he sells is vatable (meaning he must charge
VAT on the sale of each item of inventory that is sold).
x The selling price ex-VAT is C100 per item and thus the marked price must be C115 (i.e.
including 15% VAT on the C100: C100 x 115% = C115).
x Mr. Seller sells one item for cash, thus immediately receiving C115 from the customer.
x Mr. Seller is effectively acting as an agent for the tax authorities in that he must pay over to the
tax authority the C15 VAT received from the customer. Thus, C15 of the C115 is money
received on behalf of the tax authorities and does not belong to Mr. Seller.
Required: Record all related transactions in the ledger accounts of the seller.
Solution 1: VAT on sale of goods

Bank (A) Revenue (I)
Rev & CTP: VAT 115 Bank 100
Current tax payable: VAT (L)

Bank 15
The seller would then have to pay the tax authorities the C15 in VAT, thus settling the liability owing to
the tax authorities. The net effect is that the seller’s bank increases by only C100 (C115 – C15) which
was why only C100 was recognised as income.
Bank (A) Revenue (I)
Rev & CTP: VAT 115 CTP: VAT 15 Bank 100

Bank 15 Bank 15
Comment: It is clear from the above example that before we can record a sale, we need to know whether
we are a VAT vendor or not. If we are a VAT vendor, and assuming the goods are not exempt or zero-
rated, we must charge our customer VAT (i.e. the marked price will include 15% VAT). Thus, our
marked price will be greater than the selling price. The selling price is recognised as revenue. The VAT
included in our marked price is owed to the tax authorities and is thus a liability until paid.
Example 2: VAT on sale of goods (output VAT)

Mr. A sells goods to Mr. B for C115 (the marked price). Assume VAT is levied at 15%.
Required:
a) Show the relevant journals processed in Mr. A’s ledger assuming:
i) Mr. A is not a VAT vendor
ii) Mr. A is a VAT vendor
b) How would your answer change if:
i) Mr. B is not a VAT vendor
ii) Mr. B is a VAT vendor.
Solution 2A: VAT on sale of goods – seller is a vendor or a non-vendor

i. Mr. A is not a VAT vendor:
Mr. A has therefore not included VAT in the marked price of C115. In this case:
Marked price = Selling price + VAT = SP + 0 .: MP = SP
Bank/ Debtors (A) Revenue (I)
Revenue 115 Bank/ Debtors 115
Comment: Since the invoiced price does not include VAT, the full invoice value belongs to Mr. A.
ii. Mr. A is a VAT vendor:
Mr. A has thus charged VAT. Thus, the marked price of C115 includes VAT.
Thus, MP = SP + VAT
Since VAT = SP x 15%, we can also say that MP = SP + SP x 15% = SP + SP x 0.15
Chapter 5 223
Solution 2A Continued…
Apply this logic to the example in order to calculate:
x Selling price:
MP = SP + (SP x 0.15) ; substitute MP = C115
Thus: C115 = SP x 1,15
SP = C115 / 1,15 = C100 (or: C115 / 115 x 100)
x VAT:
MP = SP + VAT; substitute MP = C115 and substitute SP = C100
Thus: C115 = C100 + VAT ; thus VAT = C115 – C100 = C15 (or: C115 / 115 x 15)
Bank/ Debtors (A) Revenue (I)
Rev & CTP:VAT 115 Bank/Debtors 100

Bank/Debtors 15
Comment: A total of C115 is received. Of this, only C100 (100/115 x C115) belongs to Mr. A and the
balance of C15, constituting VAT (15/115 x C115), must be paid over to the tax authorities.
Solution 2B: VAT on sale of goods – purchaser is a vendor or a non-vendor

There would be no difference in the way the journals are recorded in Mr. A’s books, since it is of no
consequence to Mr. A whether or not Mr. B is able to claim back the VAT that Mr. B pays.
A: 2.3 The purchase of goods VAT Vendors who buy

vatable supplies may:
If the purchaser is a vendor for VAT purposes, the VAT he x Claim back VAT paid
incurs is generally able to be claimed back from the tax (this is called input VAT)
authorities. VAT incurred is often called ‘input VAT’.
Example 3: VAT on purchase of goods (input VAT)

Let us continue using the same example 2 above, where Mr. A was a VAT vendor. Assume
that Mr. A originally purchased these goods (mentioned in example 2) from Mr. Z, also a
VAT vendor, for the marked price of C69. Since Mr. Z is a VAT vendor, it means that the marked
price of C69 would have included 15% VAT. Thus, the total amount of C69 paid by Mr. A includes
VAT of C9 (15/115 x C69) and C60 for the goods (100/115 x C69).
Since Mr. A is a VAT vendor, he is able to claim back this C9 VAT (input VAT) from the tax authority
and soon receives this refund from the tax authority.
Required: Record the related journal entries in Mr. A's ledger.
Solution 3: VAT on purchase of goods
Inventories (A) Bank (A)

Bank (1) 60 Invent & VAT (1) 69
CTR: VAT (2)
9
Current tax receivable: VAT (A)

Bank (1) 9
Bank (2) 9
Journals:
1) Mr A purchases and pays for the inventory, where the marked price of C69 includes VAT of C9.
2) Mr A claims and receives the VAT refund (C9) from the tax authorities.
Notice:
x The inventory is measured at C60 and not C69 since although Mr. A initially pays C69 for the
purchase, he receives C9 back from the tax authorities, the net cost to Mr. A being C60 (see the
bank account: C69 paid – C9 received).
224 Chapter 5
Before we can record a purchase, we need to know:

x if we, the purchaser, are classified as a ‘VAT vendor’; and
x if the supplier (i.e. seller) is classified as a ‘VAT vendor’ or not; and
x if the supply of goods or services is considered to be a ‘vatable supply’ or not.
If we, the purchaser, are not classified as a VAT vendor, then we need not worry about recording
VAT. However, if we are a VAT vendor, then we must record VAT where it exists. If the
supplier is not a VAT vendor, or the goods are not vatable supplies, then there is no VAT to
record (i.e. VAT does not exist). However, if the supplier is a VAT vendor and the goods or
services are vatable supplies, then VAT will have been charged (i.e. VAT does exist). Since, as
a VAT vendor, we can claim it back, we must record this VAT separately from the cost of the
goods or services acquired.
Example 4: VAT on purchase of goods (input VAT)
Mr. B buys goods from Mr. A for C115 (the marked price).
Required: Show the journals posted in Mr. B’s ledger assuming:

i) Mr. B (purchaser) is a VAT vendor and Mr. A (seller) is not a VAT vendor
ii) Mr. B (purchaser) is a VAT vendor and Mr. A (seller) is a VAT vendor
iii) Mr. B (purchaser) is not a VAT vendor and Mr. A (seller) is not a VAT vendor
iv) Mr. B (purchaser) is not a VAT vendor and Mr. A (seller) is a VAT vendor
Solution 4: VAT on purchase of goods

Comment: This example illustrates the various combinations of scenarios that could exist when the
seller and purchaser are VAT vendors and are not VAT vendors. Notice that the only time the
purchaser of goods claims VAT back from the tax authorities is when both the purchaser and the entity
he purchased from (i.e. the seller) are VAT vendors.
i. Mr. B is a VAT vendor and Mr. A is not a VAT vendor
Bank (A) Inventories (A)
115 115
Explanation: Mr. B is a VAT vendor and would thus be able to claim back any VAT that he paid
(input VAT) – however, Mr. A is not a VAT vendor and thus had not charged Mr. B any VAT.
ii. Mr. B is a VAT vendor and Mr. A is a VAT vendor
115 100
Current tax receivable: VAT (A)

15
Explanation: Mr. A is a VAT vendor and will thus have included C15 VAT in the C115 marked price.
Mr. B is a VAT vendor and is thus able to claim back this C15 VAT paid (input VAT) from the tax
authorities. Thus, the inventory cost C100 (C115 MP - C15 VAT claimed back from the authorities).
iii. Mr. B is not a VAT vendor and Mr. A is not a VAT vendor
115 115
Explanation: Mr. B is not a VAT vendor which means he is not able to claim back any VAT that he
pays (input VAT). However, this is irrelevant since Mr. A is not a VAT vendor and has thus not
charged VAT.
iv. Mr. B is not a VAT vendor and Mr. A is a VAT vendor
115 115
Explanation: Mr. A is a VAT vendor and will thus have included C15 VAT in the C115 marked price.
However, Mr. B is not a VAT vendor, meaning he is unable to claim back any VAT paid (input VAT).
Since Mr. B may not claim back any VAT paid, the inventories cost him the full amount of C115.
Chapter 5 225
A: 3 Employees’ Taxation
This is a tax that the employee effectively incurs. The company, however, generally has the
responsibility of calculating the tax, deducting it from the salary of the employee and paying it
over to the tax authorities within a specified period of time. This means that employees’ tax is
what we refer to as a ‘withholding tax’. Thus, the company is simply acting as an agent for the
tax authorities and does not incur this tax expense itself: it is a tax expense incurred by the
employee. For this reason, the employees’ tax is not included in the company’s tax expense on
the face of the statement of comprehensive income. The company’s salaries and wages expense
will include this employees’ tax (i.e. this salaries and wage expense is measured at the gross
amount – including the employees’ tax!). In South Africa, employees’ tax is also called PAYE
(Pay As You Earn).
Example 5: Employees’ tax
AM Limited is a newly formed company with only one employee hired (as a secretary)
with effect from 1 December 20X1.
x The employee earns a gross monthly salary of C12 000.
x The employee’s tax on his salary has been calculated to be C3 510 per month.
x The employee was paid in cash on 30 December 20X1, but the employee’s tax was
only paid to the tax authorities on 7 January 20X2, which was after the financial year
ended 31 December 20X1.
Required:
a) Post the journals in AM Limited’s ledger for the year ended 31 December 20X1.
b) Prepare the statement of comprehensive income and statement of financial position at
31 December 20X1.
c) Post the journals in AM Limited’s ledger for the year ended 31 December 20X1.
Solution 5: Employees’ tax

a) Ledger accounts at year-end (i.e. before employee’s tax paid to the tax authority)
Salaries (E) Bank (A)
Bank & CTP (1) 12 000 Salaries (1) 8 490
Current tax payable: employees tax (L)

Salaries (1) 3 510
(1) Payment to the employee of C8 490 (his salary net of employees’ tax) and the balance of C3 510, being
employees’ tax deducted from the employee’s salary, recorded as owing to the tax authorities.
Comment: Notice how the salaries account shows the gross amount of the salary (C12 000). In other
words, the salaries expense includes:
x the net amount that will be paid to the employee (C8 490) plus
x the employee’s tax that will be paid to the tax authorities on behalf of the secretary (C3 510).
b) Financial statements at year-end (i.e. before employees’ tax paid to the tax authority)
AM Limited
20X1
Administration expenses C
- Salaries and wages 12 000
AM Limited
20X1
Current Liabilities C
- Current tax payable: employees’ tax 3 510
226 Chapter 5
Solution 5: Employees’ tax continued...

Comment: Note that the salaries are shown at the gross figure of C12 000 in the statement of
comprehensive income and NOT the net amount received by the employee. The reason is twofold:
x the taxes paid may not be claimed back by the company (as in the case of VAT) so the cost to the
company is truly C12 000 (see the bank account after payment is made to the tax authorities), and
x employees’ tax is a tax incurred by the employee and is not incurred by the company – therefore
the portion deducted and paid over to the tax authorities should not be shown separately as a tax
expense since the employer does not incur this tax expense, but incurs a salary expense instead.
c) Ledger accounts after year-end (i.e. showing payment of the employee’s tax)
Salary (E) Bank(A)
Bank & CTP(1) 12 000 Salaries (1) 8 490
CTP: ET (2) 3 510
12 000
Current tax payable: employees tax (L)
Bank (2) 3 510 Salaries (1) 3 510
(2) Payment to the tax authorities of the employees’ tax withheld from the employee.
Comment: It is clear from the bank account that, although the employee only receives C8 490, the
entity has to pay a total of C12 000 to retain the services of this employee. Thus the salaries expense
in the statement of comprehensive income is C12 000.
A: 4 Income Tax
Income tax is a term commonly used by the various countries’ tax authorities to refer to the
primary income tax levied on a company’s profits. In South Africa, the standard rate of income
tax applied to companies is currently 28%, but there are many other rates possible depending
on factors, such as the size of the company, and of course the possibility that your tax
jurisdiction is another country entirely. For ease of quick calculations, we will generally use
30% in this textbook instead of the actual rate of 28%.
It is important to understand that the relevant tax rate/s is not levied on the company’s profit
before tax (i.e. what is referred to as accounting profit), but on the taxable profit.
The calculation of the taxable profit and income tax is covered in depth in Section B: 3.
The journal for income tax is illustrated below. Notice how the current tax payable is debited
to the company’s income tax expense account.
Debit Credit
Income tax (E) xxx
Current tax payable: income tax (L) xxx
Current income tax charge for the current year
A: 5 Dividends Tax
A: 5.1 Overview
Dividends tax was introduced in South Africa from

1 April 2012 (the effective date), prior to which
secondary tax on companies was levied. South Africa was one of very few
countries around the world that taxed
dividends in the hands of the company
Dividends tax is a tax imposed on shareholders at a rate of
(i.e. STC).
20% of the dividend received. Secondary tax on companies
was a tax imposed on the entity declaring the dividend and had previously been levied at 10% of the
dividends declared.
Chapter 5 227
The reason why South Africa changed from secondary tax on companies to dividends tax was
to bring its tax system in line with international standards. Very few countries levy tax on
dividends by way of secondary tax on companies. By bringing its tax system in line with
international norms, South Africa has made it easier for foreign investors to understand its
economic environment and has thus encouraged investment.
Both dividends tax and the previous secondary tax on companies are taxes on dividends
declared. However, there is a critical difference between these two taxes:
x dividends tax is levied on the shareholder receiving the dividend; whereas
x secondary tax was levied on the company declaring the dividend.
The impact of this difference on our financial statements is profound. Since dividends tax is
not a tax on the entity declaring the dividend, it does not form part of that entity’s tax expense.
The entity declaring the dividend is simply responsible:
x for calculating the dividends tax that is owed by the Dividends tax
shareholder,
x Dividends tax is levied at 20%
x for withholding this tax when paying the dividend to
x Dividends tax is a tax on the
the shareholder, and then shareholder, but is paid by the
x for paying this tax to the relevant tax authority. company on behalf of the shareholder
x Dividends tax thus does not form part
A: 5.2 Measuring dividends tax of the company’s tax expense.
Dividends tax is calculated as: dividends received by the shareholder (gross) x the rate of dividends tax.
South Africa currently applies a dividends tax rate of 20%. So, if a company declares a dividend of C100,
then 20% of the dividend to be received by the shareholder is withheld by the entity declaring the dividend,
and the shareholder receives the net amount of C80. Note however, the above dividend tax implications
do not apply to dividend in specie distributions (i.e. it only applies to cash dividends).
A: 5.3 Recognition of dividends tax
The fact that dividends tax is not a tax on the entity declaring the dividend (unless the distribution is a
dividend in specie) is reflected in its journals: instead of the dividends tax being debited to the tax
expense account, the dividends tax is debited to the dividends payable account, thus reducing the
amount payable to the shareholders.
Debit Credit
Dividend declared (Eq distribution) xxx
Dividends payable to shareholders (L) xxx
Dividends declared: payable to shareholders (gross amount)
Dividends payable to shareholders (L) xxx
Current tax payable: dividends tax (L) xxx
Dividends tax: withheld from shareholders to be paid to the tax authority
Example 6: Income tax and dividends tax

The following relates to BI Limited for the year ended 31 December 20X1: C
x Profit before tax 250 000
x Estimated current income tax charge for 20X1 75 000
x Dividends declared 50 000
x Retained earnings at the beginning of the year 1 250 000
x Dividends tax is levied at 20% of the dividend to be distributed to the
shareholders (this has not yet been calculated).
x There are no components of other comprehensive income.
Required:
A Show all the tax and dividends journals from BI Limited’s perspective.
B Show the above in the BI Limited’s statement of comprehensive income, statement of changes in
equity and statement of financial position for the year ended 31 December 20X1.
228 Chapter 5
Solution 6A: Journals: income tax and dividends tax

Debit Credit
Income tax (P/L: E) Given 75 000
Current tax payable: income tax (L) 75 000
Dividend declared (Eq distribution) Given 50 000
Dividends payable to shareholders (L) 50 000
Dividends declared (gross amount before dividends tax)
Dividends payable to shareholders (L) 50 000 x 20% 10 000
Current tax payable: dividends tax (L) 10 000
Dividends tax on dividends declared to shareholders are withheld
Solution 6B: Disclosure: income tax and dividends tax

BI Limited
20X1
C
Profit before taxation 250 000
Income tax expense Just the income tax (75 000)
Profit for the year 175 000
Other comprehensive income 0
Total comprehensive income 175 000
BI Limited
Statement of changes in equity (extracts)
Retained Total
earnings
C C
Balance at 1 January 20X1 1 250 000 xxx
Total comprehensive income 175 000 175 000
Less dividends declared We show 100% of the dividend even though (50 000) (50 000)
20% is withheld and paid to the tax
authorities as dividends tax
Balance at 31 December 20X1 1 375 000 xxx
BI Limited
20X1
LIABILITIES AND EQUITY C
Current liabilities
Dividends payable 50 000 x (100% - 20%) or 50 000 – 10 000 40 000
Current tax payable: dividends tax 50 000 x 20% 10 000
Chapter 5 229
PART B:
Income Tax (current only)
B.1 Introduction
As has already been explained in Part A, income tax is the tax levied on profits. In South Africa,
there are separate tax rates and rules used for calculating the income tax levied on individuals,
companies and various other forms of business. We will focus exclusively on the income tax
applied to companies. The principles of recognition and measurement are the same no matter
whether you are dealing with income tax on an individual, company or other entity – the only
thing that changes is the calculation of this tax in terms of the tax legislation.
I don’t plan to teach you the intricacies of the tax legislation because you will learn this when
you study tax. This chapter’s objective is to simply help you account for the amount of tax
calculated. However, in order to account for this tax, you will need to know a few of the basic
principles included in the tax legislation, and these we will learn along the way.
B.2 Recognition of Income Tax
B.2.1 Overview (IAS 12.58)

Income tax is a tax on an entity’s income, where income can result from transactions that are:
x recognised in profit or loss; or
x recognised in other comprehensive income;
x recognised directly in equity.
If the underlying transaction (or event or item) is recognised in profit or loss, then the tax
thereon must also be recognised in profit or loss. This tax is recognised as an expense and is
referred to as income tax expense. It is possible to have a tax income recognised in profit or
loss. This happens if, instead of a making a taxable profit, we make a tax deductible loss.
If, however, the underlying transaction (or event or item) is recognised in other comprehensive
income, then the tax thereon must also be recognised in other comprehensive income. We will
recognise this tax as tax on other comprehensive income. If the underlying transaction is
income recognised in other comprehensive income, then there will be a tax expense recognised
in other comprehensive income (i.e. a debit to other comprehensive income). If the underlying
transaction is an expense recognised in other comprehensive income, then there will be a tax
income recognised in other comprehensive income (i.e. a credit to other comprehensive
income). The same principle applies if tax arises on items recognised directly in equity (i.e. the
related tax will also be recognised directly in equity).
B.2.2 Tax recognised in profit or loss (IAS 12.58)
The tax consequence of the income and expense items recognised in profit or loss (P/L) must
also be recognised as part of profit or loss. An example of taxable income is revenue and an
example of a tax-deductible expense is a salary expense. The entity’s taxable profit or loss for
the period is the net of all the taxable income and tax-deductible expenses. Tax is then levied
on the taxable profit and is referred to as income tax. Remember! The
following taxes are not
It is possible for there to be a variety of income taxes levied included in the entity’s
on an entity’s profits. Some countries simply levy one tax on tax expense!
x employees’ tax,
profits whilst other countries levy more than one tax (e.g. a x dividends tax, and
normal or primary income tax and a secondary income tax). x valued added tax
Since the abandonment of secondary tax on companies in
2012, South Africa now currently levies only one type of tax on an entity’s profits, which we
will simply refer to as ‘income tax’. Income tax was introduced in section A:4, the calculation
thereof is explained in section B.3 and the method of payment is explained in section B.4.
230 Chapter 5
B.2.3 Presentation of tax recognised in profit or loss (IAS 1.82)
The tax levied on the entity’s profit or loss must be reflected as a single line item in profit or
loss, called the ‘income tax expense’. This ‘income tax expense’ line item must be separately
disclosed on the face of the statement of comprehensive income.
B.2.4 Tax recognised in other comprehensive income (IAS 12.58 & .61A-.62)
The tax on items that are recognised in other comprehensive income (OCI) must also be
recognised as part of other comprehensive income. An example of an item recognised in other
comprehensive income is a revaluation surplus created when revaluing equipment.
B.2.5 Presentation of tax recognised in other comprehensive income (IAS 1.82-.82A & .90-.91)
The tax effect of each item of OCI must be presented separately. This may be done on the face
of the statement of comprehensive income or in the notes. However, although the tax effect of
each item of OCI must be presented separately, IAS 1 allows us to choose to present each item
of OCI (e.g. a revaluation surplus) gross (before tax) or net (after tax):
x Option A: Gross: before deducting the related tax. In this case the taxes on all items of OCI
are presented as a single tax line item in the ‘other comprehensive income section’, called
‘tax on other comprehensive income’. This option means that we will need to include a note
to show the tax effects of each item of OCI separately.
x Option B: Net: after deducting the related tax. In this case the total tax on OCI will not be
a separate line item in the statement of other comprehensive income (as is the case in option
A). There are two sub-options here. We could choose to show each item of OCI:
Option B-1: gross, then show the deduction of its tax effect and then net, in which case
no note will be needed since the tax effect per item is being shown on the face;
Option B-2: net, with no evidence of how much tax was deducted per item, in which
case a note would be required to show the tax effect per item. See IAS 1.91
Example 28 shows the presentation of the tax effects of items of OCI.
B.3 Measurement of Income Tax (current only) (IAS 12.46 and 49)
B: 3.1 Overview Current income tax is

calculated as
Current tax or current income tax is the tax based on the x Taxable profits
taxable profits (or tax loss) for the current period. It is (or tax loss)
x
measured by multiplying these taxable profits (or the tax
x Tax rate
loss) by the tax rate applied by the tax authorities. In
essence, current income tax is measured at the amount that is expected to be paid to (recovered
from) the taxation authorities for the current period. This measurement requires us to be able to
determine the taxable profits and also the relevant tax rate. See IAS12.46
Taxable profits are calculated in terms of the relevant tax

The difference between
legislation (i.e. the relevant country’s Tax Act). Thus, the taxable profit and
accountant needs to convert his accounting profit (calculated accounting profit includes:
in terms of IFRS) into the taxable profit (calculated in terms of x Temporary differences; &
tax legislation). To be able to do this requires a sound x Permanent differences
knowledge of this tax legislation and an understanding of how
it differs from the IFRSs. These differences can be summarised into two categories: temporary and
permanent. This section will take a look at the effect of a few temporary differences and will
explain permanent differences (i.e. non-temporary differences) a bit later.
The current income tax charge has to be estimated by the accountant since the official tax
assessment by the tax authorities, indicating the exact amount of income tax owing on the
current year’s taxable profits, will only be received long after the reporting date.
Chapter 5 231
B: 3.2 Enacted and substantively enacted tax rates
Enacted tax rates are rates that are already in law. But, a government could propose to change
the enacted rate, in which case we must assess if the proposal is substantively enacted.
The tax rate to use is:

x the enacted tax rate as at the reporting date, or
x if a new rate has been proposed, then using the new rate, if it has been substantively enacted
by reporting date (and assuming it will affect the measurement of your current tax liability
at reporting date assuming the rate is eventually enacted). see IAS 12.46
If a ‘new’ rate has been enacted on or before reporting Enacted or substantively

date, it means that the relevant country’s Tax Act has been enacted tax rates
changed on or before this date, but if a new rate has been Measure your current income tax using:
proposed but not legally enacted on or before reporting x the enacted tax rate, unless there is
date, deciding whether it has been substantively enacted x a substantively enacted tax rate
by reporting date may require professional judgement and that
a careful assessment of the circumstances. existed at reporting date, &
which will affect the
For example: measurement of current income
tax at reporting date.
x In some countries, the announcement can lead to a
new tax rate actually being implemented before the actual date of legal enactment, where
the legal enactment could take place much later: in this case, the date the new rate is simply
announced would be treated as the date of substantive enactment. See IAS 12.48
x In other countries, most or all of the legal stages for formal enactment may need to have
occurred before the new rate can be said to be substantively enacted, in which case the date
of the announcement is not important and can be ignored.
In South Africa, it is commonly held that a new rate is considered to be substantively enacted
on the date it is announced in the Minister of Finance’s Budget Speech. But if this new rate is
inextricably linked to other tax laws, it is only substantively enacted when it has not only been
announced by the Minister of Finance but when it has also been signed into statute by the
President as evidence of his approval of the change.
Whilst current tax is to be measured using either the enacted or substantively enacted tax rate at
reporting date, the over-riding rule is that it must be ‘measured at the amount expected to be paid to
(recovered from) the taxation authorities’. We must therefore use the tax rates that apply (i.e. enacted
rates) or are expected to apply (i.e. substantively enacted rates) to the current period transactions and
must thus consider the effective date of any new rates. However, if a rate has been substantively enacted
after reporting date, and even if this rate will be applied retrospectively to the current or prior reporting
periods, we must not make adjustments for this change. This is accounted for as a non-adjusting event
in terms of IAS 10 Events after the reporting period with extra disclosure of the rate change required.
The income tax rate currently enacted in South Africa is 28%, but for the sake of round numbers,
this book will assume an income tax rate of 30% unless otherwise indicated.
Example 7: Enacted and substantively enacted tax rates

On 20 Jan 20X1, the minister announced a change in the income tax rate from 30% to 28%:
x This change in tax rate will only be accepted into legislation (become enacted) if the
VAT rate is increased from 14% to 15%.
x If the new tax rate is accepted into legislation, its effective date will be 1 March 20X1
(i.e. it will apply to tax assessments ending on or after 1 March 20X1).
x The increase in the rate VAT was accepted into legislation on 15 February 20X1 and
the new income tax rate was accepted into the legislation on 21 April 20X1
Required: State at what rate the current tax should be calculated assuming:
A. The company’s year of assessment ends on 31 December 20X0.
B. The company’s year of assessment ends on 28 February 20X1.
C. The company’s year of assessment ends on or after 31 March 20X1.
232 Chapter 5
Solution 7: Enacted and substantively enacted tax rates

The new income tax rate is enacted on 21 April 20X1. Since this rate change was inextricably linked
to the proposed increase in the VAT rate, the change to the income tax rate was dependent on whether
the VAT rate was allowed to be increased. Thus, the date of substantive enactment does not occur on
the date the change was announced by the minister, but rather on the date when the VAT rate was
legislated: 15 February 20X1. Thus, the new rate becomes substantively enacted on 15 February 20X1.
A. The reporting date is 31 December 20X0.
- The currently enacted rate on reporting date is 30%.
- There is no substantively enacted tax rate on reporting date (the new rate only becomes
substantively enacted 15 February 20X1, which is after reporting date).
The current enacted tax rate of 30% should thus be used for the year ended 31 December 20X0.
B. The reporting date is 28 February 20X1.
- The currently enacted rate on reporting date is 30%.
- A new rate became substantively enacted on 15 February 20X1 (this rate was only enacted
on 21 April 20X1). Since the date it was substantively enacted occurs before the reporting
date, we have a substantively enacted tax rate (28%) on reporting date.
- However, since the effective date of the substantively enacted tax rate means that it will only
affect tax assessments ending on or after 1 March 20X1, the substantively enacted tax rate
would not be appropriate to use for the year ended 28 February20X1.
The currently enacted tax rate of 30% should thus be used for the year ended 28 February 20X1.
C. The reporting date is 31 March 20X1.
- The currently enacted rate on reporting date is still 30%.
- A new rate became substantively enacted on 15 February 20X1 (this rate was only enacted
on 21 April 20X1). Since the date it was substantively enacted occurs before the reporting
date, we have a substantively enacted tax rate (28%) on reporting date.
- Since the effective date of the substantively enacted rate means that it will affect tax
assessments ending on or after 1 March 20X1, the substantively enacted tax rate would be
appropriate to use for the year ended 31 March 20X1.
The substantively enacted tax rate of 28% should thus be used for the year ended 31 March 20X1.
B: 3.3 Taxable profits versus accounting profits Accounting profits are

defined as the:
It is important to realise that the applicable rate of income x profit or loss for a period
tax is not levied on the entity’s ‘accounting profit’ (i.e. x before deducting tax expense.
profit for the period, before tax), but on its ‘taxable profit’. Taxable profits (or tax losses)
are defined as the:
Both of these are terms that are defined in IAS 12 (see x profit (loss) for a period,
definitions alongside). The essence of these two definitions x determined in accordance with
is that ’accounting profits’ are determined in accordance the rules established by the
taxation authorities,
with the IFRSs (or other accounting standards) and ‘taxable x upon which income taxes are
profits’ are determined in accordance with the local tax payable (recoverable).
IAS 12.5
legislation. In other words:
x accounting profit comprises:
income earned Taxable profit and
less expenses incurred; Accounting profit
differ because:
x taxable profit is constituted by: x Accounting profits are calculated
income that is taxable in terms of IFRSs; and
less expenses that are deductible. x Taxable profits are calculated in
terms of local tax legislation.
The differences that arise between the accounting profit and
taxable profit can be categorised into:
x temporary differences (differences that resolve – i.e. disappear – over time); and
x permanent differences (differences that will never disappear).
Chapter 5 233
Permanent differences arise due to: Differences between

x Income that is earned but that will never be taxable accounting profits and
taxable profits include:
(i.e. the income is exempt from tax); and
x Temporary differences – the
x Expenses that are incurred but will never be deductible accounting and tax treatments of
for tax purposes (i.e. the expense is non-deductible). something differ in a year, but
over time, there is essentially no
Temporary differences (i.e. differences that arise simply difference between the two
treatments
due to issues of timing) arise when:
x Permanent differences – the
x Income that is earned in a particular period, is taxable accounting and tax treatments of
in another different period; and something differ in a year and will
never disappear over time.
x Expenses that are incurred in a particular period, are
deductible for tax purposes in another different period.
Worked example: Temporary differences disappear over time

To illustrate the fact that a temporary difference disappears over time, imagine that an entity
records income earned of C100 in year 1 but where this income will only be taxed in year 2.
This will result in year 1’s accounting profit (AP) being C100 and taxable profit (TP) being C0 (i.e.
AP > TP in year 1). Compare this to year 2’s accounting profit of C0 and taxable profit of C100 (i.e.
AP < TP in year 2). There is a difference between accounting profit and taxable profit in each of the
years (year 1 and year 2), but over a 2-year period, the accounting profit and taxable profit are both
C100, and thus the difference that arose in each of the years disappears over time (AP = TP over a 2-
year period).
We can thus convert our accounting profits into taxable profits as follows:
C
Accounting profit (profit before tax) xxx
Adjust for permanent differences xxx
Accounting profit that is taxable (in this year or in some other year) xxx
Adjust for temporary differences xxx
Taxable profit (profit that will be taxed by the tax authorities in this year) xxx
The adjustments for permanent and temporary differences that we make when converting
accounting profits into taxable profits will be explained over the next sections.
B: 3.4 Permanent differences
B: 3.4.1 Exempt income and non-deductible expenses – a general overview

The calculation of accounting profit (AP) may include items Permanent differences
of income that are exempt from tax per the tax legislation are:
(i.e. the tax authorities will not charge tax on this income).
x the differences between taxable
Income that is exempt from tax is called exempt income. profit and accounting profit for
Exempt income is income that will never be included in the a period
calculation of taxable profits (TP). x that originate in the current
period and never reverse in
Thus, if we wanted to convert accounting profit into taxable subsequent periods.
profit and the calculation of our accounting profit included These differences are also
exempt income, we would need to subtract the exempt income referred to as non-temporary
from accounting profit to calculate the taxable profit. differences
Worked example: Exempt income

If we have accounting profit of C800 that included exempt income of C100, our taxable profit would
be calculated as follows:
TP = AP: 800 – exempt income: 100 = C700.
Conversely, the calculation of accounting profit may include an expense that is not deductible
per the tax legislation. This is called a non-deductible expense. When we say an expense is non-
deductible, we are saying that the tax authorities will never allow it as a tax deduction. In other
words, the expense will never be included as a deduction in the calculation of taxable profits.
234 Chapter 5
Thus, if we wanted to convert accounting profit into taxable profit where the calculation of our
accounting profit included the deduction of an expense that was non-deductible for tax
purposes, we would have to add back the non-deductible expense to the accounting profit in
order to calculate the taxable profit.
Worked example: Non-deductible expenses

If we calculate our accounting profit to be C800, which involved deducting an expense of C100 that
is non-deductible for tax purposes, our taxable profit would be calculated as follows.
TP = AP: 800 + non-deductible expense: 100 = C900.
In summary, when converting accounting profits into taxable profits, we adjust for permanent
differences by deducting exempt income and adding back the non-deductible expenses, as
follows:
C
Accounting profit (profit before tax) xxx
Adjust for permanent differences:
Less: exempt income (income that is never going to be taxed) (xxx)
Add: non-deductible expenses (expenses that are not deductible for tax purposes) xxx
Accounting profit that is taxable (in this year or in some other year) xxx
Adjust for temporary differences xxx
Taxable profit (profit that will be taxed by the tax authorities in this year) xxx
In summary, the nature of permanent differences is that, Permanent differences

where they exist, the accounting profit and taxable profit include:
will not equal one other. More importantly, this difference x exempt income: the income
will not reverse over time. In other words, it does not matter recorded by the accountant
over what period one compares these profits – the total that the tax authorities will
never tax (exempt from tax);
accounting profit over a 100-year period will still not equal x non-deductible expenses: the
the total taxable profit over this 100-year period: the expenses recorded by the
accounting profit and taxable profit in such cases will never accountant that the tax
authorities will never allow as
equal each other. a tax deduction.
Permanent differences will cause the effective rate of tax and the applicable rate of tax to differ
from one another. Thus, since we must disclose relevant and useful information to our users,
we will be required to include a rate reconciliation in the tax expense note (see section B:5).
Example 8: Permanent differences:

exempt income and non-deductible expenses
Bottle Limited achieved a profit before tax for the year ended 28 February 20X5 of
C900 000. This profit before tax included:
x dividend income of C50 000 from its investments (exempt from income tax); and
x donations made to various charities of C30 000, (not deductible for tax purposes).
The income tax rate to be applied to taxable profits is 30%.
There were no temporary differences during the year ended 28 February 20X5 and no
components of other comprehensive income.
Required:
Calculate the current income tax for the year ended 28 February 20X5.
Solution 8: Permanent differences – current tax calculation

C
Profit before tax (accounting profit) 900 000
Adjust for permanent differences (20 000)
Less: Dividend income Exempt income (50 000)
Add: Donations expense Non-deductible expenses 30 000
Adjust for temporary differences 0
Taxable profit 880 000
Current tax at 30% 880 000 x 30% 264 000
Chapter 5 235
Solution 8: Continued …
Comment: It is interesting to note that, although the ‘applicable tax rate’ is 30%, if we compare the
tax expense with the ‘accounting profit’ (rather than the ‘taxable profit’), the ‘effective tax rate’ is only
29.33% (C264 000 / C900 000). Example 26 shows the disclosure required due to this difference.
We used these steps to calculate ‘taxable profit’ if you’ve been given ‘accounting profit’:
Step 1: Figure out how the transaction affected accounting profit (what is the accounting treatment?).
Step 2: Figure out how the transaction will affect taxable profit (what is the tax treatment?).
Step 3: Starting with the accounting profit, reverse the accounting treatment and replace it with the
tax treatment.
B: 3.4.2 Capital profits versus taxable capital gains

B: 3.4.2.1 General
The taxation of capital profits is a contentious issue, as it is effectively a tax on inflation. In
some countries, capital profits on the sale of an item are exempt from tax, whereas some
countries tax the entire capital profit and yet other countries tax only a certain portion of the
capital profit, (i.e. the remaining portion is exempt from tax). In these latter countries, the
taxable portion is often referred to as the taxable capital gain and is included in taxable profits
and taxed at the standard corporate rate of income tax (e.g. 28% in South Africa).
In South Africa, 80% of a company’s capital gains is taxable, whilst 40% of a natural person’s
capital gains is taxable. In this text, you may assume that 80% of the capital gain is taxable
unless the information provides otherwise.
B: 3.4.2.2 IFRSs: capital profits
The accountant calculates a profit or loss on the sale of a non-current asset, in accordance with
the International Financial Reporting Standards (IFRSs), as follows:
Proceeds on sale xxx
Less carrying amount (xxx)
Profit or (loss) on sale xxx
The capital profit included in the profit on sale of a non-current asset is as follows:
Less original cost (xxx)
Capital profit xxx
B: 3.4.2.3 Tax legislation: taxable capital gains

A capital gain on the sale of a non-current asset, determined in accordance with the tax
legislation, is generally calculated as follows:
Less base cost (xxx)
Capital gain xxx
Capital Gains Tax was introduced in South Africa and was effective from 1 October 2001. This
date is important since capital gains that arose on assets acquired before this date are excluded
from the Capital Gains Tax legislation. For this reason, one must establish the value as at
1 October 2001 (called the ‘valuation date value’) of all assets that were already owned on this
date. When calculating the capital gain (in terms of the Capital Gains Tax legislation) on the
disposal of any one of these assets, its value as at 1 October 2001 is used as its base cost. The
base cost for the disposal of an asset acquired on or after 1 October 2001 will simply be its cost.
Worked example: Base cost ≠ Cost price
An asset was purchased for C1 000 on 1 January 1999, was valued at C10 000 on 1 October 2001 (i.e.
its base cost) and was sold for C15 000 on 31 December 2016. In this case, the entity has made a capital
profit on disposal of C14 000 (proceeds: 15 000 – cost: 1 000) but, from a tax perspective, it has made
a capital gain of only C5 000 (proceeds: 15 000 – base cost: 10 000).
236 Chapter 5
For the purposes of this section, you may assume, unless otherwise stated, that the asset in
question was acquired on or after 1 October 2001 and thus that its base cost (in terms of the tax
legislation) equals its cost (in terms of the relevant IFRS). Example 9 compares the situation
where the base cost equals the cost and where the base cost differs from cost.
Once we have calculated the capital gain, we then calculate the portion that is taxable. This
taxable capital gain is calculated as a percentage of the capital gain, where this percentage
depends on whether or not the taxpayer is a company or an individual. As explained above, the
examples in this text assume that the inclusion rate is 80% for companies, in which case, the
taxable capital gain is calculated as:
Capital gain xxx
Multiplied by the inclusion rate for companies @ 80%
Taxable capital gain xxx
Please note that there is a lot more detail in the tax legislation regarding aspects that affect both
the calculation of the base cost and the calculation of the taxable capital gain. You will study
these other aspects when studying Taxation and are thus outside of the scope of this chapter.
B: 3.4.2.4 Difference: exempt capital profit
In summary, the capital profit (calculated by the accountant and thus included in the accounting
profits) may differ from the taxable capital gain (calculated by the tax authorities and included
in taxable profits). The accounting and tax treatment for such differences (the exempt portion
of the capital profit) will never be the same and are thus referred to as permanent differences.
The exempt portion of the capital profit is simply calculated as:
Capital profit xxx
Less taxable capital gain (xxx)
Exempt portion of the capital profit xxx
Example 9: Capital profits and taxable capital gains
Man Limited sold its plant for C120 000, when its carrying amount was C80 000.
It had originally cost C110 000. The base cost equalled its cost price.
Required:
A. Calculate the profit on sale, separating this profit into capital profit and non-capital profit.
B. Calculate the capital gain and the taxable capital gain, assuming the inclusion rate is 80%.
C. Calculate the portion of the capital profit that is exempt.
D. Calculate the capital gain and the taxable capital gain, assuming the base cost was C115 000.
E. Calculate the portion of the capital profit that is exempt, assuming the base cost was C115 000.
F. Compare the portion of the capital profit that is exempt in parts C and E and explain the difference.
Solution 9A: Profit on sale - capital and non-capital portions
C
Proceeds on sale Given 120 000
Less carrying amount Given (80 000)
Profit on sale Balancing 40 000
Capital profit Proceeds: 120 000 – Cost price: 110 000) 10 000
Non-capital profit Cost price: 110 000 – CA: 80 000; or 30 000
Balancing: Total profit: 40 000 – Capital profit: 10 000
Solution 9B: Capital gain and taxable capital gain

C
Proceeds on sale Given 120 000
Less base cost Given (110 000)
Capital gain Balancing 10 000
Inclusion rate Given @ 80%
Taxable capital gain Capital gain: 10 000 x Inclusion rate: 80% 8 000
Solution 9C: Portion of the capital profit that is exempt from tax
C
Capital profit on sale Example 9A 10 000
Less taxable capital gain Example 9B (8 000)
Exempt capital profit 2 000
Chapter 5 237
Solution 9D: Capital gain and taxable capital gain where BC ≠ CP

C
Proceeds on sale 120 000
Less base cost (115 000)
Capital gain 5 000
Inclusion rate @ 80%
Taxable capital gain 4 000
Solution 9E: Portion of the capital profit that is exempt from tax where BC ≠ CP
C
Capital profit on sale Example 9A 10 000
Less taxable capital gain Example 9D (4 000)
Exempt capital profit 6 000
Comment: The C10 000 accounting capital profit on sale is unaffected by the change in the base cost as the
base cost is purely a tax related matter and not an accounting matter.
Solution 9F: Comparing the effects of differing base costs on exempt capital profit
C
Exempt capital profit when ‘base cost = cost’, at C110 000: Example 9C 2 000
Exempt capital profit when ‘base cost ≠ cost’, at C115 000: Example 9E 6 000
Increase in exempt capital profit 4 000
Explanation: The higher base cost (the BC increased by C5 000: 115 000-110 000) led to an increase of
C4 000 in the portion of the capital profit that is exempt from tax (C2 000 - C6 000).
A higher base cost results in a smaller capital gain (the CG decreased by C5 000: C10 000 - C5 000) and
thus a smaller taxable capital gain (the TCG decreased by C4 000: C5 000 x 80%). If the taxable capital
gain gets smaller, it means that a higher portion of the capital profit will be exempt from tax.
Example 10: Exempt income and non-deductible expenses
Retailer Limited had a profit before tax for the year ended 31 December 20X2 of
C100 000, which included:
x Dividend income of C30 000 (exempt from tax);
x Donations made of C10 000 (these are not deductible for tax purposes); and a
x Capital profit of C20 000 (of which C16 000 was a taxable capital gain).
The income tax rate was 30%.
There are no temporary differences and no components of other comprehensive income.
Required:
A. Calculate the current income tax.
B. Show the income tax journal.
C. Disclose the statement of financial position and statement of comprehensive income for 20X2.
Solution 10A: Calculation - current income tax
Comment: This example shows the calculation of current tax when there are differences between
taxable profit and profit before tax that will never reverse (i.e. permanent differences).
Calculation of current income tax C
Profit before tax (given) 100 000
Adjust for permanent differences: (24 000)
x Less dividend income (not taxable) Exempt income (30 000)
x Add back donations (not deductible) Non-deductible expense 10 000
x Less capital profit (an accounting term) (20 000)
Exempt income (*)
x Add taxable capital gain (a tax term) 16 000
Adjust for temporary differences 0
Taxable profits 76 000
Current income tax 76 000 x 30% 22 800
*Instead of deducting 20 000 & adding 16 000, we could just deduct the exempt portion of the capital profit (4 000)
Solution 10B: Journal

Debit Credit
Income tax (P/L: E) 22 800
238 Chapter 5
Solution 10C: Disclosure
Retailer Limited
Note 20X2
Current liabilities C
Current tax payable: income tax See journals 22 800
Retailer Limited
Note 20X2
C
Profit before tax 100 000
Income tax expense See journals (22 800)
B: 3.5 Temporary differences Temporary differences

are caused by differences in
B: 3.5.1 Overview the timing of when items of
income and expense are
included in the accounting
It can happen that an item of income or expense is included in profit and taxable profit.
the calculation of accounting profit in a different period to the
period in which it is included in the calculation of taxable Temporary differences can be caused by:
x The accrual system
profit. In other words, we are talking about an item that will x Depreciable assets
be included in the calculation of both accounting profit and x Tax losses
taxable profit, but just not necessarily in the same period.
When this happens, the difference between the accounting profit and taxable profit in a specific year
is thus simply a difference that is temporary because if we compare the total accounting profit and the
total taxable profit over a longer time-period, the difference disappears.
There are many areas in the tax legislation that may lead to temporary differences, but for the purposes
of this text, we will limit our examples to temporary differences caused by the following three categories:
x The accountant’s system of accrual (e.g. expenses prepaid):
The accountant uses the accrual system of accounting whereas the tax authority uses a mixture
between an accrual and a cash system.
The difference between the accountant’s system of accrual and the tax authority’s hybrid system
is discussed in section B: 3.5.2.
x The accountant’s measurement of depreciable assets:
A depreciable asset can also cause differences. The accountant initially recognises the asset at its
cost and then gradually expenses this cost over its useful life (depreciation or amortisation), where
this useful life is relevant to the specific entity. The tax authorities, on the other hand, allow the
deduction of the cost at a rate that is stipulated in a generic table of rates laid down in tax
legislation. The rate at which the accountant expenses the asset as depreciation/ amortisation often
differs from the rate at which the tax authority allows the cost of the asset to be deducted from
taxable profits. The difference between the rate at which the asset is expensed (e.g. depreciation)
and the rate at which it is deducted for tax purposes (e.g. wear and tear) causes temporary
differences between the accounting profit and taxable profit. This is explained in section B: 3.5.3.
Chapter 5 239
x The method used by the tax authorities to account for tax losses:
A tax loss is a term used by the tax authorities. Instead of paying tax to the tax authorities when
making a taxable profit and receiving compensation from the tax authorities when making a tax
loss, the tax authorities require us to pay tax when making a taxable profit, but in the case of a tax
loss, there is unfortunately no compensation receivable. Instead, tax authorities typically allow
this tax loss to be carried forward to future years and deducted from future taxable profits and thus
reducing the future amount of tax payable. Since the tax loss is incurred in the current year but
cannot reduce the tax payable in the current year, but instead can reduce tax payable in future
years, this causes a temporary difference. This is explained in section B: 3.5.4.
If we know whether an item would have been included in the calculation of accounting profit in a
particular year, and whether this item would or would not also be included in that year’s calculation
of taxable profits, we can then convert our accounting profits into taxable profits. In other words, to
convert accounting profits to taxable profits we simply remove from accounting profits items that the
tax authority would not consider when calculating taxable profits for that year and replacing these
items with items that the tax authorities would consider when calculating taxable profits for that year.
Then, once we have calculated our taxable profits, we can The income tax expense
on the face of the SOCI is
calculate our current income tax for the year. Thus, temporary the total of:
differences affect the calculation of current income tax.
x Current income tax (this chapter)
Please note that temporary differences will generally also x Deferred income tax (next chapter)
lead to the recognition of deferred income tax. The total ‘tax expense’ for the year is constituted by a
combination of ‘current income tax’ and ‘deferred income tax adjustments’. Deferred tax is explained
in the next chapter.
B: 3.5.2 Temporary differences caused by the system of accrual
The accountant’s system of accrual, governed by IFRSs, results in the accountant recognising
income when it is earned and recognising expenses when they are incurred. This often requires
an accountant to utilise ledger accounts, such as the following:
x income received in advance;
x income receivable;
x expenses prepaid;
x expenses payable; and
x provisions.
In contrast, the tax authority’s system is effectively a hybrid between the accrual basis and cash basis
and is governed by a country’s tax legislation. Determining when income will be taxable and when an
expense will be tax-deductible will thus depend on the detail in the tax legislation of the country in
which the entity operates. This detail falls outside the scope of ‘financial reporting’ and is thus not
covered in this text. However, the following provides examples of how the IFRS accrual system may
differ from tax legislation, and thus lead to temporary differences:
x In many cases, tax authorities tax income on the earlier of the date of receipt (cash) or earning
(accrual) and thus:
Receivables: If we earn income before we receive it (e.g. earn it in yr 1 and receive it in yr 2), the
tax authorities will treat it as taxable income in year 1, when it’s earned. Thus, there will be no
difference in timing because the accountant will also recognise it as income in year 1, being the
year it is earned (yr 1: dr receivable, cr income and yr 2: dr bank, cr receivable).
Received in advance: If we receive cash before earning the income (e.g. receive in yr 1 but earn in
yr 2), the tax authorities will treat it as taxable income in year 1, when it’s received. Thus, there will
be a difference in timing because the accountant only recognises it as income in year 2, when it is
earned (yr 1: dr bank; cr income received in advance; yr 2: dr income received in advance, cr income).
x In most cases, tax authorities allow the deduction of an expense on the date it is incurred (i.e. the
same as the accountant), unless there is a prepayment or a provision involved, in which case the
expense could be tax-deductible before it is incurred or after it is incurred.
240 Chapter 5
Payables: If we incur an expense before we pay for it (e.g. incur in year 1 and pay in year 2), the
tax authorities will generally allow it as a deduction in year 1, when it is incurred. Thus, there will
be no difference in timing because the accountant will also recognise it as an expense in year 1,
being the year it is incurred (yr 1: dr expense, cr payable and yr 2: dr payable, cr bank).
Provisions: If we incur an expense before we pay for it (e.g. incur in year 1 and pay in year 2), but
it relates to a provision, the outcome may differ from a ‘normal’ payable. This is because, unlike a
‘payable’, a ‘provision’ is a liability of uncertain timing or amount (i.e. we may not be sure when it
will need to be paid or how much will need to be paid). Due to this uncertainty, tax authorities will
often ‘disallow’ the deduction of the related expense until year 2, when it has been paid. If this
happens, there will be a difference in timing because the accountant will recognise it as an expense
in year 1, being the year it is incurred (yr 1: dr expense, cr provision and yr 2: dr provision, cr bank).
Prepayment: If we pay cash before we incur the related expense (e.g. pay in year 1 and incur in
year 2), the tax authorities may allow it as a deduction when it is paid (yr 1). If this happens, there
will be a difference in timing because the accountant will only recognise it as an expense in year 2,
being the year it is incurred (yr 1: dr expense prepaid, cr bank and yr 2: dr expense, cr expense prepaid).
A summary of how temporary differences from the accrual system may arise is given below:
Accountant recognises: Tax authority recognises:
Income: Income:
When earned (accrual basis) When received (cash basis) or earned (accrual basis),
whichever happens first
Expenses: Expenses:
When incurred (accrual basis) When incurred (accrual basis) unless the expense:
is prepaid in which case, it may be deducted earlier
relates to a provision, in which case, it may only be
deductible later (when paid)
Example 11: Income that is receivable

Picture Limited sold inventory for C80 000 during 20X1 on credit and received payment
of C80 000 in 20X2. The tax authorities tax income when earned or received, whichever
happens first. There is no other income in either 20X1 or 20X2.
Required:
A. Show the journal entries in 20X1 and 20X2 relevant to the income and receipt above.
B. Calculate the income tax expense in each year.

Comment: This example shows how income receivable is journalised.
20X1 Debit Credit
Receivables (A) 80 000
Revenue (P/L: I) 80 000
Sale on credit to a debtor
20X2
Bank (A) 80 000
Receivables (A) 80 000
Receipt from debtor of balance owing
Solution 11B: Calculation

Comment: Income receivable does not cause a temporary difference.
Total 20X2 20X1
Calculation of current income tax: C C C
Profit before tax (accounting profit) 80 000 0 80 000
Adjust for permanent differences 0 0 0
Subtotal (accounting profits that are taxable at some stage) (A) 80 000 (1) 0 (1) 80 000 (1)
Adjust for temporary differences (movement in these differences) 0 0 0
Taxable profits (B) 80 000 (1) 0 (1) 80 000 (1)
Current tax (B x 30%) Dr: Tax expense; Cr: CT payable 24 000 0 24 000
Chapter 5 241
Notes:
1) The ‘portion of the accounting profit that is taxable’ (A) and the ‘taxable profit’ (B) do not differ in either 20X1 or in
20X2. This is because both the accountant and the tax authorities recognise the income on the same basis (on
receipt of income) in 20X1. Thus, there are no temporary differences in 20X1 or 20X2.
Example 12: Income that is received in advance

Gallery Limited received C12 000 from a tenant on 31 December 20X1 (the year-end) for
rent of a building for January 20X2.
x The tax authorities tax income at the earlier of receipt or when earned.
There is no other income in either 20X1 or 20X2
Required:
A. Show the journal entries in 20X1 and 20X2 relevant to the rent income.
B. Calculate the income tax for 20X1 and 20X2.

Comment: Part A shows how income in advance is journalised.
Bank (A) 12 000
Income received in advance (L) 12 000
Receipt of rent for January 20X2 (recognition as income is deferred)
1 January 20X2
Income received in advance (L) 12 000
Rent income (P/L: I) 12 000
Reversal of income received in advance opening balance

Comment: Income received in advance causes a temporary difference to arise in 20X1 and reverse in 20X2.
Calculation of current income tax: Total 20X2 20X1
Profit before tax (accounting profit) 12 000 12 000 0
Adjust for permanent differences (N/A in this example) 0 0 0
Subtotal (accounting profits that are taxable at some stage (A) 12 000 (3) 12 000 (2) 0 (1)
Adjust for temporary differences (movement in these differences)
- Add inc received in advance (c/ bal): taxed in current year N/A 0 12 000 (1)
- Less inc received in advance (o/ bal): taxed in a prior year N/A (12 000) (2) 0
Taxable profits (B) 12 000 (3) 0 (2) 12 000 (1)
Current tax (B x 30%) Dr: Tax expense ; Cr: CT payable 3 600 0 3 600
Notes:
1) 20X1: The accountant shows no profit for 20X1 as the income is not yet earned in 20X1 (accrual basis). But the tax
authorities want to tax the rent income in 20X1 as it was received (cash basis). In order to convert the profit before tax
into taxable profit, we must thus add C12 000 (a temporary difference arises).
2) 20X2: The accountant includes the C12 000 rent income in its profit for 20X2 as this is the period in which it is earned.
But the tax authority has already taxed this income in 20X1. Thus, to convert the profit before tax into taxable profit,
we must deduct this C12 000 (the temporary difference reverses).
3) Total (Overall): The ‘portion of the accounting profit that is taxable’ (A) and the ‘taxable profit’ (B) differ in each
individual year of 20X1 and in 20X2 (because the accountant recognises it as income in 20X2 but it gets taxed in 20X1).
However, notice that over the 2-year period the total accounting profit and total taxable profit are the same. Thus, the
differences that arose in 20X1 and 20X2 were temporary.
Example 13: Expenses that are payable

Portrait Ltd incurred rent of C10 000 in December 20X1 but only paid it in January 20X2.
x Profit before tax and before taking into account any related journals is C100 000 in
20X1 and C100 000 in 20X2.
x The tax authority allowed the cost of rent to be deducted in 20X1 when it was incurred.
x There are neither items of exempt income nor non-deductible expenses and no temporary
differences other than those that may be evident from the information provided.
242 Chapter 5
Required:
A. Show the journal entries in 20X1 and 20X2 relevant to the expense and payment above.
B. Calculate the income tax for each year.
Comment: This example shows how expenses payable are journalised.

20X1 Debit Credit
Rent expense (P/L: E) 10 000
Rent payable (L) 10 000
Rent payable as at 31 December 20X1
20X2
Rent payable (L) 10 000
Bank (A) 10 000
Payment of the rent for 20X1

Comment: Expenses payable did not cause a temporary difference.
Total 20X2 20X1
Profit before tax (accounting profit) 20X1: 100 000 – 10 000 190 000 100 000 90 000
Subtotal (accounting profits that are taxable at some stage) (A) 190 000 (1) 100 000 (1) 90 000 (1)
Adjust for temporary differences (movement in the differences) 0 0 0
Taxable profits (B) 190 000 (1) 100 000 (1) 90 000 (1)
Current tax (B x 30%) [Dr: TE ; Cr: CTP] 57 000 30 000 27 000
Notes:
1) The ‘portion of the accounting profit that is taxable’ (A) and the ‘taxable profit’ (B) do not differ in either 20X1 or in
20X2 (because the rent expense and the tax deduction both occur in 20X1 – i.e. both the accountant and tax
authorities are applying the accrual basis). Thus, there are no temporary differences in 20X1 or 20X2.
Example 14: Expenses that relate to provisions

Poster Limited estimated that it would need to pay legal costs arising from a court case in 20X1,
estimated at 31 December 20X1 to be C150 000. These legal costs were paid in 20X2.
x Profit before tax and before taking into account any related journals is C500 000 in 20X1
and C300 000 in 20X2.
x The tax authorities would only allow this provision for legal costs to be deducted when paid.
x There are neither items of exempt income nor non-deductible expenses and no temporary
differences other than those that may be evident from the information provided.
Required:
B. Calculate the income tax for each year.
Comment: This example shows how a provision for legal costs is journalised.
20X1 Debit Credit
Legal costs (P/L: E) 150 000
Provision for legal costs (L) 150 000
Provision for legal costs as at 31 December 20X1
20X2
Provision for legal costs (L) 150 000
Bank (A) 150 000
Payment of the legal costs for 20X1
Chapter 5 243

Comment: The provision caused a temporary difference to arise in 20X1 and reverse in 20X2
Total 20X2 20X1
Profit before tax (acc profit) 20X1: 500 000 – 150 000 650 000 300 000 350 000
Subtotal (acc. profits that are taxable at some stage) (A) 650 000 (3) 300 000 (2) 350 000 (1)
Adjust for temporary differences (movement in the differences)
Add provision (closing balance): not deductible in 20X1 N/A 0 150 000(1)
Less provision (opening balance): deducted in 20X2 N/A (150 000)(2) 0
Notes:
1) In 20X1: We calculated the 20X1 accounting profits after deducting legal costs as an expense (accrual basis).
But the tax authorities do not allow these costs to be deducted in 20X1 as they were not yet paid (cash basis).
Thus, to convert the 20X1 accounting profits into taxable profits, we add the C150 000 (reverse the expense).
2) In 20X2: The legal costs are not expensed in 20X2 because they had already been expensed through the 20X1
accounting profit. But the tax authorities deduct these costs in 20X2 on the basis that they have now been paid
(cash basis). Thus, to convert the 20X2 accounting profits into taxable profits, we must deduct the C150 000.
3) Total (Overall): The ‘portion of the accounting profit that is taxable’ (A) and the ‘taxable profit’ (B) differ in each of
the individual years of 20X1 and 20X2 (because the expense is recognised in 20X1 but the tax deduction is allowed
in 20X2). However, notice that over the 2-year period the total accounting profit and total taxable profit are the same.
Thus, the differences that arose in 20X1 and 20X2 were temporary.
Example 15: Expenses that are prepaid

Frame Limited paid C22 000 in December 20X1 as annual rental of its factory for 20X2. Profit
before tax and before processing any journals for this payment is C100 000 in both 20X1 and in
20X2. The tax authorities allowed the prepaid rent to be deducted in 20X1 when it is paid. There
are neither items of exempt income nor non-deductible expenses and no temporary differences
other than those that may be evident from the information provided.
Required:
B. Calculate the income tax expense for 20X1 and 20X2 and briefly explain your answer.
Comment: This example shows how expenses prepaid are journalised.
20X1 Debit Credit

Rent prepaid (A) 22 000
Bank(A) 22 000
Payment of rent for 20X2, deferred as a prepaid expense (asset)
20X2
Rent expense (P/L: E) 22 000
Rental prepaid (A) 22 000
Reversal of expense prepaid opening balance (i.e. now recognising
last year’s prepaid expense as an expense)

Comment: Expenses prepaid cause a temporary difference to arise in 20X1 and reverse in 20X2.
Total 20X2 20X1
Profit before tax (accounting profit) 20X2: 100 000 – 22 000 178 000 78 000 100 000
Subtotal (accounting profits that are taxable at some stage)(A) 178 000 (3) 78 000 (2) 100 000 (1)
Adjust for temporary differences (movement in the differences)
Less expense prepaid (c/bal): deductible in 20X1 N/A 0 (22 000) (1)
(2)
Add expense prepaid (o/bal): already deducted in 20X1 N/A 22 000 0
244 Chapter 5
Notes:
1) In 20X1: When calculating the 20X1 accounting profits we did not expense the rent paid as it has not been
incurred (accrual basis). But the tax authorities deduct this rent in 20X1 as it has been paid (cash basis). Thus,
to convert the 20X1 accounting profits into taxable profits, we must deduct the C22 000 (deduct the payment).
2) In 20X2: When calculating the 20X2 accounting profits, we expense the rent because it is now incurred (accrual
basis). But the tax authorities had already deducted the rent in 20X1 when it was paid (cash basis). Thus, to
convert the accounting profits into taxable profits in 20X2, we must add C22 000 (i.e. reverse the expense).
3) Total (Overall): The ‘portion of the accounting profit that is taxable’ (A) and the ‘taxable profit’ (B) differ in each of
the individual years of 20X1 and 20X2 (because the expense is recognised in 20X2 but the tax deduction is allowed
in 20X1). However, notice that over the 2-year period the total accounting profit and total taxable profit are the same.
Thus, the differences that arose in 20X1 and 20X2 were temporary.
B: 3.5.3 Temporary differences caused by depreciable assets

B: 3.5.3.1 Depreciable assets: depreciation expense versus tax deduction
IFRSs require that the cost of depreciable assets be expensed (as depreciation or amortisation) at a rate
that reflects the entity’s estimation regarding the manner in which the asset is expected to be used.
Tax legislation, however, requires an asset’s cost to be deducted in the calculation of taxable profits
based on standard rates set out in the tax legislation,
Depreciable assets may
irrespective of how the entity expects to use up its asset’s life. cause temporary
This deduction, calculated by the tax authorities, is often differences
called, for example, a capital allowance, wear and tear, An accountant & tax authority
depreciation for tax purposes or simply a tax deduction. may deduct the cost of the asset at
different rates (e.g. depreciation at
The amount expensed when calculating accounting profits 20% versus wear & tear at 10%).
(e.g. depreciation) and the amount deducted when calculating taxable profits (e.g. wear and tear)
would, however, still equal each other over time - in other words, if we compare the total accumulated
depreciation once the depreciable asset had been fully depreciated with the total accumulated wear
and tear once the cost had been fully deducted as wear and tear. Thus, this means that any difference
between accounting profit and taxable profit that arises because the expense (e.g. depreciation) and the
related tax deduction (e.g. wear and tear) are different amounts in any one year is only temporary.
When converting accounting profits into taxable profits, we aim to ‘reverse’ items that were included
in the calculation of accounting profits but which the tax authority would not use in the calculation of
taxable profit and ‘process’ the items that the tax authority would use when calculating taxable profits.
In this case, to convert accounting profit into taxable profit we would reverse the expense (e.g.
depreciation) by adding it back and subtract the relevant tax deduction instead (e.g. wear and tear).
Example 16: Depreciable assets - depreciation versus tax deductions
Cost of vehicle purchased on 1 January 20X1 C150 000
Depreciation on vehicles to nil residual value (straight-line method) 2 years
Wear and tear (allowed by tax authorities) (straight line method) 3 years
Income tax rate 30%
Profit before tax (after deducting any depreciation on the vehicle) in C100 000 pa
each of the years ended 31 December 20X1, 20X2 and 20X3
There are no temporary differences, no exempt income and no non-deductible expenses other than those
evident from the information provided.
Required: Calculate the current income tax per the tax legislation for 20X1, 20X2 and 20X3.
Solution 16: Depreciable assets - depreciation versus tax deductions

Calculation of current income tax Total 20X3 20X2 20X1
Profit before tax (accounting profit) 300 000 100 000 100 000 100 000
Permanent differences 0 0 0 0
Temporary differences (movement therein):
Add back depreciation (150 000 / 2 years) 150 000 0 75 000 75 000
Less wear and tear (150 000 / 3 years) (150 000) (50 000) (50 000) (50 000)
Taxable profit 300 000 50 000 125 000 125 000
Current tax at 30% (Dr TE; Cr CTP) 90 000 15 000 37 500 37 500
Chapter 5 245
Comments:
x In each of the years (20X1, 20X2 and 20X3), the accounting profit differs from the taxable profit.
x However, notice that over the 3-year period, both the accountant and tax authorities agree that the
cost of the asset that may be expensed equals C150 000. Thus, the total accounting profit is C300 000
over these three years and the total taxable profit is also C300 000 over these three years.
x Thus, the difference between the accounting and taxable profits in each individual year was simply
due to annual differences that were temporary (i.e. temporary differences).
B: 3.5.3.2 Depreciable assets: carrying amount versus tax base

When preparing the statement of financial position, an accountant would present the carrying
amount of each of the assets. In the case of depreciable assets, this is the net amount after
deducting accumulated depreciation/amortisation (e.g. cost – accumulated depreciation).
The term that is equivalent to carrying amount but calculated based on tax legislation, is the
asset’s tax base. In the case of depreciable assets, this is the net amount after deducting
accumulated deductions for tax purposes (e.g. cost – accumulated wear and tear).
A depreciable asset’s carrying amount versus tax base
x Based on the IFRSs, the asset’s carrying amount is calculated as:

Original cost xxx
Less accumulated depreciation (xxx)
Carrying amount xxx
x Based on the tax legislation, the asset’s tax base is calculated as:
Original cost xxx
Less accumulated deductions for tax purposes (e.g. wear & tear) (xxx)
Tax base xxx
Obviously, if the expense (e.g. depreciation) used to calculate accounting profits differs from the tax-
deduction (e.g. wear and tear) used to calculate taxable profits, then at year-end, the asset’s ‘carrying
amount’ (per the accounting records) and its ‘tax base’ (per the tax records) will also differ.
The fact that the carrying amount and tax base may differ has implications if the asset is sold (explained
in sections B: 3.5.3.3-4) and is used when calculating deferred tax (explained in the next chapter). In
the meantime, the following example illustrates the calculation of the carrying amount and tax base
and how these can differ during the lifetime of the asset.
Example 17: Depreciable assets - carrying amount versus tax base
Use the same information as that provided in the previous example (example 16).
Required: Calculate the carrying amount and tax base at the end of 20X1, 20X2 and 20X3.
Solution 17: Depreciable assets - carrying amount versus tax base
Comparison of carrying amounts and tax bases Carrying Tax Difference

amount base
Cost 150 000 150 000
Less: Depreciation/ Wear and tear – 20X1 (75 000) (50 000)
Carrying amount/ Tax base – end 20X1 75 000 100 000 25 000
Less: Depreciation/ Wear and tear – 20X2 (75 000) (50 000)
Carrying amount/ Tax base – end 20X2 0 50 000 50 000
Less: Depreciation/ Wear and tear – 20X3 (0) (50 000)
Carrying amount/ Tax base – end 20X3 0 0 0
Comment:
The carrying amount and tax base differ at the end of 20X1 by C25 000 and this grew to C50 000 at the end of 20X2.
However, the carrying amount and tax base are both nil at the end of 20X3. This is because, over 3 years, both the
accountant and the tax authorities have expensed the full cost of C150 000. The differences that arose in 20X1 and
20X2 reversed and are thus called temporary differences.
246 Chapter 5
B: 3.5.3.3 Depreciable assets: the effect of selling the asset – at below original cost
It can happen that an asset is sold before it has been fully depreciated (or before it has been
fully written off for tax purposes). If the asset is sold where the carrying amount and tax base
differ, the profit or loss on sale calculated in terms of IFRSs will differ from the profit or loss
on sale calculated in terms of the tax legislation.
If an asset is sold below original cost but above its tax base, the tax legislation sees this as a
‘profit on sale’, but refers to it as a ‘recoupment’. Conversely, if an asset is sold below original
cost and below its tax base, the tax legislation sees this as a ‘loss on sale’, but refers to this as a
‘scrapping allowance’ (when sold below original cost and below its tax base). Both a
recoupment and a scrapping allowance are calculated as the selling price (limited to cost price)
less the tax base.
Once again, when converting accounting profits into taxable profits, the aim is to ‘reverse’
items that were included in the calculation of accounting profits but which the tax authority
would not use in the calculation of taxable profit and ‘process’ the items that the tax authority
would use when calculating his taxable profits. In the case of the sale of a depreciable asset that
resulted in, for example, a profit on sale in terms of IFRSs and a recoupment in terms of tax
legislation, we would reverse the profit by subtracting it from the accounting profit and replace
it by adding the recoupment.
The sale of a depreciable asset (for an amount below original cost)

x Based on the IFRSs, the sale could lead to a profit or loss, calculated as:
Profit / (loss) on sale xxx
x Based on the tax legislation, the sale could lead to a recoupment or scrapping allowance:
Proceeds on sale, limited to original cost xxx
Less tax base (xxx)
Recoupment / (scrapping allowance) on sale xxx
Example 18: Profit/loss on sale versus recoupment/ scrapping allowance on sale

A company sells a vehicle on 31 December 20X2 for C110 000.
Details of the vehicle and its sale are as follows:
x Depreciation on vehicles to nil residual value (straight line method) 3 years
x Wear and tear on vehicle (according to tax authorities) (straight-line) 4 years
Other information:
x Profit before tax (after deducting any depreciation on the vehicle but before taking into account
the profit or loss on sale) was C100 000 in each of the years ended 31 December 20X1 and 20X2.
x Income tax is levied at 30%
x There are no temporary differences, no exempt income and no non-deductible expenses other than
those evident from the information provided.
Required:
A. Calculate the profit or loss on sale in 20X2 according to IFRS.
B. Calculate the recoupment or scrapping allowance on sale in 20X2 according to the tax legislation.
C. Calculate the current income tax for 20X1 and 20X2.
Solution 18A: Calculation of profit or loss on sale (IFRS)

20X2
Calculation of profit or loss on sale (IFRSs) C
Less carrying amount Cost: 150 000 – Acc depreciation: (150 000 / 3 years x 2 years) (50 000)
Profit on sale 60 000
Chapter 5 247
Solution 18B: Calculation of recoupment or scrapping allowance on sale (tax law)

20X2
Calculation of recoupment or scrapping allowance on sale C
Less tax base Cost: 150 000 – Acc wear & tear: (150 000 / 4 years x 2 years) (75 000)
Recoupment on sale/ (scrapping allowance) 35 000
Comment: Had the proceeds been less than the tax base (e.g. proceeds of C60 000), a scrapping
allowance would have arisen (Proceeds: 60 000 – TB: 75 000 = -C15 000 scrapping allowance).
Solution 18C: Calculation of current income tax

Total 20X2 20X1
Calculation of current income tax C C C
Profit before tax 20X1: given; 20X2: 100 000 + 60 000 260 000 160 000 100 000
Permanent differences (exempt income & non-deductible expenses) 0 0 0
Temporary differences (the movement in these differences)
Add back depreciation 150 000 / 3 years x 1 year 100 000 50 000 50 000
Less wear and tear 150 000 / 4 years x 1 year (75 000) (37 500) (37 500)
Less profit on sale 20X2: see part A (60 000) (60 000) 0
Add recoupment 20X2: see part B 35 000 35 000 0
Taxable profit 260 000 147 500 112 500
Current tax at 30% [Dr: TE ; Cr: CTP] 78 000 44 250 33 750
Comment:
x It can be seen from the above that, over the 2-year period:
the accounting records show that the asset caused a net loss of C40 000:
(Depreciation: 100 000 – Profit on sale: 60 000) and
the tax records show that the asset caused a net loss of C40 000:
(Wear & tear: 75 000 – Recoupment: 35 000).
Thus, the total accounting profit over the 2 years and the total taxable profit over these 2 years
were both C260 000. This means that differences in each year were simply temporary differences.
x Had the proceeds been less than the tax base, a scrapping allowance would have arisen, in which
case we would have subtracted a scrapping allowance (instead of adding a recoupment). P.S. It is
possible to have a scrapping allowance and yet, at the same time, have a profit on sale (if we sold
for C60 000, we would have a scrapping allowance of C15 000 but a profit on sale of C10 000).
B: 3.5.3.4 Depreciable assets: the effect of selling the asset – at above original cost
In the previous section, we limited our discussion to the situation in which a depreciable asset could
be sold for an amount less than the original cost. However, it is entirely possible that the asset could
be sold for more than we originally paid for it.
In this case, our profit on sale, calculated in terms of IFRSs (proceeds – carrying amount) can be split
into two components – the portion of the profit resulting from selling above original cost is referred to
as the capital profit and the remaining portion is the non-capital profit.
The profit or loss on sale of a non-current asset (capital and non-capital portions) in terms of IFRSs, is:
Profit or (loss) on sale xxx
The capital profit included in this profit on sale of a non-current asset is as follows:
Less original cost (xxx)
Capital profit or (loss) xxx
The non-capital profit included in this profit on sale of a non-current asset is as follows:
Proceeds on sale, limited to original cost xxx
Non-capital profit or (loss) xxx
248 Chapter 5
Summary: Implications of a sale above cost in terms of IFRS

Proceeds
Capital profit on sale
Profit on sale (IFRSs) Original cost
Non-capital profit on sale
Carrying amount
While the profit on sale, calculated in terms of IFRSs, can be split into its capital and non-capital
portions, this is not absolutely necessary. However, from a tax perspective, the fact that the asset has
been sold at above original cost could mean that there is a taxable capital gain. This is explained below.
A capital gain on the sale of a non-current asset, determined in accordance with the tax
legislation, is generally calculated as follows:
Less base cost (xxx)
Capital gain xxx
The base cost, which is calculated based on tax legislation, is either equal to the original cost or is a
higher amount. The calculation of the base cost is outside the scope of this chapter. For simplicity, you
may assume that the base cost equals the asset’s cost, unless the information provided states otherwise.
The taxable capital gain is then generally a percentage of the capital gain, where this percentage
depends on whether the taxpayer is a natural person or not (e.g. a company). Currently in South
Africa, the inclusion rate is 40% for a natural person and 80% for a company.
Capital gain xxx
Multiplied by inclusion rate for companies @ 80%
Summary: Implications of a sale above cost in terms of tax legislation

Proceeds
2
Capital gain, of which only a certain % is taxable (e.g. 80%)
1
Base cost
1
Original cost
3&4
Recoupment
Tax base
1: The base cost and original cost could be different amounts. If they are different amounts, then the
difference between the base cost and original cost will not be taxable. Refer to example 9.
2: A portion of the capital gain is obviously not taxable (e.g. 20% in the case of companies).
3: It makes sense that if your proceeds exceed the original cost, that a scrapping allowance (instead of a
recoupment) would not be possible.
4: Notice that the recoupment is, as always, calculated as the proceeds, limited to cost, less tax base.
The following table summarises a comparison between the various terms used by the
accountant and the tax authorities regarding depreciable assets
Accountant Tax Authorities Notes
N/A: no comparative term Base cost 1 1. Base cost either equals cost or is
greater than cost – used for CGT only
Cost Cost
2
Depreciation Tax deduction 2. Tax deduction can also be called capital
allowance/ wear & tear/ depreciation for
tax purposes etc
3 4
Carrying amount Tax base 3. Cost less Accumulated depreciation
4. Cost less Accumulated wear and tear
5 6
Capital profit on sale Capital gain & Taxable capital gain 5. Arises if proceeds > cost
6. Arises if proceeds > base cost
7 8
Non-capital profit on sale Recoupment 7. Arises if proceeds (limited to cost)>
carrying amount
8. Arises if proceeds (limited to cost)> tax base
Loss on sale 9 Scrapping allowance 10 9. Arises if proceeds < carrying amount
10. Arises if proceeds < tax base
Chapter 5 249
Example 19: Capital profit vs. capital gains on sale (proceeds > original cost)
A company sells a vehicle on 1 January 20X2 for C200 000. Details of this vehicle are:
x Cost of vehicle purchased on 1 January 20X1 C150 000
x Depreciation on vehicles to nil residual value 2 years (straight-line)
x Wear and tear on vehicle (allowed by the tax authorities) 3 years (straight-line)
Additional information:
x Profit before tax (after deducting any depreciation on the vehicle but before considering the profit or loss
on sale) in each of the years ended 31 December 20X1 and 20X2 is C100 000.
x Income tax is levied at 30%, the capital gains tax inclusion rate is 80% and the base cost is C150 000.
x There are no temporary differences, no exempt income and no non-deductible expenses other than those
Required:
A. Calculate the profit/ loss on sale in 20X2 per IFRSs: show the capital and non-capital portions.
B. Calculate the recoupment or scrapping allowance on sale in 20X2 per the tax legislation.
C. Calculate the taxable capital gain per the tax legislation.
D. Calculate the taxable profits and current income tax per tax legislation for 20X1 & 20X2.
Solution 19A: Calculation of profit or loss on sale, where it includes a capital profit
20X2
Proceeds on sale C200 000
Less carrying amount Cost: 150 000 – Acc depreciation: (150 000 / 2 x 1year) (75 000)
Capital profit Proceeds: 200 000 – Cost: 150 000 50 000
Non-capital profit Proceeds limited to cost: 150 000 – Carrying amount: 75 000 75 000
Solution 19B: Calculation of recoupment or scrapping allowance on sale (tax law)

20X2
Proceeds on sale, limited to cost Proceeds: C200 000, but limited to cost: C150 000 C150 000
Less tax base Cost: 150 000 – Acc wear & tear: (150 000 / 3 x 1year) (100 000)
Recoupment on sale/(scrapping allowance) 50 000
Solution 19C: Calculation of taxable capital gain (tax law)

20X2
Proceeds on sale Given C200 000
Less base cost Given (150 000)
Capital gain 50 000
Inclusion rate Given 80%
Taxable capital gain Capital gain: 50 000 x Inclusion rate: 80% 40 000
Solution 19D: Calculation of current income tax

Comment: over the 2-year period, the accounting records and tax records will not agree because:
x The accounting records show that the asset resulted in a profit over the 2 years of C50 000:
Profit on sale In 20X2 (see Sol 19A) C125 000
Less: depreciation In 20X1: 150 000 / 2 x 1yr (75 000)
Effect on accounting profit 50 000
x However, the tax records show that the asset resulted in a taxable profit over the 2 years of C40 000:
Taxable capital gain In 20X2 (see Sol 19C) C40 000
Recoupment In 20X2 (see Sol 19B) 50 000
Less: wear and tear In 20X1: 150 000 / 3 x 1yr (50 000)
Effect on taxable profit 40 000
x Thus, of the accounting profit of C50 000, only C40 000 is taxable. Thus, C10 000 will never be
taxed (Accounting profit: C50 000 – Taxable profit: C40 000) and is thus a permanent difference.
x Many students battle to identify adjustments as either temporary or permanent differences (e.g.
exempt income/ non-deductible expenses). Thus, the calculations below have first been shown
without this differentiation (see first calculation below). But if you can master this (see the second
alternative calculation below), it is extremely useful to be able to separately identify the permanent
differences since these will appear as reconciling items in the tax expense note’s rate reconciliation.
250 Chapter 5
Total 20X2 20X1

Current income tax C C C
Profit before tax 20X2 100 000 + PoS: 125 000 325 000 225 000 100 000
Add back depreciation 20X1: 150 000 / 2 years 75 000 0 75 000
Less wear and tear 20X1: 150 000 / 3 years (50 000) 0 (50 000)
Less profit on sale 20X2: (see Ex 19A) (125 000) (125 000) 0
Add recoupment 20X2: (see Ex 19B) 50 000 50 000 0
Add taxable capital gain 20X2: (see Ex 19C) 40 000 40 000 0
Taxable profit 315 000 190 000 125 000
Current tax at 30% Dr TE; Cr CTP 94 500 57 000 37 500
Current income tax (ALTERNATIVE calculation)

Profit before tax 20X2 100 000 + PoS: 125 000 325 000 225 000 100 000
Permanent differences:
Less capital profit 20X2 (see Ex 19A) (50 000) (50 000) 0
Temporary difference movements:
Less non-capital profit 20X2 (see Ex 19A) (75 000) (75 000) 0
Add back depreciation 20X1: 150 000 / 2 years 75 000 0 75 000
Less wear and tear 20X1: 150 000 / 3 years (50 000) 0 (50 000)
Add recoupment 20X2: (see Ex 19B) 50 000 50 000 0
Taxable profit 315 000 190 000 125 000
Current tax at 30% Dr TE; Cr CTP 94 500 57 000 37 500
B: 3.5.4 Temporary differences caused by tax losses (also known as an assessed loss)
If when calculating taxable profits you get a negative figure, A deductible tax loss is
See IAS 12.5 Reworded
it means that the entity has made a tax loss (assessed loss) …
not a taxable profit. In other words, a tax loss means that, in x the loss for a period,
terms of the tax legislation, the entity has made a loss. x calculated in terms of tax legislation,
x upon which income tax is recoverable
No current tax is payable for the year of assessment in which (i.e. a tax loss that may be deducted
there is a tax loss (i.e. there will be no current tax expense). when calculating taxable profits in a
future period).
Sometimes tax losses may be ‘carried forward’ and used as a tax deduction in the following
year/s of assessment. In other words, it may be allowed as a deduction against the taxable profits
in the following year/s, thus reducing that year’s taxable profit and thus that year’s current tax
charge (i.e. it will reduce tax payable in that future year).
If the tax loss is allowed to be carried forward and used as a tax deduction in a future year of
assessment, the tax loss is a temporary difference and is referred to as a deductible tax loss.
If the tax loss is not allowed to be carried forward and deducted in future, the tax loss is a
permanent difference, referred to as a non-deductible tax loss.
Example 20: Tax losses (assessed losses)

Depreciation on vehicles to nil residual value 2 years straight-line
Wear and tear on vehicle (allowed by the tax authority) 33% per annum
Income tax rate 30%
Profit/ (loss) before tax (after deducting any depreciation on the vehicle) for the year ended:
x 31 December 20X1: (80 000)
x 31 December 20X2: 30 000
x 31 December 20X3: 100 000
There are no temporary differences, no exempt income and no non-deductible expenses other than those
Chapter 5 251
Required:
A. Calculate the income tax per the tax legislation for 20X1, 20X2 and 20X3 assuming tax losses can
be used as a tax deduction for future financial years.
B. Calculate the income tax per the tax legislation for 20X1, 20X2 and 20X3 assuming tax losses can
NOT be used as a tax deduction for future financial years.
Solution 20A: Tax losses allowed as a deduction for future financial years
Comment: This shows the calculation of current tax where tax losses are incurred over consecutive years.
Calculation of current income tax 20X3 20X2 20X1
Profit/ (loss) before tax 100 000 30 000 (80 000)
Add back depreciation (120 000 / 2 years) 0 60 000 60 000
Less wear and tear (120 000 / 3 years) (40 000) (40 000) (40 000)
Less assessed loss brought forward (10 000) (60 000) 0
Taxable profit/ (tax loss) 50 000 (10 000) (60 000)
Current tax at 30% [Dr: TE; Cr: CTP] 15 000 0 0
Solution 20B: Tax losses NOT allowed as a deduction for future financial years
Comment: This shows the calculation of current tax where tax losses are not allowed as a deduction in
the following years and how this simply results in a higher tax charge.
20X3 20X2 20X1
Calculation of current income tax C C C
Profit/ (loss) before tax 100 000 30 000 (80 000)
Add back depreciation (120 000 / 2 years) 0 60 000 60 000
Less wear and tear (120 000 / 3 years) (40 000) (40 000) (40 000)
Less assessed loss brought forward 0 0(1) 0
Taxable profit/ (tax loss) 60 000 50 000 (60 000)
Current tax at 30% [Dr: TE; Cr: CTP] 18 000 15 000 0
Note:
1) The tax loss of C60 000 in 20X1 is not carried forward to the 20X2 financial year which results in a
tax expense of C15 000 being incurred.
2) Let’s compare Part A and Part B: the total of the current tax charges over the 3 years is lower in Part
A (C15 000) than in Part B (C33 000). The difference of C18 000 is due to the fact that, in Part B,
the tax loss of C60 000 was not allowed as a deduction (C60 000 x 30%).
B: 3.6 Permanent differences and temporary differences
The following is an example that involves differences between accounting profit and taxable
profit that are both permanent and temporary differences.
Example 21: Temporary differences and permanent differences

Coin Limited has profit before tax of C100 000 for the year ended 31 December 20X1.
This profit has been correctly calculated after taking into account the following information:
x Interest income of C1 600 is still receivable (taxable in 20X1). (2)
x Electricity of C2 400 is due for 20X1 but has not yet been paid (deductible in 20X1). (3)
x Rent income received in advance (i.e. in respect of 20X2): C4 000 (taxable in 20X1). (1)
x The water bill for the first month in 20X2 has already been paid: C3 200 (deductible in 20X1). (4)
x Dividend income of C800 was earned during 20X1 (exempt from tax).
x A fine of C4 800 was incurred during 20X1 (not deductible for tax purposes).
x Depreciation was expensed during the year. The asset was purchased for C56 000 and is being
depreciated at 25% pa on cost. The tax authority allows a capital allowance at 10% of cost.
x Research costs expensed in 20X1 amounted to C6 400. The tax authority allows research costs to be
written-off over 4 years.
x A provision for legal fees was increased by C7 200 in 20X1. The legal costs will only be tax
deductible in the year that the legal costs are paid. No legal costs were paid in 20X1.
Required:
Calculate the current tax and show the related journal for the year ended 31 December 20X1.
252 Chapter 5
Solution 21: Temporary differences and permanent differences

Comment: This is a comprehensive example showing a calculation of taxable profits that involves
temporary differences and permanent differences (also known as non-temporary differences).
Calculation of current income tax C
Profit before tax (accounting profit) Given 100 000
Add/(less) permanent differences:
Less exempt income: dividend income Given (800)
Add back non-deductible items: fines Given 4 800
104 000
Add/(less) movement in temporary differences See note 1: interest and electricity
Add income received in advance: rent See note 2 4 000
Less prepaid expense: water See note 3 (3 200)
Add back depreciation See note 4: 56 000 x 25% 14 000
Less capital allowance See note 4: 56 000 x 10% (5 600)
Add back research expense See note 5 6 400
Less research deduction allowed See note 6: 6 400 / 4 years (1 600)
Add back provision for legal fees See note 7 7 200
Current tax at 30% [Dr: TE; Cr: CTP] 119 200 x 30% 37 560
The current tax journal will be: Debit Credit

Current income tax for the year
Explanatory notes:
(1) At 31 December 20X1, both the interest receivable and electricity payable had already been included in
the calculation of the 20X1 profit before tax (accounting profits) of C100 000, because:
x the accountant will have recognised the interest receivable as interest income in 20X1 (debit interest
receivable and credit interest income) on the grounds that it was earned in 20X1; and
x the accountant will have recognised the electricity payable as an electricity expense in 20X1 (debit
electricity expense and credit electricity payable) on the grounds that it was incurred in 20X1.
Similarly, we are told that the interest was taxable in 20X1 and the electricity was tax-deductible in 20X1.
Thus, since the tax authority ‘agrees’ that the interest is income in 20X1 and that the electricity is an
expense in 20X1, no adjustment is made to the 'profit before tax’ in order to convert it into the ‘taxable
profit’ (i.e. there is no difference between the accounting and tax treatment of these amounts).
(2) Rent received in advance will not have been included in the ‘profit before tax’ (accounting profits)
because amounts received in advance are recognised as liabilities…not income (i.e. received but not yet
earned) (debit bank and credit income received in advance).
However, we are told that this tax authority will tax this rent in 20X1 on receipt of the rental amount (i.e.
even though it is received in advance).
Thus, to convert ‘profit before tax’ into ‘taxable profits’, we need to add the income received in advance.
(3) The prepaid water will not have been included in the ‘profit before tax’ (accounting profits) because
prepayments are recognised as assets…not expenses (i.e. paid but not yet incurred) (debit prepaid
expense and credit bank).
However, we are told that the tax authority will deduct the cost of water in 20X1 when payment is made
(i.e. even though it is paid in advance).
Thus, to convert the ‘profit before tax’ into ‘taxable profits’, we need to deduct the prepaid expense.
(4) Depreciation will have been deducted in the calculation of the 20X1 ‘profit before tax’ (accounting
profits). We are told that this depreciation is calculated at 25% per annum.
However, this tax authority will deduct a capital allowance calculated at a different rate (10% pa on cost).
Since the depreciation deducted when calculating profit before tax (accounting profits) will not be the
same amount as the capital allowance deducted by the tax authority, the accountant’s depreciation must
be added back (reversed) and then the tax authority’s capital allowance must be deducted.
Please note: Both the accountant and the tax authority ‘agree’ that the full cost of C56 000 will be
deducted – the issue is simply how much to deduct each year.
Chapter 5 253
Solution 21 Continued…
(5) The research costs of C6 400 were expensed in full when calculating the 20X1 profit before tax.
However, the tax authority deducts the C6 400 over 4 years, thus only C1 600 is deductible in 20X1.
Thus, we remove (add back) the C6 400 and deduct the C1 600 to calculate taxable profit.
(6) The increase in the provision for legal costs of C7 200 will have already been included in the
calculation of the 20X1 profit before tax (accounting profits), on the grounds that it was incurred in 20X1
(debit legal expense and credit provision for legal costs).
However, this tax authority will only allow a deduction for legal costs when they have actually
been paid. Since no legal costs have been paid in 20X1, no tax deduction will be allowed in 20X1.
Thus, to convert ‘profit before tax’ into ‘taxable profits’, we add back (reverse) the legal cost expense.
B.4 Payment of Income Tax
B: 4.1 Overview
The payment system regarding income tax is important to understand. It requires two
prepayments of tax during the year. These are called provisional tax payments. In order to make
each of these payments, the entity will have to estimate the total year’s current income tax half
way through the year and then again at the end of the year. These tax estimates are made by
applying the tax legislation to the profits in the same manner as would be applied by the tax
authority. However, it is important to note that, when making provisional tax payments during
the course of the year, these tax estimates are obviously based on estimated profits (even the
second provisional payment, due on the last day of the current year, would still be based on
estimated profits because the actual profits will only be known with certainty a few months
later when the financial statements have been finalised).
The entity then estimates the total current income tax yet again when the accounting records
for the current year are being finalised, at which point the actual profit on which the current
income tax charge will be based is now known. This third estimate is made for purposes of
measuring the current income tax to be recognised as an expense in the financial statements.
This third estimate is then documented on an official form, commonly referred to as a ‘tax
return’, and submitted to the tax authorities. The tax authorities assess this ‘tax return’ and send
the entity an official assessment thereof, commonly referred to as a ‘tax assessment’. The
receipt of the ‘tax assessment’ will typically occur after the financial statements for the current
year under review have been authorised for issue. Now, it is important to understand that this
third estimate made by the accountant was calculated by applying the tax legislation to the
actual profits and in the same manner as would be applied by the tax authority. Thus, in a
perfect world, this should mean that the tax estimated by the accountant, and recognised as the
current income tax expense for the year (and also documented in the ‘tax return’), will equal
the tax calculated by the tax authorities (documented in the ‘tax assessment’). However, we
don’t live in a perfect world and thus differences may arise that will require an adjustment.
In this regard, if the ‘tax assessment’ indicates that the tax authorities disagree with the total tax
calculated per the ‘tax return’ that was submitted by the entity, an adjustment will have to be
made to the current income tax expense that was recognised. This adjustment will have to be
made in the year in which the assessment is received. The assessment may also require the
entity to make a further top-up payment, if the provisional payments were insufficient, or may
lead to the entity receiving a refund if the provisional payments were greater than required.
B: 4.2 Income tax: provisional payments and estimates
Since the income tax charge is generally very large and the calculation of the actual taxable
profits is only finalised after the end of the year of assessment (which is generally the same as
the financial year), tax authorities normally require companies to make two provisional
payments during the year of assessment.
254 Chapter 5
The requirement for provisional payments to be made during the year is intended to reduce the
cash flow shortages of the government during the year and also to ease the company’s burden
of paying an otherwise very large single sum at the end of the year.
In South Africa, two provisional payments are required Provisional tax

to be made as follows:
Companies must make provisional tax
x half the estimated tax for the year is to be paid within payments
the first 6 months of the year of assessment; and x every 6 months
x the balance of the estimated tax for the year is to be x based on an estimated taxable profit.
paid on or before the end of the last 6 months of the year of assessment.
These payments are based on estimates made during the year of the expected profit for the year
(please note: tax legislation allows provisional payments to be based on a ‘base amount’ instead
of profits, but this option will be best explained when you study the subject ‘Taxation’ rather
than ‘Financial Accounting’). Since circumstances continuously change during the course of
any one year, the expected profit for the year that is estimated half way through the year, (for
purposes of the first provisional payment), will typically differ from the expected profit for the
year that is estimated at the end of the year, (for purposes of the second provisional payment).
After the end of the financial year, when finalising the accounting records, the accountant will
be able to calculate the actual profit for the year. At this point, he will apply the tax legislation
to these actual profits (in the same manner as would be applied by the tax authority) in order to
calculate the estimated current income tax for the year. We still refer to this an estimate of the
tax because the tax authorities must first assess our estimate before it can be said to be final.
As mentioned before, in a perfect world, one would imagine that the accountant’s third and
final estimate of tax should equal the tax calculated by the tax authorities because the accountant
bases his final estimate on final taxable profits, calculated by applying the same legislation that
will be applied by the tax authorities. However, we don’t live in a perfect world and thus
differences may arise that would then require an adjustment to be made.
The final accurate amount of income tax for the year will only be known once the tax authority
has assessed the estimate made by the company. This final tax amount will only be known when
the entity receives this official ‘tax assessment’, which typically occurs well after the financial
year has ended and the financial statements have been published. Thus, whether we over-
provided or under-provided the income tax expense in the statement of comprehensive income
of a financial year, can only ever be discovered in a following financial year. Thus, any
adjustment to correct an over-provision or under-provision of a prior year’s income tax expense
will be made in the financial period in which the relevant assessment is received.
B: 4.3 The first provisional payment (the 1st estimate of current income tax)
The first payment must be made within six months after the beginning of the financial year.
Therefore, if a company has a 28 February year-end, the first provisional payment will fall due
on 31 August (and the second will fall due on the 28 February).
The first provisional tax payment reflects half the tax the company estimates it will owe for the
full year. The first payment is only half of the total estimated tax because the payment is made
halfway through the year (the rest will be paid when paying the second provisional payment).
The first provisional payment is calculated as:

x (Estimated taxable profit for the year x Tax rate) ÷ 2.
The journal for the first provisional payment is as follows:
Debit Credit
Current tax payable/ receivable: income tax (L/A) xxx
Bank (A) xxx
Payment of first provisional payment
Chapter 5 255
B: 4.4 The second provisional payment (the 2nd estimate of current income tax)
The second payment must be made on a date not later 1st and 2nd Provisional
than the last day of the financial year. Thus, if a company Payment
has a 28 February year-end, the second provisional
x 1st provisional payment =
payment must be made not later than 28 February.
(estimated taxable profits for the yr
x tax rate) / 2
The second provisional payment represents the
x 2nd provisional payment =
estimated balance still owing to the tax authorities, after
(estimated taxable profits for the yr
taking into account the fact that the first provisional x tax rate) – (1st provisional pmt)
payment has already been made.
The second provisional payment is calculated as:

x (Estimated taxable profit for the year x Tax rate) - First Provisional Payment.
The journal for the second provisional payment is the same as the first:
Debit Credit
Bank (A) xxx
Payment of second provisional payment
Note: the second provisional payment is still based on estimated taxable profits for the year
(although this estimate will generally differ from the estimated taxable profits when making the
first provisional payment) because, due to the complexities involved in finalising financial
statements for the year, the actual taxable profit is only known with accuracy a few months
after the financial year-end (i.e. after the due date for the second provisional payment).
B: 4.5 The final estimate of current income tax (the 3rd estimate of current income tax)
The accountant makes the final estimate of current income taxation for the current year while
preparing the annual financial statements for publication.
The final estimate of current tax, for purposes of recognising the current income tax expense
for the year, is calculated as:
x Actual taxable profits for the year x Tax rate.
The journal for the final estimated current income tax for the year is:
Debit Credit
Income tax (P/L: E) xxx
Recording estimated current tax in the current year
This estimate is shown as the current portion of the income taxation in the taxation note. Please
note: the total income taxation expense for the year includes both a current portion and a
deferred portion – this chapter explains only the current tax portion – the deferred tax portion
is explained in the next chapter.
The final estimate of how much tax will be charged by the tax authority for the year is seldom
equal to the sum of the first and second provisional payments. This simply results in either a
balance owing to or by the tax authority. This is shown in the statement of financial position as
a current tax asset or a current tax liability.
Example 22: The provisional payments and tax estimate

A company pays C60 000 as the first provisional payment on 30 June 20X1, and C40 000 as
the second provisional payment on 31 December 20X1.
When finalising the 20X1 financial statements, the accountant estimated taxable profits for
20X1 to be C400 000.
No tax was owing to or receivable from the tax authority at the beginning of 20X1.
256 Chapter 5
Required:
A. Calculate the current income tax expense for 20X1 and current tax payable/ receivable at 31 December 20X1.
B. Show the relevant ledger accounts.
C. Present the income tax expense and the income tax payable in the financial statements for the year
ended 31 December 20X1. Ignore deferred tax.
Solution 22A: Calculations: current income tax expense/ payable

C
Balance payable to/receivable from the tax authorities Given 0
Total income tax expense for 20X1 400 000 x 30% 120 000
Total payments made in respect of 20X1 tax 60 000 + 40 000 (100 000)
Balance of tax still payable at 31 December 20X1 20 000
Solution 22B: Ledger accounts

Income tax expense (E) Current tax payable/ receivable (L/A)
CTP: IT 120 000 Bank 60 000 Opening bal 0
Bank 40 000 Inc Tax Exp: 120 000
Balance c/f 20 000
Bank (A) 120 000 120 000
CT P/R 60 000 Balance b/f 20 000
CT P/R 40 000
Company name
20X1
C
Profit before taxation xxx
Income tax expense (120 000)
Profit for the year xxx
Company name
20X1
Current liabilities C
Current tax payable: income tax 20 000
In certain instances, a company may need to make a third provisional payment (generally
referred to as top-up payment) if it is feared that the first and second provisional payments will
be significantly lower than the final tax charge expected from the tax authority’s assessment.
The ability to make this third provisional payment (top-up payment) is useful because there are
heavy penalties and interest that would otherwise be charged by the tax authority if the
provisional payments are significantly less than the final tax amount per the official tax
assessment.
B: 4.6 The formal tax assessment and resulting under/ over provision of current tax
This section, dealing with possible under/over-provisions, deals with whether the current
income tax expense had been correctly estimated by the entity. Once the entity finalises the
estimate of its current income tax expense for the year, it journalises it and the estimate is then
also submitted to the tax authorities (i.e. the entity submits its ‘tax return’). The tax authorities
then assess this ‘tax return’ and send their ‘tax assessment’ to the entity. This official ‘tax
assessment’ arrives after the financial statements have been finalised.
Chapter 5 257
The assessment will show the tax charge for the whole
year, per the tax authority’s calculations, minus the Tax assessment
provisional payments made by the company leaving The assessment should provide
either a balance owing or receivable. confirmation that
x the tax authority agrees with
Generally, the current income tax that is estimated by the x the current tax expense calculated by
the entity.
company should equal the actual final income tax charge
per the assessment. In some cases, however, the tax authority may, for example, not allow the
deduction of certain of the expenses claimed. In an instance like this, it will mean that the
income tax charge per the assessment will be greater than the estimated current income tax
expense that was recognised in the company’s financial statements.
Since the assessment will be received by the company after the financial statements have been
finalised, any adjustment relating to the tax expense of the previous year will have to be
processed in the financial year in which the assessment is received. The adjustment will either
be an under-provision adjustment (increasing the current income tax expense) or an over-
provision adjustment (decreasing the current income tax expense). This adjustment is calculated
as follows:
Income tax charge per the assessment relating to 20X1 (received in 20X2) xxx
Less the current income tax estimated in 20X1, journalised in 20X1 (xxx)
Under/(over) provision of the 20X1 current income tax, journalised in 20X2 xxx
The journal adjusting for an under-provision of a prior year’s current income tax expense is as
follows:
Debit Credit
Income tax (E) xxx
The under-provision of tax in yr 1 is adjusted in yr 2
The journal adjusting for an over-provision of a prior year’s current income tax expense is as
follows:
Debit Credit
Income tax (E) xxx
The over-provision of tax in yr1 is adjusted in yr 2
B: 4.7 The formal tax assessment and resulting under/ overpayment of current tax
This section, dealing with any under/over-payment deals with the actual cash outflow made to
the tax authority. Compare this to the previous section that deals with the expenses incurred
and whether these were under/over-provided.
When receiving the tax assessment, it will also become apparent whether or not our provisional
payments were sufficient. We may find that our provisional payments:
x were too much, (i.e. we overpaid) in which case the assessment will indicate that a refund
will be paid to us, or
x Were too little (i.e. we underpaid), in which case the assessment will indicate that we need
to make a further top-up payment.
Example 23A: First provisional payment of income tax in 20X1

Carl Limited has a 31 December year-end. For the purposes of making the first provisional
payment, which falls due on 30 June 20X1, the accountant estimated the taxable profits for the
whole of the 20X1 year to be C100 000, being 25% higher than 20X0 taxable profits of
C80 000 (C80 000 x 1,25).
Required: Calculate the first provisional payment due and post the entries in t-account format assuming
it was paid on due date. The income tax rate is 30%
258 Chapter 5
Solution 23A: First provisional payment of income tax in 20X1

Comment:
x The payment is debited to the current tax payable account. The tax expense is not affected.
x Assuming there was no opening balance owing to the tax authority, the current tax payable account will
temporarily have a debit balance until the current tax charge for the current year is journalised (dr tax
expense and cr current tax payable) (this occurs when finalising the financial statements).
The first provisional tax payment (paid on 30 June 20X1): (C100 000 x 30%) / 2 = C15 000
Bank (A) Current tax payable/ receivable (L/A)
CT P/R (1) 15 000 Bank (1) 15 000
(1) Payment of the first provisional tax payment
Example 23B: Second provisional payment of tax in 20X1

Example continued from example 23A: On 31 December 20X1 (6 months later) the
financial director estimated that the taxable profits for the entire 20X1 year will amount to
C112 000 (i.e. not C100 000).
Required: Calculate the second provisional payment due and post the entries in the ledger accounts
assuming it was paid on due date.
Solution 23B: Second provisional payment of tax in 20X1

The second provisional tax payment: (C112 000 x 30%) – C15 000 = C18 600
CT P/R (1) 15 000 Bank (1) 15 000
CT P/R (2) 18 600 Bank (2) 18 600
(2) Payment of the second provisional tax payment
Example 23C: Current income tax expense estimate for 20X1

Example continued from example 23B: The accountant made his final estimate of the
taxable profit for the year (when finalising the financial statements ended 31 December
20X1 on 18 March 20X2) to be C130 000. No top-up payment was considered necessary.
Required: Calculate the income tax and show the related ledger accounts for the 20X1 year.
Solution 23C: Current income tax expense estimate for 20X1

Comment:
x The current tax estimate is part of the tax expense line in the statement of comprehensive income.
x The current tax expense estimated by the accountant: C130 000 x 30% = C39 000
20X1 year 20X1 year 20X1 year
CT P/R (1) 15 000 Bank (1) 15 000 Inc tax exp (3)39 000
CT P/R (2) 18 600 Bank (2) 18 600
Balance c/d 5 400
39 000 39 000
(4)
Balance b/d 5 400
Income tax expense (E)
20X1 year
CTP: IT (3) 39 000
(3) The final estimate of current tax made by the accountant.
(4) The entity has the option of making a third provisional payment (top-up), but we were told that
the company chose not to make a top-up payment.
Chapter 5 259
Example 23D: Under/ over provisions of 20X1 income tax

Example continued from example 23C:
The official tax assessment was received on 31 May 20X2 showing:
x 20X1 taxable profits assessed at C150 000, and
x 20X1 tax assessed at C45 000 (C150 000 x 30%).
Required: Calculate the under/ over provision of tax in 20X1 and post all related entries in the ledger.
Solution 23D: Under/ over provisions of 20X1 income tax

Calculation: Under/ (over)-provision of 20X1 current income tax expense:
Assessed tax for 20X1: 45 000 – Current income tax expense in 20X1: 39 000 = C6 000 under-provision.
Explanation: The tax assessment states that the tax for the 20X1 is C45 000, but the accountant only
recognised a current income tax expense of C39 000 in 20X1. Thus, the 20X1 current income tax
expense was under-estimated – or, as we say, under-provided.

20X1 year: 20X1 year 20X1 year:
CT P/R (1) 15 000 Bank (1) 15 000 Inc tax exp (3) 39 000
CT P/R (2) 18 600 Bank (2) 18 600
Balance c/d 5 400
39 000 39 000
20X2 year:
O/ balance b/d 5 400
Inc tax exp - 6 000
(U/prov tax)(4)

20X1 year: 20X1 year:
CT P/R (3) 39 000 P/L 39 000
20X2 year:
CT P/R (4) 6 000
(4) The 20X2 tax expense is adjusted for the under-provision of the tax expense in 20X1.
Example 23E: Income tax transactions in 20X2

Example continued from example 23D:
x The first provisional tax payment of C30 000 is paid in 20X2.
x The entity failed to pay a second provisional payment.
x The current tax expense for 20X2 was estimated at C50 000.
Required: Post all related entries in the ledger.
Solution 23E: Income tax transactions in 20X2

20X1 year: 20X1 year: 20X1 year:
CT P/R (1) 15 000 Bank (1) 15 000 Inc tax exp (3) 39 000
CT P/R (2) 18 600 Bank (2) 18 600
Balance c/d 5 400
39 000 39 000
20X2 year: 20X2 year: 20X2 year:
CT P/R (5) 30 000 Bank (5) 30 000 Balance b/d 5 400
Inc tax exp- 6 000
U/prov tax (4)
Balance c/d 31 400 Inc tax exp (6) 50 000
61 400 61 400
Balance b/d 31 400
260 Chapter 5
Solution 23E: Continued …

20X1 year 20X1 year
CT P/R (3) 39 000 P/ L 39 000
20X2 year 20X2 year
CT P/R (4) 6 000
CT P/R (6) 50 000 P/L 56 000
Notes:
(5) Payment of the first (and only) provisional payment made in 20X2
(6) Recognising the accountant’s final estimate of current tax relating to the 20X2 taxable profits.
Example 24: Under / over-payments and under/ over-provisions of tax

A company made two provisional payments: C40 000 as the first provisional payment on
30 June 20X1, and C20 000 as the second provisional payment on 31 December 20X1.
x The accountant estimated the income tax for 20X1 to be C70 000.
x No tax was owing to or receivable from the tax authority at the beginning of 20X1.
x The 20X1 tax assessment arrived in May 20X2, showing taxable profit of C240 000.
x Income tax is levied at 30%.
Required:
A. Calculate the under or over provision of the 20X1 tax expense.
B. Show the journal entry relating to the under/over provision processed in the ledger accounts.
C. Calculate the under/over payment relating to 20X1.
D. Show the under/over payment in the ledger.
E. Process the journals in the ledger accounts assuming any refund is received or top-up is paid.
Solution 24A: Calculation: under/ over-provision in 20X1

C
Income tax expense in 20X1 (estimate) Given 70 000
Assessed tax for 20X1 (final) Taxable profits per assessment: 240 000 x 30% (72 000)
Over/ (under) provision of 20X1 tax expense (2 000)
Solution 24B: Ledger accounts: under-provision
Income tax expense (E) Current tax payable/ receivable (L/A)

20X2 CT P/R 2 000 O/balance 10 000
20X2 TE 2 000
Comment:
x The 20X2 o/balance in the CTP account of C10 000 is the net effect of the payments in 20X1 of
C60 000 (cr: 40 000 + 20 000) and the income tax expense in 20X1 of C50 000 (i.e. cr: 60 000 –
dr: 50 000 = net credit of C10 000 at end 20X1).
x Notice that the under-provision of the 20X1 tax expense is processed in the 20X2 ledger accounts.
Solution 24C: Calculation: under/ over-payment in 20X1

C
Provisional payments made in respect of 20X1 40 000 + 20 000 60 000
Assessed tax for 20X1 (final) 240 000 x 30% (72 000)
(Under-payment)/over-payment in respect of 20X1 tax assessment (12 000)
Conclusion:
This situation requires a further payment since we have effectively underpaid (P.S. Since the
assessment has already been received, this would not be referred to as a third provisional payment
(top-up payment) but simply a ‘further payment’ – provisional payments are the payments made before
the tax assessment is received).
Chapter 5 261
Solution 24D: Ledger accounts: under-payment
Comment:
The revised balance in the tax payable account of C12 000 reflects the under-payment of tax. No
journal is processed for an under-payment. All we do is journalise the payment when it is made.
Income tax expense (E) Current tax payable/ receivable (L)

20X2 CT P/R(1) 2 000 Balance 10 000
20X2 Tax(1) 2 000
Balance 12 000
Solution 24E: Ledger accounts: if top-up payment made
Bank (A) Current tax payable/ receivable (L)

20X2 CT P/R 12 000 Bank 12 000 Balance 10 000
20X2 Tax 2 000
12 000 12 000
B.5 Disclosure of Income Tax – A Brief Introduction
B: 5.1 Overview
IAS 1 and IAS 12 require certain tax disclosures in the statement of comprehensive income,
statement of financial position and related notes. On occasion, tax may also be disclosed in the
statement of changes in equity. The disclosure of tax in the statement of changes in equity is
covered in the chapters dealing with items that are charged directly to equity.
B: 5.2 Statement of financial position disclosure
IAS 1 requires that the amount of current taxes owing or receivable be shown on the face of the
statement of financial position as current assets or current liabilities.
The amount owing to (or from) the tax authority may relate to a variety of taxes, for instance:
x VAT;
Disclosure
x Employees’ tax;
x Dividends tax; and Remember that amounts
x Income tax. owing for various types of
taxes discussed in the beginning of the
chapter must be disclosed separately.
Each of these balances (asset or liability) must be
disclosed separately, unless your entity:
x is legally allowed to settle these taxes on a net basis and
x either intends to settle the asset or liability on a net basis or intends to settle the liability and
realise the asset at the same time.
Example 25: Disclosure of current tax assets and liabilities (set-off)

The tax authority owes a company an amount of C50 000 VAT.
This same company owes the tax authority an amount of C180 000 in income tax.
Required: Show the disclosure of the current tax asset and liabilities in the statement of financial
position assuming that:
A. the tax authority allows the VAT and income tax to be settled on a net basis and the company
intends to settle on a net basis.
B. the tax authority does not allow the VAT and income tax to be settled on a net basis;
262 Chapter 5
Solution 25: Disclosure of current tax assets and liabilities (set-off)

Comment:
A: Set-off is allowed since there is a legal right of set-off and an intention to settle net.
B: Set-off is not allowed since there is no legal right of set-off.
Company name
As at …
Part A Part B
Current assets Calculations: C C
Current tax receivable: VAT A: N/A (set-off against the liability) 0 50 000
B: Given
Current liabilities
Current tax payable: income tax A: 180 000 liability – 50 000 asset 130 000 180 000
B: Given
B: 5.3 Statement of comprehensive income disclosure
IAS 1 (chapter 3) requires that the taxes levied on the entity’s profits should be disclosed as a
tax expense line item on the face of the statement of comprehensive income. This line item
should be presented in the profit or loss section of the statement of comprehensive income and
should be referenced to a supporting note. The supporting note should also provide details of
all the major components of the tax expense (current and deferred).
The note should also provide a reconciliation explaining why the effective rate of tax differs
from the applicable or standard rate of tax (i.e. this chapter mainly used 30% as the income tax
rate being applied). This reconciliation can be presented in terms of absolute amounts or as
percentages.
Effective tax rate:
The effective tax rate is simply calculated as the tax
expense as a percentage of accounting profit (e.g. profit x taxation expense in the SOCI
before tax). x expressed as a percentage of
accounting profit (e.g. the profit
before tax in the SOCI). See IAS 12.86
The effective tax rate will differ from the applicable tax
rate due to permanent differences, over/under provisions or rate changes. Please note that
temporary differences will not cause the applicable tax rate and effective tax rate to differ. This
is because temporary differences will be accounted for by processing a deferred tax adjustment,
and where this deferred tax will be included in the tax expense. Deferred tax is explained in the
next chapter. A rate change that affects the rate reconciliation refers to when the tax rate
changes in a way that affects the measurement of deferred tax. Temporary differences and
related deferred tax, as well as the concept of rate changes in the rate reconciliation, will all be
explained in chapter 6 on deferred tax.
The following is an example of the basic layout for this note:
Company name
Notes to the financial statements (extracts)
For the year ended …
20X2 20X1
12. Income tax expense C C
x Income tax: current tax xxx xxx
current tax for the current year xxx xxx
current tax under/ over provided in a prior year xxx xxx
x Income tax: deferred tax (covered in the next chapter) xxx xxx
Total tax expense per the statement of comprehensive income xxx xxx
Note continued on the next page
Chapter 5 263
Company name
Notes to the financial statements (extracts) continued …
20X2 20X1
12. Income tax expense continued … C C
Rate reconciliation:
Applicable tax rate (ATR) Standard/ applicable rate: 30% x% x%
Tax effects of:
Profit before tax Profit before tax x ATR xxx xxx
Less exempt income Exempt income x ATR (xxx) (xxx)
Add non-deductible expenses Non-deductible expenses x ATR xxx xxx
Under/ (over) provision of current tax Per above xxx xxx
Tax per SOCI (P/L section) xxx xxx
Effective tax rate (ETR) Taxation expense/ profit before tax x% x%
The applicable tax rate differs from that of the prior year because a change to the corporate
income tax rate was substantively enacted on … (date).
Example 26: Disclosure involving exempt income & non-deductible expenses

This example follows on from example 10, which dealt with an entity called Retailer.
A summary of the example is as follows:
x Profit before tax was C100 000: it included
- dividend income of C30 000,
- donations incurred of C10 000,
- a capital profit of C20 000 of which C16 000 was a taxable capital gain.
x Income tax was C20 400.
Required: Disclose this information in Retailer Limited’s statement of comprehensive income and
tax expense note for the year ended 31 December 20X2. Ignore deferred tax.
Solution 26: Disclosure involving exempt income and non-deductible expenses

Comment:
x This example shows the disclosure of current tax when there are permanent differences.
x Only these permanent differences appear as reconciling items in the rate reconciliation in the
income tax expense note.
x Temporary differences do not appear as reconciling items in the tax rate reconciliation.
Retailer Limited
20X2
4. Income tax expense C
Income tax: current tax for the current year 22 800
22 800
Tax rate reconciliation:
Applicable tax rate 30%
Tax effects of:
Profits before tax 100 000 x 30% 30 000
Dividend income (exempt income) 30 000 x 30% (9 000)
Donations (non-deductible expenses) 10 000 x 30% 3 000
Capital profit (exempt income) (20 000 – 16 000) x 30% (1 200)
Total income tax per the statement of comprehensive income 22 800
Effective tax rate (Actual tax: 22 800/ PBT: 100 000) 22,8%
264 Chapter 5
Retailer Limited
Note 20X2
C
Income tax expense 4 (22 800)
Example 27: Disclosure involving an under-provision

This example follows on from example 23 (A-E), which dealt with an entity called Carl.
The information from example 23 is summarised here for your convenience:
x Current tax payable at 31 December 20X2 was C31 400 (20X1: C5 400);
x Income tax estimated for 20X2 was C50 000 and for 20X1 was C39 000;
x It was discovered in 20X2 that the 20X1 income tax estimate of C39 000 was under-
estimated by C6 000.
Assume the following additional information:
x Profit before tax is C166 667 in 20X2 (C130 000 in 20X1);
x The related income was all taxable and the related expenses were all deductible;
x There were no items of other comprehensive income;
x There were no temporary differences.
Required: Disclose the above information in the company’s statement of financial position; statement
of comprehensive income and the tax expense note for the year ended 31 December 20X2.
Solution 27: Disclosure involving an under-provision

Comment: This shows how to disclose current tax if current tax was under-estimated in the prior year.
A Limited
For the year ended 31 Dec 20X2
20X2 20X1
Income tax expense 56 000 39 000
- Current tax: for the current year 50 000 39 000
- Current tax: under-provision of a prior year 6 000 0
Total income tax per statement of comprehensive income 56 000 39 000
Reconciliation
Applicable tax rate 30% 30%
Tax effects of:
Profits before tax 20X2: 166 667 x 30%; 50 000 39 000
20X1: 130 000 x 30%
Under-provision of current tax in a prior year Per above 6 000 0
Total income tax per the statement of comprehensive income 56 000 39 000
Effective tax rate 20X2: Actual tax: 56 000 / PBT: 166 667 33,6% 30%
20X1: Actual tax: 39 000 / PBT: 130 000
A Limited
Note 20X2 20X1
C C
Profit before tax Given 166 667 130 000
Income tax expense 4 (56 000) (39 000)
Profit for the year 110 667 91 000
Other comprehensive income 0 0
Chapter 5 265
Solution 27: Continued…

A Limited
Note 20X2 20X1
Current Liabilities C C
- Current tax payable: income tax 31 400 5 400
Example 28: Disclosure involving other comprehensive income

The following information relates to Suri Limited for its year ended 31 December 20X2:
x Profit before tax C200 000
x Income tax expense C60 000
x Other comprehensive income (OCI) includes the following: Before tax After tax
- Increase in OCI due to a revaluation surplus on machinery C60 000 C42 000
- Increase in OCI due to a gain on a cash flow hedge C50 000 C35 000
x The profit before tax includes no items of exempt income, no non-deductible expenses and no
temporary differences.
x The tax on OCI is deferred tax.
x The income tax rate is 30%. There are no other taxes levied on profits.
Required: Disclose the above in the statement of comprehensive income and related notes showing:
A. Items of OCI after tax (i.e. net) in the statement of comprehensive income.
B. Items of OCI before tax (i.e. gross) in the statement of comprehensive income.
Solution 28A: Disclosure of other comprehensive income after tax

Suri Limited
Notes 20X1
C
Profit for the period 140 000
Other comprehensive income (net of tax) 6 77 000
Revaluation surplus increase, net of tax 42 000
Gain on a cash flow hedge, net of tax 35 000
Suri Limited
20X1
Income taxation expense: current tax for the current year 60 000
60 000
Reconciliation:
Applicable tax rate Given 30%
Effective tax rate (Tax expense: 60 000 / profit before tax: 200 000) 30%
Gross Tax Net
6. Tax effects of other comprehensive income C C C
Revaluation surplus increase 60 000 (18 000) 42 000
Gain on a cash flow hedge 50 000 (15 000) 35 000
110 000 (33 000) 77 000
266 Chapter 5
Solution 28B: Disclosure of other comprehensive income before tax
Suri Limited
20X1
Notes C
Other comprehensive income (before tax) 77 000
x Items that may never be reclassified to profit or loss:
Revaluation surplus increase 60 000
Deferred tax on the revaluation surplus increase (18 000)
Gain on a cash flow hedge 50 000
Deferred tax on the gain on the cash flow hedge (15 000)
Suri Limited
20X1
Income taxation
- Current tax for the current year 60 000
60 000
Reconciliation:
Applicable tax rate Given 30%
Effective tax rate (Tax expense: 60 000 / profit before tax: 200 000) 30%
Notice the following:

x The total amount of other comprehensive income is the same for both parts.
x The note showing the tax effect of other comprehensive income is only given if the tax effect of
each item of other comprehensive income is not presented on the face of the statement of
comprehensive income. In this case, the tax effect of each item has been shown on the face of the
statement of comprehensive income and thus this note was not required.
x There was no difference between the applicable tax rate and the effective tax rate in either part
since there were no items of exempt income, non-deductible expenses and no other factors (e.g.
over-under provision of prior year current tax) that could have caused these rates to differ.
x Tax effects of OCI do not affect income tax expense (which is a profit or loss item).
Chapter 5 267
Summary
The main types of tax

affecting a business entity
VAT Income tax

15% on vatable supplies 28%* of taxable profits (i.e. the portion of the
profit before tax that is taxable)
VAT vendors: * the examples in this book typically use a
x Charge VAT 30% tax rate simply to make the answers
easier for you to calculate in your head
x Claim VAT
Incurred:
Non-vendors:
x Current (charged)
x Don’t charge VAT
x Deferred (next chapter)
x Can’t claim VAT
Current
VAT vendors must keep a record of VAT
x Estimate of CY assessment
x VAT on purchases (Input VAT)
x Adjustments to PY estimates
x VAT on sales (Output VAT)
Current tax is calculated as

x See summary calculations overleaf
Differences between accounting

profits and taxable profits
Temporary differences: Permanent differences:

These cause deferred tax These cause reconciling items in the rate
reconciliation
x Depreciation (IFRS: Expense) (Tax Act: deductible x Capital profit (IFRS: Income) (Tax Act: part or
allowance – often a different amounts) all of this may be a capital gain, 80% of which is
x Income received in advance (IFRS: Liability) taxable – the rest is exempt, being the
(Tax Act: income) permanent difference)
x Expenses prepaid (IFRS: Asset) (Tax Act: x Dividend income (IFRS: Income) (Tax Act:
expense) generally all exempt – i.e. not taxable)
x Non-capital profit on sale of asset (IFRS: x Fines (IFRS: Expense) (Tax Act: not deductible)
Income) (Tax Act: Recoupment – often a x Donations (IFRS: Expense) (Tax Act: generally
different amounts) not deductible)
x Loss on sale of asset (IFRS: Expense) (Tax Act:
a deductible scrapping allowance - often a
different amounts)
Dividends tax (replaces STC)

x A tax on the shareholder
x Levied at 20% on the dividend received by the shareholder
x The 20% is deducted from the dividend before it is paid to the shareholder
x The company withholds the 20% tax and pays it over to the tax authorities
x The tax is not part of the entity’s tax expense line item (because it is the
shareholder’s expense)
x Exemptions arise only in a limited number of circumstances
268 Chapter 5
Summary calculations
Calculation of current income tax (converting accounting profit into taxable profit)
Profit before tax xxx
Adjust for permanent differences
(less exempt income and add non-deductible expenses):
Less exempt dividend income (xxx)
Less exempt capital profit
- Less capital profit SP - CP (xxx)
- Add taxable capital gain (SP – BC) x 80% xxx
Add non-deductible fines xxx
Add non-deductible donations xxx
Profit before tax that the accountant knows will be taxable at some stage xxx
Adjust for temporary differences:
Add depreciation xxx
Less wear and tear (xxx)
Less non-capital profit on sale; or SP (limited to CP) - CA (xxx) or
Add loss on sale xxx
Add recoupment on sale; or SP (limited to CP) - TB xxx or
Less scrapping allowance on sale (xxx)
Add income received in advance (c/balance) xxx
Less income received in advance (o/balance) (xxx)
Less expense prepaid (c/balance) (xxx)
Add expense prepaid (o/balance) xxx
Add provision (c/b) xxx
Less provision (o/b) (xxx)
Taxable profits/ (loss) xxx
Income tax (28% of taxable profits) xxx
Useful comparative calculations relating to the sale of non-current assets

Accountant Tax Authority
PoSA = Proceeds – CA = (CP + NCP) TPoSA = TCG + Recoup
CP = Proceeds – Cost; CG = Proceeds – Base cost
Part of the CP may be exempt from tax: TCG = CG X inclusion rate (80% for companies and
Exempt CP = CP - TCG 40% for individuals in SA);
NCP/ (NCL) = Proceeds (limited to cost) – CA Recoup/ (SA) = Proceeds (limited to cost) – TB
CA = Cost - AD TB = Cost –AW&T
Key
POSA: Profit on sale of asset TPoSA = Taxable profit on sale of asset
CP: Capital Profit CG: Capital gain
NCP: Non-Capital Profit on sale BC: Base cost
NCL: Non-Capital Loss on sale TCG: Taxable capital gain
CA: Carrying Amount TB: Tax Base
AD: Accumulated Depreciation Recoup: Recoupment
SA: Scrapping allowance
AW&T: Accumulated wear & tear
Chapter 5 269
Gripping GAAP Taxation: deferred taxation
Chapter 6
Taxation: Deferred Taxation
Reference: IAS 12, FRG 1 and IAS 1(including any amendments to 10 December 2018)
Contents Page
1. Introduction to the concept of deferred tax 272
1.1 The inter-relationship of current tax, deferred tax and tax expense 272
Example 1: Current and deferred tax interaction 273
1.2 Creating a deferred tax asset 274
Example 2A: Creating a deferred tax asset 274
Example 2B: Reversing a deferred tax asset 275
1.3 Creating a deferred tax liability 276
Example 3A: Creating a deferred tax liability 276
Example 3B: Reversing a deferred tax liability 277
1.4 Deferred tax balance versus the current tax payable balance 278
1.5 Recognition of deferred tax adjustments 278
2. Measurement of deferred tax: the two methods 279
2.1 Overview 279
2.2 The income statement approach 279
Example 4A: Income received in advance (income statement approach) 280
2.3 The balance sheet approach 282
Example 4B: Income received in advance (balance sheet approach) 283
Example 4C: Income received in advance (journals) 284
Example 4D: Income received in advance (disclosure) 285
3. Deferred tax caused by year-end accruals and provisions 286
3.1 Overview 286
3.2 Expenses prepaid 286
Example 5: Expenses prepaid 287
3.3 Expenses payable 290
Example 6: Expenses payable 290
3.4 Provisions 292
Example 7: Provisions 292
3.5 Income receivable 295
Example 8: Income receivable 295
4. Deferred tax caused by non-current assets 297
4.1 Overview 297
4.2 Deductible assets 298
Example 9: Cost model – PPE – Deductible and depreciable 299
4.3 Non-deductible assets and the related exemption 302
4.3.1 Overview 302
4.3.2 The exemption from recognising deferred tax liabilities 303
Example 10: Cost model – PPE – Non-deductible and depreciable 304
Example 11: Cost model – PPE – Non-deductible and non-depreciable 307
4.4 Non-current assets measured at fair value 309
4.4.1 Overview 309
4.4.2 Non-current assets measured at fair value and presumed intentions 310
4.4.2.1 Non-depreciable assets measured using IAS 16’s revaluation model 310
4.4.2.2 Investment property measured using IAS 40’s fair value model 310
Example 12: Non-current asset at fair value and presumed intentions 311
4.4.3 Measuring deferred tax based on management intentions 312
4.4.3.1 Intention to sell the asset (actual or presumed intention) 312
4.4.3.2 Intention to keep the asset 312
4.4.4 Measuring deferred tax if the fair valued asset is also non-deductible 313
Example 13: Revaluation above cost: PPE: Non-deductible; depreciable: keep 314
Example 14: Revaluation above cost: PPE: Non-deductible; depreciable: sell 316
Example 15: Revaluation above cost: PPE: Non-deductible; non-depreciable: keep 318
270 Chapter 6

4.5 Sale of a non-current asset 319
Example 16: Non-current asset sold at a profit with a recoupment 320
Example 17: Non-current asset sold at a loss with a scrapping allowance 321
Example 18: Sale of a deductible, depreciable asset (plant): below cost 322
Example 19: Sale of a deductible, depreciable asset (plant): above cost 324
Example 20: Sale of a non-deductible, non-depreciable asset: below cost 326
Example 21: Sale of a non-deductible, non-depreciable asset: above cost 327
Example 22: Sale of a non-deductible, depreciable asset: below cost 329
Example 23: Sale of a non-deductible, depreciable asset: above cost 331
5. Exemption from deferred tax 333
6. Measurement: enacted tax rates versus substantively enacted tax rates 334
Example 24: Enacted and substantively enacted tax rates 335
7. Rate changes and deferred tax 336
Example 25: Rate changes: journals 337
Example 26: Rate changes: journals and disclosure 337
8. Deferred tax assets 339
8.1 What causes a deferred tax asset? 339
8.2 Deferred tax assets: recognition 340
Example 27: Recognising deferred tax assets: tax loss to expire: discussion 341
Example 28: Recognising deferred tax assets: deductible temporary differences 342
8.3 Deferred tax assets: measurement 343
8.4 Deferred tax assets: disclosure 343
Example 29: Tax losses: deferred tax asset recognised in full 344
Example 30: Tax losses: deferred tax asset recognised in full then written-down 346
Example 31: Tax losses: deferred tax asset recognised partially 347
9. Disclosure of income tax 350
9.1 Overview 350
9.2 Accounting policy note 350
9.3.1 Face of the statement of financial position 350
9.3.1.1 Non-current asset or liability 350
9.3.1.2 Show deferred tax per category of tax 350
9.3.1.3 Setting-off of deferred tax assets and liabilities 351
Example 32: Set-off of deferred tax assets and liabilities 351
9.3.2 Deferred tax note (asset or liability) 352
9.3.2.1 The basic structure of the deferred tax note 352
9.3.2.2 A deferred tax reconciliation may be required 352
9.3.2.3 Extra detail needed on unrecognised deferred tax assets 353
9.3.2.4 Extra detail needed on recognised deferred tax assets 353
9.3.2.5 Extra detail needed on unrecognised deferred tax liabilities 353
9.4.1 Face of the statement of comprehensive income 353
9.4.2 Tax on profit or loss – the income tax expense note 354
9.4.2.1 Basic structure of the income tax expense note 354
9.4.2.2 Effect of deferred tax assets on the income tax expense note 355
9.4.2.3 Tax relating to changes in accounting policies and correction of errors 356
9.4.2.4 Extra detail required with regard to discontinuing operations 356
9.4.3 Tax on other comprehensive income 356
10. Summary 358
Chapter 6 271
1. Introduction to the Concept of Deferred Tax
1.1 The inter-relationship of current tax, deferred tax and tax expense
As mentioned in the previous chapter, the total income tax expense for disclosure purposes is
broken down into two main components:
x current tax; and Accounting profit and
taxable profit
x deferred tax.
x Accounting profit is profit or loss for
The total tax expense, presented on the face of the statement the period before deducting tax
of comprehensive income, is the tax incurred on the expense. IAS12.5
accounting profits. These accounting profits are calculated x Taxable profit is the profit or loss for
based on the international financial reporting standards the period, determined in accordance
with the rules established by the
(IFRSs). The IFRSs involve the concept of accrual and thus
taxation authorities, upon which income
the tax expense is based on the concept of accrual). taxes are payable (or recoverable).
IAS12.5
This current tax is the income tax on the current period’s

taxable profits. These taxable profits are calculated based on
Tax expense is defined as:
tax legislation (discussed in the previous chapter). The tax
legislation is not based on the accrual concept, and thus, for x the aggregate amount
example, income could well be included in taxable profits x included in the determination of P/L
before the income is earned (i.e. before it is included in for the period in respect of
x current tax and deferred tax. IAS12.5
accounting profits)!
Thus, the total income tax expense (tax incurred on Tax expense equals:
accounting profits) and the current tax (tax charged on
taxable profits) are generally different amounts because: x Current tax expense (or income); plus
x Deferred tax expense (or income).
x accounting profits are calculated in accordance with
the international financial reporting standards (IFRSs), and
x taxable profits are calculated in accordance with tax legislation.
The current tax (the amount based on tax legislation) is Current tax is defined as:
debited to the tax expense account (debit tax expense; credit
current tax payable). This tax expense account is then x amount of income taxes
adjusted upwards or downwards so that the account reflects x payable/(recoverable) in respect of
x taxable profit/ (tax loss)
the total income tax expense (i.e. the amount based on
x for the period. IAS12.5
IFRSs). This adjustment is called a deferred tax adjustment
and is thus simply an accrual of tax.
Deferred tax is not defined
This deferred tax adjustment, results in the creation of a but the logic of it is that it
deferred tax asset or liability (i.e. if the deferred tax arises:
x when income/expenses (in other
adjustment requires a debit to the tax expense account, the
words: A/Ls) are treated differently
credit entry will be to a deferred tax liability account). Thus, x under IFRSs (accounting profit); and
before we process a deferred tax adjustment, we must ensure x under tax legislation (taxable profit)
that the deferred tax liability or deferred tax asset may be x where these differences will reverse
recognised (does it meet the recognition criteria). (i.e. they are temporary).
Deferred tax liabilities are generally recognised (unless IAS 12 exempts it from being recognised), but
deferred tax assets are often unable to be recognised (either because IAS 12 exempts it or the deferred
tax asset does not meet the recognition criteria). Although the logic (described above) of why we
process a deferred tax adjustment holds true (commonly referred to as the income statement approach),
IAS 12 describes the measurement of the deferred tax asset liability or asset using what is commonly
referred to as the balance sheet approach and we use these measurements of the deferred tax asset or
liability balances to balance back to the deferred tax adjustment. However, the basic logic
underpinning the deferred tax adjustment that was described above remains unchanged.
There are a number of complexities that surround the concept of deferred tax, particularly
recognition and measurement in certain circumstances. Let’s work through the following very
basic example (based on example 16 from chapter 5) to illustrate the basic logic of deferred tax.
272 Chapter 6
Example 1: Current and deferred tax interaction:

Depreciation on vehicles to nil residual value (straight-line method) 2 years
Wear and tear (allowed by tax authorities) (straight line method) 3 years
Income tax rate 30%
Profit before tax (after deducting any depreciation on the vehicle) C100 000 pa
in each of the years ended 31 December 20X1, 20X2 and 20X3
There are no temporary differences, no exempt income and no non-deductible expenses other than
those evident from the information provided.
Required:
A. Calculate the current income tax (tax on taxable profits per the tax legislation) for 20X1 to 20X3.
B. Calculate the total tax expense incurred (tax on accounting profits per IFRS) for 20X1 to 20X3.
C. Calculate the difference between the current income tax (A) and the tax expense incurred (B) and
thus whether an adjustment to the amount currently recognised in the tax expense account (A)
would be required since we need to disclose the total tax incurred as calculated per IFRS (B).
Solution 1: Current and deferred tax interaction:

Comments:
x In each of the years 20X1 and 20X2, the current tax charge per the tax legislation is more than the tax expense
that is ‘incurred’ (per IFRS). Since our tax expense account is first debited with the current tax charge, we will
then need to credit this account (so as to reduce it) in order to reflect the tax incurred. This adjustment (of
C7 500, in each of the first two years) is a deferred tax adjustment.
x In the year 20X3, the current tax charge per the tax legislation is less than the tax expense that is ‘incurred’ (per
IFRS). Since our tax expense account is first debited with the current tax charge, we will then need to debit this
account further (so as to increase it) in order to reflect the tax incurred. This adjustment (of C15 000) is a
deferred tax adjustment.
A: Current income tax Total 20X3 20X2 20X1

C C C C
Permanent differences 0 0 0 0
Movement in temporary differences
Add back depreciation (150 000 / 2 years) 150 000 0 75 000 75 000
Less wear and tear (150 000 / 3 years) (150 000) (50 000) (50 000) (50 000)
Taxable profit 300 000 50 000 125 000 125 000
Current tax (tax on taxable profit) at 30% 90 000 15 000 37 500 37 500
Dr: Tax expense; Cr: Current tax payable
B: Tax expense incurred Total 20X3 20X2 20X1

C C C C
Tax incurred (tax on accounting profit) at 30% 90 000 30 000 30 000 30 000
C: Comparison of current tax & Tax expense Total 20X3 20X2 20X1
C C C C
Current tax (on taxable profits, per tax legislation) 90 000 15 000 37 500 37 500
Tax incurred (on accounting profits, per IFRS) 90 000 30 000 30 000 30 000
Adjustment needed: (credit)/ debit tax expense - 15 000 (7 500) (7 500)
Any difference between the current tax and the tax incurred (see solution 1C) means that, since
we need to present the tax incurred rather than the current tax charge, we will need to process an
adjustment that will account for the difference. This adjustment is a deferred tax adjustment.
The following sections will now show how processing a deferred tax adjustment will result either
in the creation of:
x a deferred tax asset (section 1.2), or
x a deferred tax liability (section 1.3).
Chapter 6 273
1.2 Creating a deferred tax asset (a debit balance) Deferred tax asset is
defined as: IAS12.5
A debit balance on the deferred tax account reflects the x the amounts of taxes recoverable
accountant’s belief that tax has been charged but which x in future periods in respect of:
has not yet been incurred. This premature tax charge must - deductible temporary differences
be deferred (postponed). In some ways, this treatment is - unused tax losses carried forward;
- unused tax credits carried forward.
similar to that of a prepaid expense.
Example 2A: Creating a deferred tax asset (debit balance)

The estimated current tax charged by the tax authority in 20X1 is C30 000.
The accountant calculates that the tax incurred for 20X1 to be C24 000.
The C6 000 excess will be deferred to future years.
There are no components of other comprehensive income.
Required: Show the ledger accounts and disclose the tax expense and deferred tax for 20X1.
Solution 2A: Creating a deferred tax asset (debit balance)

Comment:
The tax expense in the statement of comprehensive income must always show the tax that we believe was incurred for the
year. Thus, the tax expense account must show C24 000: we first record the current tax charge (C30 000) and then defer a
portion thereof (C6 000) to be recognised as a tax expense in future(deferred tax asset).
Ledger accounts: 20X2

Income tax expense (E) Current tax payable: income tax (L)
(1)
CTP 30 000 DT (2) 6 000 Inc Tax Exp (1) 30 000
_____ P/L (3) 24 000
30 000 30 000
Deferred tax: income tax (A) Profit or loss (closing account)

Inc Tax Exp (2) 6 000 Inc Tax exp (3) 24 000
Notes:
(1) We record the current tax charge (the estimated amount that will be charged/ assessed by the tax authority).
(2) We record a deferred tax adjustment: we defer a portion of the current tax expense to future years so that the balance
in the tax expense account is the amount we believe has been incurred (i.e. C24 000).
Notice the deferred tax account now has a debit balance of C6 000, meaning we have created a deferred tax asset:
this reflects tax charged in 20X1 that will only be incurred in the future (similar to a prepaid expense).
(3) Please note that it is only the income tax expense account that is closed off to profit or loss (because the current tax
payable is a liability and the deferred tax account is an asset).
Disclosure for 20X1: (the deferred tax asset note will be ignored at this stage)
Entity name
As at … 20X1 C
ASSETS
Non-current assets
- Deferred tax: income tax 6 000
Entity name
Statement of comprehensive income 20X1
For the year ended …20X1 Note C
Income tax expense (current tax: 30 000 – deferred tax: 6 000) 3. (24 000)
Profit for the period xxx
Total comprehensive income xxx
274 Chapter 6
Entity name
For the year ended …20X1 C
3. Income tax expense
Income taxation expense 24 000
- Current 30 000
- Deferred (6 000)
Example 2B: Reversing a deferred tax asset
Use the same information as that given in Example 2A and the following extra information:
x The tax charged in terms of tax legislation is C42 000 in 20X2 (it was C30 000 in 20X1).
x The tax incurred in terms of IFRSs is C48 000 in 20X2 (it was C24 000 in 20X1) P.S. notice
that this means the C6 000 ‘excess’ tax charged in 20X1 (see solution 2A) is now incurred.
Required: Show the ledger accounts and disclose the tax expense and deferred tax in 20X2.
Solution 2B: Reversing a deferred tax asset
Comment:
Notice that, over the period of 2 years, the total current tax charged by the tax authorities (20X1: 30 000 + 20X2: 42 000 =
C72 000) equals the tax expense recognised in the accounting records:
x tax expense in 20X1: C24 000 (see solution to Example 2A); plus
x tax expense in 20X2: C48 000.
CTP (1) 42 000 Balance b/d xxx
DT (2) 6 000 Profit or loss(3) 48 000 Bal c/d xxx Inc Tax Exp (1) 42 000
48 000 48 000 xxx xxx
Balance b/d xxx
Deferred tax: income tax (A) Profit or loss (closing account)
Balance b/d 6 000 Inc Tax Exp (2) 6 000 Inc Tax exp(3) 48 000
6 000 6 000
Balance b/d 0
Notes:
(1) Recording the current tax charge (estimated amount that will be charged by the tax authorities).
(2) Recording a deferred tax adjustment: we reverse the deferred tax asset that had been recognised in 20X1. This
adjustment reflects the current tax charge that was deferred in 20X1, but which is now incurred in 20X2.
The 20X2 tax expense = current tax charge (42 000) + deferred tax adjustment (6 000) = tax incurred (48 000):
(3) Please note that it is only the income tax expense account that is closed off to profit or loss (because the current tax
payable is a liability and the deferred tax account is an asset).
(4) Please note: the reason the opening balance in the current tax payable is reflected by ‘xxx’ (i.e. instead of at C30 000,
which was the closing balance in this account in solution 2A), is because we have not been given all the information
(e.g. we do not know how much was paid to the tax authorities or if any over or under provision was required).
Disclosure for 20X2:
Entity name
As at … 20X2 Note C C
ASSETS
Non-current assets
- Deferred tax: income tax 0 6 000
Entity name
Statement of comprehensive income 20X2 20X1
For the year ended …20X2 Note C C
Profit before tax xxx xxx
Income tax expense (20X2: current tax: 42 000 + deferred tax: 6 000) 3. (48 000) (24 000)
Profit after tax xxx xxx
Total comprehensive income xxx xxx
Chapter 6 275
Entity name
Notes to the financial statements 20X2 20X1
For the year ended ……20X2 C C
Income taxation expense 48 000 24 000
- Current 42 000 30 000
- Deferred 6 000 (6 000)
1.3 Creating a deferred tax liability (credit balance) A deferred tax liability
is defined as:
A credit balance in the deferred tax account reflects the
x the income taxes payable
accountant’s belief that tax has been incurred, but that it has
x in future periods, in respect of
not yet been charged by the tax authority. It thus shows the
x taxable temporary differences
amount that will be charged by the tax authority in the future. IAS12.5 Reworded very slightly
This is similar to how we account for an expense payable.
Example 3A: Creating a deferred tax liability (credit balance)
The following information relates to the income tax calculations in 20X1:
x it is expected that the tax authorities will charge tax of C15 000,
x the tax incurred (i.e. based on IFRSs): C22 000.
Solution 3A: Creating a deferred tax liability (credit balance)
Comment:
x The tax in the statement of comprehensive income must reflect the amount incurred for the year rather than the amount
charged, thus the tax expense in 20X1 must show C22 000 (not the C15 000 tax charge).
x We first record the tax charge of C15 000 in the tax expense account, and then must increase our tax expense by
C7 000 (thus creating a deferred tax liability). Please note: we don’t yet officially owe this to the tax authorities yet, so
we can’t credit ‘current tax payable’ and thus we credit ‘deferred tax liability’ instead.
x The deferred tax account ends up with a credit balance of C7 000, thus it is a deferred tax liability.
Income tax expense (E) Current tax payable: income tax
CTP (1) 15 000 Inc Tax Exp (1)15 000
DT(2) 7 000 P/L (3) 22 000
22 000 22 000
Deferred tax: income tax (L) Profit or loss (closing account)

Inc Tax Exp (2) 7 000 Inc Tax exp (3) 22 000
Notes:
(1) Recording the current tax charge of C15 000 (the estimated amount that will be charged by the tax authorities).
(2) Recognising a deferred tax adjustment: we are recording the extra tax of C7 000 that has been incurred but which
will only be charged/assessed by the tax authorities in future years, creating a deferred tax liability (Incurred: C22 000
– Charged: C15 000). This is not tax currently owing to the tax authorities but is the tax that we will owe in the future,
thus it is not a current tax liability but a deferred tax liability.
(3) The income tax expense account is closed off to profit or loss (all income and expense accounts are ‘closed-off’ at
year-end). (Please note current tax payable is a liability and the deferred tax account is an asset).

Entity name
Statement of comprehensive income Note 20X1
Income tax expense Current tax: 15 000 + Deferred tax: 7 000 3. (22 000)
Profit for the year xxx
276 Chapter 6
Entity name
As at …20X1 C
LIABILITIES
- Deferred tax: income tax 7 000
Entity name
Income taxation expense 22 000
- Current 15 000
- Deferred 7 000
Example 3B: Reversing a deferred tax liability
Use the same information given in Example 3A plus the following extra information:
20X1
x the estimated current tax charge by the tax authorities (i.e. based on tax legislation) was C15 000,
x the tax incurred estimated by the accountant (i.e. based on IFRSs): C22 000.
20X2:
x the estimated current tax charge by the tax authorities (i.e. based on tax legislation): C19 000,
x the tax incurred estimated by the accountant (i.e. based on IFRSs): C12 000.
Solution 3B: Reversing a deferred tax liability

Comment:
x The deferred tax liability (a non-current liability) of C7 000, recognised in 20X1, must be reversed in 20X2
since it now forms part of the current tax payable liability instead (a current liability).
x Notice that over the period of 2 years, the total current tax charged by the tax authorities (15 000 + 19 000
= C34 000) is also recognised as a total tax expense in the accounting records:
- tax expense in 20X1: C22 000, plus
- tax expense in 20X2: C12 000.
Income tax (E) Current tax payable: income tax
CTP (1) 19 000 DT (2) 7 000 Bal b/d (4) xxx
P/L (3) 12 000 Bal c/d xxx Inc Tax Exp (1) 19 000
19 000 19 000 xxx xxx
Bal b/d xxx
Deferred tax: income tax (L) Profit or loss (closing account)

Balance b/d 7 000 Inc Tax exp (3) 12 000
Inc Tax Exp (2) 7 000
Bal c/d 0
7 000 7 000
Balance b/d 0
Notes:
(1) Recording the current tax charge (amount that we estimate will be charged by the tax authority) for 20X2.
(2) Recording the deferred tax adjustment for 20X2: we are reversing the 20X1 deferred tax liability of C7 000.
(3) Please note: it is only the income tax expense account that is closed off to profit or loss (income and expenses are
closed-off at year-end but the current tax payable is a liability and the deferred tax account is an asset).
(4) Please note: the reason the opening balance in the current tax payable is reflected by ‘xxx’ (i.e. not C15 000 shown in
this account per solution 3A), is because we have not been given all the relevant information (e.g. we do not know
how much was paid to the tax authorities or if any over or under provision was required).
Chapter 6 277

Entity name
For the year ended …..20X2
Note 20X2 20X1
C C
Income tax expense (current tax and deferred tax) 3. (12 000) (22 000)
Profit for the year xxx xxx
Entity name
As at ……..20X2
20X2 20X1
LIABILITIES C C
- Deferred Tax 0 7 000
Entity name
For the year ended …20X2
20X2 20X1
- current 19 000 15 000
- deferred (7 000) 7 000
1.4 Deferred tax balance versus the current tax payable balance (IAS 1.56)
The deferred tax balance differs from current tax payable balance in the following ways:
x the current tax payable / receivable account: reflects the amount currently owing to or by the tax
authorities, estimated based on tax legislation. This payable shows tax that has been charged by
the tax authorities and is thus presented as a current liability or asset; whereas
x the deferred tax asset / liability account: reflects the additional amount that will be owing in the
future to or by the tax authorities, estimated based on tax legislation. Since this tax is not currently
owed to or by the tax authorities, this account is presented as a non-current liability or asset.
A deferred tax adjustment will therefore not affect the current tax payable account.
1.5 Recognition of deferred tax adjustments (IAS 12.57 – 68C)
Just as with current tax, a deferred tax adjustment will be Recognition of deferred tax
recognised in profit or loss if the underlying transaction or adjustments:
event (e.g. depreciation) was recognised in profit or loss. In x If the TD arose due to something in P/L
other words, the deferred tax adjustment necessary due to the then the DT adj is recognised in P/L.
depreciation amount differing from the related tax deduction x If the TD arose due to something in OCI,
then the DT adj is recognised in OCI.
(e.g. wear and tear), must also be recognised in profit or loss.
x If the TD arose due to something in
Thus, this deferred tax adjustment is included in the tax equity, then the DT adj is recognised in
expense recognised in profit or loss. equity
However, if an underlying transaction or event is recognised in other comprehensive income, any

deferred tax adjustment arising from it is also recognised in other comprehensive income. For example:
a revaluation surplus arising when revaluing property, plant and equipment (explained in chapter 8
section 4) is recognised in other comprehensive income and thus the related deferred tax adjustment is
not recognised as part of the tax expense in profit or loss but in other comprehensive income instead.
Similarly, if an underlying transaction or event is recognised directly in equity, the deferred tax
thereon will be recognised directly in equity. An example of this is the adjustment to the
opening retained earnings due to the correction of an error.
278 Chapter 6
Please remember, the deferred tax adjustment is only processed if the deferred tax asset or liability
may be recognised. In this regard, we may be exempted from recognising certain deferred tax
adjustments, commonly called ‘deferred tax exemptions’, (see section 5). Furthermore, although
deferred tax liabilities are generally always recognised (unless it involves a ‘deferred tax exemption’),
the recognition of deferred tax assets may not always be possible (either because IAS 12 exempts it or
the deferred tax asset does not meet the recognition criteria) (see section 8).
2. Measurement of Deferred Tax: The Two Methods
2.1 Overview
Deferred tax is measured using the relevant tax rates. The tax rate to be used is explained in section 3.
Although deferred tax is always considered to be a non-current liability (or asset), IAS 12 expressly
prohibits the discounting (present valuing) of these deferred tax balances.
There are two methods of measuring deferred tax: The income statement and
x the income statement approach; and balance sheet approaches:
x the balance sheet approach. x Income statement approach:
DT adj = (Accounting profits – Taxable
The previous version of IAS 12 referred to the income profits) x tax rate
statement method. This method required that deferred tax x Balance sheet approach:
be measured based on the difference between: DTA/L bal = (CA – TB) x tax rate
x accounting profits, and x The DT adjustment and balances will
x taxable profits. be the same for both approaches.
The latest version of IAS 12 refers only to the balance sheet method. This method requires
deferred tax to be measured based on the difference between:
x the carrying amount (CA) of the assets and liabilities, and
x the tax base (TB) of each of the assets and liabilities.
Although the method used will not alter the final answer in any way, you are generally required to
present your workings and discussions using the balance sheet method. The income statement method
is still explained here since it is considered helpful in understanding that the concept of deferred tax is
simply a product of the accrual basis. Furthermore, to know how to calculate the deferred tax using
the ‘income statement approach’ enables you to check your ‘balance sheet approach’ calculations.
2.2 The income statement approach
Remember the essence that you learned from Chapter 5: the accountant calculates the estimated
current tax for the year, by converting his accounting profits (calculated in terms of IFRSs) into
taxable profits (calculated in terms of tax legislation). This is done as follows:
Conversion of accounting profits into taxable profits: C
Profit before tax (accounting profits) A
Adjusted for differences that are permanent in nature: xxx
- less exempt income (e.g. certain capital profits and dividend income) (xxx)
- add non-deductible expenses (e.g. certain donations and fines) xxx
Accounting profits that are taxable (B x 30% = tax expense incurred) B
Adjusted for movements in temporary differences: xxx
- add depreciation xxx
- less depreciation for tax purposes (e.g. wear and tear) (xxx)
- add income received in advance (closing balance): if taxed when received xxx
- less income received in advance (opening balance): if taxed when received (xxx)
- less expenses prepaid (closing balance): if deductible when paid (xxx)
- add expenses prepaid (opening balance): if deductible when paid xxx
- add provisions (closing balance): if deductible when paid xxx
- less provisions (opening balance): if deductible when paid (xxx)
Taxable profits (C x 30% = current tax charge) C
Chapter 6 279
As can be seen from the calculation on the prior page, the difference between accounting profits
and taxable profits may be classified into two main types:
x temporary differences; and
x permanent differences.
Accounting Profits (A) = Profit before tax

Exempt income/ non-
+/-
deductible expenses
Taxable Accounting profits Portion of the accounting Tax
(B) = profits that are fully taxable X 30% = Expense
although not necessarily now
Movement in temporary Deferred tax

+/- X 30% =
differences expense/ income
Taxable Profits (C) = Profits that are taxable now, Current tax
X 30% =
based on tax laws expense
The difference between accounting profits (A) and the taxable accounting profits (B) include those
differences that will never reverse (e.g. income that is included in the accounting profit but that will
never be taxed and expenses that are included in accounting profit but that will never be deducted).
These are called permanent differences (also known as non-temporary differences).
The difference between taxable accounting profits (B above) and taxable profits (C above) is
caused by the movement in temporary differences. This movement relates to timing issues, e.g.
when income is taxed versus when it is recognised in the accounting records.
A deferred tax adjustment is made for the movement relating to temporary differences only.
Example 4A: Income received in advance (income statement approach)
An entity receives rent of C10 000 in 20X1 that relates to rent that will be earned in 20X2 and
then receives rent of C110 000 in 20X2 (all of which was earned in 20X2). The entity has no
other income. The tax authority taxes income on the earlier of receipt or earning. The income
tax rate is 30%. There are no other transactions affecting any of the related accounts.
Required: Calculate, for 20X1 and 20X2, the current tax expense, the deferred tax adjustment and the
tax expense to appear in the statement of comprehensive income and show the related ledger accounts.
Solution 4A: Income received in advance (income statement approach)

Comment:
x Rent of C10 000 is received in 20X1, before it is earned. The accountant thus delays recognising it as income.
However, the tax authorities treat it as taxable income in 20X1. Thus, accounting profits and taxable profits differ,
which means we have a timing difference and thus we recognise deferred tax.
x Since the tax authorities include the receipt in taxable profit in 20X1, the current tax charge in 20X1 includes C3 000.
x In order to match the C3 000 tax charged in 20X1 to the period in which we recognise the income of C10 000 (20X2),
we defer recognising the tax charge as an expense until 20X2. Thus, we first record the current tax charge of
C3 000 (debit tax expense; credit current tax payable) and then we defer recognising it as a tax expense until
20X2 (debit deferred tax asset; credit tax expense). In other words, we are creating a deferred tax asset.
W1. Current income tax calculation 20X1 20X2
Profits Tax at Profits Tax at
30% 30%
Profit before tax (accounting profits) (1) (7)
0 120 000
Adjusted for exempt income and non-deductible expenses: 0 0
Taxable accounting profits and tax expense (3) (9) 0 0 120 000 36 000
(3) (9)
Adjusted for movement in temporary differences: 10 000 3 000 (10 000) (3 000)
Add income received in advance (c/balance): taxed now (2) 10 000 0
Less income received in advance (o/bal): previously taxed(8) (0) (10 000)
Taxable profits and current income tax (2) (8)
10 000 3 000 110 000 33 000
280 Chapter 6

Bank (A) Rent received in advance (L)
(1)
RRIA 10 000 Bank (1) 10 000
CTP (2) 3 000 DT (3) 3 000 Inc Tax Exp (2) 3 000
P/L (5) 0
3 000 3 000
Deferred tax: income tax (A)
Inc Tax Exp (3 & 4) 3 000

Bank Rent received in advance (L)
Rent inc. (6) 110 000 Balance b/f 10 000
Rent (7) 10 000
10 000 10 000
Balance b/d 0
(8)
CTP:NT 33 000 Balance b/f 3 000
DT (9) 3 000 P/L (9) 36 000 Balance c/d 36 000 Inc Tax Exp (8) 33 000
36 000 36 000 36 000 36 000
Balance b/d 36 000
Deferred tax: income tax (A) Rent income (I)
Balance b/f 3 000 Bank (6) 110 000
Inc Tax Exp (9) 3 000 RRIA (7) 10 000
Balance c/d 0 P/L 120 000
3 000 3 000 120 000 120 000
Balance b/d 0
Notes:
(1) 20X1: The rent received in 20X1 is not yet earned and is thus not recognised as income but as a liability.
(2) 20X1: Current tax charge: the tax authority taxes income on the earlier date of receipt or earning: the rent is received
in 20X1 and earned in 20X2 (in 20X1, we call this rent received in advance) and is therefore taxed in 20X1 (the
earlier date).
(3) 20X1: Deferred tax adjustment: We did not recognise the rent income (because it is not yet earned) and thus do not
recognise the related current tax of C3 000 (because it is not yet incurred). Thus we defer the C3 000 to a future
period: credit tax expense & debit deferred tax asset. Tax expense in 20X1 is zero.
(4) 20X1: The deferred tax account has a debit balance at the end of 20X1 and is thus an asset. This deferred tax asset is
similar to an expense prepaid asset because we are charged tax in 20X1 (current tax in 20X1) that we believe is only
incurred in 20X2 (tax expense in 20X2).
(5) 20X1: The tax that appears on the face of the statement of comprehensive income is zero since it reflects the tax
owing on income earned. Since no income has been earned, no tax is reflected.
(6) 20X2: We receive rent of C110 000 in 20X2. All of this is earned in 20X2, so no adjustment is made.
(7) 20X2: The income received in advance in 20X1 of C10 000 is reversed and recognised as income in 20X2 since it is
earned in 20X2.
Thus, income earned in 20X2 is 120 000 (110 000 received in 20X2 + 10 000 received in 20X1)
(8) 20X2: Current tax charge: the tax authority only charges current tax in 20X2 of C33 000, (i.e. tax on rent received in
20X2 of C110 000): the previous rent income of C10 000 was received and taxed in 20X1.
(9) 20X2: Deferred tax adjustment: We recognise rent income of C120 000 in 20X2 (see notes 6 & 7) and thus the tax
expense should be C36 000 (at 30%).
Since the current tax charge for 20X2 is only C33 000, we must increase the tax by C3 000. To do this, we reverse
the deferred tax asset that was created in 20X1 (the tax that was charged/ prepaid in 20X1 is now incurred in 20X2).
Chapter 6 281
2.3 The balance sheet approach

The income statement approach involved first calculating Temporary differences are
the deferred tax adjustment. We then use this to adjust the defined as:
deferred tax opening balance to obtain the closing balance. x differences between
x an asset’s or a liability’s:
The balance sheet approach, on the other hand, is the - carrying amount in the SOFP; and
method whereby we first calculate the deferred tax - tax base. IAS 12.5 reworded
balances; and then balance back to the deferred tax
adjustment (i.e. we calculate the adjustment by comparing the opening deferred tax balance with the
closing deferred tax balance).
Taxable temporary
The idea behind the balance sheet approach is that the differences are defined as:
deferred tax balance (asset or liability) represents the x those that will result in
expected future tax payable or receivable on the expected x taxable amounts
future transactions that have already been recognised in the x in determining taxable profit (tax loss)
financial statements. The expected future transactions that x of future periods
x when the CA of the asset or liability is
have already been recognised are reflected in the assets and recovered or settled. IAS 12.5
liabilities in our statement of financial position:
x assets represent the expected future inflow of economic benefits, or future income, and
x liabilities represent the expected future outflow of economic benefits, or future expenses.
Let us consider a couple of examples: Deductible temporary
differences are defined as:
x the carrying amount of plant (an asset) reflects the
x those that will result in
future inflow of economic benefits (future income x amounts that are deductible
from future transactions involving the plant); and x in determining taxable profit (tax loss)
x of future periods
x the carrying amount of a loan liability reflects the x when the CA of the asset or liability is
future outflow of economic benefits (future recovered or settled. IAS 12.5
expenses involving the loan).
It surely makes sense that if we have already recognised the future income, by recognising an asset,
and the future expenses, by recognising a liability, that we should also recognise the expected future
tax (deferred tax) arising from this future profit or loss (future income less future expenses).
If the future income exceeds the future expenses, we have an expected future profit and thus
there would be a future tax payable (deferred tax liability). Conversely, if the future expenses
exceeded the future income, we have an expected future loss and thus there would be a future
tax saving (deferred tax asset).
Tax base is defined as:
When using the balance sheet approach to calculate
deferred tax, we compare the carrying amount of each x the amount attributed to that A or L
x for tax purposes. IAS 12.7
of the assets and liabilities with its tax base:
x The carrying amount of an asset or liability is the The tax base of an asset is
balance recognised in terms of IFRSs; defined as:
x The tax base of an asset or liability is effectively its x the amount that will be deductible for
tax purposes
balance calculated based on tax legislation. In other x against any taxable economic benefits
words, the tax base is really just the tax authority’s that will flow to an entity
equivalent of a carrying amount. However, the tax base x when it recovers the CA of the asset.
of an asset and the tax base of a liability are both defined If those economic benefits
in IAS 12, and so we must know how to apply these x will not be taxable,
definitions when calculating a tax base. x the TB of the A is its CA. IAS 12.7 Reworded
The definition of the tax base of an asset (see pop-up) refers to two types of assets: an asset that
represents an future inflow of economic benefits that will be taxable and an asset that represents
a future inflow of economic benefits that will not be taxable. Simply speaking:
x If the inflow will be taxable (e.g. a plant earning taxable profits), the tax base is the future deductions.
x If the inflow will not be taxable (e.g. an investment earning exempt dividend income), the
tax base will be its carrying amount.
282 Chapter 6
The definition of a tax base of a liability (see pop-up) The tax base of a liability is
refers to two types of liabilities: liabilities that represent defined as:
income received in advance and other liabilities (i.e. x its carrying amount,
those that represent expenses). Simply speaking: x less any amount that will be deductible
x if the liability is income received in advance, for tax purposes
- in respect of that liability
the tax base will be its carrying amount less the portion
- in future periods.
that won’t be taxable in the future (i.e. the portion of the
carrying amount that will be taxed in the future); If the L is income received in advance,
the tax base of this liability is:
x in the case of any other liability,
x its carrying amount,
the tax base will be its carrying amount less any
x less any of the revenue that will not be
portion that represents future deductions (i.e. the taxable in future periods. IAS 12.8 Reworded
portion of the carrying amount that will not be
allowed as a tax deduction in the future).
Thus, in summary:
x The difference between the carrying amount and tax base is called a temporary difference.
x Temporary differences multiplied by the tax rate give us the deferred tax balance (SOFP).
x The difference between the opening and closing deferred tax balance in the statement of
financial position will give you: the deferred tax journal adjustment (SOCI).
Carrying amount: Tax base:

Temporary difference x 30%
Deferred tax balance: beginning of year
Opening balance Opening balance
Movement:
DT journal
adjustment
Carrying amount: Tax base:

Temporary difference x 30%
Deferred tax balance: end of year
Closing balance Closing balance
A useful format for calculating deferred tax using the balance sheet approach is as follows:
Carrying Tax base Temporary Deferred Deferred

amount (per IAS difference tax tax
(SOFP) 12) (b) – (a) (c) x 30% balance/
(a) (b) (c) (d) adjustment
Opening balances X A/ L
Movement: deferred tax
Dr Tax: SOCI
adjustment
X Cr DT: SOFP
Dr/ Cr: DT asset/ liability; and
Or vice versa
Cr/Dr: Tax income/ expense
Closing balances X A/ L
Example 4B: Income received in advance (balance sheet approach)

A company receives rent income of C10 000 in 20X1 that relates to rent earned in 20X2 and
then receives C110 000 in rent income in 20X2 (all of which was earned in 20X2).
The company has no other income.
The tax authority taxes income on the earlier of receipt or earning (i.e. same info as 4A).
Required:
Calculate the deferred income tax adjustment using the balance sheet approach for both years.
Chapter 6 283
Solution 4B: Income received in advance (balance sheet approach)

Comment: Calculating deferred tax using the balance sheet approach (see W1) involves comparing the
accountant’s carrying amount of an asset or liability with the equivalent balance from the perspective of a tax
authority, which we call the tax base. The carrying amounts are the same as those in the statement of financial
position. We now need to calculate the tax bases. To calculate the tax bases (W2), we use the rules per IAS 12.
W1. Deferred income tax (balance sheet approach):
Income received in advance Carrying Tax base Temporary Deferred Def tax
amount difference tax at 30% balance/
(SOFP) (IAS 12) (b) – (a) (c) x 30% adj
(a) (b) (c) (d)
Opening balance – 20X1 0 0 0 0
(3)
Deferred tax adj. – 20X1 (10 000) 0 10 000 3 000 Dr DT
(balancing: movement) Cr TE
Closing balance – 20X1 (1) (10 000) 0 10 000 3 000 Asset (2)
(5)
Deferred tax adj. – 20X2 10 000 0 (10 000) (3 000) Cr DT
(balancing: movement) Dr TE
Closing balance – 20X2 (4) (6)
0 0 0 0
Notes:
1) During 20X1, the C10 000 rent is received in advance (a liability).
The accountant recognises the receipt as a liability, BUT whereas the tax authority treats it as income. Thus, the
accountant reflects an income received in advance account (L) with a carrying amount of C10 000. Since the tax
authority treats it as income, it will have no such liability, and thus the tax base is zero.
This results in a temporary difference of C10 000 and therefore a deferred tax balance of C3 000.
2) The tax base of a liability that represents income received in advance is that portion of the liability that will
be taxed in the future.
As the tax authority taxes the income now (upon receipt, which in this example, is earlier than earning), there
will be no future tax payable. Hence, the tax base is nil.
The difference between the carrying amount and the tax base represents the portion of the liability that won’t be taxed
in the future with the result that the deferred tax balance is an asset to the company: the tax that has been ‘prepaid’.
3) The deferred tax adjustment in 20X1 will be a credit to the statement of comprehensive income.
4) During 20X2, the C10 000 rent that was received in advance in 20X1 is now recognised as income because it is earned
(the accountant debits the liability and credits income) and thus the accountant’s liability reverses out to zero.
As mentioned above, the tax authority had no such liability since he treated the receipt as income in 20X1.
The tax base is thus nil.
Thus, the carrying amount and the tax base are now both zero, with the result that the temporary difference
is now zero and the deferred tax is zero.
5) The deferred tax adjustment in 20X2 is a debit to the statement of comprehensive income.
6) The carrying amount of the liability is zero since the income was earned in 20X2 thus the balance on this
liability account was reversed out to income
W2. Tax base (income received in advance – a liability): 20X1 and 20X2
20X1 20X2
Carrying amount at year end 10 000 0
Less that which won’t be taxed in the future (10 000) (0)
(20X1: all 10 000 won’t be taxed in future because all of it is taxed in 20X1)
(20X2: not applicable since there is no carrying amount to consider)
This means that there will be no related current tax charge in the future. 0 0
W2.1 Tax base rule for a liability: income received in advance (per IAS 12):
The tax base of income received in advance is the carrying amount of the liability less the portion
representing income that will not be taxable in future periods.
Example 4C: Income received in advance (journals)

Current income tax is (see current income tax calculation in Example 4A for workings):
x 20X1: 3 000 and 20X2: 33 000.
Required: Show the tax journals using the above and the deferred tax calculation per example 4B.
284 Chapter 6
Solution 4C: Income received in advance (journals)

20X1 Debit Credit
Income tax expense (P/L: E) 3 000
Current tax payable per tax law (see calculation in part A)
Deferred tax: income tax (A) 3 000
Income tax expense (P/L: I) 3 000
Deferred tax adjustment (see calculation in part B)
20X2
Current tax payable per tax law (see calculation in part A)
Deferred tax: income tax (L) 3 000
Deferred tax adjustment (see calculation in Part B)
Example 4D: Income received in advance (disclosure)

Current income tax expense is (see current income tax calculation in Example 4A):
x 20X1: 3 000 (this was paid in 20X2) and 20X2: 33 000 (this was paid in 20X3)
Deferred tax balances are (see ledger account in example 4A or deferred tax table in example 4B)
x 20X1 opening balance: nil;
x 20X1 closing balance: 3 000 (debit) and
x 20X2 closing balance: nil.
Required: Disclose deferred tax in the SOFP, SOCI, deferred and current tax notes for both years.
Solution 4D: Income received in advance (disclosure)

Comment: Notice that deferred tax adjustments have no lasting impact on ‘profit or loss’ or ‘assets and liabilities’:
x Impact on tax expense (see Note 15): DT income (20X1): 3 000 – DT expense (20X2): 3 000 = 0
x Impact on assets (see SOFP): there was a deferred tax asset in 20X1 but this balance was nil in 20X2
Company name
Statement of financial position (extracts) Note 20X2 20X1
ASSETS
Non-current assets
Deferred tax: income tax 6 0 3 000
LIABILITIES
Current liabilities
Current tax payable: income tax 33 000 3 000
Income received in advance 0 10 000
Company name
Statement of comprehensive income (extracts) For the Note 20X2 20X1
year ended 31 December 20X2 C C
Profit before taxation 120 000 0
Income tax expense 15 (36 000) (0)
Profit for the year 84 000 0
Total comprehensive income 84 000 0
Company name
Notes to the financial statements (extracts) Note 20X2 20X1
For the year ended 31 December 20X2 C C
6. Deferred tax asset
The closing balance is constituted by the effects of:
x Year-end accruals 0 3 000
Chapter 6 285
Company name
Notes to the financial statements (extracts) continued … Note 20X2 20X1
Income taxation per the statement of comprehensive income 36 000 0
x Current 33 000 3 000
x Deferred 3 000 (3 000)
3. Deferred Tax Caused By Year-End Accruals And Provisions
3.1 Overview Year-end accrual balances:

There are five potential balances in the statement of x income received in advance;
financial position that result directly from the use of the x expenses prepaid;
x expenses payable;
accrual system, each of which can cause deferred tax. The
x income receivable; and
impact of income received in advance was explained in x provisions
example 4 above. The deferred tax effect of each of the
remaining four types of accruals will now be discussed. Since IAS 12 refers only to the use of the
balance sheet approach, the following solutions focus on this approach.
3.2 Expenses prepaid
Tax base of an asset –the
An expense prepaid is an asset and thus, when we measure its essence of the definition is:
tax base, we apply the definition of the ‘tax base of an asset’
(the essence of this definition is in the pop-up alongside). If the asset’s FEB are taxable the:
x TB = future tax deductions
However, you can think of the tax base as being the tax If the asset’s FEB are not taxable, the
authority’s equivalent of a carrying amount. x TB = CA See IAS 12.7
Generally, tax authorities allow the deduction from taxable profits of certain expenses when the
expense is incurred. However, they may, depending on the tax laws, allow the deduction of a payment
that is made before the expense is incurred (prepaid expense). In this case, the accountant recognises
the payment as an asset (expenses prepaid) but the tax authorities recognise it as a tax-deduction. From
a balance sheet approach, we now have an asset with a tax base of nil (we apply the definition of a ‘tax
base of an asset’: an ‘expense prepaid’ asset represents nil future tax deductions because it represents
a payment that has already been deducted for tax purposes). The difference between this asset’s
carrying amount and tax base initially causes a taxable temporary difference, which results in the
recognition of a deferred tax liability. However, when the expense is incurred, the accountant will
reverse the expense prepaid asset and recognise the expense. At this point, the asset’s carrying amount
and tax base are both nil and thus the temporary difference will disappear, and the related deferred tax
liability must be reversed via an adjusting deferred tax entry. This is best explained by way of example:
Worked example 1: Deferred tax on expenses prepaid
An amount is paid in 20X1 but only incurred as an expense in 20X2.
The tax authorities deduct the payment when calculating taxable profits in 20X1.
x The accountant recognises the payment as an asset in 20X1 ( ‘expenses prepaid’) but will reverse
this asset and recognise it as an expense in 20X2 (i.e. the carrying amount of the ‘expenses prepaid’
asset at 20X1 will reverse to nil at the end of 20X2).
x However, the tax authorities treat this payment as a tax deduction in 20X1. This means the tax
base of the expense prepaid asset will be nil at 20X1 (and 20X2).
We calculate the tax base using the relevant definition of the ‘tax base of an asset’ per IAS 12:
the ‘tax base of an asset’ equals the ‘future deductions’. Since the tax laws resulted in the payment
being a tax-deduction in 20X1, then at the end of 20X1 we would conclude that are no future
deductions expected from the ‘expenses prepaid’ asset, thus the tax base is nil.
Another way of looking at the tax base is that it is effectively the tax authority’s equivalent of
the carrying amount and, since there is no asset from the perspective of the tax authorities (it
was treated as a deduction), the tax base must be nil.
x Since the expense prepaid asset has a carrying amount at the end of 20X1 but the tax base is nil,
we have a temporary difference on which we must recognise deferred tax: the difference between
the carrying amount of the expense prepaid and its tax base is a taxable temporary difference,
which will thus lead to a deferred tax liability. This difference reverses when the accountant
reverses the asset and recognises the incurred expense instead.
286 Chapter 6
Example 5: Expenses prepaid

Profit before tax is C20 000 in 20X1 and in 20X2, according to the accountant and the tax
authority, before taking into account the following information:
x An amount of C8 000 in respect of electricity for January 20X2 is paid in December 20X1.
x The tax authority allows the full payment as a deduction against taxable profits in 20X1.
x The company paid the current tax owing to the tax authorities for 20X1, in 20X2.
x There are no differences between accounting profit and taxable profit other than those that
may be evident from the information provided and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax for 20X1 and 20X2 using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the related journal entries in ledger account format.
D. Disclose the tax adjustments for the 20X2 financial year.
Solution 5A: Expenses prepaid (deferred tax – balance sheet approach)

Comment:
x We calculate the deferred tax balance by comparing the carrying amount and tax base:
Carrying amounts: The accountant recognises a payment of C8 000 made in 20X1 as an ‘expense prepaid’
(thus this asset has a carrying amount of C8 000 at the end of 20X1). This ‘expense prepaid’ asset is reversed
in 20X2 when it is recognised as an expense (thus this asset’s carrying amount is nil at the end of 20X2).
Tax base: The tax base is calculated in terms of IAS 12 (see W2). But, we can also work it out logically by
likening it to the tax authority’s equivalent of a carrying amount: the payment is tax-deductible in 20X1 and
thus, in the tax authorities’ view, there is no asset at all, thus the tax base is nil at the end of 20X1 & 20X2.
x End of 20X1: Since the asset’s carrying amount and tax base are not equal at the end of 20X1, it causes a taxable
temporary difference on which a deferred tax liability is recognised.
The deferred tax is a liability because it represents a premature tax saving due to the tax-deduction (i.e. like
income received in advance, which we recognise as a liability instead of as income).
The tax saving is premature because the entity is granted the tax deduction and thus receives the tax saving
before it incurs the electricity expense.
End of 20X2: At the end of 20X2, the expense prepaid has been reversed and thus now has a carrying amount
of nil. Since the carrying amount and tax base are now both nil, there is no longer a temporary difference and
thus the deferred tax liability must be nil.
x When using the balance sheet approach, we first calculate the deferred tax closing balance, and then, by
comparing it to the deferred tax opening balance, we work backwards to the deferred tax adjustment (journal).

Expenses prepaid Carrying Tax Temporary Deferred Deferred tax
amount base difference tax at 30% balance/
(per SOFP) (IAS 12) (b) – (a) (c) x 30% adjustment
(a) (b) (c) (d)
Opening balance: 20X1 0 0 0 0
Movement (balancing) 8 000 0 (8 000) (2 400) Cr DT; Dr TE (Jnl 3)
Closing balance: 20X1 8 000 0 (8 000) (2 400) Liability
Movement (balancing) (8 000) 0 8 000 2 400 Dr DT; Cr TE (Jnl 6)
Closing balance: 20X2 0 0 0 0
W2. Tax base (expenses prepaid – an asset):

20X1 20X2
Applying the definition of a tax base of an asset that is related to an expense C C
Carrying amount 8 000 0
(1) (2)
Less amount that won’t be deducted for tax purposes in the future (8 000) 0
Amount that will be deducted from taxable profits in the future 0 0
Notes (explaining the amounts in W2):
1) 20X1: The C8 000 will not be deducted in the future since it is all deducted in 20X1 (the first year).
2) 20X2: There is no adjustment to the carrying amount in 20X2 since there is no carrying amount in 20X2: the
carrying amount is now zero since the expense was incurred in 20X2 and thus the asset balance was
transferred to the expense account (see journal 4 in the 20X2 ledger accounts below).
Chapter 6 287
Solution 5B: Expenses prepaid (current tax)

Comments:
x 20X1: The tax authority allows the prepayment of C8 000 as a deduction in 20X1 (20 000 – 8 000 = 12 000
taxable profit), but the accountant recognises the C8 000 as a prepaid expense, an asset, not an expense,
(20 000 – 0 = 20 000 profit before tax). Thus, in order to convert accounting profits (profit before tax) into
taxable profits, we must deduct the payment (we deduct the expense prepaid).
x 20X2: The accountant recognises (deducts) the C8 000 as an expense in 20X2 since this is when it is incurred (20 000
– 12 000 = 8 000 profit before tax) but the tax authority, having already allowed the C8 000 as a deduction in 20X1,
will not deduct it again in 20X2, (20 000 – 0 = 20 000 taxable profit). Thus, in order to convert accounting profits
(profit before tax) into taxable profits, we reverse the expense (we add the expense prepaid).
W3. Current income tax: 20X1 20X2

Profits Tax at 30% Profits Tax at 30%
Profit before tax (accounting profits) 20 000 12 000
Adjust: exempt income/ non-deductible expenses: 0 0
Taxable accounting profits and tax expense 20 000 12 000
Adjust: movement in temporary differences: (8 000) 8 000
Add expense prepaid (o/bal): deducted in 20X1 0 8 000
Less expense prepaid (c/bal): deductible in 20X1 (8 000) (0)
Taxable profits and current income tax 12 000 3 600 20 000 6 000
Note: we journalise the current tax charge of C3 600 in 20X1 and the current tax charge of C6 000 in 20X2.
Solution 5C: Expenses prepaid (ledger accounts)

Comment: Notice that over the 2 years:
the accountant recognises tax expense of C9 600 (6 000 + 3 600) as incurred; and this equals
the actual tax charged by the tax authority over the 2 years is C9 600 (3 600 + 6 000).
The difference relates purely to when the tax is incurred versus when the tax is charged, thus the difference reverses
out once the tax has both been charged and incurred (see the zero deferred tax balance at the end of 20X2).
Bank (A) Expenses prepaid (A)
Exp Prepaid(1) 8 000 Bank (1) 8 000
CTP (2) 3 600 Inc tax exp (2) 3 600
DT (3) 2 400 Profit or loss 6 000
6 000 6 000
Deferred tax: income tax (L)
Inc tax exp (3) 2 400
Electricity (E) Expenses prepaid (A)
Exp Prepaid (4) 8 000 Profit or loss 8 000 Balance b/f 8 000 Electricity (4) 8 000
Balance c/f 8 000
8 000 8 000
Balance b/d 0
CTP (5) 6 000 DT (6) 2 400 Bank (7) 3 600 Balance b/f 3 600
_____ Profit or loss 3 600 Balance c/f 6 600 Inc tax exp (5) 6 000
6 000 6 000 9 600 9 600
Balance b/d 6 600
Deferred tax: income tax (L) Bank (A)
Balance b/f 2 400 CTP (7) 3 600
Inc tax exp (6) 2 400
2 400 2 400
Balance b/d 0
288 Chapter 6
Notes (describing the journals that are posted in the ledger):

1) The electricity payment of C8 000 is recognised as an asset (expense prepaid) since the expense is not yet incurred.
2) Current tax charged by the tax authority in 20X1.
3) Deferred tax adjustment in 20X1: In order to recognise a deferred tax liability balance (see solution 5A/ W1), we must
process a ‘deferred tax adjustment’: credit deferred tax liability and debit tax expense.
Notice that, by debiting the tax expense, we increase it. If we look at this from an income statement approach, it is
necessary to increase the tax expense because we believe the current tax charge was too small in 20X1 (i.e. the tax
saving we were given by the tax authorities in 20X1 had not yet been earned from an IFRS point of view).
4) Reverse the expense prepaid: The expense is incurred in 20X2, so the expense prepaid (asset) is reversed
out to electricity expense (reducing profits). Thus, the expense prepaid asset now has a nil carrying amount.
6) Deferred tax adjustment in 20X2: In order to adjust a deferred tax liability balance to a nil balance at the end of 20X2
(see solution 5A/ W1), we process another ‘deferred tax adjustment’: debit deferred tax liability and credit tax expense.
Notice that, by crediting the tax expense, we decrease it. If we look at this from an income statement approach, it is
necessary to decrease the tax expense in 20X2 because we believe the current tax charge was too big in 20X2 (i.e. the
tax saving we were given by the tax authorities in 20X1 has, from an IFRS viewpoint, now been earned in 20X2).
7) Payment to the tax authorities of the balance owing to them for 20X1 (the prior year).
Solution 5D: Expenses prepaid (disclosure)

Comment: Notice that deferred tax has no lasting impact on ‘assets and liabilities’ or ‘profit or loss’:
x Impact on liabilities (see SOFP): there was a deferred tax liability in 20X1 but this reversed to nil in 20X2.
P.S. Tthe DT liability balance at end 20X1 is C2 400, being 30% of the expense prepaid balance at end 20X1 –when
the expense prepaid balance reverses in 20X2, so too does the deferred tax liability).
x Impact on tax expense (see Note 15 below): DT expense (20X1): 2 400 – DT income (20X2): 2 400 = 0
Company name
Statement of financial position Note 20X2 20X1
ASSETS
Current assets
Expense prepaid 0 8 000
LIABILITIES
Current liabilities
Company name
Statement of comprehensive income (extracts) Note 20X2 20X1
Profit before taxation 20X2: 20 000 – 8 000 12 000 20 000
Company name
Notes to the financial statements (extracts) 20X2 20X1
6. Deferred tax asset/ (liability)
x Year-end accruals 0 (2 400)
Income taxation 3 600 6 000
x current 6 000 3 600
x deferred (2 400) 2 400
Tax expense per the statement of comprehensive income 3 600 6 000
Chapter 6 289
3.3 Expenses payable Tax base of a liability –the

essence of the definition is:
An expense payable is a liability and thus, when we See IAS 12.8
measure its tax base, we apply the definition of the ‘tax If the L represents expenses:
base of a liability’ (the essence of this definition is in x TB = (CA – future deductions)
the pop-up alongside). This is an example of a liability If the L represents income received in
that represents expenses (as opposed to a liability that advance:
represents income). x TB = (CA – non-taxable portion)
The tax authority generally allows expenses to be deducted when they have been incurred
irrespective of whether or not the amount incurred has been paid. This is the same as the accrual
system applied by most IFRSs and thus there would generally be no deferred tax on an expense
payable balance (i.e. the tax authorities allow the tax-deduction in the same year that the
accountant recognises the expense).
Example 6: Expenses payable
x A telephone expense of C4 000, incurred in 20X1, is paid in 20X2.
x The tax authority will allow the full expense to be deducted in 20X1.
The current tax owing to the tax authorities is paid in the year after it is charged.
There are no other temporary differences, no exempt income and no non-deductible expenses and no
taxes other than income tax at 30%.
There are no components of other comprehensive income
Required:
A. Calculate the deferred income tax for 20X1 and 20X2 using the balance sheet approach.
C. Show the related journal entries in ledger account format.
D. Disclose the tax adjustments for the 20X2 financial year.
Solution 6A: Expenses payable (deferred tax)

Comments: We calculate the deferred tax balance by comparing the carrying amount and tax base.
x Since both the accountant and tax authorities ‘recognise’ the C4 000 cost as an expense/ deduction in 20X1 and since
this cost remained unpaid at the end of 20X1, there would be both a carrying amount and tax base for expenses payable
at the end of 20X1 of C4 000.
x After the cost is paid in 20X2, the expense payable carrying amount and tax base reverse to nil.
x Since there is no temporary difference at any stage, there is also no deferred tax.

Carrying Tax Temporary Deferred tax Deferred
amount base difference at 30% tax
Expenses payable
(per SOFP) (IAS 12) (b) – (a) (c) x 30% balance/
(a) (b) (c) (d) adjustment
Opening balance: 20X1 0 0 0 0 N/A
Movement (balancing) (4 000) (4 000) 0 0 N/A
Closing balance: 20X1 (4 000) (4 000) 0 0 N/A
Movement (balancing) 4 000 4 000 0 0 N/A
Closing balance: 20X2 0 0 0 0 N/A
W2. Tax base (expenses payable – a liability): 20X1 20X2

Apply the definition of a tax base of a liability representing an expense: C C
Carrying amount of the liability 4 000 0
(1) (2)
Less deductible in the future 0 0
4 000 0
Notes (explaining amounts in W2):
1) 20X1: None of the C4 000 will be deducted in the future since it is deducted in 20X1 (as an incurred expense)
2) 20X2: There is no adjustment to the carrying amount since there is no carrying amount: the carrying amount is zero
in 20X2 because the expense was paid in 20X2 with the result that the 20X1 liability was reversed.
290 Chapter 6
Solution 6B: Expenses payable (current tax)

Comments: Since both the accountant and tax authorities recognise the telephone cost of C4 000 as an expense/
deduction in 20X1, the accounting profit and taxable profit are the same in both years. In other words, no adjustments
are required in order to convert accounting profits (profit before tax) into taxable profits.
W3. Current income tax: 20X1 20X2

Profits Tax at 30% Profits Tax at 30%
Profit before tax (accounting profits) (1) (4)
16 000 20 000
(20 000 – 4 000) and (20 000 – 0)
Exempt income and non-deductible expenses: 0 0
Taxable accounting profits and tax expense 16 000 4 800 20 000 6 000
Movement in temporary differences 0 0 0 0
Note: we journalise the current tax charge of C4 800 in 20X1 and the current tax charge of C6 000 in 20X2.
Solution 6C: Expenses payable (ledger accounts)

Ledger accounts - 20X1
Telephone (E) Expenses payable (L)
EP(1) 4 000 Tel (1) 4 000
CTP (2&3) 4 800 Inc tax exp (2) 4 800
Ledger accounts – 20X2

Bank Expenses payable (L)
EP(4) 4 000 Bank(4) 4 000 Balance b/f 4 000
CTP (6) 4 800
Income tax (E) Current tax payable: income tax (L)

CTP (5&3) 6 000 Bank (6) 4 800 Balance b/f 4 800
Balance c/f 6 000 Inc tax exp (5) 6 000
10 800 10 800
Balance b/d 6 000
Notes (explaining amounts in the ledger accounts):

(1) The telephone expense is incurred but not paid in 20X1 and is thus recognised in 20X1 as an expense
(debit) and expense payable (credit).
(2) Current tax charged by the tax authority in 20X1.
(3) Deferred tax adjustment: not applicable. Since the accountant and tax authority both treat the expense payable
as an expense/ deduction in the calculation of profits, there is no temporary difference and therefore no deferred
tax adjustment (see solution 6A/ W1)
(4) Although the telephone expense is paid in 20X2, there is no telephone expense in 20X2. The payment
of the expense in 20X2 simply results in the reversal of the expense payable account.
(5) Current tax charged by the tax authority in 20X2.
(6) The balance owing to the tax authority at the end of 20X1 is paid in 20X2.
(7) The carrying amount and tax base is nil, thus there is no deferred tax balance (See 6A: W1).
Solution 6D: Expenses prepaid (disclosure)
Company name
As at 31 December 20X2 Note C C
LIABILITIES
Current liabilities
Expense payable 0 4 000
Chapter 6 291
Company name
Statement of comprehensive income (extracts) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation 20X1: 20 000 – 4 000 20 000 16 000
Company name
x current 6 000 4 800
x deferred 0 0
Total tax expense per the statement of comprehensive income 6 000 4 800
3.4 Provisions Tax base of a liability –the

See IAS 12.8
A provision is a liability and thus to measure its tax base,
we apply the definition of the ‘tax base of a liability’ (the If the L represents expenses:
x TB = (CA – future deductions)
essence of this definition is repeated alongside). A
If the L represents income in advance:
provision is a liability that relates to expenses.
x TB = (CA – non-taxable portion)
A provision is a liability of uncertain timing or amount (please see chapter 18). Thus, although tax
authorities generally treat expenses as being tax-deductible when they have been incurred, if the
expense relates to a provision (dr expense and cr provision, as opposed to dr expense and cr expense
payable), they are often more reluctant to allow the deduction of the expense due to the level of
uncertainty (i.e. they treat the expense with more ‘suspicion’). Thus, although the expense may have
been ‘incurred’ in terms of IFRSs, the tax authority may refuse to allow the deduction of an expense
that has been ‘provided for’ until it is paid (i.e. the deduction will only be allowed in the future).
If this happens, a temporary difference will arise because:
x the accountant recognises the expense (i.e. debit expense and credit liability), and thus there will
be a carrying amount for this liability, but
x since the expense relates to a provision (a liability that involves uncertainty), the tax authority
delays allowing the expense as a tax-deduction and thus there is a nil tax base for this liability.
In other words, from a balance sheet approach, there will be a carrying amount for the provision but
no tax base. Similarly, from an income statement approach, the accountant recognises an expense, but
the tax authority does not yet allow the expense as a tax-deduction.
The temporary difference that arises is a deductible temporary difference, resulting in the recognition
of a deferred tax asset. This deferred tax asset reflects the future tax saving that we expect when the
tax authorities eventually allow the tax-deduction of the expense. When the provision is reversed, the
related deferred tax asset will also be reversed (i.e. the provision will be derecognised when the amount
is paid, which is also when the expense will be deducted and the tax saving realised).
Example 7: Provisions
x A provision for warranty costs of C4 000 is journalised in 20X1 and paid in 20X2.
x The tax authority will allow the warranty costs to be deducted only once paid.
x The current tax owing to the tax authority is paid in the year after it is charged.
x There are no differences between accounting profit and taxable profit other than those
evident from the information provided and no taxes other than income tax at 30%.
292 Chapter 6
Required:
A. Calculate the deferred income tax using the balance sheet approach.
C. Show the related ledger accounts.
D. Disclose the above information.
Solution 7A: Provisions (deferred tax)

Comments: We calculate the deferred tax balance by comparing the carrying amount and tax base:
x Carrying amounts: The accountant recognises an expense and provision in 20X1 of C4 000. This ‘provision’
liability is reversed in 20X2 when it is paid (thus this liability’s carrying amount is nil at the end of 20X2).
x Tax base: The tax base is calculated in terms of IAS 12 (see W2). However, we can also work it out by likening
it to the tax authority’s equivalent of a carrying amount.: the expense is not tax-deductible in 20X1 and thus, in
the tax authorities’ view, there is no liability at all and so the tax base is nil at the end of 20X1 & 20X2.

Provision: warranty cost Carrying Tax Temporary Deferred Deferred tax
amount base difference tax at 30% balance/
(per SOFP) (IAS 12) (b) – (a) (c) x 30% adjustment
(a) (b) (c) (d)
Movement (balancing) (4 000) 0 4 000 1 200 Dr DT; Cr TE
Closing balance – 20X1 (4 000) 0 4 000 1 200 Asset
Movement (balancing) 4 000 0 (4 000) (1 200) Cr DT; Dr TE
Closing balance – 20X2 0 0 0 0
W2. Tax base (provisions) 20X1 20X2

Apply the definition of a tax base of a liability representing an expense C C
Carrying amount of the liability 4 000 0
(1) (2)
Less deductible in the future (4 000) (0)
Tax base 0 0
Notes (explanations regarding W2):
1) The liability is a provision (which the tax authorities consider ‘suspicious’) reflecting an expense that will only
be deducted in the future, when paid. Thus, the entire carrying amount will be deducted in the future (20X2).
2) The liability is reversed in 20X2 because the amount provided for at the end of 20X1 is paid in 20X2 (cr bank,
dr provision). The liability carrying amount is thus nil. Similarly, the amount provided for in 20X1 and paid in
20X2, is deducted for tax purposes in 20X2 and thus, at the end of 20X2, there will be no future deductions.
Solution 7B: Provisions (current tax)

Comments:
x 20X1: In 20X1, the tax authority disallows the expense of C4 000 as a deduction (taxable profit = 20 000 – 0 =
20 000), but the accountant recognises the C4 000 as an expense, (profit before tax = 20 000 – 4 000 = 16 000).
Thus, in order to covert accounting profits (profit before tax) into taxable profits, we must reverse the expense.
x 20X2: The accountant recognised (deducted) the C4 000 as an expense in 20X1 and thus there is no expense in
20X2 (profit before tax = 20 000 – 0 = 20 000), but the tax authority allows the C4 000 as a deduction in 20X2
on the basis that it is now paid, (taxable profit = 20 000 – 4 000 = 16 000). Thus, in order to convert accounting
profits (profit before tax) into taxable profits, we must deduct the amount expensed in the prior year 20X1.
20X1 20X2
Current income tax: Profits Tax at 30% Profits Tax at 30%
(20 000 – 4 000) and (20 000 – 0)
Movement in temporary differences: 4 000 1 200 (4 000) (1 200)
x Less provision opening balance (0) (4 000)
x Add provision closing balance 4 000 0
Notes: We journalise the current tax charge of C6 000 in 20X1 and the current tax charge of C4 800 in 20X2.
Chapter 6 293
Solution 7C: Provisions (ledger accounts)

Warranty costs (E) Provision for warranty costs (L)
Provision (1) 4 000 WC (1) 4 000
CTP (2) 6 000 DT (3) 1 200 Inc tax exp(2) 6 000
Balance c/f 4 800
6 000 6 000
Balance b/f 4 800
Deferred tax: income tax (A) (2)
(3)
Inc tax 1 200
Bank Provision for warranty costs (L)
Provision (4) 4 000 Bank (4) 4 000 Balance b/f 4 000
CTP (7) 6 000
Income tax (E) Current tax payable: income tax (L)

CTP (5) 4 800 Bank (7) 6 000 Balance b/f 6 000
DT (6) 1 200 Inc tax (5) 4 800
Balance b/f 6 000
Balance b/f 1 200 Inc tax (6) 1 200
Notes (explaining the amounts in the ledger accounts):

1) Warranty costs, estimated at C4 000, are incurred but not paid in 20X1 and thus an expense and
provision are recognised in 20X1.
3) Deferred tax adjustment in 20X1: To recognise a deferred tax asset balance (see solution 7A/ W1), we must
process a ‘deferred tax adjustment’: debit deferred tax asset and credit tax expense. We recognise a deferred tax
asset because the warranty expense (already incurred) will result in a future tax saving (future taxable
profits will be reduced when the warranty expense is eventually allowed as tax-deduction).
Notice that, by crediting tax expense, we decrease it. From an income statement approach, we decrease the tax
expense because the current tax charge is too big in 20X1 (i.e. we were not allowed to deduct an expense that
had been incurred from an IFRS point of view). Another way of looking at this is, since the tax authority
disallows the deduction of the warranty costs in 20X1, the 20X1 current tax is greater than the tax expense
incurred, thus requiring a deferral of part of the 20X1 tax charge to future years (like an expense prepaid).
4) Payment of the warranty costs in 20X2: this reduces the liability’s carrying amount at the end of 20X2 to nil.
6) Deferred tax adjustment in 20X2: To adjust a deferred tax asset balance to a nil balance at the end of 20X2 (see
solution 7A/ W1), we process another ‘deferred tax adjustment’: credit deferred tax asset and debit tax expense.
Notice that, by debiting the tax expense, we increase it. From an income statement approach, we need to
increase the tax expense in 20X2 because the current tax charge is too small in 20X2 (i.e. the tax saving we
were given by the tax authorities in 20X2 had, from an IFRS viewpoint, already been earned in 20X2).
7) Payment to the tax authorities in 20X2 of the current tax owing to them for 20X1 (the prior year’s tax).
Solution 7D: Provisions (disclosure)

Comment: The deferred tax asset eventually reverses and its effect on profits is nil over 2 years (-1 200 +1 200).
Company name
Non-current assets
Current liabilities
Provision for warranty costs 0 4 000
294 Chapter 6
Company name
Profit before taxation (20X1: 20 000 – 4 000) 20 000 16 000
Company name
x Year-end accruals 0 1 200
x current 4 800 6 000
x deferred 1 200 (1 200)
3.5 Income receivable

Tax base of an asset –the
Income receivable is an asset and thus, when we measure
its tax base, we apply the definition of the ‘tax base of an If the asset’s FEB are taxable the:
asset’ (the essence of this definition is in this pop-up). x TB = future deductions
If the asset’s FEB are not taxable, the
x TB = CA that is not taxable
Income receivable is income that has been earned but not yet
received. Tax authorities generally tax income on the earlier of the date the income is earned or the
date it is received. This means that, in the case of income receivable, the tax authorities will generally
tax this income in the same year that the accountant recognises it as income. If this occurs, there is no
difference in the timing of when income is earned versus when it is taxed and thus there would be no
deferred tax implications from the income receivable balance.
However, let us prove this logic by applying the definition of the tax base of an asset . In the case of
income receivable, the tax base is defined as the portion of the asset’s carrying amount that is ‘not
taxable in the future’. The entire income receivable carrying amount at the end of the year will
generally reflect future benefits (future inflows) that will not be taxable in the future because they will
have already been taxed. Thus, the tax base of income receivable will generally equal its carrying
amount. In other words, to calculate the tax base of income receivable, we deduct from its carrying
amount the portion thereof that has not yet been taxed and will thus still be taxed in the future, where
this portion is normally nil (i.e. TB of an asset = CA – portion of CA that will be taxed in the future =
the portion of the CA that will not be taxed in the future). Since the tax base and carrying amount are
equal, there is no temporary difference and no deferred tax.
Example 8: Income receivable
x Interest income of C6 000 is earned in 20X1 but only received in 20X2.
x The tax authority will tax the interest income when earned.
x The current tax owing to the tax authorities is paid in the year after it is charged.
Required:
D. Disclose the above information.
Chapter 6 295
Solution 8A: Income receivable (deferred tax)

Comments: We calculate the deferred tax balance by comparing the carrying amount and tax base.
x Since both the accountant and tax authorities ‘recognise’ the C6 000 interest as an income/ taxable income in 20X1
and since this income remained receivable at the end of 20X1, there would be both a carrying amount and tax base for
income receivable at the end of 20X1 of C6 000.
x When the interest is received in 20X2, the income receivable carrying amount and tax base reverse to nil.
x Since there is no temporary difference at any stage, there is also no deferred tax.
Carrying Tax base Temporary Deferred tax Deferred
Income receivable amount (IAS 12) difference at 30% tax balance/
(per SOFP) (b) – (a) (c) x 30% adjustment
(a) (b) (c) (d)
Opening balance – 20X1 0 0 0 0 N/A
Movement (balancing) 6 000 6 000 0 0 N/A
Closing balance – 20X1 6 000 6 000 0 0 N/A
Movement (balancing) (6 000) (6 000) 0 0 N/A
Closing balance – 20X2 0 0 0 0 N/A
W2. Tax base (income receivable – an asset): 20X1 20X2

i.e. applying the definition of the tax base of an asset that represents income C C
Carrying amount 6 000 0
(1) (2)
Less portion that will be taxed in the future (0) (0)
Tax base 6 000 0
Notes (explaining the amounts in W2):
1) When looking at the carrying amount at the end of 20X1, we conclude that none of it will be taxed in
the future since all the income receivable will be taxed when it is earned i.e. in the current year (20X1).
2) The carrying amount at the end of 20X2 will now be zero since the income receivable was received in
20X2. No amount is taxable in the future since it was all taxed in 20X1.
Solution 8B: Income receivable (current tax)

Comments: Since both the accountant and tax authorities recognise the interest of C6 000 as income in 20X1 when
it is earned, the accounting profit and taxable profit are the same in both years. In other words, no adjustments are
required in order to convert accounting profits (profit before tax) into taxable profits.
20X1 20X2
Current income tax: Profits Tax at 30% Profits Tax at 30%
(20 000 + 6 000) and (20 000 + 0)
Movement in temporary differences: 0 0 0 0
Notes: We journalise the current tax charge of C7 800 in 20X1 and the current tax charge of C6 000 in 20X2.
Solution 8C: Income receivable (ledger accounts)
Income receivable (A) Interest income (I)
Int income(1) 6 000 Inc receivable(1) 6 000
(2)
CTP 7 800 Inc tax exp (2) 7 800

Income receivable (A) Bank (A)
Balance b/d 6 000 Bank (3) 6 000 Int receivable (3) 6 000 CTP (5) 7 800
CTP (4) 6 000 Balance b/d 7 800
Bank (5) 7 800 Inc tax exp (4) 6 000
296 Chapter 6
Notes (explaining amounts in the ledger accounts)::

1) Interest is earned in 20X1, but is not yet received.
2) Current tax charged for 20X1.
3) The interest is received and thus reverses the income receivable account to zero.
4) Current tax charged for 20X2.
5) Payment of current tax for 20X1 in 20X2.
Solution 8D: Income receivable (disclosure)

Company name
Current assets
Income receivable 0 6 000
Current liabilities
Company name
Profit before taxation (20X1: 20 000 + 6 000) 20 000 26 000

Company name
x current 6 000 7 800
x deferred 0 0
4. Deferred tax caused by non-current assets
4.1 Overview
Non-current assets could
be:
Recognition of deferred tax (and the exemption)
x deductible for tax purposes; or
Non-current assets can cause temporary differences and we x non-deductible for tax purposes.
normally recognise deferred tax on all temporary differences This could affect whether deferred tax
– but there is an exception. A temporary difference will be is recognised.
exempt from the recognition of deferred tax if the cost of the asset is non-deductible for tax purposes
(i.e. no tax allowances/wear and tear is allowed on the cost of the asset for tax purposes).
If we acquire a non-current asset that is non-deductible, it means its tax base will start off at nil (and
will remain nil). Since the carrying amount starts off at cost, it means that a temporary difference will
arise on initial acquisition. This temporary difference is generally exempt from deferred tax.
The deferred tax implications arising from:
x non-current assets that are deductible are explained in section 4.2; and
x non-current assets that are non-deductible are explained in section 4.3.
Another issue is that, so far, when adjusting deferred tax, the contra entries have always been recognised
in profit or loss as a tax expense (e.g. dr tax expense; cr deferred tax liability). However, if the asset is
measured at fair value under the revaluation model, the contra entry may be the ‘revaluation surplus’
account instead and thus recognized in other comprehensive income. Please see section 4.4 and chapter 8.
Chapter 6 297
Measurement of deferred tax (and management intentions)
The measurement of the deferred tax balance arising from non-current assets is, in principle, no
different to the measurement of deferred tax arising from other assets or liabilities. In essence,
the deferred tax balance must always be measured in a way that is:
x ‘consistent with the expected manner of recovery or settlement’ of the underlying asset. IAS 12.51A
Generally, this means that, if deferred tax is to be recognised on a temporary difference, it is normally
simply measured at the amount of the temporary difference multiplied by the appropriate tax rate.
1. the deferred tax balance is measured as:
Temporary difference x applicable tax rate
2. the temporary difference is measured as:
Tax base (of the asset)
Less carrying amount (of the asset)
However, if the manner in which management expects to recover the carrying amount of a non-current
asset (e.g. management may intend to make income through the use of the asset or through selling it)
might affect the measurement of the future tax that could be payable, then we should take these
management intentions into account when measuring the deferred tax balance. This is because how
we earn future profits from the asset (e.g. through using the asset to make normal operating profits or
selling the asset and perhaps making a capital profit) may impact on the measurement of the future
tax, and it is this future tax that must be reflected in the measurement of our deferred tax balance.
However, if the non-current asset is measured under the cost model (e.g. cost less accumulated
depreciation), management intentions would not have an impact on the measurement of the
related deferred tax balance. It is only if the non-current asset is measured at fair value
(revaluation model or fair value model), that we need to consider management intentions (i.e.
whether management intends to make income from the use of the asset or through selling it).
Interestingly, sometimes we will use management’s actual intentions to measure the deferred
tax, but in other cases we are forced to use presumed intentions (e.g. under certain
circumstances, despite management intending to use an asset, we may have to measure the
deferred tax balance based on a presumed intention to sell the asset).
Measurement of the deferred tax balance when the non-current asset is measured at fair value
(considering management intentions, whether actual or presumed) is explained in section 4.4.
Derecognition of deferred tax when the non-current asset is sold
If we sell a non-current asset, the amount we sell it for (sale proceeds) will affect the amount of current
tax payable. This could get fairly complex (e.g. involving recoupments/ scrapping allowances and
taxable capital gains) and was explained in detail chapter 5.
By contrast, the deferred tax implication arising from the sale of a non-current asset is very simple: if
the asset is sold, the carrying amount of the asset is derecognised, and any remaining tax base will fall
away, at which point both the carrying amount and tax base will be nil and thus, since any temporary
difference will have disappeared, any related deferred tax balance must be derecognised.
A few examples involving the sale of non-current assets are included in section 4.5. Notice how the
purpose of the deferred tax adjustment is simply to reverse the deferred tax balance to zero.
4.2 Deductible assets
Non-current assets are initially recognised at cost. The cost of these assets will either be
depreciated (e.g. plant) or not depreciated (e.g. land). However, whether or not an asset is
depreciated, the cost thereof is always ultimately expensed through profit or loss (by way of
depreciation and/or simply when the cost of the asset is expensed on derecognition). Thus, the
non-current asset’s carrying amount always starts off at cost and gradually reduces to nil by the
time its useful life has ended or it has been derecognised.
298 Chapter 6
From a tax-perspective, the cost of a non-current asset is generally deductible when calculating
taxable profits (e.g. through wear and tear). Since the tax base of a non-current asset is defined
as ‘future tax-deductions’, if the asset’s cost is deductible, then its initial tax base will reflect
its cost. This tax base will then gradually reduce to nil, as and when the deductions are granted
(i.e. the tax base at the end of each year must reflect the future tax deductions remaining).
Thus, in the case of a tax-deductible asset, the carrying amount and tax base both start off at
cost and will both ultimately reduce to nil. However, the rate at which the cost is deducted from
taxable profits may not be the same as the rate at which the asset is expensed through, for
example, depreciation. For example, plant may be depreciated at 10% per annum whereas it is
allowed as a tax-deduction at 20% per annum. This means that there will be differences between
the plant’s carrying amount and tax base over its useful life. These are temporary differences
on which we must recognise deferred tax.
Please note that the difference between the carrying Deductible NCAs
amount and tax base is temporary because, as soon as the normally cause temporary
asset has been fully written off by both the accountant and differences over time because:
the tax authorities (or if the asset is disposed of), the x the CA will reduce to zero and
x the TB will reduce to zero
carrying amount and tax base will be the same: both will
x but the CA and TB will reduce by
be zero (similarly, from an income statement perspective, different amounts each year.
the cost of the asset will have both been expensed and
been deducted for tax purposes). It is because these differences are temporary differences, that
deferred tax must be recognised. This deferred tax will reverse to zero by the time the carrying
amount and tax base are zero.
If the tax base (expected future tax-deductions) exceeds the carrying amount (expected future
taxable income from the asset):
x the difference is called a deductible temporary difference (because it means we expect a
future net tax-deduction); and
x we will recognise a deferred tax asset (a future tax saving).
Conversely, if the tax base (expected future tax-deductions) is less than the carrying amount
(expected future taxable income from the asset):
x the difference is called a taxable temporary difference (because it means we expect a future
taxable profit); and
x we will recognise a deferred tax liability (a future tax payable).
Example 9: Cost model: PPE:
x Deductible and
x Depreciable assets
Profit before tax is C20 000, according to both the accountant and the tax authority, in each
of the years 20X1, 20X2 and 20X3, before taking into account the following information:
x A plant was purchased on 1 January 20X1 for C30 000 and is depreciated straight-line at 50% p.a.
x The tax authority allows a tax deduction thereon at 33 1/3 % straight-line.
x This entity paid the tax authority the current tax owing in the year after it was charged.
x The income tax rate is 30%.
Required:
B. Calculate the current income tax for 20X1, 20X2 and 20X3.
D. Disclose the above in as much detail as is possible for all three years.
Solution 9A: Deferred tax

Comment:
x Temporary differences arise because the rate at which the asset’s cost is expensed as depreciation (2 years)
differs from the rate it is allowed as a tax-deduction (3 years), and thus the carrying amount and tax base differ.
x Since the carrying amounts and tax bases differ, temporary differences arise on which deferred tax must be
recognised. In this example, deductible temporary differences arise and thus deferred tax assets are recognised.
Chapter 6 299
x A deductible temporary difference arises at the end of both 20X1 and 20X2 because, at the end of each of these
years, the future tax deductions (tax base) exceed the future economic benefits (carrying amount):
Tax base = future tax-deductions (see TB at the end of 20X1: C20 000 and 20X2: C10 000)
Carrying amount = future economic benefits (see CA at the end of 20X1: C15 000 & 20X2: C0).
Thus, for example, at the end of 20X1, we are expecting future income of C15 000 (carrying amount) and a
future tax-deduction of C20 000 (tax base). This means we expect a future net tax-deduction of C5 000 (a
deductible temporary difference) and thus we expect a future tax saving of C1 500 (deferred tax asset).
x Notice the total depreciation of C30 000 (C15 000 x 2 years) equals the total tax-deductions of C30 000
(C10 000 x 3 years). In other words, both the accountant and tax authority eventually write-off the plant’s cost.
x Management intentions are ignored: we only consider these when measuring a deferred tax balance if the
underlying asset is measured at a fair value exceeding cost (see section 4.4). This example involves the cost
model, which means the asset’s carrying amount cannot possibly exceed cost. Thus, we simply apply the income
tax rate to the entire temporary difference because the temporary difference reflects future taxable profits / tax
deductions that will be taxed at the normal tax rate, irrespective of how they arose (i.e. through sale or use):
Intention to sell the asset: no capital profits are possible and thus the entire TD simply reflects an expected
recoupment (or scrapping allowance) that would be taxable (or tax deductible) at 30%;
Intention to keep the asset: the entire TD would simply reflect expected future taxable profits from the use
of the asset (e.g. through the sale of products that it makes) that would be taxable at 30%.

Plant: Carrying Tax Temporary Deferred tax Deferred tax
x Depreciable amount base difference at 30% balance/
x Deductible (per SOFP) (IAS 12) (b) – (a) (c) x 30% adjustment
(a) (b) (c) (d)
Purchase 30 000 30 000 0 0
Deprec/ deduction (15 000) (10 000) 5 000 1 500 Dr DT; Cr TE
Closing balance: 20X1 15 000 20 000 5 000 1 500 Asset
Deprec/ deduction (15 000) (10 000) 5 000 1 500 Dr DT; Cr TE
Closing balance: 20X2 0 10 000 10 000 3 000 Asset
Deprec/ deduction 0 (10 000) (10 000) (3 000) Cr DT; Dr TE
W2. Tax base (depreciable assets): 20X1 20X2 20X3

i.e. applying the definition of the tax base of an asset C C C
Original cost 30 000 30 000 30 000
Less accumulated tax deductions 20X1: 30 000 x 33 1/3 % x 1 yr (10 000) (20 000) (30 000)
20X2: 10 000 x 2 years
20X3: 10 000 x 3 years
Future deductions (i.e. deductions that will still be granted) 20 000 10 000 0
Solution 9B: Current tax

Comments: Accounting profit (profit before tax) is reached after deducting depreciation/impairment, being the
portion of an asset’s cost that has been expensed in terms of IFRSs. However, the related tax-deduction that is used
in calculating taxable profit is based on tax legislation. Thus, to convert accounting profits (profit before tax) into
taxable profits, we must add back the accountant’s depreciation/impairment and subtract the tax authority’s tax-
deduction (e.g. wear and tear).
20X1 20X2 20X3
Current income tax: Profits Tax: Profits Tax: Profits Tax:
30% 30% 30%
(1) (1) (4)
Profit before tax 5 000 5 000 20 000
(20X1 & 20X2: 20 000 – depr: 15 000)
(20X3: 20 000 – depr: 0)
Exempt income/ non-deductible exp’s: 0 0 0
Taxable accounting profit 5 000 5 000 20 000
Movement in temporary differences: (1) 5 000 5 000 (10 000)
- add back depreciation: 30 000 x 50% 15 000 15 000 0
- less tax deduction: 30 000 x 33 1/3% (10 000) (10 000) (10 000)
Taxable profit & current income tax (3) 10 000 3 000 10 000 3 000 10 000 3 000
Notes: We will journalise a current tax charge of C3 000 in each of the years 20X1, 20X2 and 20X3.
300 Chapter 6
Solution 9C: Ledger accounts

Depreciation (E) Plant: cost (A)
20X1 20X1 Bank 30 000
Plant: AD (1) 15 000 P/L 15 000
20X2 Plant: accumulated depreciation (A)
Plant: AD (1) 15 000 P/L 15 000 20X1 Depr(1) 15 000
20X2 Depr(1) 15 000
20X2 Bal 30 000
20X1 20X1 ITE (2) 3 000
CTP (2) 3 000 DT (3) 1 500 Balance c/f 3 000
P/L 1 500 3 000 3 000
20X2 20X2 Bank (4) 3 000 20X1 Bal b/f 3 000
CTP (2) 3 000 DT (3) 1 500 Balance c/f 3 000 20X2 ITE (2) 3 000
P/L 1 500 6 000 6 000
20X3 20X2 Bal b/f 3 000
CTP (2) 3 000 20X3 Bank (4) 3 000 20X3 ITE (2) 3 000
DT (3) 3 000 P/L 6 000 Balance c/f 6 000 6 000
20X3 Bal b/f 3 000

20X1 ITE (3) 1 500
20X2 ITE (3) 1 500 Balance c/f 3 000
3 000 3 000
20X2 Bal b/f 3 000
20X3 ITE (3) 3 000
3 000 3 000
20X3 Bal b/f 0
(1) Depreciation of the plant (the cost is expensed over 2 years – thus no depreciation in 20X3).
(2) Current tax charge: C3 000 is recorded in 20X1, 20X2 and 20X3 (C9 000 in total): see solution 9B.
(3) Deferred tax adjustment: The deferred tax adjustment in 20X1 and 20X2 involved recognising/ increasing a
deferred tax asset (i.e. debit deferred tax asset and credit tax expense), whereas in 20X3, it involved reversing
the deferred tax asset (i.e. credit deferred tax asset and debit tax expense): see solution 9A/ W1.
(4) Tax paid to the tax authorities in respect of the current tax charged in the prior year.
Solution 9D: Disclosure

Comment: Notice the following:
x After three years, when the plant’s carrying amount and tax base are both nil, the effect of deferred tax
is also reversed (solution 9A): the deferred tax asset has a nil balance (see the SOFP) and the net effect
of the deferred tax adjustments is nil (see the ‘income tax expense’ note: 1 500 + 1 500 – 3 000).
x The total tax expense of C9 000 recognised in terms of IFRSs (C1 500 + C1 500 + C6 000) equals the total
current tax of C9 000 charged by the tax authority (C3 000 x 3 years) (see the ‘income tax expense’ note).
x The existence of deferred tax does not cause the effective tax rate to differ from the applicable tax rate (see the
‘income tax expense’ note).
Entity name
Statement of financial position 20X3 20X2 20X1
As at …20X3 Note C C C
ASSETS
Non-current assets
Deferred tax: income tax 4 0 3 000 1 500
Property, plant and equipment 0 0 15 000
LIABILITIES
Current liabilities
Current tax payable: income tax 3 000 3 000 3 000
Chapter 6 301
Entity name
Statement of comprehensive income Note 20X3 20X2 20X1
For the year ended 20X3 C C C
Income tax expense 12 (6 000) (1 500) (1 500)
Profit for the period 14 000 3 500 3 500
Other comprehensive income 0 0 0
Total comprehensive income 14 000 3 500 3 500
Entity name
Notes to the financial statements 20X3 20X2 20X1
For the year ended 20X3 C C C
4. Deferred tax asset
x Property, plant and equipment 0 3 000 1 500
Income taxation expense 6 000 1 500 1 500
x Current 3 000 3 000 3 000
x Deferred 3 000 (1 500) (1 500)
Applicable tax rate (given) 30% 30% 30%
Effective tax rate (tax expense/ profit before tax) 30% 30% 30%
4.3 Non-deductible assets and the related exemption
4.3.1 Overview
Non-deductible assets
with taxable FEB result in
As mentioned in section 4.2, non-current assets are temporary differences on
initially recognised at cost. Thus, the non-current asset’s acquisition date because:
carrying amount always starts off at cost, and gradually x the CA starts off at cost
reduces to nil by the time its useful life has ended or it has x the TB will start off at zero.
been derecognised.
From a tax-perspective, the cost of a non-current asset Tax base of an asset –the
could either be deductible or non-deductible in the essence of the definition is:
calculation of taxable profits. This affects its tax base. If the asset’s FEB are taxable the:
x TB = future tax deductions
The tax base of a non-current asset reflects the ‘future If the asset’s FEB are not taxable, the :
tax-deductions’ that will be granted. x TB = CA See IAS 12.7
If the cost of a non-current asset is:

x deductible for tax-purposes, then the tax base starts off at cost and gradually reduces to nil
(see section 4.2).
x not deductible for tax-purposes, then the tax base starts off at nil and simply remains nil.
An exempt temporary
Interestingly, in the case of a non-deductible asset, if the difference is
tax base starts off at nil, it means that, on the date of initial a temporary difference on
acquisition, the carrying amount and tax base will differ: which we do not recognise def. tax.
the carrying amount will equal the asset’s cost but the tax
base will be nil. In other words, a temporary difference arises on initial acquisition. Due to
accounting complications that would occur if we were to recognise deferred tax on this
temporary difference, we generally treat this as a temporary difference on which we must not
recognise deferred tax – in other words, this temporary difference is exempt from deferred tax.
The next section explains the reasoning behind the exemption from deferred tax in more detail.
302 Chapter 6
4.3.2 The exemption from recognising deferred tax liabilities (IAS 12.15 and IAS 12.24)
A taxable TD on
IAS 12.15 states that (the following is slightly reworded): acquisition date is an
x a deferred tax liability shall be recognised for all exempt TD if it relates to:
taxable temporary differences, x the initial acquisition of an A or L:
- does not relate to goodwill;
x except where the deferred tax liability arises from:
- does not relate to a business
goodwill; or combination; and
the initial recognition of an asset or liability which: - does not affect accounting profit
is not a business combination and or taxable profit. IAS 12.15 reworded
at the time of the transaction, affects neither accounting profit nor taxable profit.
Please note: There is a similar exemption from recognising deferred tax assets: for more
information relating to both exemptions, please see section 5.
IAS 12.15 simply means that a deferred tax liability should always be recognised on taxable
temporary differences except if it meets the requirements to be exempted from deferred tax.
Please note: Although we are focussing on the exemption from recognising deferred tax liabilities
arising from non-current assets in this section, the exemption from recognising deferred tax liabilities
could arise on the acquisition of goodwill and/ or a variety of others assets or liabilities.
Let us apply IAS 12.15 to a non-deductible asset that is not acquired through a business combination:
x A taxable temporary difference will arise on the initial recognition thereof because:
A non-deductible asset is an asset whose cost is not allowed as a deduction when
calculating taxable profits. In such cases, the tax base on date of purchase is zero.
The carrying amount on date of purchase is, as always, the asset’s cost.
Our tax base and carrying amount are usually the same on initial recognition (i.e. date
of purchase) but as you can see, in the case of a non-deductible asset, we have a
temporary difference that arises on initial recognition (TB: zero - CA: cost).
This temporary difference is taxable since these future economic benefits (CA of an
asset = future economic benefits = cost) exceeds the future tax deductions (TB = 0).
x The initial recognition (i.e. purchase) does not affect accounting profit or taxable profit:
It does not affect accounting profit (the purchase involves a debit to the asset account
and a credit to bank or a liability account – it does not affect income or expenses), and
It does not affect taxable profit (the purchase itself does not cause taxable income and
there are no tax-deductible expenses flowing from this purchase).
x Thus, although a deferred tax liability is normally recognised on taxable temporary
differences, no deferred tax is recognised on this taxable temporary difference since it meets
the requirements in IAS 12.15 to be exempted from deferred tax.
Why do we have an
You may be wondering why this taxable temporary exemption?
difference was exempted from the requirement to It is interesting to consider
recognise a deferred tax liability. the reason why such an
exemption was required at all.
Let us consider this question with specific reference to the In order to recognise a DTL on a
purchase of a non-deductible asset. As already explained, the taxable TD we obviously need to credit
the DTL and debit something else.
purchase of a non-deductible asset leads to a taxable
The problem was that, in certain
temporary difference that would normally have led to the situations, such as the acquisition of a
recognition of a deferred tax liability, which would have non-deductible asset, no-one agreed on
required a credit to the deferred tax liability account. But let’s what we should debit!
think where we could have put the corresponding debit... And so the exemption from having to
recognise this DT liability arose!
x We cannot debit ‘tax expense’ because:
deferred tax adjustments made to the tax expense account are those relating to temporary
differences that cause taxable profits to differ from accounting profits, so debiting tax expense
would clearly be inappropriate because the purchase of the asset:
did not affect accounting profit, and
did not affect taxable profit.
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x We cannot debit the asset’s cost because:

an asset may only be recognised if the item meets the asset definition: obviously the
creation of a deferred tax asset cannot possibly represent an inflow of future economic
benefits to the entity and thus the asset definition is not met; and
an asset should be measured at its cost, being its purchase price and any other cost
necessary to bring the asset to a location and condition enabling it to be used in the
manner intended by management: a deferred tax liability is definitely not part of the
purchase price nor a cost necessary to enable an asset to be used.
The mystery behind exempt temporary differences is thus simply this: where there is no logical
contra-account, the deferred tax on the temporary difference was simply ignored.
Let us consider the effect of the exemption on non-deductible items that involve property, plant
and equipment, by way of example.
Non-deductible items of property, plant and equipment may either be depreciable or non-
depreciable, which means that we could be faced with the following possible combinations:
x Non-deductible but depreciable: see example 10; and
x Non-deductible and non-depreciable: see example 11.

x Non-deductible and
x Depreciable
Profit before tax is C20 000, according to both the accountant and the tax authority, in each of the
years 20X1, 20X2 and 20X3, before taking into account the following information:
x A building was purchased on 1 January 20X1 for C30 000.
x This building is depreciated by the accountant at 50% p.a. straight-line to a nil residual value.
x The tax authority does not allow a tax deduction on this type of building.
x This company paid the tax authority the current tax owing in the year after it was charged.
Required:

Building: Carrying Tax Temporary Deferred tax Deferred
x Non-deductible amount base difference at 30% tax balance/
x Depreciable (SOFP) (IAS 12) TD x 30% adjustment
(2)
Purchase 30 000 0 (30 000) 0 Exempt IAS 12.15
Depreciation/ deduction (1) (15 000) (0) 15 000 (2)
0 Exempt IAS 12.15
Closing balance: 20X1 (2) 15 000 0 (15 000) (2)
0 Exempt IAS 12.15
Depreciation/ deduction (1) (15 000) (0) 15 000 (2)
0 Exempt IAS 12.15
Closing balance: 20X2 (2) 0 0 0 (2)
0
Depreciation/ deduction (1) (0) (0) 0 0
Notes:
(1) The carrying amount shows how the accountant recognises the building’s cost and then depreciates it
at 50% pa (i.e. no depreciation in 20X3 since the asset was fully depreciated at the end of 20X2). In
contrast, the tax base column shows that the tax authorities will not allow the deduction of the cost of
this building: (thus the tax base column shows the purchase at nil and obviously nil deductions after).
304 Chapter 6
(2) A temporary difference arises on acquisition since there will be no tax deductions on the asset.
However, there is no deferred tax on this temporary difference due to the IAS 12.15 exemption.
The exemption applies to all aspects of the original cost, including the depreciation, which (if you
think about it) is simply a reallocation of part of this original cost.
This depreciation causes the temporary difference balance to reduce each year (i.e. the original
temporary difference will eventually reverse, once this asset is fully depreciated).
But while a portion of the exempt temporary difference still exists, the fact that no deferred tax is
recognised on it means that it will cause the applicable tax rate and the effective tax rate to differ. You
will therefore find exempt temporary differences in the tax rate reconciliation in the tax expense note
(they act much like a non-deductible expense – a permanent difference – see chapter 5).
W2. Tax base (depreciable assets): 20X1, 20X2 and 20X3 C

i.e. applying the definition of the tax base of an asset
Original cost that will be allowed as a tax deduction Not allowed as a deduction at all 0
Less accumulated tax deductions (e.g. wear & tear) Not allowed as a deduction at all 0
Deductions still to be made (decrease in taxable profits in the future) 0

20X3 20X2 20X1
Current income tax: Profit Tax at Profit Tax at Profit Tax at
30% 30% 30%
Profit before tax (accounting profits) (1) 20 000 5 000 5 000
(20X1 and 20X2: 20 000 - 15 000),
(20X3: 20 000 - 0)
Exempt income & non-deductible expenses: 0 0 0
Movement in temporary differences: exempt
x Building – exempted (2) 0 15 000 15 000
- add depreciation 0 15 000 15 000
(20X1 & 20X2: 30 000 x 50%)
- less tax deduction (0) (0) (0)
Taxable accounting profits 20 000 20 000 20 000
Movement in temporary differences: normal 0 0 0
Taxable profits and current income tax 20 000 6 000 20 000 6 000 20 000 6 000

(1) The profit was given before depreciation had been processed and must therefore first be adjusted for
depreciation. Notice that there is no depreciation in 20X3 since the asset was fully depreciated in 20X2.
(2) The depreciation and tax deduction are not the same amount, thus resulting in a temporary difference.
P.S. there will be no deferred tax on this temporary difference due to the IAS 12.15 exemption.
20X1 20X1
CTP (Sol 10B) 6 000 ITE (Sol 10B) 6 000
P/L 6 000 Balance c/f 6 000
6 000 6 000 6 000 6 000
20X2 20X2 Bank 6 000 Balance b/f 6 000
CTP (Sol 10B) 6 000 Balance c/f 6 000 20X2
P/L 6 000 ITE (Sol 10B) 6 000
6 000 6 000 12 000 12 000
CTP (Sol 10B) 6 000 20X3
P/L 6 000 ITE (Sol 10B) 6 000
6 000 6 000 Balance c/f 12 000 12 000
Balance b/f 6 000
Chapter 6 305
Depreciation (E) Building: cost (A)

20X1 20X1 Bank 30 000
Build: AD (W1) 15 000 P/L 15 000
20X2
Build: AD (W1) 15 000 P/L 15 000
Building: accumulated depreciation (A)
20X1 Depr(W1) 15 000
20X2 Depr(W1) 15 000
Balance 30 000

Comments:
x Note there is a reconciling item in the tax rate reconciliation for 20X1 and 20X2 because deferred tax on the
temporary difference was not recognised (i.e. exempt temporary differences cause reconciling items).
x This is because the cost of the asset is not deductible and thus the effect of the depreciation expense will never
reverse in future years (the depreciation has the same effect as, for example, a non-deductible fine).
Entity name
ASSETS
Non-current assets
Deferred tax: income tax Ex 10A 0 0 0
Property, plant and equipment Ex 10A 0 0 15 000
LIABILITIES
Current liabilities
Current tax payable: income tax Ex 10B/C 6 000 6 000 6 000
Entity name
Statement of comprehensive income 20X3 20X2 20X1
For the year ended 20X3 Note C C C
Profit before tax Ex 10B 20 000 5 000 5 000
Profit / (loss) for the period 14 000 (1 000) (1 000)
Other comprehensive income Given 0 0 0
Total comprehensive income / (loss) 14 000 (1 000) (1 000)
Entity name
x Current Ex 10B 6 000 6 000 6 000
x Deferred Ex 10A: W1 0 0 0
Reconciliation:
Applicable tax rate 30% 30% 30%
Tax effects of:
Profit before tax 20X1 & 20X2: 5 000 x 30% 6 000 1 500 1 500
20X3: 20 000 x 30%
Exempt temporary difference:
x depreciation on cost of non-deductible asset 0 4 500 4 500
20X1 & 20X2: 15 000 x 30%
Tax expense 6 000 6 000 6 000
Effective tax rate 20X1 & 20X2: 6 000 / 5 000 30% 120% 120%
20X3: 6 000 / 20 000
306 Chapter 6

x Non-deductible and
x Non-depreciable asset
Profit before tax is C20 000, according to both the accountant and the tax authority, in each
of the years 20X1, 20X2 and 20X3, before taking into account the following information:
x Land was purchased on 1 January 20X1 for C30 000.
x Land is not depreciated.
x The tax authority does not allow a tax deduction on land.
x This company paid the tax authority the current tax owing in the year after it was charged.
Required:

Land: Carrying Tax Temporary Deferred Def tax
x Non-deductible amount Base(3) difference tax at 30% balance/
x Non-depreciable (SOFP) (IAS 12) TD x 30% adj
(2)
Purchase: cost 30 000 0 (30 000) 0 Exempt IAS 12.15
0 Exempt IAS 12.15
(1)
Depreciation/ deduction (0) (0) 0 0
0 Exempt IAS 12.15

(2)
Closing balance: 20X3 30 000 0 (30 000) 0 Exempt IAS 12.15
Notes:
(1) The carrying amount remains at C30 000 since it is not depreciated.
The tax base is zero from the start since there are no future deductions allowed on the cost of land.
(2) A temporary difference arises since there will be no tax deductions on the asset.
There is no deferred tax on this temporary difference due to the IAS 12.15 exemption.
Since there is no depreciation, the original temporary difference will never reverse.
The exemption of the related temporary difference acts much like a non-deductible expense and you
will therefore find it in the tax rate reconciliation in the tax expense note.
(3) The tax base is calculated in the same way as in example 10A, (see working 2).

20X3 20X2 20X1
Current income tax: Profit Tax: 30% Profit Tax: 30% Profit Tax: 30%
(1)
Profit before tax (accounting profits) 20 000 20 000 20 000
Exempt income & non-deductible expenses 0 0 0
Exempt temporary differences: movement (2) 0 0 0
Taxable accounting profits 20 000 20 000 20 000
Normal temporary differences: movement 0 0 0
Taxable profits and current income tax 20 000 6 000 20 000 6 000 20 000 6 000
Notes:
(1) Profit was given before depreciation had been processed, but no adjustment is necessary since there is
no depreciation on land.
(2) Although there is an exempt temporary difference, being equal to the original cost, there is no exempt
temporary difference in the taxable profit calculation since there is no depreciation and thus no
movement in temporary differences.
Chapter 6 307

20X1 20X1
CTP (W2) 6 000 ITE (W2) 6 000
P/ L 6 000 Balance c/f 6 000
6 000 6 000 6 000 6 000
CTP (W2) 6 000 Balance c/f 6 000 20X2
P/L 6 000 ITE (W2) 6 000
6 000 6 000 12 000 12 000
CTPT (W2) 6 000 20X3
P/L 6 000 ITE (W2) 6 000
6 000 6 000 Balance c/f 12 000 12 000
Balance b/f 6 000
Bank Land: cost (A)

20X1 Land: cost 30 000 20X1 Bank 30 000

Entity name
ASSETS
Non-current assets
Deferred tax: income tax W1 0 0 0
Property, plant and equipment W1 30 000 30 000 30 000
LIABILITIES
Current liabilities
Current tax payable: income tax 11C 6 000 6 000 6 000
Entity name
Statement of comprehensive income 20X3 20X2 20X1
Profit before tax (W2 – unadjusted) 20 000 20 000 20 000
Other comprehensive income (given) 0 0 0
Entity name
3. Income tax expense (2)
x Current W2 6 000 6 000 6 000
x Deferred (1) W1 0 0 0
Notes:
(1) Since there is no movement in temporary differences (see W1), there is no deferred tax adjustment.
(2) Although an exempt temporary difference arose on the original cost, there is no need for a rate
reconciliation since there is no movement in the temporary difference and therefore no effect on either
accounting profit (there is no depreciation) nor taxable profit (there is no tax deduction). Compare this
to example 10D where a rate reconciliation was required since the asset subsequently affected
accounting profits (through the depreciation charge) while no deferred tax was recognised.
308 Chapter 6
4.4 Non-current assets measured at fair value (IAS 12.51A-C)
4.4.1 Overview (IAS 12.51A-C)
As we know, the deferred tax balance must be measured in a way that is

x ‘consistent with the expected manner of recovery or settlement’ of the underlying asset. IAS 12.51A
If the way in which management expects to recover the carrying amount of an asset (e.g. a
management intention to use the asset or to sell the asset) may affect the measurement of the future
tax that could be payable, then we must take these management intentions into account when
measuring the deferred tax balance.
In other words, management intentions become important when the tax authority taxes income
differently depending on how the income is generated. Deferred tax &
measurement at fair value:
For example, different tax calculations may apply to:
x Capital profits made on the sale of an asset (i.e. If the carrying amount of an asset is
profit made by selling at above cost); and measured at a FV greater than cost:
x Profits other than capital profits. x we must account for deferred tax on
the portion above cost (i.e. CA – Cost)
x we must account for deferred tax on
If an asset is measured using the cost model, its carrying the portion below cost as well
amount is its depreciated cost (cost less accumulated x we measure the DT using the rate at
depreciation). Under the cost model, the carrying amount which future proceeds from the asset
may never exceed this depreciated cost. Thus, even if will be taxed (based on the intention
to use/ sell the asset).
management intends to sell the asset at more than its cost (i.e.
at a capital profit), the carrying amount under the cost model will not reflect this expected selling price
and thus the measurement of the related deferred tax balance will not be complicated by a potential
capital profit / taxable capital gain.
Although all prior examples have involved only the cost model, it is possible for non-current
assets to be measured at fair value instead, for example:
x Property, plant and equipment and intangible assets may be measured at fair value using the
revaluation model offered by IAS 16 (see chapter 8 and chapter 9 respectively); or
x Investment property may be measured at fair value using the fair value model offered by
IAS 40 (see chapter 10).
If the asset is measured at fair value (whether using the revaluation model or fair value model), the
carrying amount could end up being:
x greater than the asset’s original cost; or
x less than the asset’s original cost.
Bearing in mind that the carrying amount of an asset reflects the future economic benefits from the
asset, if the carrying amount is measured at fair value and management intends to sell the asset, this
means the carrying amount reflects the expected selling price of the non-current asset (i.e. as opposed
to sales income from the sale of inventory that the non-current asset makes). Thus, if this carrying
amount is greater than cost, it means we are expecting to sell the asset at an amount greater than cost,
which means that a capital gain is expected. This could affect the measurement of our deferred tax
balance if the tax authority taxes capital gains in a different manner to other income (incidentally, if
we actually sell it at this expected selling price, the sale will affect the measurement of our actual
current tax payable – not deferred tax).
If the carrying amount is less than cost, the possibility that the expected future economic
benefits could include a capital profit obviously does not exist.
Although the deferred tax balance is normally measured based on how management intends to earn
the future economic benefits, there are two exceptions, where despite management’s actual intentions,
the deferred tax balance is measured based on a presumed intention to sell the asset. Section 4.4.2
explains when we must use presumed intentions and section 4.4.3 explains how these management
intentions (actual or presumed) affect the measurement of the deferred tax balance.
Chapter 6 309
The above explains the measurement of deferred tax if the non-current asset is measured at fair value.
However, if the non-current asset is measured at fair value, it may also affect the recognition of
deferred tax. In this regard, all adjustments to the deferred tax asset or liability covered in this chapter
so far have involved recognising a contra-adjustment to tax expense in profit or loss (e.g. credit
deferred tax liability and debit tax expense). However, if the non-current asset is measured at fair value
under the revaluation model, , the contra entry when adjusting deferred tax may need to be recognised
as an adjustment to the revaluation surplus, which is part of other comprehensive income (e.g. credit
deferred tax liability and debit revaluation surplus).
Think about it like this, we recognise the deferred tax asset or liability arising from temporary
differences caused by the carrying amounts of other underlying assets and liabilities (e.g. plant).
If there is a movement in the carrying amount of the underlying asset that was caused by an
adjustment affecting profit or loss (e.g. credit plant and debit depreciation expense), then the
deferred tax adjustment must be recognised in profit or loss (tax expense). However, if the non-
current asset is measured at fair value under the revaluation model (see chapter 8), movements
to its carrying amount from revaluations to fair value may affect the ‘revaluation surplus’,
which is an account recognised in other comprehensive income (debit plant and credit
revaluation surplus). If this happens, this change in carrying amount will cause a change in the
temporary difference, but any resulting deferred tax adjustment (caused by the revaluation) will
not be recognised in profit or loss, but in other comprehensive income, by debiting or crediting
the revaluation surplus account (not tax expense). This is covered in more depth in chapter 8
where the revaluation of property, plant and equipment is explained in detail.
4.4.2 Non-current assets measured at fair value and presumed intentions (IAS 12.51B-C)
We normally measure the deferred tax balance based on the expected tax consequences relevant
to the manner in which management intends to recover the asset. However, we ignore
management’s actual intentions and presume the intention is to sell the asset if it is a:
x non -depreciable asset measured at fair value in terms of the revaluation model in IAS 16; IAS 12.51B; or
x investment property measured at fair value in terms of the fair value model in IAS 40. IAS 12.51C
4.4.2.1 Non-depreciable assets measured using IAS 16’s revaluation model (IAS 12.51B)
If the asset is a non-depreciable asset that is measured at fair value in terms of the revaluation
model in IAS 16 Property, plant and equipment, then the presumption is always that the
management intention is to sell the asset. IAS 12.51B
The reasoning for this presumption is based on the

Study tip
reasoning behind depreciation:
Revise IAS 16’s revaluation
x depreciation reflects that part of the carrying amount model in chapter 8
that will be recovered through use (i.e. depreciation (section 4).
is expensed during the same periods in which
revenue is earned through usage); and thus
x if you can’t depreciate an asset, it means that it can’t be used up and thus the presumption
is that the carrying amount (fair value) can only have been measured based on the potential
sale of the asset – even if an attempt had indeed been made to measure the asset’s fair value
based on usage.
Land is generally a non-depreciable asset.
4.4.2.2 Investment property measured using IAS 40’s fair value model (IAS 12.51C)
Study tips
If the asset is an investment property that is measured in terms
of the fair value model in IAS 40 Investment property, then Revise IAS 40’s fair value
model in chapter 10
the presumption should be that the management intention is (section 4.5 & 5.3).
to sell the asset. However, the presumption in the case of
investment property is a rebuttable presumption (notice that the presumption in the case of property,
plant and equipment was not rebuttable).
310 Chapter 6
The presumption that investment property would be sold would be rebutted if the:
x Investment property is depreciable (i.e. had the cost model been used, this particular
property would have been depreciated – in other words, the presumption could never be
rebutted in the case of land since land would not have been depreciable); and
x The investment property is held within a business model the objective of which is to
consume substantially all the economic benefits embodied in the investment property over
time, rather than through sale. IAS 12.51C
Example 12: Non-current asset measured at fair value and presumed intentions
An entity owns a non-current asset that it intends to keep and use. This asset is measured at
its fair value of C140 which exceeds its original cost of C100.
The tax authorities allow the cost of this asset to be deducted over 10 years.
The asset’s base cost is C100 and only 80% of capital gains are included in taxable profits.
The tax authorities levy tax of 30% on taxable profits.
Required: Briefly explain how the deferred tax balance should be measured assuming:
A. The non-current asset is a plant measured in terms of IAS 16’s revaluation model.
B. The non-current asset is a land measured in terms of IAS 16’s revaluation model.
C. The non-current asset is a building measured in terms of IAS 40’s fair value model.
D. The non-current asset is a land measured in terms of IAS 40’s fair value model.
Solution 12: Non-current asset measured at fair value and presumed intentions
Comment: In this example, normal profits (i.e. profits from trading) are taxed at 30% but only 80% of a capital
gain is included in taxable profits and taxed at 30% (i.e. 80% of the capital gain is taxable). Thus, since capital profits
are taxed differently, we must consider management’s intention – or presumed intention.
A. The asset is plant (depreciable) revalued in terms of IAS 16 Property, plant and equipment.
- IAS 12.51B applies to revalued assets but only to non-depreciable assets.
- Since this plant is depreciable, IAS 12.51B does not apply to it. Thus, we must measure the
deferred tax balance in terms of IAS 12.51A using management’s real intention: the deferred
tax balance will reflect the tax payable/receivable on profits derived from the use of the asset.
B. The asset is land (non-depreciable) measured in terms of IAS 16’s revaluation model.
- IAS 12.51B states that we must presume that all non-depreciable assets measured at fair value
in terms of IAS 16 are to be sold.
- Thus, the deferred tax balance must reflect the tax payable/receivable on profits from the sale of the
asset, even though management intends to recover the carrying amount through usage.
C. The asset is an investment property measured in terms of IAS 40’s fair value model.
- IAS 12.51C states that we should presume investment properties measured under the fair value
model are to be sold. However, the presumption is rebuttable if the property is depreciable and is
held within a business model the objective of which is to consume substantially all the economic
benefits from the investment property over time, rather than through sale.
- In this case, the asset is a building and a building is depreciable (i.e. a building would have been
depreciated had the cost model applied to it). Thus, if the property is held within a business
model the objective of which is to consume substantially all the asset’s future economic
benefits over time, rather than through sale, both criteria for rebuttal will be met and the
deferred tax balance will then be measured based on the actual intention to use the asset.
- If the related business model does not involve consuming substantially all the economic
benefits embodied in the investment property over time, then the deferred tax balance must
reflect the presumed intention to sell. Thus, the balance will reflect the tax that will be
payable/ receivable on profits derived from the sale of the asset, even though management
actually intends keeping the asset and thus recovering the carrying amount through usage
D. The asset is an investment property measured in terms of IAS 40’s fair value model.
- IAS 12.51C states that we should presume investment properties measured under the fair
value model are to be sold. Although the presumption can be rebutted in the case of some
investment properties, the presumption in this case may not be rebutted since one of the
requirements for rebuttal is not met: the asset must be depreciable, but land is not depreciable.
- Thus, the deferred tax balance must reflect the presumed intention to sell: the balance will
reflect the tax payable/ receivable on profits derived from the sale of the asset, even though
management intends to recover the carrying amount through usage.
Chapter 6 311
4.4.3 Measuring deferred tax based on management intentions (IAS 12.51A-C)
If the asset is measured at fair value, we must consider what the management intentions are
regarding how the carrying amount of the asset is expected to be recovered. Sometimes we
have to base the measurement of our deferred tax balance on management’s actual intentions
and sometimes we need to base it on the presumed intention to sell the asset.
Management expectations can really only relate to one of the following three intentions. Notice
how the deferred tax calculation differs in each case:
x Sell the asset:
If the intention is to sell the asset, then measure the deferred tax liability or asset to reflect
the tax that would be due or receivable in terms of tax legislation if the asset was sold. The
tax that will be due in terms of tax legislation on the sale of the asset could involve
recoupments/scrapping allowances and capital gains.
x Keep the asset:
If the intention is to keep the asset, then measure the deferred tax liability or asset to reflect
the tax that would be due or receivable in terms of tax legislation based on the income
expected from the use of the asset.
x Keep the asset for a period of time and then sell it:
If the intention is to keep and then sell the asset, then measure the deferred tax liability or asset to
reflect the tax that would be due or receivable in terms of tax legislation on the expected income
from the use of the asset plus the sale of the asset.
4.4.3.1 Intention to sell the asset (actual or presumed intention)
If the asset is measured at fair value and the intention is to sell the asset, the deferred tax on the
revaluation will be measured using the following logic:
x The fair value is the expected selling price of the actual asset.
x The tax deductions do not change simply because the You can find more
asset is measured at fair value (i.e. the tax authority will examples on assets
revalued to FV where the
not increase or decrease the tax deductions allowed). intention is to sell in
x The deferred tax caused by the asset is measured x Chapter 8: example 13: revaluation to a
based on the tax that would be due on the sale FV that does not exceed cost
thereof at its carrying amount. This could involves: x Chapter 8: example 16 – 18: revaluation
to a FV that exceeds cost.
Recoupment (or scrapping allowance), and a
Taxable capital gain: if the asset was revalued to a fair value that exceeded cost.*
* If the asset is revalued to a fair value that does not exceed cost, the taxable profits cannot
involve a capital gain, because capital gains only arise on the proceeds above cost, but
could involve a recoupment or scrapping allowance.
4.4.3.2 Intention to keep the asset You can find more
examples on assets
revalued to FV where
If the asset is measured at fair value and the intention is the intention is to keep:
to keep the asset, the deferred tax caused by this asset x Chapter 8: example 13: revaluation to
will be measured using the following logic: a FV that does not exceed cost
x The fair value is the expected future revenue from the x Chapter 8: example 14 - 15:
revaluation to a FV that exceeds cost
sale of items produced by the asset;
x The tax deductions will not change simply because the asset has been measured at fair value;
x The deferred tax caused by the asset must be measured based on the tax that applies if sales
income were earned to the value of its carrying amount.
Thus, any increase in the carrying amount when re-measuring an asset to fair value would
mean extra sales income is expected but no extra tax deductions would be expected.
312 Chapter 6
4.4.4 Measuring deferred tax if the fair-valued asset is also non-deductible
It can happen that the non-current asset that is measured at fair value is a non-deductible asset
(i.e. an asset the cost of which is not deductible when calculating taxable profits).
x any temporary difference arising from the initial recognition of such an asset (other than
an asset acquired through a business combination) is exempt from deferred tax; but
x any further temporary difference arising from the revaluation of such an asset is not exempt
from deferred tax (see IAS 12.15 and section 4.3 for revision of the exemption).
The principle that the deferred tax balance should reflect the future tax based on the relevant
intention (to keep or sell) does not change. This is explained below.
If the asset is non-deductible and the intention is to keep the asset, the temporary difference caused by:
x the portion of the carrying amount up to depreciated cost would not lead to deferred tax (that
portion of the temporary difference is exempt from deferred tax in terms of the IAS 12.15);
x the portion of the carrying amount above depreciated cost (i.e. the revaluation surplus) would
lead to the recognition of deferred tax and this deferred tax would be measured by calculating
the tax that would be due/ receivable assuming this increase in carrying amount reflected future
sales (i.e. deferred tax on this increase is measured at tax rates applicable to operating profits).
If the asset is non-deductible and the intention is to sell the asset, the temporary difference caused by:
x the portion of the carrying amount up to depreciated cost would not lead to deferred tax (that
portion of the temporary difference is exempt from deferred tax in terms of the IAS 12.15);
x the portion of the carrying amount above depreciated cost (i.e. the revaluation surplus) would
lead to the recognition of deferred tax and this deferred tax would be measured as the tax that
would be due/ receivable assuming the asset were sold. Thus:
x If the asset’s fair value does not exceed cost,
the deferred tax balance will be nil: You can find more
examples on non-
There is no recoupment possible because there deductible assets in:
are no prior deductions to recoup; and
There is no taxable capital gain possible since x Chapter 8: example 21: intention to keep
(depreciable);
the expected selling price is less than cost.
x Chapter 8: example 20: intention to sell
x If the asset’s fair value does exceed cost, the (depreciable).
deferred tax balance will reflect tax on the
extent to which the fair value over cost is included in taxable profits:
There is no recoupment possible because there are no prior deductions to recoup; but
A taxable capital gain is possible to the extent that the excess of the fair value over
cost is included in taxable profits.
Let us consider why we provide deferred tax on the revaluation surplus by using, as an example,
a non-deductible asset that has been revalued upwards in terms of IAS 16’s revaluation model:
x The taxable temporary difference that arose when the asset was initially acquired (equal to
the cost of the asset) is exempt from deferred tax in terms of IAS 12.15: the exemption
applies to the initial recognition of a non-deductible asset.
x As this asset’s cost is depreciated (or impaired), its carrying amount (depreciated cost) decreases
and the resulting decrease in the temporary difference is also exempt from deferred tax in terms
of IAS 12.15: the exemption from recognising deferred tax on the initial recognition of the cost of
a non-deductible asset, applies equally to the movement in temporary differences relating to this
cost (i.e. the exemption applies when it relates to the gradual writing-off of this same initial cost).
x When this asset is revalued upwards, we are adding an amount to the carrying amount
(depreciated cost): this debit is not related to the initial recognition of an asset and thus the
exemption from deferred tax in IAS 12.15 does not apply (it only applies to the temporary
difference arising as a direct result of the initial recognition of the cost of the asset – a revaluation
has nothing to do with the initial recognition and is simply a remeasurement of the asset).
Chapter 6 313
Example 13: Revaluation above cost: PPE: intention to keep

x Non-deductible
x Depreciable
An item of property, plant and equipment was purchased for C1 200 on 1 January 20X1.
x Depreciation is calculated over a total useful life of 4 years to a nil residual value (straight-line).
x The tax authorities do not grant any tax deductions on this asset.
x The asset was revalued to fair value of C1 440 on 31 December 20X2.
The profit before tax and before depreciation (fully taxable) is C1 720 in 20X4.
Required: Assuming management has the intention to keep the asset:
A. Calculate the current income tax for 20X4.
B. Calculate all deferred tax balances and adjustments.
C. Disclose the tax expense note for 20X4. Comparatives are not required.
Solution 13: Intention to keep

Comment:
x This asset is revalued in terms of IAS 16’s revaluation model but since it is depreciable, management’s actual
intention to keep it is not over-ridden by IAS 12.51B’s presumed intention to sell. See example 15 where we
ignore management’s intention to keep the asset and presume the intention is to sell the asset instead.
x This situation (a non-deductible, depreciable asset that is to be kept) is also covered in chapter 8’s
example 21, where this example also shows the revaluation journals and related deferred tax journals.
Solution 13A: Current tax 20X4

C
Profit before tax and before depreciation 1 720
Depreciation (C1 440 – 0) / 2 remaining years x 1 year (720)
Add back depreciation Per above: not deductible 720
Current income tax at 30% 516
Solution 13B: Deferred tax

Comments:
x The calculations of the closing deferred tax balances of C252 and C126 in the deferred tax table in W1, were
supported by W2. Instead of using W2, we could use a slightly more detailed version of the deferred tax table
in W1. These alternative workings are shown separately in W3 This alternative is used in chapter 8, example 21.
Either layout achieves the same answer.
x When the deferred tax movement is caused by an adjustment to revaluation surplus, (other comprehensive
income: OCI), the contra entry when debiting/crediting deferred tax is the revaluation surplus, not tax expense.
The DT adjustment is recognised in OCI instead of P/L. See section 4.4.1 and chapter 8.
W1. DT on PPE - intention to keep (FV greater than CP)
x Non-deductible Carrying Tax Temporary Deferred
x Depreciable amount base differences tax
Cost: 1/1/20X1 1 200 0 (1 200) 0 Exempt IAS12.15
Depreciation / Deductions: 20X1 (300) 0 300 0 Exempt IAS12.15
Balance: 31/12/20X1 900 0 (900) 0 Exempt IAS12.15
Depreciation / Deductions: 20X2 (300) 0 300 0 Exempt IAS12.15
600 0
RS: 31/12/20X2 (reval @ YE) 840 0 (840) (252) Cr DT; Dr RS
Balance: 31/12/20X2 1 440 0 (1 440) (252) L (See W2)
Depreciation / Deductions: 20X3 (historic) (300) 0 300 0 Exempt IAS12.15

Depreciation / Deductions: 20X3 (extra) (420) 0 420 126 Dr DT; Cr RS
Balance: 31/12/20X3 720 0 (720) (126) L (See W2)
Depreciation / Deductions: 20X4 (historic) (300) 0 300 0 Exempt IAS12.15
Depreciation / Deductions: 20X4 (extra) (420) 0 420 126 Dr DT; Cr RS
Balance: 31/12/20X4 0 0 0 0
314 Chapter 6
W2. DT balances: Future tax on expected operating profits

At 31/12/20X2: CA = 1 440 At 31/12/20X3: CA = 720
Taxable Tax Taxable Tax
profits at 30% (1) profits at 30% (1)
Extra future profits 840 420
31/12/X2: ACA (1) (1 440) – DC (2) (600)
31/12/X3: ACA (1) (720) – DC (2) (300)
Less extra future deductions 0 0
Extra future taxable profits/ tax 840 252 (3)
420 126 (3)
Notes:
(1) The tax is measured at 30% since the revalued amount will be recovered through operating profits.
(2) ACA = actual carrying amount after revaluation
(3) DC = depreciated cost (also called historical carrying amount/ HCA)
W3. DT balances: an alternative calculation to W2
x Instead of using W2, the DT balance of C252 at 31 December 20X2 (see W1) could be calculated using the
following structure, which would replace the line that reads ‘Balance: 31/12/20X2’ in the W1 table.
CA TB TD DT
Balances: 31/12/20X2 1 440 0 (1 440) (252) L
CA before revaluation: 600 0 (600) 0 Exempt (0%) (1)
Depreciated cost: 1 200 – 300 x 2yrs
Effect of revaluation - up to cost: 600 0 (600) (180) (0-600) x 30% (2)
Depreciated cost 600 – FV, limited to
cost 1 200
Effect of revaluation – above cost: 240 0 (240) (72) (0-240) x 30% (2)
Cost 1 200 – FV 1 440
x Instead of using W2, the DT balance of C126 at 31 December 20X3 could be calculated using the following
structure, which would replace the line that reads ‘Balance: 31/12/20X3’ in the W1 table.
CA TB TD DT
Balances: 31/12/20X3 720 0 (720) (126) L
CA before revaluation: 300 0 (300) 0 Exempt (0%) (1)
Depreciated cost 1 200 – 300 x 3yrs
Effect of revaluation - up to cost: 420 0 (420) (126) (0-420) x 30% (2)
Depreciated cost 300 – FV, limited to
cost 720 (cost not a limiting factor)
Effect of revaluation – above cost: 0 0 0 0 (0-0) x 30% (2)
N/A
Notes:
(1) DT is not recognised because it is exempt
(2) DT is recognised and measured at the tax that will be due if the future benefits are earned as operating profits.
Entity name
For the year ended …20X4 C C
Income taxation expense 516 xxx
x Current 13A 516 xxx
x Deferred 13B: W1 (the DT adj was credited to RS not TE) 0 xxx
Applicable tax rate 30% xxx
Tax effects of
x Profit before tax 1 000 (13A) x 30% 300 xxx
x Non-deductible depreciation 720 (13B: W1) x 30% 216 xxx
Tax expense on face of statement of comprehensive income 516 xxx
Effective tax rate 516 / 1 000 51,6% xxx
Chapter 6 315
Example 14: Revaluation above cost: PPE: intention to sell

x Non-deductible
x Depreciable
x Depreciation is calculated at 25% pa to a nil RV (straight-line).
x The asset was revalued to fair value of C1 440 on 31 December 20X2.
x The tax authorities do not grant any tax deductions on this asset and the capital gain inclusion rate is 80%
x The profit before tax and before depreciation (fully taxable) is C1 720 in 20X4.
Required: Assuming management intends to sell the asset:
B. Calculate the deferred tax balances and adjustments.
Solution 14: Intention to sell

Comment:
x This situation (a non-deductible, depreciable asset that is to be sold) is covered in chapter 8’s
example 20, where this example shows the revaluation journals and related deferred tax journals.
x Notice that since the revaluation surplus is recognised in OCI, the deferred tax adjustment is not
recognised in the tax expense account (P/L) but directly in the RS account, being an OCI account.
Solution 14A: Current tax

The answer is identical to the calculation shown in example 13A.

Comments: The closing deferred tax balances in the deferred tax table in W1, were calculated in W2. Instead of
using W2, we could use a slightly more detailed deferred tax table in W1. These alternative workings are shown
separately in W3. This alternative is used in chapter 8, example 20. Either layout achieves the same answer.
W1: DT on PPE - intention to sell (FV greater than CP)

x Depreciable amount base differences tax
Cost: 1/1/20X1 1 200 0 (1 200) 0 Exempt IAS12.15
Depreciation / Deductions 20X1 (300) 0 300 0 Exempt IAS12.15
Balances: 31/12/20X1 900 0 (900) 0 Exempt IAS12.15
Depreciation / Deductions 20X2 (300) 0 300 0 Exempt IAS12.15

600 0 (600)
RS: 31/12/20X2 (reval @ YE) 840 0 (840) (57,6) Cr DT; Dr RS
Balances: 31/12/20X2 1 440 0 (1 440) (57,6) L (W2: 0 + 57,6)
Depreciation / Deductions (historic) (300) 0 300 0 Exempt IAS12.15

Depreciation / Deductions (extra) (420) 0 420 57,6 Dr DT; Cr RS
Balances: 31/12/20X3 720 0 (720) 0 (W2: 0 + 0)
Depreciation / Deductions (historic) (300) 0 300 0 Exempt IAS12.15

Depreciation / Deductions (extra) (420) 0 420 0
Balances: 31/12/20X4 0 0 0 0
W2. DT balances: Tax on expected sale of PPE At 31/12/X2: At 31/12/X3:

CA = 1 440 CA = 720
W2.1 Tax on recoupment: Taxable Tax at Taxable Tax at
profits 30% profits 30%
Selling price (1 440), limited to cost price (1 200) 1 200 720
Less tax base 0 0
Recoupment and related tax (1) 1 200 0 720 0
316 Chapter 6
W2. Continued… At 31/12/X2: At 31/12/X3:

Taxable Tax at Taxable Tax at
W2.2 Tax on taxable capital gain:
profits 30% profits 30%
Selling price 1 440 720
Less base cost (assumed = cost) (1 200) (1 200)
Capital gain/ (loss) 240 (480)
Inclusion rate (given) 80% 80%
Taxable capital gain/ (loss) and related tax (2) 192 57,6 (384) 0
Total tax (tax on recoupment + tax on taxable capital gain) 57,6 0
Notes:
1. There is no recoupment possible: since the asset was not deductible, there can be no recoupment of anything.
2. If we sold for C720 at end 20X3, a tax-deductible capital loss of C384 would arise and may be available to
reduce any future taxable capital gains. Capital losses (opposite of capital gains) are ignored in this text. Thus
the possible deferred tax asset of C115,2, (being the possible future tax saving of C384 x 30%), was ignored.
W3. DT balances: an alternative calculation to W2

x The line in the DT table (W1) that reads ‘Balance: 31/12/20X2’ could be replaced by:
CA TB TD DT
Balances: 31/12/20X2 1 440 0 (1 440) (57,6) L
CA before revaluation 600 0 (600) 0 TD 600 = Exempt (1)
Depreciated cost: 1 200 – 300 x 2yrs
Effect of revaluation - up to cost: 600 0 (600) 0 TD 600 x 0% (2)
Depreciated cost 600 – FV, limited to cost 1 200
Effect of revaluation - above cost 240 0 (240) (57,6) TD 240 x 80% x 30% (3)
Cost 1 200 – FV 1 440
x The line in the DT table (W1) that reads ‘Balance: 31/12/20X3’ could be replaced by.
Balances: 31/12/20X3 720 0 (720) 0 L
CA before revaluation 300 0 (300) 0 TD 300 = Exempt (1)
Depreciated cost 1 200 – 300 x 3yrs
Effect of revaluation - up to cost: 420 0 (420) 0 TD 420 x 0% (2)
Depreciated CA 300 – FV, limited to cost 720
(cost not a limiting factor)
Effect of revaluation - above cost 0 0 0 0 TD 0 x 80% x 30% (3)
N/A
Notes:
1) This portion of the TD is exempt from DT since it relates to depreciated cost – no DT is recognised
2) This portion of the TD normally reflects the increase in the expected recoupment reflected by the revaluation
but this is a non-deductible asset (i.e. no tax-deductions are granted) and thus no recoupment would be possible.
We get around this by simply multiplying this TD by 0% (instead of 30%).
(e.g. at the end of 20X2, just before revaluation, the TD of C600 means that, if it were a deductible asset and it
was sold, it would cause a recoupment of C600, but after the revaluation upwards by C600 to original cost of
C1 200 , it would cause a recoupment of C1 200 – being an increase in the recoupment of C600).
3) This portion of the TD reflects the capital gain. In this example, only 80% of the capital gain is included in
taxable profits, which are then taxed at 30% (i.e. the DT on this TD is calculated at an effective tax rate of 24%).

Entity name
For the year ended …20X4 C C
x Current Sol 14A and Sol 13A 516 xxx
x Deferred Sol 14B: W1 (the DT adj was credited to RS not TE) 0 xxx
Tax effects of
x Profit before tax 1 000 (Sol 14A/13 A) x 30% 300 xxx
x Non-deductible depreciation 720 (Sol 14B: W1) x 30% 216 xxx
Effective tax rate 516 / 1 000 51,6% xxx
Chapter 6 317
Example 15: Revaluation above cost: PPE: intention to keep

x Non-deductible
x Non-depreciable
x The item is land and is not depreciated.
x The tax authorities do not grant any tax deductions on this asset. The base cost is C1 200.
x The land was revalued to fair value of 2 040 on 31 December 20X2.
x The land was sold for C1 800 during 20X4.
x The inclusion rate of the capital gain in taxable profits is 80%.
The profit before tax and before the sale (fully taxable) is C1 000 in 20X4.
Required:
Assuming management’s intention is to keep the asset:
B. Calculate the deferred tax balances and adjustments.
Solution 15: Intention to keep

Comment:
x This asset is revalued in terms of IAS 16’s revaluation model and since the asset is non-depreciable,
management’s real intention to keep the asset is over-ridden by IAS 12.51B’s presumed intention.
The deferred tax is thus measured on the presumed intention to sell the asset even though
management’s real intention is to keep the asset.
x This situation is also covered in chapter 8’s example 22, where the focus is on the revaluation journals
and related deferred tax journals.
Solution 15A: Current tax

20X4
Profit before tax and before the sale 1 000
Loss on sale Proceeds: 1 800 – CA: 2 040 (FV) (240)
Profit before tax 760
Add back loss on sale 240
Add taxable capital gain (Proceeds: 1 800 – Base cost: 1 200) x 80% 480
Current income tax at 30% 444
W1. DT on PPE: intention to keep

x Non-depreciable amount base differences tax
Cost: 1/1/20X1 1 200 0 (1 200) 0 Exempt IAS 12.15
Movement: 20X1 0 0 0 0 Exempt IAS 12.15
Balances: 31/12/20X1 1 200 0 (1 200) 0 Exempt IAS 12.15
Movement: 20X2 0 0 0 0 Exempt IAS 12.15
1 200 0 (1 200) 0 Exempt IAS 12.15
RS – 31/12/20X2 840 0 (840) (202) Cr DT; Dr RS
Balances: 31/12/20X2 2 040 0 (2 040) (202) L (W2: 0 + 202)
Movement: 20X3 0 0 0 0
Balances: 31/12/20X3 2 040 0 (2 040) (202) L
Sold (CA) (2 040) 0 2 040 202 Dr DT; Cr RS
Balances: 31/12/20X4 0 0 0 0 L
318 Chapter 6
W2. DT balances: Tax on future profits from expected sale of land

At 31/12/20X2: CA = 2 040
W2.1 Tax on recoupment: Taxable profits Tax at 30%
Selling price (2 040), limited to Cost price (1 200) 1 200
Less tax base 0
Recoupment and related tax (1) 1 200 0
W2.2 Tax on taxable capital gain:

Selling price 2 040
Capital gain 840
Inclusion rate 80%
Taxable capital gain and related tax 672 202
Total deferred tax balance 202
Notes: (the above amounts have been rounded up to zero decimal point where necessary)
(1) There is no recoupment possible: since the asset was not deductible, there can be no recoupment of anything.
Entity name
20X4 20X3
x Current Sol 15A 444 xxx
x Deferred Sol 15B W1 (the DT adj. was credited to RS not TE) 0 xxx
Tax effects of
x Profit before tax Sol 15A: 760 x 30% 228 xxx
x Exempt capital loss Sol 15A: (Loss on sale: 240 + Taxable 216 xxx
capital gain: 480) x 30%
Effective tax rate Tax: 444 / Profit before tax: 760 58,4% xxx
4.5 Sale of a non-current asset
When a non-current asset is sold:

x the accounting records could reflect either a:
profit (capital and/or non-capital), or
loss; and
x the tax records could reflect either a:
taxable profit (recoupment and/or capital gain) or
a deductible loss (scrapping allowances and/or a capital loss).
Recoupments and scrapping allowances can only ever apply to an asset that is deductible.
Please note that capital losses are not covered in this text.
These differences are covered in detail in chapter 5. A summary of the calculations in the
accounting records and tax records follows.
Chapter 6 319
IFRS and the accounting records Tax legislation and the tax records
Total profit or loss Total profit or loss
Proceeds xxx Proceeds xxx
Less carrying amount (xxx) Less tax base (xxx)
Profit or (loss) on sale xxx Profit or (loss) on sale xxx
Capital portion Taxable capital gain
Proceeds xxx Proceeds xxx
Less cost (xxx) Less base cost (xxx)
Capital profit xxx Capital gain xxx
Inclusion rate for companies @ 80%
Non-capital portion Recoupment / Scrapping allowance
Proceeds limited to cost xxx Proceeds limited to cost xxx
Less carrying amount (xxx) Less tax base (xxx)
Non-capital profit or (loss) xxx Recoupment/ (scrapping allowance) xxx
A recoupment is the reversal of tax deductions allowed in prior years whereas a scrapping
allowance is simply the granting of a further deduction where the asset is sold at a loss.
The following two examples simply revise how the sale of an asset affects current tax (see
chapter 5). The examples after these two examples then show the deferred tax implications of
the sale of an asset, which is, in fact very simple: if the asset is sold, the carrying amount of the
asset is derecognised, and any remaining tax base falls away, at which point both the carrying amount
and tax base will be nil and thus, since any temporary difference will have disappeared, any related
deferred tax balance must be derecognised. So we simply reverse the deferred tax balance to zero.
Example 16: Non-current asset sold at a profit with a recoupment
A company purchases an asset for C1 200 on 1 January 20X1.
x The company depreciates this asset over 3 years, straight-line to a nil residual value.
x The tax authority allows this cost to be deducted over 4 years.
x The company sells the asset for C900 on 1 January 20X3.
Required:
A. Calculate the depreciation expensed and the taxdeductions granted to 31 December 20X2.
B. Calculate the net cost of the asset to the company after having sold it.
C. Calculate the profit on sale and the recoupment of tax deductions, if any.
D. Compare the effect of the asset on profit before tax and on taxable profits over the years affected.
Solution 16A: Depreciation versus Tax deductions

Depreciation and Tax deductions Depreciation Tax deductions
20X1: [(C1 200 – 0) / 3 years]; and [C1 200 / 4 years] 400 300
31/12/20X2: Cumulative 800 600
Solution 16B: Cost to company

Net cash outflow to company C
Cost of purchase (1/1/20X1) 1 200
Cost recovered through sale (1/1/20X3) (900)
Net cost to company 300
Solution 16C: Profit on sale versus Recoupment on sale

W1. Profit/ (loss) on sale C
Proceeds 900
Less carrying amount (1 200 – 800) (400)
Profit on sale 500
320 Chapter 6
W2. Recoupment/ (scrapping allowance) on sale

Proceeds (900) limited to cost (1 200) (cost is greater, so proceeds not limited) 900
Less tax base (1 200 cost – 600 allowances to date) (600)
Recoupment / (scrapping allowance) 300
Solution 16D: Comparison of effect of the asset on Profit before tax and Taxable profits
The real net cost to the company is 300 (see example 16B). This is reflected in both:
x Profit before tax:
Depreciation in 20X1 & 20X2: 800 (Sol 16A) – Profit on sale in 20X3: 500 (Sol 16C W1) = 300
x Taxable profit:
Tax deductions in 20X1 & 20X2: 600 (Sol 16A) – Recoupment on sale in 20X3: 300 (Sol 16C) = 300
Example 17: Non-current asset sold at a loss with a scrapping allowance
A company purchases an asset for C1 200 on 1 January 20X1.
x The company depreciates this asset over 3 years, straight-line to a nil residual value.
x The tax authority allows this cost to be deducted over 4 years.
x The company sells the asset for C300 on 1 January 20X3.
Required:
A. Calculate the depreciation expense and tax deductions granted to 31 December 20X2.
B. Calculate the net cost of the asset to the company after having sold it.
C. Calculate the loss on sale and the recoupment of tax deductions, if any.
D. Compare the effect of the asset on profit before tax and on taxable profits over the years affected.
Solution 17A: Depreciation versus capital allowances

Depreciation and Tax deductions Depreciation Tax deductions
31/12/20X2: Cumulative 800 600
Solution 17B: Cost to company

Net cash outflow to company C
Cost of purchase 1 200
Cost recovered through sale (300)
Net cost to company 900
Solution 17C: Loss on sale versus scrapping allowance

W1. Profit or loss on sale C
Proceeds 300
Less carrying amount (1 200 – 800) (400)
Loss on sale (100)
W2. Recoupment / (scrapping allowance) on sale

Proceeds (300) limited to cost (1 200) (cost is greater, so proceeds not limited) 300
Less tax base (1 200 – 600) (600)
Scrapping allowance (300)
Comment: The real net cost to the company is 900 (see solution 17B). This should be reflected by both:
x A net tax deduction of 900: deductions granted: 600 + extra deduction (scrapping allowance): 300
x A net expense of 900: depreciation expensed: 800 + extra expense (loss on sale): 100
Solution 17D: Comparison of effect of the asset on Profit before tax and Taxable profits
The real net cost to the company is 900 (see example 17B). This is reflected in both:
Depreciation in 20X1 & 20X2: 800 (Sol 17A) + Loss on sale in 20X3: 100 (Sol 17C W1) = 900
x Taxable profit:
Tax deductions in 20X1 & 20X2: 600 (Sol 17A) + Scrapping allowance in 20X3: 300 (Sol 17C) = 900
Chapter 6 321
Example 18: Sale of a deductible, depreciable asset (plant) at below cost with
deferred tax implications
A plant was purchased on 1 January 20X1 for C30 000 and sold on 1 January 20X2 for C21 000.
x The depreciation rate used by the accountant is 50% p.a. straight-line;
x The rate of wear and tear allowed as a tax deduction is 33 1/3 % p.a. straight-line
x The profit before tax is C20 000 in 20X1 and 20X2, according to both the
accountant and the tax authority, before taking into account the asset in any way.
x Assume that there is no other information relating to any of the affected accounts
The income tax rate is 30% and there are no components of other comprehensive income.
Required:
B. Calculate the current income tax for 20X2.
D. Disclose the above in as much detail as is possible for 20X2.

Plant: Carrying Tax Temporary Deferred DT
x Deductible amount base difference tax at 30% balance/
x Depreciable (per SOFP) (IAS 12) TD x 30% adjustment
Purchase 30 000 30 000 0 0
Depreciation/ deduction (15 000) (10 000) 5 000 1 500 Dr DT Cr TE
Closing balance – 20X1 15 000 20 000 5 000 1 500 Asset
Sale: write off CA & TB (15 000) (20 000) (5 000) (1 500) Cr DT Dr TE
Closing balance – 20X2 0 0 (1) 0 0
(1) The tax base of an asset represents the deductions still to be made for tax purposes (e.g. wear and
tear allowance): after the asset is sold, there can be no further deductions.

W2. Profit on sale – per accountant 20X2
Proceeds 21 000
Less carrying amount 15 000
Cost 30 000
Less accumulated depreciation (1 yr x 15 000) (15 000)
Profit on sale: non-capital profit 6 000
W3. Recoupment on sale – per tax authority

Proceeds (limited to cost): the cost is not a limiting factor in this example 21 000
Less tax base (20 000)
Cost 30 000
Less accumulated capital allowance (1 yr x 10 000) (10 000)
Recoupment on sale 1 000
W4. Current income tax - 20X2 Profits Tax at 30%

Profit before tax (accounting profits) (20 000 + 6 000) 26 000 7 800
Movement in temporary differences: (5 000) (1 500)
- less profit on sale (W3) (6 000)
- add recoupment (W4) 1 000
Taxable profits and current income tax 21 000 6 300
322 Chapter 6
Solution 18C: Ledger

Comment: Notice that the balance on the deferred tax reverses out: the net expenses since 20X1 to
20X2 total C9 000 in terms of both the accountant and the tax authority:
x Accountant: depreciation of C15 000 less profit of C6 000
x Tax authority: capital allowance of C10 000 less recoupment of C1 000.
20X1 20X1 ITE 3 000
CTP 3 000 DT (W1) 1 500 20X2 ITE (W4) 6 300
P/L 1 500 Balance b/d 9 300
3 000 3 000
20X2
CTP: IT (W4) 6 300
DT (W1) 1 500 P/L 7 800
7 800 7 800

20X1 IT 1 500 20X2 IT 1 500
Company name
Note 20X2 20X1
C C
Profit before tax (20 000 + 6 000)/(20 000 – 15 000) 26 000 5 000
Income tax expense 15. (7 800) (1 500)
Company name
Note 20X2 20X1
ASSETS C C
Non-current assets
Property, plant and equipment (W1) 0 15 000
Deferred tax (W1) 6. 0 1 500
Company name
For the year ended 31 December
20X2 20X1
6. Deferred tax asset/ (liability) C C
x Property, plant and equipment (W1) 0 1 500

x Current (W4) 6 300 3 000
x Deferred (W1) 1 500 (1 500)
Chapter 6 323
Example 19: Sale of a deductible, depreciable asset (plant) at above cost

A plant was purchased on 1 January 20X1 for C30 000 and sold on 1 January 20X2 for
C35 000.
x The depreciation rate used by the accountant is 50% p.a. straight-line;
x The rate of wear and tear allowed as a tax deduction is 33 1/3 % p.a. straight-line.
x The base cost for the purposes of calculating the taxable capital gain, is C31 000;
x The profit before tax and before taking into account the sale, is C20 000 according to
both the accountant and the tax authority for 20X1 and 20X2;
x The inclusion rate of the capital gain in taxable profits is 80%;
x The income tax rate is 30% and there are no components of other comprehensive
income.
x Assume that there is no other information relating to any of the affected accounts.
Required:
D. Disclose the above in the statement of comprehensive income, the tax expense note and deferred tax asset
or liability note for the year ended 31 December 20X2.

The calculation of the deferred tax using the balance sheet approach is identical to the calculation
under example 18:
x Whether the asset is sold at above or below original cost does not change its carrying amount or
tax base at the end of year 20X2.
x Both are simply zero since the asset has been sold.
x In other words, what the asset is sold for (selling proceeds), has no bearing on deferred tax.
x The price the asset sells for only affects the current income tax calculation, in the form of
recoupment or scrapping allowances, and capital gains tax.
W1. Recoupment on sale – per tax authority 20X2

Proceeds (35 000) limited to cost (30 000): (thus 30 000 is a limiting factor) 30 000
Less tax base (20 000)
Cost 30 000
Less accumulated capital allowance (1 yr x 10 000) (10 000)
Recoupment 10 000
W2. Taxable capital gain – per tax authority 20X2

Proceeds 35 000
4 000
Inclusion rate @ 80%

Proceeds 35 000
Less carrying amount (15 000)
Cost 30 000
Less accumulated depreciation (1 yr x 15 000) (15 000)

- capital profit (35 000 – 30 000) 5 000
- non-capital profit (30 000 – 15 000) 15 000
324 Chapter 6
W4. Taxable profits and current income tax - 20X2 Profits Tax at 30%
Profit before tax (accounting profits) (20 000 + profit on sale: 20 000) 40 000
Exempt income: exempt portion of capital profit
Less capital profit W3 (5 000)
Add taxable capital gain W2 3 200
Taxable accounting profits and tax expense 38 200
Movement in temporary differences: (5 000)
Less non-capital profit on sale W3 (15 000)
Add recoupment on sale W1 10 000
Solution 19C: Ledger

20X1 20X1: IT exp 3 000
CTP 3 000 DT 1 500 Balance c/f 3 000
P/L 1 500 3 000 3 000
3 000 3 000 20X1: Bal b/f 3 000
20X2 Balance c/f 12 960 20X2: IT exp 9 960
CTP 9 960 12 960 12 960
DT 1 500 P/L 11 460 20X2: Bal b/f 12 960
Total 11 460 11 460

20X1: Tax exp 1 500
20X1: Bal c/f 1 500
1 500 1 500
20X1 Bal b/f 1 500
20X1: Tax exp 1 500
1 500 1 500
20X2 Bal b/f 0
Entity name
Note 20X2 20X1
C C
Profit before tax (20K + 20K) (20K – 15K) 40 000 5 000
Name
20X2 20X1
x Property, plant and equipment W1 (example 18A) 0 1 500

x Current W4 9 960 3 000
x Deferred W1 (example 18A) 1 500 (1 500)
Chapter 6 325
Example 20: Sale of a non-deductible, non-depreciable asset at below cost

Entity Ltd purchased land for C30 000 on 1 January 20X1
x The land was sold on 1 January 20X2 for C20 000.
x The local tax authority taxes 80% of capital gains but does not allow the deduction of
capital losses.
x The profit before tax but before taking into account the sale is C20 000 according to
both the accountant and the tax authority and for both 20X2 and 20X1.
Required:
C. Disclose this in the statement of comprehensive income, statement of financial position and tax
expense note for the year ended 31 December 20X2.
W1. Calculation of deferred income tax (balance sheet approach):

Land: Carrying Tax Temporary Deferred DT
x Non-deductible amount base difference tax at 30% balance/
x Non-depreciable (per SOFP) (IAS 12) TD x 30% adjustment
Purchase 30 000 0 (30 000) 0 Exempt
Depreciation/ deductions (0) (0) 0 0 0
Closing balance – 20X1 30 000 0 (30 000) 0 Exempt
Sale: write off of CA & TB (30 000) (0) 30 000 (0) Exempt

W2. Recoupment/ scrapping allowance on sale – per tax authority 20X2
Proceeds (20 000) limited to cost (30 000): (therefore 30 000 is not a limiting factor) 20 000
Less tax base (no deductions of cost allowed for this land) (0)
Recoupment 20 000
Recoupment is not possible (since no deductions were allowed, there is nothing to recoup!) (20 000)
Recoupment * 0
Note:
There appeared to be a recoupment because the tax base is nil, but, we must remember that the tax
base is nil because the asset was non-deductible and not because all the tax deductions had been
granted.
W3. Profit/ (loss) on sale – per accountant 20X2

Proceeds 20 000
x Cost 30 000
x Less accumulated depreciation (this land is not depreciated) (0)
Loss on sale (10 000)
W4. Taxable profits and current income tax - 20X2 Profits Tax at 30%
Profit before tax (accounting profits) (20 000 – 10 000) 10 000
Movement in temporary differences: exempt (IAS 12.15) 10 000
x Add back loss on sale of land W3 10 000
x Add recoupment: not applicable W2 (not deductible) 0
Movement in temporary differences: normal 0
326 Chapter 6
Entity Ltd
Note 20X2 20X1
C C
Profit (loss) before tax (20 000 – 10 000) (20 000 + - 0) 10 000 20 000
Entity Ltd
Note 20X2 20X1
C C
ASSETS
Non-current assets
Property, plant and equipment W1 0 30 000
Deferred tax: income tax W1 6 0 0
Entity Ltd
20X2 20X1
x Current W4 6 000 6 000
x Deferred W1 0 0
Tax rate reconciliation

Tax effects of:
x Profit before tax (10 000 x 30%); (20 000 x 30%) 3 000 6 000
x Exempt temporary differences (add loss: 10 000 x 30%) 3 000 0
Tax expense per statement of comprehensive income 6 000 6 000
Effective tax rate (6 000/ 10 000) (6 000 / 20 000) 60% 30%
Example 21: Sale of non-deductible, non-depreciable asset at above cost

Daisy Limited purchased land for C30 000 on 1 January 20X1. This land:
x was then sold on 1 January 20X3 for C40 000;
x was not depreciated and no deductions had been allowed for tax purposes;
x had a base cost, for the purposes of calculating the taxable capital gain, of C30 000
and the inclusion rate of the capital gain in taxable profits was 80%.
The profit before tax and before taking into account the sale, is C20 000 according to both
the accountant and the tax authority for 20X2 (and 20X1).
The income tax rate is 30%
Required:
C. Disclose this in the statement of financial position, statement of comprehensive income and the
tax expense note for the year ended 31 December 20X2.
Chapter 6 327
Comment:
x The calculation of deferred tax using the balance sheet approach is identical to the calculation
under example 20 since the amount that the asset is sold for does not affect the deferred tax
calculation in any way.
x The deferred tax calculation focuses only on the calculation of the carrying amount and tax base.
x The fact that this asset was sold at above original cost does not affect its carrying amount or tax
base: both are simply reduced to zero when the asset is sold since the asset no longer belongs to
the company.

Taxable profits and current income tax – 20X1:

Proceeds (40 000) limited to cost (30 000): (therefore 30 000 is a limiting factor) 30 000
Less tax base (no deductions against cost allowed) (0)
Recoupment 30 000
Exemption (since no deductions were allowed, there can be no recoupment) (30 000)
Recoupment after exemption 0

Proceeds 40 000
10 000
Inclusion rate 80%

Proceeds 40 000
Cost 30 000
Less accumulated depreciation (no depreciation on this land) (0)
- capital profit (selling price: 40 000 – cost price: 30 000) 10 000
- non-capital profit (cost price: 30 000 – carrying amount: 30 000) 0
W4. Taxable profits and current income tax - 20X2 C

Profit before tax (accounting profits) (20 000+ profit on sale: 10 000) 30 000
- Exempt income: exempt portion of capital profit (2 000)
Less capital profit W3 (10 000)
Add taxable capital gain W2 8 000
- Exempt temporary difference: (IAS 12.15) 0
Less non-capital profit W3 (0)
Add recoupment W1 (exempted in terms of IAS 12.15) 0
- Movement in temporary differences: W1 (example 20) 0
Taxable profits and current income tax 28 000
Current income tax at 30% 8 400
328 Chapter 6
Entity name
Note 20X2 20X1
C C
Profit (loss) before tax (20 000 + 10 000) (20 000 + - 0) 30 000 20 000
Entity name
Note 20X2 20X1
ASSETS C C
Non-current assets
Property, plant and equipment W1 (Example 20) 0 30 000
Deferred tax: income tax W1 (Example 20) 6 0 0
Entity Name
20X2 20X1
x Current W4 8 400 6 000
x Deferred W1 (Example 20) 0 0
Tax effects of:
x Profit before tax (30 000 x 30%) (20 000 x 30%) 9 000 6 000
x Exempt capital profit (10 000 – 8 000) x 30% (600) 0
Effective tax rate (8 400/30 000) & (6 000 / 20 000) 28% 30%
Example 22: Sale of non-deductible, depreciable asset at below cost

A building was purchased for C30 000 on 1 January 20X1 but was sold on 1 January 20X2
for C28 000. The building had been depreciated at 10% p.a. on cost. No deductions for
the cost of the building had been allowed by the tax authorities.
The profit before tax and before taking into account the sale according to both the accountant and the
tax authority, is as follows:
x 20X1: C50 000
x 20X2: C20 000
Required:
Chapter 6 329

W1. Calculation of deferred income tax (balance sheet approach):
Building: Carrying Tax Temporary Deferred DT
x Non-deductible amount base difference tax at 30% balance/
x Depreciable (per SOFP) (IAS 12) TD x 30% adjustment
Purchase 30 000 0 (30 000) 0 Exempt
Depreciation/ deductions (3 000) (0) 3 000 0 Exempt
Closing balance – 20X1 27 000 0 (27 000) 0 Exempt
Sale: write off of CA and TB (27 000) (0) 27 000 (0) Exempt

Proceeds (28 000) limited to cost (30 000): (therefore 30 000 is not a limiting factor) 28 000
Less tax base (no deductions of cost allowed for this land) (0)
Recoupment 28 000
IAS 12.15 exemption (since no deductions were allowed, there can be no recoupment) (28 000)
Recoupment after exemption 0

Proceeds 28 000
Cost 30 000
Less accumulated depreciation (30 000 x 10%) (3 000)
Profit on sale (all a ‘ non-capital profit’ since selling price was below original cost) 1 000
W4. Calculation of current income tax 20X2 20X1

Profit before tax (accounting profits) (20 000 + profit on sale: 1 000) 21 000 47 000
(50 000 – depreciation: 3 000)
Movement in temporary differences: IAS 12.15 exemption (1 000) 3 000

- Add depreciation 30 000 x 10% 0 3 000
- Less profit on sale W3 (1 000) 0
Movement in temporary differences: normal 0 0
Taxable profits 20 000 50 000
Current income tax at 30% 6 000 15 000
Entity name
Note 20X2 20X1
C C
Profit (loss) before tax (20K + 1K) (50K – 3K) 21 000 47 000
330 Chapter 6
Entity name
ASSETS
Non-current assets
Property, plant and equipment W1 0 27 000
Deferred tax: income tax W1 0 0
Name
x Current W4 6 000 15 000
x Deferred W1 0 0

Tax effects of:
Profit before tax (21 000 x 30%) (47 000 x 30%) 6 300 14 100
Exempt temporary differences (less profit on sale: 1 000 x 30%) (300) 900
(add depreciation: 3 000 x 30%)
Effective tax rate (6 000/ 21 000) (15 000 / 47 000) 28.6% 31.9%
Example 23: Sale of non-deductible, depreciable asset at above cost

A building cost C30 000 on 1 January 20X1 and was sold on 1 January 20X2 for C40 000.
x Depreciation of 10% per annum was provided (residual value: nil).
x No deductions were allowed by the tax authorities.
x Its base cost, for the purposes of calculating the taxable capital gain, is C30 000 and the
inclusion rate of the capital gain in taxable profits is 80%.
x The profit before tax and before taking into account the sale, is C20 000 according to
both the accountant and the tax authority for 20X2 and 20X1.
Required:

The deferred tax calculation is identical to the calculation in example 22: the fact that the asset is sold
at above cost does not change its CA or TB: both become zero once sold.
W1 Recoupment on sale – per tax authority 20X2

Proceeds (40 000) limited to cost (30 000): (therefore 30 000 is a limiting factor) 30 000
Less tax base no deductions allowed on this building (0)
Recoupment 30 000
IAS 12.15 exemption (30 000)
Recoupment after exemption (1) 0
Notes
(1) There is no recoupment, because no deductions have been allowed previously. There is no DT
implication due to the exemption in IAS12.15
Chapter 6 331

Proceeds 40 000
Capital gain 10 000
Inclusion rate 80%

Proceeds 40 000
Cost 30 000
Less accumulated depreciation (30 000 x 10%) (3 000)

- capital profit (proceeds: 40 000 – cost: 30 000) 10 000
- non-capital profit (cost: 30 000 – carrying amount: 27 000) 3 000
W4. Calculation of current income tax - 20X2 20X2 20X1

Profit before tax (accounting profits) (20 000 + 13 000) 33 000 17 000
(20 000 – 3 000)
Exempt income: exempt portion of capital profit (2 000) 0
Less capital profit W3 (10 000) 0
Add taxable capital gain W2 8 000 0
Movement in temporary differences: exempt (IAS 12.15): (3 000) 3 000

Add depreciation 0 3 000
Less non-capital profit W3 (3 000) 0
Add recoupment (1) W1 0 0
Movement in temporary differences: normal 0 0
Taxable profits 28 000 20 000
Entity name
Note 20X2 20X1
C C
Profit before tax (20 000 + 13 000) (20 000 - 3 000) 33 000 17 000
Entity name
Note 20X2 20X1
ASSETS C C
Non-current assets
Property, plant and equipment W1: Example 22 0 27 000
Deferred tax: income tax W1: Example 22 6 0 0
332 Chapter 6
Entity name
20X2 20X1
x current W4 8 400 6 000
x deferred W1: Example 22 0 0
Tax effects of:
Profit before tax (33 000 x 30%) 9 900 5 100
(17 000 x 30%)
Non-deductible depreciation (3 000 x 30%) 0 900
Exempt capital profit less non-taxable capital profit: 2 000 x 30% (600) 0
IAS 12.15 exempt temporary difference: non-capital profit (900) 0
less IAS 12.15 exempt non-capital profit:
3 000 x 30%
Effective tax rate (8 400/ 33 000) (6 000 / 17 000) 25.5% 35.3%
5. Exemption from Deferred Tax (IAS 12.15 and IAS 12.24)
IAS 12 offers two exemptions from the requirement to recognise deferred tax:
x IAS 12.15 provides us an exemption from recognising deferred tax liabilities; and
x IAS 12.24 provides us an exemption from recognising deferred tax assets.
The exemption from recognising deferred tax liabilities is covered in depth in section 4.3.2.
This section summarises the exemption relating to both deferred tax liabilities and deferred tax
assets.
A deferred tax liability is normally recognised on taxable temporary differences, but if the
taxable temporary difference meets the criteria in IAS 12.15, it is exempt from deferred tax.
The following is a summary of the relevant IAS 12 paragraph (IAS 12.15):

x a deferred tax liability shall be recognised for all taxable temporary differences,
x except where the deferred tax liability arises from:
x goodwill; or
x the initial recognition of an asset or liability, which
x did not arise through a business combination, and which
x at the time of the transaction, affects neither accounting profit nor taxable profit.
Similarly, a deferred tax asset is normally recognised on deductible temporary differences, but
if this difference meets the criteria in IAS 12.24, it may be exempt from deferred tax.
The following is an extract of the relevant IAS 12 paragraph (IAS 12.24):

x a deferred tax asset shall be recognised for all deductible temporary differences,
x except where the deferred tax asset arises from the:
- initial recognition of an asset or liability, which
- did not arise through a business combination, and
- at the time of the transaction, affects neither accounting profit nor taxable profit.
Chapter 6 333
In other words, no deferred tax would be recognised on Important! The

the temporary differences that arise on the initial exemptions from deferred
recognition of an asset or liability where the initial tax (IAS 12.15 & IAS 12.24)
recognition affects neither accounting profit nor taxable
profit, and where the asset or liability is not acquired as x only apply to the initial recognition
(e.g. the cost of purchase);
part of a business combination.
x applies to any asset (not just non-
We covered some examples that showed the exemption current assets) or liability;
from recognising a deferred tax liability on the taxable x do not apply to acquisitions arising
through business combinations.
temporary difference arising on the acquisition of non-
current assets (see section 4.3.2).
Since the exemption principles apply equally to the exemption from recognising a deferred tax
asset on deductible temporary differences, this text does not include any further examples.
6. Measurement: Enacted Tax Rates Versus Substantively Enacted Tax Rates
The measurement of current tax and deferred tax is essentially the same: they are both measured
at the amount we expect to pay (or recover from) the tax authorities. See IAS 12.46 -.47
The current income tax is the estimated tax that will be charged for the current period:
x the current period’s taxable profits (current year transactions per the tax legislation);
x multiplied by the tax rates that we expect will be applied by the tax authorities.
The measurement of deferred tax differs only in that is Deferred tax assets or
the estimated future tax payable/ receivable. Deferred liabilities are measured at:
tax relates to the estimate of the future tax on future
transactions (i.e. future taxable income and future tax x tax rates that are expected to
deductions) or in other words, the future tax expected on apply to the period when
the future recovery of assets and settlement of liabilities. x the A is realised or the L settled;
x based on tax rates (& tax laws) that
Current tax and deferred tax are both measured at the are
amount we expect to pay (or recover from) the tax - enacted at reporting date, or
authorities. Thus, if there is an enacted rate at year end - substantively enacted at
that the government proposes to change, we measure the reporting date. IAS 12.47 Reworded
current tax or deferred tax, using the:
x enacted tax rate at the reporting date, or the
x proposed new rate, if it has been substantively enacted by reporting date. Re-worded IAS 12.46-47
In other words, if there is an announcement proposing to change the tax rate currently enacted
at reporting date, we will generally measure our current tax using the rate currently enacted at
reporting period (if this is the rate that we expect the tax authorities will use to tax our current
taxable profits) but will often measure our deferred tax, because it relates to the future, using
the proposed new rate if it is probably the rate that will be used by the tax authorities when the
taxable income or tax deductions eventually arise. We assume this will be the case if the
proposed new rate is substantively enacted by reporting date.
A substantively enacted
Professional judgement is needed when deciding if a rate that tax rate that has an
has been proposed (i.e. announced but not enacted) on or effective date that won’t
before reporting date, is substantively enacted by reporting affect the current tax assessment but
date. We will need to consider all circumstances around the will affect future assessments,
proposal. See chapter 5, section B: 3.2 for an example. x the current tax payable will be
measured using the enacted rate,
whereas
In South Africa, it is commonly held that a new rate is x the deferred tax liability (or
considered to be substantively enacted on the date it is asset) will be measured using the
announced in the Minister of Finance’s Budget Speech. substantively enacted tax rate.
But if this new rate is inextricably linked to other tax laws, it is only substantively enacted when it has
not only been announced by the Minister of Finance, but also been signed into statute by the President,
as evidence of his approval of the change.
334 Chapter 6
If the new rate is enacted after the reporting date but had not already been substantively enacted
by reporting date, then our deferred tax balance at reporting date must remain measured using
the old rate (i.e. the rate that was currently enacted at reporting date).
This is interesting because a new tax rate that is enacted after the reporting period means that
we now know that our taxes payable in the future will no longer be based on the old rate.
However, the deferred tax balance at reporting date must not be adjusted to reflect the new rate
because a change in tax rate in the period after reporting period but before publication of the
financial statements is what is referred to as a non-adjusting event.
To compensate for the problem of not being allowed to adjust our deferred tax balances to
reflect this newly enacted rate, our notes disclose the new rate and the effect that the change in
tax rate will have on our deferred tax balances if we think that this information would be useful
to our users. See IAS 10.21
At time of writing, the currently enacted tax rate in South Africa was 28% for most companies
and no new tax rates had been proposed. For sake of ease of calculation, however, we will use
30% as the income tax rate.
Example 24: Enacted and substantively enacted tax rates

A change in the income tax rate from 30% to 29% is announced on 20 January 20X1.
x No significant changes were announced to other forms of tax.
x The new tax rate will apply to tax assessments ending on or after 1 March 20X1.
x The new tax rate was enacted on 21 April 20X1.
Required:
State at what rate the current and deferred tax balances should be calculated assuming:
A. The company’s year of assessment ends on 31 December 20X0.
B. The company’s year of assessment ends on 28 February 20X1.
C. The company’s year of assessment ends on or after 31 March 20X1.
Solution 24: Enacted and substantively enacted tax rates
Tax rates to be used in measuring the Ex 4: A Ex 4: B Ex 4: C

following balances: Year end: Year end: Year end:
31 December 20X0 28 February 20X1 31 March 20X1
Current tax payable/ receivable 30% 30% 29%
Deferred tax liability/ asset 30% 29% 29%
Comments in general:
x The date of substantive enactment is 20 January 20X1 (no significant changes to other taxes were
announced at the time).
x The effective date is 1 March 20X1.
x Whilst current tax is to be measured using the enacted or substantively enacted tax rate at reporting
date, the over-riding rule is that it must be ‘measured at the amount expected to be paid to
(recovered from) the taxation authorities’.
x We must use the tax rates that apply or are expected to apply to the current period transactions
and must therefore take cognisance of the effective date of any new rates. When measuring
current tax, we will normally use the enacted tax rates.
x Whilst deferred tax is also to be measured using the enacted or substantively enacted tax rate at
reporting date, the over-riding rule is that it must be ‘measured at the tax rates that are expected
to apply to the period when the asset is realised or the liability is settled’. We must use the tax
rates that are expected to apply to the future period transactions and must therefore take special
notice of substantively enacted tax rates but still take cognisance of the effective date of these
new rates. When measuring deferred tax, we will normally use the substantively enacted tax rates.
Chapter 6 335
Explanations for each part (A, B and C):

A. The new tax rate is not enacted at reporting date (enacted on 21 April 20X1) and it is not even
substantively enacted at reporting date (substantively enacted on 20 January 20X1).
Thus, the current tax payable/receivable balance will remain measured on the old rate (being the
currently enacted tax rate).
The deferred tax balance will also remain measured on the old rate (the currently enacted tax
rate). A note disclosing the fact that a new rate will apply to the deferred tax balances in future
and showing the expected amount of the reduction in the balances should be included (this is
referred to as a ‘non-adjusting event after the reporting event’).
B. The new tax rate is not enacted at reporting date (enacted on 21 April 20X1) but it is substantively
enacted at reporting date (substantively enacted on 20 January 20X1).
The current tax payable will be based on the old rate (being the currently enacted tax rate at
reporting date), since although the new rate was substantively enacted before reporting date, it
was not also effective before reporting date (the over-riding rule is that current tax is to be
‘measured at the amount expected to be paid to the taxation authorities’).
The deferred tax balance will be based on the new rate since the new rate was substantively
enacted before reporting date.
C. The new tax rate is not enacted at reporting date (enacted on 21 April 20X1) but it is substantively
enacted at reporting date (substantively enacted on 20 January 20X1).
The current tax payable is to be measured using the substantively enacted tax rate because the
effective date thereof (tax assessments ending on or after 1 March 20X1) was before reporting
date which means that this new rate will be apply to the current year taxable profits. The current
tax payable will thus be based on the new rate, since the new rate was substantively enacted and
effective before reporting date.
The deferred tax balance will be based on the new rate since the new rate was substantively
enacted before reporting date.
7. Rate Changes and Deferred Tax (IAS 12.47)
A deferred tax balance is simply an estimate of the tax owing to the tax authority in the future
or the tax savings expected from the tax authority in the future. The estimate is made based on
the temporary differences multiplied by the applicable tax rate. If this tax rate changes, so does
the estimate of the amount of tax owing by or owing to the tax authority in the future. Therefore,
if a company has a deferred tax balance at the beginning of a year during which the rate of tax
changes, the opening balance of the deferred tax account will need to be re-estimated.
This is effectively a change in accounting estimate, the adjustment for which is processed in
the current year’s accounting records.
If this happens, it means that the tax expense account in the current year will include an adjustment to
the prior year deferred tax balance. This will then mean that the effective rate of tax in the current year
will not equal the applicable tax rate. The difference between the effective and the applicable rate of
tax results in the need for a tax rate reconciliation in the tax note.
These principles apply not only if a new rate was enacted by reporting date, but also if it was
substantively enacted by reporting date. In South Africa, the date on which a rate change is announced
by the Minister of Finance is generally referred to as the date of substantive enactment (assuming that
there were no other significant changes to other tax rates that were also announced at the same time).
The date at which the rate becomes applicable is the enacted date. The deferred tax balance is always
adjusted for the new rate unless the date of substantive enactment occurs after year end (e.g. if it is
enacted or substantively enacted on/before year-end, then the deferred tax balance is adjusted for the
new rate but if this is not the case, and it is only substantively enacted after year-end, then the deferred
tax balance is not adjusted). If there is a change in rate made after reporting date, it is accounted for as
a non-adjusting event in terms of IAS 10 Events after the reporting period. (Also see section 6).
336 Chapter 6
Example 25: Rate changes: journals

The closing balance of deferred tax at the end of 20X1 is C60 000.
Required:
Show the journal entries relating to the rate change in 20X2 assuming that:
A. the balance in 20X1 is an asset and that the rate was 30% in 20X1 and 40% in 20X2;
B. the balance in 20X1 is a liability and that the rate was 30% in 20X1 and is 40% in 20X2;
C. the balance in 20X1 is an asset and that the rate was 40% in 20X1 and is 30% in 20X2;
D. the balance in 20X1 is a liability and that the rate was 40% in 20X1 and is 30% in 20X2.
Solution 25: Journals

Ex 25A Ex 25B Ex 25C Ex 25D
1 January 20X2 Calculations Debit/ Debit/ Debit/ Debit/
(Credit) (Credit) (Credit) (Credit)
Deferred tax: (a); (b); (c); (d) 20 000 (20 000) (15 000) 15 000
income tax (A/L)
Income tax (E) (20 000) 20 000 15 000 (15 000)
Rate change: adjustment to DT opening balance
Notes
(a) Tax rate increased by 10%: DTA: 60 000 / 30 % x (40% – 30%) = 20 000 (DT asset increases)
(b) Tax rate increased by 10%: DTL: 60 000 / 30 % x (40% – 30%) = 20 000 (DT liability increases)
(c) Tax rate decreased by 10%: DTA: 60 000 / 40 % x (40% – 30%) = 15 000 (DT asset decreases)
(d) Tax rate decreased by 10%: DTL: 60 000 / 40 % x (40% – 30%) = 15 000 (DT liability decreases)
Example 26: Rate changes: journals and disclosure

The opening balance of deferred tax at the beginning of 20X2 is C45 000, (credit balance).
Deferred tax is due purely to temporary differences caused by capital allowances on the
property, plant and equipment.
x The tax rate in 20X1 was 45% but changed to 35% in 20X2.
x The profit before tax in 20X2 is C200 000, all of which is taxable in 20X2.
x No balance was owing to or from the tax authority at 31 December 20X1 and no
payments were made to or from the tax authority during 20X2.
x There are no other temporary differences.
x There is no exempt income and no non-deductible expenses.
Required:
A. Calculate the effect of the rate change.
B. Show the calculation of deferred income tax using the balance sheet approach.
C. Calculate the current income tax for 20X2.
D. Post the related journal in the ledger accounts.
E. Disclose the above in the financial statements for the year ended 31 December 20X2.
Solution 26A: Rate change

The opening balance in 20X2 (closing balance in 20X1) was calculated by multiplying the total
temporary differences at the end of 20X1 by 45%.
Therefore, the temporary differences (TD) provided for at the end of 20X1 (opening deferred tax
balance in 20X2) are as follows:
Old deferred tax balance = Temporary difference x applicable tax rate

.: C45 000 = Temporary difference x 45%
.: Temporary difference = C45 000 / 45%
.: Temporary difference = C100 000
The credit balance means that the company is expecting the tax authority to charge them tax in the
future on the temporary difference of C100 000.
Chapter 6 337
If the tax rate is now 35%, the estimated future tax on this temporary difference of C100 000 needs to
be changed to:
Revised deferred tax balance = Temporary difference x applicable tax rate
.: New deferred tax balance = C100 000 x 35%
.: New deferred tax balance = C35 000
An adjustment to the opening deferred tax balance in 20X2 must be processed:

Dr/ (Cr)
Deferred tax balance was (45 000) Balance: credit
Deferred tax balance should now be (35 000) Balance: credit
Adjustment needed 10 000 Adjustment: debit deferred tax, credit tax expense
Non-current assets: Carrying Tax Temporary Deferred Deferred tax

x Depreciable (IFRS) (IAS 12) TD x % adjustment
Opening balance @ 45% xxx xxx (100 000) (45 000) Liability
Rate change (100 000 x 10%) 10 000 Dr DT Cr TE
Opening balance @ 35% (100 000) (35 000)
Movement (1) 0 0 0 0
Closing balance – 20X2 xxx xxx (100 000) (35 000) Liability
Notes:
(1)
The question stated that there were no other temporary differences other than the balance of
temporary differences at 31 December 20X1.
Solution 26C: Current tax
Taxable profits and current income tax - 20X2 Profits Tax at 35%
Profit before tax (accounting profits) (given) 200 000

Exempt income and non-deductible expenses: (given) 0
Movement in temporary differences: (given) 0 0
Solution 26D: Ledger accounts
The credit balance of the deferred tax account must be reduced, thus requiring this account to be
debited. The contra entry will go to the tax expense account, since this is where the contra entry was
originally posted when the 45 000 was originally accounted for as a deferred tax liability.
Income tax (E) Deferred tax (L)

CTP 70 000 DT (1) 10 000 Inc tax (1) 10 000 Balance b/f 45 000
Total c/f 60 000 Balance c/d 35 000
70 000 70 000 45 000 45 000
Total b/f 60 000 Balance b/d 35 000
P/L 60 000
60 000 60 000
Current tax payable: income tax (L)

Inc tax 70 000
338 Chapter 6
Solution 26E: Disclosure
Entity name
Note 20X2 20X1
C C
Profit before tax (given) 200 000 xxx
Income tax expense 3 (60 000) xxx
Profit for the year 140 000 xxx
Total comprehensive income 140 000 xxx
Entity name
Note 20X2 20X1
LIABILITIES C C
Deferred tax: income tax 26A or 26B or 26D 4 35 000 45 000
Current liabilities
Current tax payable: income tax 26C or 26D 70 000 0
Entity name
20X2
Income taxation 60 000
x Current 200 000 x 35% 70 000
x Deferred
- Current year Ex 26B: (no temporary differences) 0
- Rate change Ex 26A or 26B (10 000)
Tax expense per the statement of comprehensive income 60 000
Tax Rate Reconciliation
Tax effects of:
Profit before tax 200 000 x 35% 70 000
Rate change Ex 26A or Ex 26B (10 000)
Tax expense charge per statement of comprehensive income 60 000
Effective tax rate 60 000/ 200 000 30%
Please note: There was insufficient information to be able to provide the comparatives for the tax note.
4. Deferred tax liability 20X2 20X1
The closing balance is constituted by the effects of: C C
x Property, plant and equipment 35 000 45 000
8. Deferred Tax Assets (IAS 12.34)
8.1 What causes a deferred tax asset?
Essentially, an asset reflects an inflow of economic benefits expected in the future. Thus, when talking
about deferred tax assets, this inflow of economic benefits refers to the income tax savings or relief we
are expecting in the future. We could be expecting a future tax saving because, for example, we know of
a future tax deduction that will reduce our future taxable profits and thus reduce our future tax expense.
Chapter 6 339
IAS 12 refers to three categories that could result in a deferred tax asset:
x Deductible temporary differences (DTDs)
For example: if a plant’s tax base is greater than its carrying amount, it means the future
tax deductions relating to the plant, such as future capital allowances (tax base), is
greater than the future inflow of economic benefits from the plant (carrying amount):
thus the plant will cause a future net tax deduction (not a net taxable benefit) that will
reduce future taxable profits and thus reduce the future income tax;
x Unused tax credits (UTCs)
For example: in some countries, entities are able to reduce their future tax by carrying
forward tax credits calculated in terms of legislation;
x Unused tax losses (assessed losses) (UTLs)
For example: if an entity makes a tax loss in the current year, it may be allowed to carry
this loss forward to future years in which it makes a taxable profit, and thereby reduce
the amount of profits upon which income tax is levied. Thus, this represents a future
tax saving (i.e. an unused tax loss will reduce future income tax).
In summary, all three categories are generally able to be carried forward from one year to the next until
they are able to be used in a way that reduces the future income tax charge. Thus, all three categories
represent future tax savings. A future tax saving is obviously an asset to the entity, but it will obviously
only be recognised if it meets the recognition criteria (see section 8.2).
8.2 Deferred tax assets: Recognition
Whereas most DTLs are
Although a deferred tax asset (DTA) may exist (section 8.1), recognised, not all DTAs
are recognised!
whether we should recognise it in the accounting records
depends on whether the inflow of future economic benefits is probable. Similarly, we would only
recognise a deferred tax liability if we could conclude the outflow was probable, but the probability of
the flow of benefits is more difficult to prove when dealing with deferred tax assets.
All three deferred tax assets, whether arising from DTDs, UTCs, and UTLs, are affected in the same
way: they may only be recognised if the inflow of future economic benefits is probable. However, it is
the deferred tax asset arising from an unused tax loss that is generally the most difficult to recognise.
The reason why it is more difficult to recognise deferred To recognise or not to
tax assets on unused tax losses than on unused tax credits recognise… that is the
or deductible temporary differences is simply that, if we question!
make a tax loss, it may mean that we are already in x A DTA may only be recognised if the
financial difficulty, in which case it is possible that we future tax saving is probable.
may never make future profits big enough to be able to x It may be difficult to recognise a
deduct the tax loss and realise the related tax saving. DTA on unused tax losses
Worked Example 2: Tax losses may or may not reflect probable future tax savings
Consider the two scenarios below. In both cases, the tax rate is 30% and we are allowed to carry
the tax losses forward to future years when they may be set-off against future taxable profits.
Scenario 1:We make a tax loss in 20X1 of C100 000 and expect to make a taxable profit in 20X2
of C300 000 (before carrying forward the tax loss from 20X1).
Scenario 2:We make a tax loss in 20X1 of C100 000 and expect to make another tax loss in 20X2 of C300 000
(before carrying forward the tax loss from 20X1) after which we expect to cease trading.
Solution to Worked Example 2: Tax losses may or may not reflect probable future tax savings
Scenario 1:
20X2 20X1
Calculation of current income tax: C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ forward 300 000 (100 000)
Tax loss brought forward (100 000) 0
Taxable profit/ (tax loss) 200 000 (100 000)
Current income tax at 30% 60 000 0

Since the company expects to make taxable profits of C300 000, before adjusting for tax losses brought
forward, the tax loss of C100 000 will be able to be used to reduce the future tax from C90 000 (C300 000
x 30%) to C60 000 (calculation above). This is clearly a tax saving of C30 000.
340 Chapter 6
Conclusion: This predicted saving is therefore a deferred tax asset of C30 000 at the end of 20X1 which
should be recognised if the future taxable profits are probable.
Scenario 2:
20X2 20X1
Calculation of estimated current income tax: C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ forward (300 000) (100 000)
Taxable profit/ (tax loss) (400 000) (100 000)
Conclusion:
x We would not recognise the deferred tax asset at the end of 20X1 since, at this date, it was not
considered probable that we would make sufficient taxable profits in the future.
x If, however, our forecast for the years beyond 20X2 had indicated that sufficient profits were expected
to be made, thus enabling us to utilise the C100 000 tax loss, then we would be able to recognise the
deferred tax asset of C30 000 at 31 December 20X1 (assuming that the tax loss does not expire in terms
of tax legislation before the company becomes sufficiently profitable to be able to utilise it).
Conceptual Framework (CF) implications:

IAS 12 has not been updated for the new 2018 CF. Thus, the reference to a probable inflow of future
economic benefits is one of the two recognition criteria in the 2010 CF. The recognition criteria per the
2018 CF require information to be both relevant and a faithful representation. The IASB will update IAS 12 in time
but believes the outcome will not change if the recognition criteria in the 2018 CF were applied instead.
The two most important paragraphs in IAS 12 guiding us as on whether to recognise the
deferred tax asset are:
x IAS 12.34: A deferred tax asset shall be recognised for:
- the carry forward of unused tax losses (also called assessed losses) and unused tax credits
- to the extent that it is probable that future taxable profit will be available against which
the unused tax losses and unused tax credits can be utilised. IAS 12.34
x IAS 12.24: A deferred tax asset shall be recognised for:
- all deductible temporary differences
- to the extent that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised (except if the temporary difference is exempted). IAS 12.24
These paragraphs clarify that the decision regarding whether to recognise the deferred tax asset
is the same in all three cases: there must be sufficient future taxable profits expected such that
we can conclude that we will be able to utilise the future deduction, unused tax credit or unused
tax loss, and thus that the future benefit (tax saving) is probable.
Taxable profits are considered to be available if the entity currently has more taxable temporary
differences than deductible differences. In this case, the deferred tax assets on the deductible temporary
differences will be recognised in full on the basis that the deferred tax liabilities on the taxable temporary
differences are greater, and thus the entity’s net deferred tax balance will be a liability. IAS 12.28
If the entity does not have sufficient taxable temporary differences against which the deductible
temporary differences can be off-set (i.e. the net deferred tax balance will be an asset), then the deferred
tax asset may only be recognised if it is probable that there will be sufficient future taxable profits against
which the deductible temporary differences may be off-set. When estimating the probable future profits,
we must obviously ignore taxable profits arising from future (further) deductible temporary differences.
See IAS 12.29
Example 27: Recognising deferred tax assets: tax loss expected to expire: discussion
Human Limited made a tax loss of C100 000 in 20X1.
x There was no tax loss brought forward from 20X0.
x The entity’s final management-reviewed forecast shows a further tax loss of C50 000 in 20X2
(before considering the tax loss from 20X1).
x Per the tax legislation, the 20X1 tax loss will expire on 31 December 20X2.
Required: Explain whether or not a deferred tax asset should be recognised at the end of 20X1.
Chapter 6 341
Solution 27: Recognising DTA: tax loss expected to expire:

A deferred tax asset exists because of the tax loss incurred in 20X1 that has the potential of producing
an economic benefit in the form of a future tax saving.
The potential future tax saving is C30 000 (tax loss available for carry-forward: C100 000 x 30%)
However, the deferred tax asset reflecting this potential future tax saving must not be recognised because
the expected future economic benefits is not probable. This is because management has budgeted a further tax
loss of C50 000 in 20X2, which means we will be unable to use the 20X1 tax loss to reduce tax in 20X2 (i.e.
there will be no tax charge in 20X2 for us to be able to reduce) and, since the 20X1 tax loss expires on
31 December 20X2 if not used, this tax loss will expire on this date and never result in a tax saving. Thus,
there are no future economic benefits probable.
The following calculation proves that the tax saving would not happen:
20X2 20X1
W1. Calculation of current income tax: C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ forward (50 000) (100 000)
Reverse 20X1 unutilised tax loss expiring 31/12/20X2 100 000
Taxable profit/ (tax loss) (50 000) (100 000)
Example 28: Recognising deferred tax asset: deductible temporary differences

Animal Limited owned a computer which it purchased on 1 January 20X1 for C100 000.
x The tax authorities allow a deduction of 20% in 20X1, 40% in 20X2 and 40% in 20X3.
x The computer is depreciated on the straight-line basis over 2 years to a nil residual value.
x There are no items of exempt income or non-deductible expenses.
x There are no temporary differences other than those arising from the above.
Required: Calculate and prove what portion of the deferred tax asset balance should be recognised at
31 December 20X1 assuming that the entity’s final management-reviewed forecast shows:
A. minimum profits before tax of C240 000.
B. a profit before tax of C10 000 in 20X2 after which the company is expecting to close down.
C. a total loss before tax of C240 000 (C120 000 in 20X2 and 20X3) and due to an economic
meltdown in the country, the company is planning to possibly close down before the end of 20X3.
Solution 28 (A, B and C): Recognising DTA: deductible temporary difference

W1. DT on computer: Carrying Tax Temporary Deferred DT
x Depreciable (per SOFP) (IAS 12) TD x 30% adj.
Purchase 100 000 100 000 0 0
Depreciation/deductions (50 000) (20 000) 30 000 9 000 Dr DT Cr TE
Closing balance – 20X1 50 000 80 000 30 000 9 000 Asset
Future depr/deductions: X2 & X3 (50 000) (80 000) 30 000 (9 000) Cr DT Dr TE
Scenario A Scenario B Scenario C
W2. Future income tax payable
C C C
Future profit before tax 240 000 10 000 (240 000)
Future exempt income and non-deductible expenses 0 0 0
Future profit before tax that is taxable 240 000 10 000 (240 000)
Future movement in temporary differences: (30 000) (30 000) (30 000)
- Add future depreciation CA: 50 000 – RV: 0 50 000 50 000 50 000
- Less future tax deduction TB: 80 000 - 0 (80 000) (80 000) (80 000)
Future income tax payable at 30% 63 000 0 0
342 Chapter 6
W3. Future tax savings

Tax that would be due on ‘future A: 240 000 x 30% 72 000 3 000 0
profit before tax that is taxable’ B: 10 000 x 30%
C: loss = 0 tax
Future income tax payable at 30% W2 above 63 000 0 0
Future tax saving due to deduction of temp differences 9 000 3 000 0
Conclusion:
By looking at the tax that would have been payable had there been no deductible temporary differences, and
comparing it to the tax that is payable after taking into account these differences, one can assess the extent to
which the future deductible temporary differences will result in tax savings and thus whether the company
should recognise a deferred tax asset, and if so at what amount. The deferred tax asset at 31 December 20X1
should thus be measured at: Scenario A Scenario B Scenario C
Deferred tax asset balance to be recognised: C9 000 C3 000 C0
8.3 Deferred tax assets: measurement

The deferred tax asset balance is simply measured as the tax on the deductible temporary
difference using the usual balance sheet approach. This is the same principle we have been
using to measure the deferred tax balances in previous examples. The only difference is that,
with deferred tax assets, we could be limited to the amount that should be recognised (as evident
in scenario B in the prior example). As a result, a variety of situations could arise:
x deferred tax assets could arise in the current year that you are not able to recognise:
Traditionally no entry is processed for these deferred tax assets although it would not be
incorrect to process 2 journal entries that effectively contra each other out (the latter
approach is useful for audit trail purposes and will help with your disclosure):
debit DT asset, credit tax expense (recognising the deferred tax asset); and
credit DT asset, debit tax expense (immediately reversing the deferred tax asset).
This text follows the first approach, where no deferred tax journal is processed.
x deferred tax assets that arose in a prior year and which you did not recognise as an asset in
a prior year but which you are now recognising in the current year due to the recognition
requirements now being met:
debit DT asset, credit tax expense
x deferred tax assets that arose in a prior year and which you did not recognise as an asset in
a prior year but which you are now recognising in the current year due to the recognition
requirements now being met:
debit DT asset, credit tax expense;
x deferred tax assets that were recognised in a prior year but which you now need to partially
or fully write-off (i.e. write-down) as they no longer meet the recognition requirements:
credit DT asset, debit tax expense;
x deferred tax assets that were recognised and then either partially or fully written-down in
prior years, but which are now being partially or fully reinstated (i.e. a write-back):
debit DT asset, credit tax expense.
8.4 Deferred tax assets: disclosure
There are numerous disclosure requirements relating to deferred tax assets. These are
comprehensively discussed in section 10.3, but the following is a brief summary:
The tax expense note should include the amount of:

x current year deferred tax assets that are not recognised;
x prior year deferred tax assets that are now recognised in the current year;
x prior year deferred tax assets that were recognised but are now written-down;
x the write-back of previously written-down deferred tax assets.
Chapter 6 343
The deferred tax asset/liability note requires disclosure of:

x the amount of the temporary differences that were not recognised as deferred tax assets;
x the expiry date relating to these unrecognised deferred tax assets, if applicable.
Example 29: Tax losses: deferred tax asset recognised in full
Wear and tear on vehicle (allowed by the tax authorities) 2 years straight-line
Income tax rate 30%
Profit or loss before tax (after deducting any depreciation on the vehicle) for the year ended:
x 31 December 20X1 Loss: C40 000
x 31 December 20X3 Profit: C400 000
Other information:
x There are no temporary differences other than those evident from the information provided.
x The company recognised deferred tax assets in full, since:
it had always expected to make sufficient future taxable profits and therefore
it expected to realise the related tax savings.
Required:
A. Calculate the taxable profits and current tax per the tax legislation for 20X1 to 20X3.
B. Calculate the deferred income tax balances for 20X1 to 20X3.
C. Show all tax-related journals that would be processed in 20X1, 20X2 and 20X3.
D. Disclose the above tax-related information in the financial statements for 20X3.
Solution 29A: Calculation of current income tax

W1 Calculation of current income tax 20X3 20X2 20X1
Profit before tax 400 000 (20 000) (40 000)
Add back depreciation (120 000 / 4 years) 30 000 30 000 30 000
Less capital allowance (120 000 / 2 years) 0 (60 000) (60 000)
Taxable profit/ (tax loss) created in current year 430 000 (50 000) (70 000)
Tax loss brought forward (120 000) (70 000) 0
Solution 29B: Calculation of deferred income tax

W2 Deferred income tax Carrying Tax base Temporary Deferred tax DT balance
amount difference at 30%
W2.1 Vehicle (SOFP) (IAS 12) (b) – (a) (c) x 30%
Balance: 1 Jan 20X1 0 0 0 0
Purchase of asset 120 000 120 000 0 0
Depreciation (30 000) (60 000) (30 000) (9 000)
Balance: 31 Dec 20X1 90 000 60 000 (30 000) (9 000) Liability
Depreciation (30 000) (60 000) (30 000) (9 000)
Balance: 31 Dec 20X2 60 000 0 (60 000) (18 000) Liability
Depreciation (30 000) 0 30 000 9 000
Balance: 31 Dec 20X3 30 000 0 (30 000) (9 000) Liability
W2.2 Tax loss
Movement 0 70 000 70 000 21 000
Balance: 31 Dec 20X1 0 70 000 70 000 21 000 Asset
Movement 0 50 000 50 000 15 000
Balance: 31 Dec 20X2 0 120 000 120 000 36 000 Asset
Movement 0 (120 000) (120 000) (36 000)
Balance: 31 Dec 20X3 0 0 0 0
344 Chapter 6
Solution 29C: Journals

Journals 20X1 Debit Credit
Income tax expense (P/L: E) W2.1 9 000
Origination: DT adjustment due to temporary differences: vehicle (20X1)
Deferred tax: income tax (A) W2.2 21 000
Origination: DT adjustment due to tax loss being created (20X1)
Journals 20X2
Origination: DT adjustment due to temporary differences: vehicle (20X2)
Origination: DT adjustment due to tax loss being created (20X2)
Journals 20X3
Deferred tax: income tax (L) W2.1 9 000
Reversal: DT adjustment due to temporary differences: vehicle (20X3)
Deferred tax: income tax (A) 36 000
Reversal: DT adjustment due to tax loss being used (20X3)
Income tax expense (P/L: E) Sol 29A W1 93 000
Current tax estimated based on current taxable profits (20X3)

Entity name
Note 20X3 20X2
Non-current assets C C
Entity name
Note 20X3 20X2
C C
Profit before tax 400 000 (20 000)
Income tax income/ (expense) 12 (120 000) 6 000
Profit for the period 280 000 (14 000)
Total comprehensive income 280 000 (14 000)
Entity name
20X3 20X2
The deferred tax balance comprises tax on the following types of temporary differences:
x Property, plant and equipment W2.1 (9 000) (18 000)
x Tax losses W2.2 0 36 000
(9 000) 18 000
Chapter 6 345
Entity name
Notes to the financial statements continued …
20X3 20X2
Income taxation expense
x Current Journals 93 000 0
x Deferred Journals: 20X3: 9 000 cr – 36 000 dr 27 000 (6 000)
20X2: 9 000 dr – 15 000 cr
120 000 (6 000)
Effective tax rate 20X3: 120 000 / 400 000; 20X2: 6 000 / 20 000 30% 30%
Example 30: Tax losses: deferred tax asset recognised in full then written-down
Repeat Example 29 assuming that:
x deferred tax assets had been recognised in full in 20X1 but
x in 20X2 sufficient future taxable profits were no longer probable, with the result that
deferred tax assets could only be recognised to the extent that taxable temporary
differences were available.
The information from Example 29 is repeated here for your convenience:
Capital allowance on vehicle allowed by the tax authorities 2 years straight-line
Income tax rate 30%
Profit or loss before tax (after deducting any depreciation on the vehicle) for the year ended:
x 31 December 20X3 Profit: C400 000
Other information:
x There are no temporary differences other than those evident from the question.
Required: Show the deferred tax asset/ liability note and the tax expense note for 20X2.
Solution 30: Tax losses: deferred tax asset recognised in full then written-down
Although W2.1 and W2.2 are the same as in Example 29, a further working (W2.3 below), showing
the prior year DTA written-down and the current year DTA that is now not recognised, is useful.
W2.3 Vehicle: Tax loss:

Summary of def tax: W2.1 W2.2
Recognised Total Recognised Unrecognised
Movement (9 000) 21 000 21 000 0
Balance: 31 Dec 20X1 (9 000) 21 000 21 000 0
Movement: (9 000) 15 000
x Prior year DTA written-down (21 – 9) (12 000) 12 000
x Current year DTA not recognised (15 – 9) 9 000 6 000
Balance: 31 Dec 20X2 (18 000) 36 000 18 000 18 000
Comment:
Since future taxable profits are no longer probable from 20X2, from 20X2 the total deferred tax
balance must not go into debit (i.e. must not become a deferred tax asset). The unrecognised portion
is simply the balancing amount.
346 Chapter 6
Entity name
20X2 20X1
x Property, plant and equipment W2.1 (Sol 29B) (18 000) (9 000)
x Tax losses W2.2 (Sol 29B) 18 000 21 000
0 12 000
A deferred tax asset of C18 000 relating to a tax loss of C60 000 has not been recognised
(20X1 unrecognised deferred tax asset: nil). The tax loss has no expiry date.

x Current W1 (Sol 29A) 0 0
x Deferred
x Current year movement in temp differences Calc (1) (below) (6 000) (12 000)
x Prior year DTA written down W2.3 12 000 0
x Current year DTA not recognised W2.3 6 000 0
Tax expense per the statement of comprehensive income 12 000 (12 000)
Tax effects of:
x Profit before tax (20 000 loss x 30%) / (40 000 loss x 30%) (6 000) (12 000)
x Prior year DTA now written down Per above 12 000 0
x Current year DTA not recognised Per above 6 000 0
Tax expense per the statement of comprehensive income 12 000 (12 000)
Effective tax rate (12 000 exp / 20 000 loss) (12 000 inc / 40 000 loss) (60%) 30%
Calculations:
(1) The DT adjustments arising from the current year movement in TDs (these amounts have been extracted
from W2.1 and W2.2 of Solution 29B – or you could extract them from the journals in Solution 29C) are
calculated as follows:
20X1: 9 000 dr + 21 000 cr = 12 000 credit expense
20X2: 9 000 dr + 15 000 cr = 6 000 credit
Example 31: Tax losses: deferred tax asset recognised partially

Repeat Example 29 (Example 29’s information was repeated in Example 30), but now
assume that:
x the entity has never been able to recognise deferred tax assets in excess of its taxable
temporary differences
Required: Show how your answer to Example 29 would change.
Solution 31A: Calculation of current income tax

There would be no change to the calculation of current income tax
Solution 31B: Calculation of deferred income tax

There would be no change to the calculation of deferred tax with the exception of a further calculation
(W2.3 on the next page) to show the amount of the deferred tax asset and liability that will be
recognised for the temporary difference arising from:
x the vehicle and
x from the tax loss (relating to income tax).
Chapter 6 347
W2.3 Vehicle: Tax loss:

Summary of def tax: W2.1 W2.2
Recognised Total Recognised Unrecognised
Movement (9 000) 21 000 9 000 12 000
Balance: 31 Dec 20X1 (9 000) 21 000 9 000 12 000
Movement (9 000) 15 000 9 000 6 000
Balance: 31 Dec 20X2 (18 000) 36 000 18 000 18 000
Movement: 9 000
a) Portion of DTA used (36 000) (36 000)
b) Prior year unrecog. DTA now recognised 18 000 (18 000)
Balance: 31 Dec 20X3 (9 000) 0 0 0
Comment:
The effect of this approach is that the total deferred tax balance cannot go into debit. The unrecognised
portion is simply the balancing amount. Since in 20X3 the tax loss is utilised and resulted in a tax
saving of C36 000, it is fair to say that the asset has been used up. Since 18 000 of this asset has not
been recognised yet, this portion must now be recognised.
Solution 31C: Journals
Journals 20X1 Debit Credit

Income tax expense (P/L:E) Sol 29B (W2.1) 9 000
Originating: DT adjustment due to temporary differences: vehicle (20X1)
Deferred tax: income tax (A) Sol 29B (W2.2/ W2.3) 9 000
Originating: Deferred tax asset recognised for deductible temporary
differences relating to the tax loss, limited to the amount of the deferred
tax liability at year end (c/b 21 000 limited to 9 000 - DTA o/b 0)
Journals 20X2
Income tax expense (P/L: E) Sol 29B (W2.1) 9 000
Originating: DT adjustment due to temporary differences: vehicle (20X2)
Deferred tax: income tax (A) Sol 29B (W2.2/ W2.3) 9 000
Originating: Deferred tax asset recognised for deductible temporary
differences relating to the tax loss, limited to the amount of the deferred
tax liability at year end (c/b 36 000 limited to 18 000 – DTA o/b 9 000)
Journals 20X3
Deferred tax: income tax (L) Sol 29B (W2.1) 9 000
Reversing: DT adjustment due to temporary differences: vehicle (20X3)
Income tax expense (P/L: E) Sol 29B (W2.2/ W2.3) 36 000
Deferred tax (A) 36 000
Reversing: DT adjustment due to tax loss being used (20X3)
Prior year unrecognised DTA on the tax loss now recognised: this portion
of the DTA had never been recognised and yet it has now been used
Income tax expense (P/L: E) Sol 29A (W1) 93 000
Current tax payable: income tax 93 000
Current tax charge in 20X3
348 Chapter 6
Entity name
Statement of financial position Note 20X3 20X2 20X1
As at ……..20X3 C C C
Deferred tax: income tax W2.3 5 9 000 0 0
Entity name
Statement of comprehensive income Note 20X3 20X2 20X1
For the year ended …..20X3 C C C
Profit before tax 400 000 (20 000) (40 000)
Income tax expense 15 (102 000) 0 0
Profit for the period 298 000 (20 000) (40 000)
Other comprehensive income 0 0 0
Total comprehensive income 298 000 (20 000) (40 000)
Entity name
For the year ended 31 December C C C

x Property, plant and equipment (9 000) (18 000) (9 000)
x Tax loss 0 18 000 9 000
(9 000) 0 0
Unprovided deferred tax assets 0 18 000 12 000
The 20X2 unprovided deferred tax asset was due to a tax loss of C60 000 (20X1 a tax loss of C40 000).
Income taxation
x Current 29A: W1 93 000 0 0
x Deferred
x Current year movement in temp diff’s Calc (1) 27 000 (6 000) (12 000)
x Current year DTA not recognised W2.3 0 6 000 12 000
x Prior year unrecognised DTA now Sol 31C/
recognised W2.3/jnl (18 000)
Tax expense in the statement of compr. income 102 000 0 0
30% 30% 30%
Applicable tax rate
Tax effects of:

x Profit before tax (400Kx 30%) (20K loss x 30%) 120 000 (6 000) (12 000)
(40K loss x 30%)
x Current year DTA not recognised Above 0 6 000 12 000
x Prior yr unrecognised DTA now recognised Above (18 000) 0 0
Tax expense per the statement of compr. income 102 000 0 0
Effective tax rate (102 000 / 400 000) (0/loss) (0/loss) 25.5% N/A N/A
(1) DT adj to tax expense due to temporary differences: vehicle (9 000) cr 9 000 dr 9 000 dr
DT adj to tax expense due to temporary differences: tax loss 36 000 dr (15 000) cr (21 000) cr
(adjustments extracted from W2.1 and W2.2 in Solution 29B)
27 000 dr (6 000) cr (12 000) cr
Chapter 6 349
9. Disclosure of Income Tax (IAS 12.79 – 12.88)
9.1 Overview
IAS 1 and IAS 12 require certain tax disclosure in the statement of comprehensive income,
statement of financial position and related notes to the financial statements.
Where the tax is caused by profits or losses, this tax:

x is presented as part of the tax expense in the profit or loss section of the statement of
comprehensive income; and
x is supported by a note (the tax expense note).
Comprehensive basis
Where the tax is caused by gains or losses recognised x the term used to describe the
directly in equity (other comprehensive income), this tax is: method whereby
x shown as a separate line item in the other x the tax effects of all temporary
comprehensive income section of the statement of differences are recognised
comprehensive income; or
x deducted from each component thereof; and
x supported by a note (the tax on other comprehensive income note): this note shows the tax
effect of each component of other comprehensive income.
9.2 Accounting policy note
Although not specifically required, it is important for foreign investors to know how a local
company measures line items in its financial statements. In this regard, a brief explanation of
the method of calculation is considered appropriate.
A suggested policy note appears below.
Entity name
20X2 20X1
1. Accounting policies C C
1.1 Deferred tax
Deferred tax is provided on the comprehensive basis. Deferred tax assets are provided
where there is reason to believe that these will be utilised in the future.
9.3 Statement of financial position disclosure
9.3.1 Face of the statement of financial position
9.3.1.1 Non-current asset or liability (IAS 1.56)
The deferred tax asset or liability is always classified as a non-current asset or liability. Even if
an entity believes that some of its deferred tax balance will reverse in the next year, the amount
may never be classified as current. See IAS 1.56
9.3.1.2 Show deferred tax per category of tax
Although not specifically mentioned in IAS 12, it makes sense to disclose the deferred tax for
each type of tax as separate line items. For example, if there was another tax in addition to
income tax, the deferred tax for each type would be disclosed separately. Since STC was
replaced with dividends tax, there is no tax on profits in South Africa other than income tax.
350 Chapter 6
9.3.1.3 Setting-off of deferred tax assets and liabilities (IAS 12.74)
If there is a deferred tax asset and a deferred tax liability, these should be disclosed as separate
line-items on the face of the statement of financial position (i.e. they should not be set-off
against one another) unless IAS 12.74:
x Current tax assets and liabilities are legally allowed to be set-off against each other when
making tax payments; and
x The deferred tax assets and liabilities relate to taxes levied by the same tax authority on:
the same entity; or on
different entities in a group who will settle their taxes on a net basis or at the same time.
Example layout of tax balances in the statement of financial position is shown below:
Entity name
As at ……..20X2
20X2 20X1
Non-current assets/ Non-current liabilities C C
- Deferred tax: income tax 5. xxx xxx
Current assets/ Current liabilities
- Current tax payable: income tax xxx xxx
- Current tax payable: value added tax xxx xxx
Example 32: Set-off of deferred tax assets and liabilities

At 31 December 20X2 there is
x a deferred tax asset relating to a tax levied by a local tax authority: C20 000; and
x a deferred tax liability relating to income tax levied by a national tax authority: C80 000.
Required:
Disclose the deferred tax asset and liability in the statement of financial position assuming:
A. the local and national tax authorities are considered to be part of one central tax authority and this
central tax authority allows each of these taxes to be settled on a net basis;
B. the local and national tax authorities are considered to be part of one central tax authority but this
central tax authority does not allow each of these taxes to be settled on a net basis is.
Solution 32A: Settlement on a net basis is allowed

Entity name
As at ……..20X2
Note 20X2 20X1
Non-current liabilities C C
- Deferred tax (80 000-20 000) 4. 60 000 xxx
Solution 32B: Settlement on a net basis is not allowed
Entity name
As at ……..20X2
Note 20X2 20X1
ASSETS C C
Non-current assets
- Deferred tax: local tax 5. 20 000 xxx
LIABILITIES
- Deferred tax: income tax 4. 80 000 xxx
Chapter 6 351
9.3.2 Deferred tax note (asset or liability)
9.3.2.1 The basic structure of the deferred tax note (IAS 12.81 (g)(i))
The deferred tax balance may reflect an asset or liability balance and therefore it makes sense
to explain, in the heading of the note, whether the balance is an asset or liability (if, for example,
you reflect liabilities in brackets, then the heading would be: asset/ (liability)). In practice, it is
also common to disclose on the face of the statement of financial position whether the deferred
tax is as asset or liability.
You must disclose the amount of the deferred tax asset and liability recognised for each:
x type of temporary difference (e.g. property, plant and equipment, prepayments and provisions);
x unused tax losses; and
x unused tax credits. IAS 12.81 (g) (i)
Example of the layout of a deferred tax asset/ liability note:
Entity name
For the year ended continued …
20X2 20X1
5. Deferred income tax asset / (liability) C C
x Provisions xxx xxx
x Year-end accruals xxx xxx
x Property, plant and equipment (xxx) xxx
x Unused tax loss xxx (xxx)
(xxx) (xxx)
Tip
Be careful not to confuse the breakdown of the deferred tax movement (i.e. the statement of
comprehensive income effect) with the deferred tax closing balance (i.e. the statement of financial
position effect) when compiling this note. In an exam situation, you can find the closing balance easily
in your deferred tax balance sheet approach working (see section 2.3)
9.3.2.2 A deferred tax reconciliation may be required (IAS 12.81 (g) (ii))
For each type of temporary difference, unused tax loss and unused tax credit, the amount of the
deferred tax adjustment recognised in profit or loss must be disclosed.
This separate disclosure could be provided in the tax expense note. Alternatively, one may be
able to identify the deferred tax adjustment that was recognised in profit or loss by simply
comparing the opening and closing balances per type of temporary difference (e.g. property,
plant and equipment).
On occasion, however, it is not possible to identify each deferred tax adjustment per type of
temporary difference that was recognised in profit or loss by simply comparing the opening and
closing balances per type of temporary difference.
This could happen, for example, when the difference between the opening and closing balance
of deferred tax resulting from the temporary differences on property, plant and equipment may
have involved ‘other comprehensive income’ (e.g. a revaluation surplus), in which case, the
deferred tax movement would be due to:
x a deferred tax adjustment recognised in ‘other comprehensive income’, and
x a deferred tax adjustment recognised in ‘profit or loss’ (i.e. tax expense),
In such cases, a reconciliation between the opening and closing balance of deferred tax per type
of temporary difference would be required.
352 Chapter 6
Example of the layout of the reconciliation that may be needed in the deferred tax asset/ liability note:
Entity name
20X2 20X1
5. Deferred income tax asset / (liability) continued ... C C
… Continued from note 5 on prior page:
Reconciliation:
Opening deferred tax balance relating to PPE (xxx) xxx
Deferred tax recognised in other comprehensive income:
- revaluation surplus xxx xxx
Deferred tax recognised in profit or loss 6. xxx (xxx)
Closing deferred tax balance relating to PPE (xxx) (xxx)
9.3.2.3 Extra detail needed on unrecognised deferred tax assets (IAS 12.81 (e))
In respect of any unrecognised deferred tax assets, disclosure must be made of:
x the amount of the deductible temporary difference, unused tax loss and unused tax credit;
x the expiry date of the tax loss/ tax credit, if any. IAS 12.81 (e)
The following is an example of what might then be included in the above deferred tax note:
Example of the detail regarding unrecognised deferred tax assets in the deferred tax asset/ liability note:
Entity name
20X2 20X1
5. Deferred income tax asset / (liability) continued ... C C
… Continued from note 5 above:
x A potential tax saving on a tax loss of C1 000 was not recognised as a deferred tax asset.
x This tax loss will not expire.
9.3.2.4 Extra detail needed on recognised deferred tax assets

An entity shall disclose the amount of a deferred tax asset and the nature of the evidence
supporting its recognition, when:
x the entity has suffered a loss in either the current or preceding period in the tax jurisdiction
to which the deferred tax asset relates; and
x the utilisation of the deferred tax asset is dependent on future taxable profits in excess of
the profits arising from the reversal of existing taxable temporary differences. IAS 12.82
9.3.2.5 Extra detail needed on unrecognised deferred tax liabilities (IAS 12.81 (i))
We must also disclose the amount of income tax relating to dividends proposed or declared before the
financial statements were authorised for issue, but which were not recognised as a liability.
9.4 Statement of comprehensive income disclosure
9.4.1 Face of the statement of comprehensive income
Income tax and any other forms of tax considered to be a tax levied on the entity’s profits are
combined to reflect the income tax expense in the statement of comprehensive income
(sometimes referred to as tax expense). The tax expense must be reflected as a separate line
item in the statement of comprehensive income (required by IAS 1, chapter 3).
The tax effect of other comprehensive income may be shown on the face of the statement of
comprehensive income or in the notes. The following example adopts the option of presenting
tax on other comprehensive income in the notes. IAS 1.90
Chapter 6 353
Example of the disclosure of tax expense on the face of the statement of comprehensive income:
Entity name
20X2 20X1
C C
Income tax expense 6. xxx xxx
Profit for the period xxx xxx
Other comprehensive income xxx xxx
x Items that may be reclassified to profit or loss
Cash flow hedge, net of reclassification adjustments and tax 23 xxx xxx
x Items that may never be reclassified to profit or loss
Revaluation surplus, net of tax 24 xxx xxx
9.4.2 Tax on profit or loss – the income tax expense note
9.4.2.1 Basic structure of the income tax expense note (IAS 12.79 - .80)
The tax expense line item in the statement of comprehensive income should be referenced to a
supporting note.
The supporting note gives details of the adjustments made in the tax expense account.
Step 1
Separate the tax note into the two main types of tax levied on company profits: income tax and
any other tax that may be levied on the entity’s profits.
Step 2
Separate the two types of tax into the two types of tax adjustments: the current adjustment and
the deferred adjustment. IAS 12.80 (a) & (c)
x In respect of current tax, show the:
x Current tax for the current year; IAS 12.80 (a)
x Any under/ (over) provision of current tax in a prior year/s. IAS12.80(b)
x In respect of deferred tax:
x The adjustment on the current year movement in temporary differences IAS 12.80 (c)
x The effects of rate changes on prior year deferred tax balances. IAS 12.80 (d)
Step 3
Include a reconciliation explaining why the effective rate of tax differs from the applicable rate
of tax (only if these rates differ, of course!). IAS 12.81(c)
x The reconciliation can be provided in either or both of the following forms:
a reconciliation between tax expense (income) and the product of accounting profit
multiplied by the applicable tax rate(s); or
a reconciliation between the average effective tax rate and the applicable tax rate.
x The reconciliation should also include:
The basis on which the applicable tax rate(s) was computed (if a computation was
required); IAS 12.81 (c)
An explanation regarding any changes in the applicable tax rate(s) compared to the
previous accounting period. IAS 12.81(d)
354 Chapter 6
Example of the layout of a basic income tax expense note:
Entity name
20X2 20X1
C C
x Income tax xxx xxx
current income tax

current year provision xxx xxx
prior year under/ (over) provision xxx xxx
deferred income tax 5.
current year deferred tax: xxx xxx
prior year deferred tax: rate change xxx (xxx)
x Other taxes levied on company profits xxx xxx
current xxx xxx

deferred xxx xxx
Tax expense per the statement of comprehensive income xxx xxx
Applicable tax rate (ATR) Income tax rate: 30% x% x%

Tax effects of:

Current tax under/ (over) provision Per above xxx (xxx)
Deferred tax rate change Per above xxx xxx
Add other taxes on co. profits Per above: current + deferred xxx xxx
9.4.2.2 Effect of deferred tax assets on the income tax expense note (IAS 12.80 (e) - (g))
The following must be disclosed relative to the deferred tax expense:

x Reductions in the deferred tax expense caused by recognising a previously unrecognised
deferred tax asset. IAS 12.80 (f)
x Increases in the deferred tax expense if you recognised a deferred tax asset in a prior year
and this deferred tax asset subsequently needs to be written-down IAS 12.80 (g)
x Decreases in the deferred tax expense if a previous write-down of a deferred tax expense
now needs to be reversed IAS 12.80 (g)
The following must be disclosed relative to the current tax expense:

x Decreases in current tax expense where a deferred tax asset that has not been recognised
has now been utilised (i.e. the tax expense has now been effectively reduced). IAS 12.80 (e)
Chapter 6 355
Example of the layout of a detailed income tax expense note:
Entity name
For the year ended ...
20X2 20X1
x Income tax xxx xxx
current income tax
current year provision 80(a) xxx xxx
prior year under/ (over) provision 80(b) xxx xxx
deferred income tax 5.
current year movement in temporary differences 80(c)
prior year def tax balance: rate change adjustment 80(d) xxx (xxx)
current year def tax asset: not recognised xxx xxx
prior year recognised def tax asset: write-down/ (back) 80(g) xxx (xxx)
prior year unrecognised def tax asset: recognised: 80(f) 0 (xxx)
x Other taxes levied on profits xxx xxx
current xxx xxx
deferred xxx xxx
Applicable tax rate (ATR) Income tax rate: 30% x% x%
Tax effects of:
Prior year under/ (over) provision Per above xxx xxx
Prior year deferred tax balance: rate change Per above xxx (xxx)
Current year deferred tax asset not recognised Per above xxx xxx
Prior year recognised def tax asset written-down/ (back) Per above xxx (xxx)
Prior year unrecog def tax asset now recognised Per above 0 (xxx)
Other tax on companies Per above xxx xxx
9.4.2.3 Tax relating to changes in accounting policies and correction of errors (IAS 12.80 (h))
The tax on an adjustment that had to be made in the current year because it was impracticable to
process in the relevant prior year must be shown separately from other tax if it was caused by either:
x a change in accounting policy or
x correction of error
This can be done in aggregate (i.e. current plus deferred tax). IAS 12.80 (h)
9.4.2.4 Extra detail required with regard to discontinuing operations (IAS 12.81 (h))
In respect of discontinued operations, the tax expense relating to:

x the gain or loss on discontinuance; and
x the profit or loss from the ordinary activities of the discontinued operation for the period,
together with the corresponding amounts for each prior period presented.
9.4.3 Tax on other comprehensive income (IAS 12.81 (a) and (b))
The statement of comprehensive income shows the following separately from one another:
x Profit or loss; and
x Other comprehensive income (OCI, being part of equity).
356 Chapter 6
Tax on profit or loss is shown in the ‘income tax expense’ line item and details thereof are disclosed
in the ‘income tax expense’ note. Tax on other comprehensive income (OCI), on the other hand, is
not recognised as an expense. Instead it is recognised by netting it off in the relevant OCI ledger
account. Although this netting off occurs, the tax effect (current plus deferred tax) must still be
separately disclosed. The tax effect must be separately disclosed for each item of OCI that exists.
Chapter 3 explained that each item of other comprehensive income, classified by nature must be:
x presented as separate line items on the face of the statement of comprehensive income, and
x grouped under the relevant category heading of either:
- items that may be reclassified to profit or loss; and
- items that will never be reclassified to profit or loss. IAS 1.82A
An item of other comprehensive income may have been affected by a tax adjustment and may
also have been affected by a reclassification adjustment (where applicable) during the period.
For each such item of other comprehensive income:
x any reclassification adjustment that may have occurred must be separately disclosed;
x the tax adjustment that may have occurred must be separately disclosed, and where there was a
reclassification adjustment, then the related tax effect must also be separately disclosed.
The abovementioned reclassification adjustments and tax effects may be presented on either
the face of the statement of comprehensive income, or in the notes. IAS 1.90
This textbook adopts the approach of presenting each item of other comprehensive income net
of any reclassification and tax adjustments on the face of the statement and presenting the
reclassification adjustments (where applicable) and tax effects in the notes.
Example of the layout of OCI notes showing the disclosure of the tax effects
Entity name
20X2 20X1
23. Other comprehensive income: cash flow hedge C C
Cash flow hedge gain/ (loss) xxx (xxx)
Tax on gain/ loss (xxx) xxx
Reclassification of cash flow gain (xxx) (xxx)
Tax on reclassification of cash flow gain/ (loss) xxx xxx
Cash flow hedge gain/ (loss), net of reclassifications and tax xxx (xxx)
24. Other comprehensive income: revaluation surplus
Revaluation surplus increase/ (decrease) xxx (xxx)
Tax on increase/ (decrease) (xxx) xxx
Revaluation surplus increase/ (decrease), net of tax xxx (xxx)
Chapter 6 357
10. Summary
Income tax expense line item

in the statement of comprehensive income
includes:
Income tax: current tax plus deferred tax
Current income tax

x Current year estimate
x taxable profits x tax rate
x Prior year estimate under/ (over) provided

x assessment for the prior year – current tax recognised in prior year
Deferred income tax

x current year adjustment =
movement in temporary differences x tax rate
or
temporary differences at end of year x tax rate - temporary differences at beginning of year x tax rate
x prior year adjustment due to rate change = opening def. tax balance / old rate x difference in tax rate
x deferred tax on OCI adjustments are NOT included in the income tax expense line item of the P/L
section: they are included with the OCI line-items in the OCI section
Dividends tax
x Dividend tax replaced STC with effect from 1 April 2012
x Dividend tax is levied on the shareholder as a percentage of the dividend received (now 20%)
x Dividend tax is not a tax on the entity and is thus not included in the entity’s tax expense and
similarly, there are no deferred tax consequences
Deferred tax is Recognised on

certain
Temporary differences:
Calculations: Examples of items that cause temporary

differences
x Balance sheet approach x Accruals:
x new IAS 12 x income received in advance
x Income statement approach x expenses prepaid
x old IAS 12 x Provisions
See next page for the calculations x Non-current assets
Summary continues on the next page …
358 Chapter 6
Deferred tax @ 30 % Equals

Timing Taxable profits
adjustment for
difference per RoR
the year
Versus
Income
Taxable profits
statement
per accountant
approach
Methods of
calculation
Carrying value of
Balance sheet
Assets &
approach
Libilities
Versus
Deferred tax @ 30 % Equals Tax Base of

Temporary
balance at end of Assets &
difference
year Liabilities
Note that the 30% rate is given as the applicable tax rate which could change depending on the scenario.
The portion that The portion that

will be deducted will not be taxed
or
in the future in the future
Tax base
The portion that The portion that

will not be deducted will be taxed
or
in the future in the future
Chapter 6 359
Measurement of tax:
x Use enacted; or
x Substantively enacted tax rates
If a new rate is announced before reporting date:
x Use prof judgement to decide whether it has been substantively enacted
x In SA, it is generally considered substantively enacted
o If the new rate is not linked to other tax laws:
On the date announced by the Minister of Finance
o If the new rate is inextricably linked to changes to other tax laws, when:
announced by the Minister of Finance; and
President has approved the change.
Measuring current tax Measuring deferred tax

The amount expected to be paid to (recovered The amt calculated using tax rates that are
from) the taxation authorities IAS 12.46 expected to apply to the period when the asset is
realised or the liability is settled IAS 12.47
Affected by management intentions
Management intentions (IAS 12.51 A-C)

x Keep: income tax rates x TD (unless it is land in which case always use rates/ calculations
applicable to the portion that is a taxable capital gain)
x Sell: use rates/ calculations applicable to the portion that is a taxable capital gain
x Keep then sell: combination of rates/ calculations
x Presumed intentions: we presume the intention is to sell if the asset is:
x non-depreciable PPE (land) measured in terms of IAS 16’s revaluation model; or
x investment property measured in terms of IAS 40’s fair value model (this is rebuttable if the
property is depreciable and is held within a business model that intends to earn substantially
all the benefits over time rather than through a sale)
Recognition of Deferred tax (DT):

Deferred tax arises from temporary differences (TD)
If it is a taxable TD If it is a deductible TD If it is an exempt TD

Recognise a DTL Recognise a DTA Do not recognise DTA/L
Exempt Temporary differences

x The exemption applies only to initial recognition (i.e. the initial cost and anything stemming from that
cost e.g. depreciation on cost or impairments to cost or impairments reversed).
x The exemption thus does not apply to revaluation surpluses and anything stemming from that
revaluation surplus (i.e. the extra depreciation caused by the revaluation surplus)
Temporary differences due

to Non-current assets
Deductible Not deductible

TB = portion that will be TB = portion that will be
deducted in the future deducted in the future
= Cost – cumulative amounts =0
already deducted
Deferred tax balance = Deferred tax balance = nil because

(TB – CA) x tax rate Temporary differences (TB – CA) are exempt from DT IAS 12.15
Thus, no DT unless it is revalued to FV and then only that portion of
the carrying amount relating to the revaluation results in def-tax
Non-deductible assets cause reconciling items in the tax rate recon:

x Depreciation (if depreciable)
x Impairments
x Profit or loss on sale
360 Chapter 6
Gripping GAAP Property, plant and equipment: the cost model
Chapter 7
Property, Plant and Equipment: The Cost Model
Reference:
IAS 16, IAS 36, IAS 12, IAS 20, IFRIC 1, IFRS 13, IAS 21(incl. any amendments to 1 December 2018)
Contents: Page
1. Introduction 363
2. Recognition 363
2.1 Overview 363
2.2 Meeting the definition 363
2.3 Meeting the recognition criteria 364
2.4 Recognising significant parts 364
Example 1: Significant parts 364
3. Initial measurement 365
3.1 Overview 365
3.2 Cost and the effect of the method of acquisition 365
3.2.1 Item acquired by way of cash (or something similar) 365
Example 2: Cash payments – ‘within’ vs ‘beyond’ normal credit terms 366
3.2.2 Item acquired via an asset exchange 366
Example 3: Asset exchange – fair values are known 367
Example 4: Asset exchange – involving cash and cash equivalents 367
Example 5: Asset exchange – with no commercial substance 368
3.2.3 Item acquired via a government grant 368
Example 6: Government grant is a non-monetary asset 369
Example 7: Government grant is a monetary asset (to acquire another asset) 369
3.3 Initial costs 370
3.3.1 Overview 370
3.3.2 Purchase price 370
Example 8: Initial costs: purchase price 370
Example 9: Initial costs: purchase price with settlement discount 371
3.3.3 Directly attributable costs 372
Example 10: Initial costs: purchase price and directly attributable costs 372
Example 11: Initial costs: purchase price, directly attributable costs and
significant parts 373
3.3.4 Future costs: dismantling, removal and restoration costs 374
3.3.4.1 Future costs: overview 374
3.3.4.2 Future costs: existing on acquisition 374
Example 12: Initial cost involving future costs 374
3.3.4.3 Future costs: caused/increases over time 375
Example 13: Subsequent costs involving future costs 375
3.3.4.4 Future costs: caused/increases over time – more detail 376
3.4 Subsequent costs 377
3.4.1 Day-to-day servicing 377
Example 14: Vehicle repainting 377
Example 15: Vehicle acquired without engine: engine purchased afterwards 377
Example 16: Vehicle engine overhaul – extending the useful life 378
Example 17: Vehicle engine service 378
3.4.2 Replacement of parts and de-recognition of assets 378
3.4.2.1 Derecognition of the old part 378
3.4.2.2 Capitalisation of a new part 379
Example 18: Replacement of a part 379
Example 19: Replacement of a part that was not previously identified 380
Chapter 7 361

3.4.3 Major inspections 380
Example 20: Major inspection performed 380
Example 21: Major inspection purchased as part of the asset 381
Example 22: Major inspection derecognised 382
4. Subsequent measurement 382
4.1 Overview 382
4.2 Cost model 383
4.3 Depreciation 383
4.3.1 Overview 383
4.3.2 Residual value and the depreciable amount 384
4.3.3 Method of depreciation 384
4.3.3.1 Straight-line method 384
4.3.3.2 Diminishing balance method 384
4.3.3.3 Units of production method 385
4.3.3.4 Choosing a method 385
4.3.4 Useful life 386
4.3.5 Depreciating the whole asset or the parts thereof 386
4.3.6 Depreciation journal 387
Example 23: Depreciation calculation with many dates 387
Example 24: Depreciable amount and straight-line depreciation 387
Example 25: Depreciation using diminishing balance 388
Example 26: Depreciation using units of production 388
Example 27: Depreciation of a self-constructed asset 388
4.3.7 Change in estimate 389
Example 28: Units of production with a change in total expected production 390
4.4 Impairments 390
4.4.1 Overview 390
4.4.2 Recoverable amount 391
4.4.3 Comparing the carrying amount with the recoverable amount 391
4.4.4 Depreciation in periods following an impairment 391
Example 29: Cost model – impairment loss 393
Example 30: Cost model – reversal of impairment loss 393
Example 31: Cost model – a summary example (the asset is not depreciated) 395
Example 32: Cost model – a summary example (the asset is depreciated) 396
5. Derecognition 397
6. Deferred tax consequences 398
6.1 Overview 398
6.2 Comparing the carrying amount and tax base 398
Example 33: Deferred tax caused by the purchase, depreciation and sale of PPE 399
Example 34: Deferred tax involving the impairment of PPE 401
6.3 Deferred tax exemptions 402
Example 35: Deferred tax involving exempt temporary differences 403
7. Disclosure 403
7.1 Overview 403
7.2 Accounting policies and estimates 404
7.5 Further encouraged disclosure 405
7.6 Disclosure regarding fair value measurements 405
7.7 Sample disclosure involving property, plant and equipment 406
Example 36: Cost model disclosure – no impairment 407
Example 37: Cost model disclosure – with impairments 408
8. Summary 412
362 Chapter 7
1. Introduction
This chapter deals with a vital component of most businesses: its property, plant and
equipment. Property, plant and equipment refers to the physical (tangible) assets that are used
to make profits. There are many different types of property, plant and equipment, each of
which shares one important characteristic: they are used by the business over more than one
year, and are used to generate income. They are thus non-current in nature.
This chapter teaches you when to recognise an asset as an item of Examples of
property, plant and equipment, how to measure it, and how to items of PPE
disclose it. Measurement of this asset involves two stages: initial include:
measurement and subsequent measurement. x land;
x buildings;
x plant;
Initial measurement is always at cost and subsequent measurement involves:
x equipment (factory);
x choosing the measurement model: cost or revaluation; x equipment (office);
x depreciation; and x furniture; and
x impairment testing. x vehicles.
With regard to the two measurement models: this chapter explains the use of the cost model
and the next chapter explains the revaluation model.
The cost model first measures the asset at cost. The asset is The PPE carrying amount
then subsequently measured to reflect the effects of usage (under the cost model) is
reflected by three amounts:
(depreciation) and the effects of any damage (impairments).
x Cost: this shows how much it was
Please note that 'damage', for purposes of impairment testing, initially measured at (see section 3).
includes all kinds of events, such as physical damage or even x Accumulated depreciation: this
a downturn in the economy. Thus, when measuring the asset shows the cumulative effect of usage
using the cost model, its carrying amount is measured as a of the asset.
combination of three amounts: x Accumulated impairment losses: this
shows the cumulative effect of
x cost damage (any kind – not just physical)
x less accumulated depreciation, and to the asset.
x less accumulated impairment losses.
‘Accumulated depreciation’ and ‘accumulated impairment losses’ do not need to be disclosed

separately, and thus we may combine these amounts into a single account (‘accumulated
depreciation and impairment losses’ account) if we prefer.
2. Recognition (IAS 16.6 - .10 and 16.43 - .47)
2.1 Overview
Before we can recognise the acquisition of an item as ‘property, plant and equipment’, it must meet:
x the definition of property, plant and equipment; and
x the recognition criteria.
PPE is defined as:
2.2 Meeting the definition (IAS 16.6) x tangible items, that are held :
- for use in the production or
Before one can recognise an asset as ‘property, plant and equipment’, supply of goods or services,
the definition thereof must be met. This definition (see pop-up - for rental to others or
alongside) requires that the item be tangible. This means that it must - for administration
have a physical form (e.g. a machine has physical form but a patent purposes; and
x are expected to be used
does not). A second aspect to the definition is that we must be during more than one period.
planning to use the asset. We could use it in one of three ways – we IAS 16.6
could use it to produce or supply goods or services (e.g. a machine that we use to make inventory or a
machine that we use to resurface roads), to rent to third parties (e.g. a machine that we rent out to
someone) or for administration purposes (e.g. a building that we use as our head office). The third
issue is that we must plan to use the item for more than one period. An asset that will be used for a
year or less is a current asset (property, plant and equipment is a non-current asset).
Chapter 7 363
2.3 Meeting the recognition criteria (IAS 16.7 - .10) Recognition criteria
(per IAS 16):
If this definition is met, the next step is to check if the recognition x the inflow of future
economic benefits to the
criteria are also met. There are two recognition criteria in IAS 16: the entity is probable; and
expected inflow of future economic benefits from the asset must be x the asset’s cost can be
probable, and the asset must have a cost that is reliably measurable. reliably measured.
IAS 16.7 reworded
Recognition criteria: Conflict between IAS 16 and the Conceptual Framework:

The two recognition criteria provided in IAS 16 (see grey box above) differ from the two recognition criteria
in the new ‘2018 Conceptual Framework’, which are that an item should only be recognised if it provides relevant
information and would be a faithful representation of the phenomena it purports to present.
However, the IASB concluded that we should continue to use the two recognition criteria in IAS 16 because these will
still achieve the same outcome of relevance and faithful representation.
2.4 Recognising significant parts (IAS 16.43-47)

When recognising an item of property, plant and equipment, we must consider whether it has
significant parts, in which case each significant part should be recognised in a separate asset
account. A part of an asset is considered to be significant if the cost of that part is significant in
relation to the total cost of the asset. The idea behind recognising each part separately is that
this will enable us to make more accurate estimates of depreciation because we will then be
able to depreciate each part separately (significant parts often have different useful lives and
residual values to the remaining parts of the item of property, plant and equipment). See IAS 16.43
Example 1: Significant parts

Whoosh Limited bought a ship for C1 000 000 cash on 30 June 20X1. It has three parts:
x Engine: C300 000 (a significant part)
x Hull: C500 000 (a significant part)
x Various other moving and non-moving parts: C200 000 (individually insignificant).
On 30 June 20X1, the total other property, plant and equipment had a carrying amount of C3 000 000.
Required:
a) Show the journal entry to record the purchase of the ship.
b) Present the ship in the detailed statement of financial position on the date of acquisition.
Solution 1A: Significant parts: Journals

Ship: engine: cost (A) 300 000
Ship: hull: cost (A) 500 000
Ship: other insignificant parts: cost (A) 200 000
Bank (A) 1 000 000
Purchase of ship
Solution 1B: Significant parts: Disclosure
Whoosh Limited
As at 30 June 20X1
20X1
Non-current assets C
Property, plant and equipment Other: 3 000 000 + Ship: 1 000 000 4 000 000
Comment: When disclosing the ship in the SOFP, did you notice how a single line item for total property,
plant and equipment is shown:
x the separate (significant) parts are not disclosed separately, and
x the ship is not disclosed separately.
364 Chapter 7
3. Initial Measurement (IAS 16.15 – 16.28)
3.1 Overview PPE is initially

measured at its:
Once we decide that an item must be recognised as property, plant x cost IAS 16.15
and equipment (i.e. it meets the definition and recognition criteria), it must be measured at cost.
Cost is a defined term (see grey box alongside) that clarifies that cost
could be a cash amount (or cash equivalent), a fair value, or in certain Cost is defined as
cases, it could even be an amount simply attributed to that asset. x the amount of cash or cash
equivalents paid; or
The cost of the asset on the date it is initially recognised is called the x the fair value of the
initial cost (see section 3.3). This initial cost includes: consideration given (if it is not
x its purchase price (see section 3.3.2); cash) at the time of acquisition
x directly attributable costs (see section 3.3.3); and or construction; or
x certain future costs (see section 3.3.4). See IAS 16.16 x the amount attributed to that
asset if initial recognition is
per other IFRSs. Reworded IAS 16.6
Later in the asset’s life, further costs may be incurred in relation to
the asset, which we refer to as subsequent costs (see section 3.4).
Initial costs
These subsequent costs include, for example: include:
x Day-to-day servicing (i.e. repairs and maintenance);
x purchase price
x Replacement of parts; and
x directly attributable costs
x Major inspections.
x certain future costs See IAS 16.16
The method of acquisition can affect the measurement of cost (see section 3.2 below).
3.2 Cost and the effect of the method of acquisition
How an item of property, plant and equipment is acquired could affect the measurement of its cost:
x If the acquisition is paid for in cash (or a cash equivalent), the measurement of cost is based on
the cash price equivalent (see section 3.2.1).
x If the acquisition does not involve cash but an exchange of some other asset/s (e.g. we swop a
machine for a vehicle), the acquired item’s cost could be the fair value of the asset given up, the
fair value of the asset acquired or the carrying amount of the asset given up (see section 3.2.2).
x If the acquisition was by way of a government grant (e.g. if the government gave us a machine),
the item’s cost could be measured at its fair value or could be measured at a nominal amount
(used purely for recording purposes), or an item’s cost could be reduced by the amount of grant if
the grant was received in cash to help subsidise this cost (see section 3.2.3).
3.2.1 Item acquired by way of cash (or something similar) (IAS 16.23)
If payment is deferred
If the acquisition price is paid in cash (or something similar to
beyond normal credit terms,
cash), then the cost of the item is the cash price equivalent on cost is the present value of the
date of recognition. cash payments.
Note:
The cash price equivalent is the amount of the cash payment Total amount we’ll pay
(i.e. the nominal amount) if the payment occurs immediately Less: present value of the payment (cost)
on date of acquisition or within normal credit terms. = Interest (expensed over the pmt
period, or capitalised: section 3.2.3)
However, the cash price equivalent is not the future cash payment/s (nominal amount) if the payment is
delayed beyond normal credit terms. In this case, the cash price equivalent is the present-value of the
future cash payment/s, measured at date of recognition (i.e. the amount that would have been paid had it
been paid in full on date of recognition). The difference between this cash price equivalent (the present
value of the future cash payments) and the total future cash payments (the nominal amount) is interest.
This interest is generally recognised as an interest expense. However, interest may need to be capitalised
(i.e. recognised as part of the cost of the asset) if the interest meets the definition of ‘borrowing costs’, the
asset meets the definition of a ‘qualifying asset’, and the criteria for capitalisation are met. Borrowing costs
and whether they should be capitalised or expensed is covered in IAS 23 Borrowing costs and is explained
in detail in chapter 14, but a basic overview is also provided in section 3.3 of this chapter.
Chapter 7 365
Example 2: Cash payments – ‘within’ vs ‘beyond’ normal credit terms

Washy Limited purchased a machine on 1 January 20X1. The purchase price is C100 000,
payable on 31 December 20X1. There were no individually significant parts.
Required: Show the journal entries relating to the purchase and payment of the machine assuming:
A. Payment within one year is considered to be within normal credit terms.
B. Payment within one year is considered to be beyond normal credit terms. The present value of this
amount, calculated using an appropriate interest rate of 10%, is C90 909.
Solution 2: Cash payment – ‘within’ vs ‘beyond’ normal credit terms

Part A Part B
Dr/ (Cr) Dr/ (Cr)
Machine: cost (A) Part A: Cash payment 100 000 90 909
Part B: Present value of cash payment
Finance cost (E) Part B: 90 909 x 10% (or balancing) - 9 091
Payables (L) (100 000) (100 000)
Purchase of machine, measured at the cash price equivalent (CPE)
[Comment: in Part A, the CPE = the cash amount, whereas in Part B, the CPE =
the present value of the cash amount, with the difference recognised as interest]
Payables (L) 100 000 100 000

Bank (A) (100 000) (100 000)
Payment made to supplier of machine
Comment: The payable date is the same in both parts, but in Part A, the date is considered to be:
Part A: within normal credit terms, so the asset is measured at the cash amount.
Part B: beyond normal credit terms, so the asset is measured at the present value of the cash amount.
3.2.2 Item acquired via an asset exchange (IAS 16.24 – 16.26)

Sometimes an item of property, plant and equipment is not acquired Fair value is defined
in exchange for a cash payment, but involves an exchange of a non- as:
monetary asset instead (e.g. we could acquire a machine by giving x the price that would be:
up a vehicle) …or it could involve an exchange of a combination of received to sell an asset, or
non-monetary and monetary assets. paid to transfer a liability
x in an orderly transaction
The cost of an item acquired through an exchange of assets is x between market participants
ideally measured at the fair value of the asset/s given up. x at the measurement date IFRS 13.9
However, the cost of the asset would be taken to be the fair value of the asset received instead, if:
x the fair value of the asset given up is not available; or
x the fair value of the asset received is ‘more clearly evident’. See IAS 16.26
If we cannot reliably measure the fair value of either of the assets, then the cost of the acquired
asset is assumed to be the carrying amount of the asset given up.
Similarly, the cost of the acquired asset is measured at the carrying amount of the asset given
up if the exchange of assets is deemed to have no commercial substance (e.g. two vehicles are
exchanged, of the same vintage, with the same mileage and in the same condition.
An exchange is considered to have no commercial substance if the exchange of assets:
x will not change the future cash flows in any way (risk, timing or amount);
x will not change the value of the operation that is to use the asset; or
x any expected change in cash flows or value is insignificant relative to the fair value of the
assets exchanged. See IAS 16.25
An exchange of similar assets generally leads to an exchange having no commercial substance,
but an exchange of dissimilar assets could also have no commercial substance.
The diagram on the following page may help to visualise the treatment of exchanges of assets.
366 Chapter 7
Exchange of assets
Use fair value Use carrying amount of asset given up

x of the asset/s given up; or x if the exchange lacks commercial substance;
x of the asset received – if this is more clearly or
evident. See IAS 16.26 x if the FV’s of both assets were unable to be
Only use FV if it is reliably measurable! reliably measurable. See IAS 16.24
Example 3: Asset exchange - fair values are known

Don Limited exchanged a machine (asset given up) for a vehicle (asset acquired):
x Machine: Carrying amount (cost was C18 000) 10 000 10 000 10 000
Fair value 11 000 11 000 unknown
x Vehicle: Fair value 12 000(1) 15 000(2) 12 000
(1) The difference in fair values is considered to be immaterial.
(2) The difference in fair values is considered to be material and the fair value of the vehicle is ‘more clearly evident’
than the fair value of the machine.
Required: For each scenario, show how you would journalise the exchange and explain your answer.
Solution 3: Asset exchange - fair values known

Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Vehicle: cost (A) See comments below 11 000 15 000 12 000
Machine: cost (A) Given (18 000) (18 000) (18 000)
Machine: acc. depreciation (-A) Cost 18 000 – CA: 10 000 8 000 8 000 8 000
Profit on exchange of assets (I) Balancing (1 000) (5 000) (2 000)
Exchange of machine (given up) for vehicle (acquired)
Comment:
Scenario A: Explanation:
The vehicle is measured at the FV of the machine (FV of asset given up): 11 000
The asset sold is removed from the books (derecognised) and the new asset is recognised at the fair value of
the asset given up because the fair value of the asset given up (machine) is readily available.
Note: Where the fair value of the asset given up and fair value of the asset received are materially different,
the fair value of the asset received may be considered ‘more clearly evident’. In this example, however, we
were told that the difference between the two fair values (C1 000) is immaterial.
Scenario B: Explanation:
The vehicle is measured at the FV of the vehicle (FV of asset received): 15 000
The asset given up must be derecognised and the newly acquired asset must be recognised at the fair value of
the acquired asset.
This fair value is used because the difference in the fair values is material, and thus the fair value of the asset
acquired is assumed to be ‘more clearly evident’ than the fair value of the asset given up.
Scenario C: Explanation:
The vehicle is measured at the FV of the vehicle (FV of asset received): 12 000
The asset given up is derecognised and the newly acquired asset is recognised at the fair value of the acquired
asset. The reason is that the fair value of the asset given up is not available.
Example 4: Asset exchange - involving cash and cash equivalents

A company gave up a vehicle and cash in exchange for a machine. Consider the
following two scenarios: Scenario A Scenario B
x Vehicle: Carrying amount (cost was C18 000) 10 000 10 000
Fair value 10 000 unknown
x Cash: 1 000 1 000
x Machine: Fair value unknown 12 000
Required: For situation A and B, show the related journal entry for the asset exchange.
Chapter 7 367
Solution 4: Asset exchange - involving cash and cash equivalents

Scenario A Scenario B
Dr/ (Cr) Dr/ (Cr)
Vehicle: accumulated depreciation and impairment losses (-A) 8 000 8 000
Vehicle: cost (A) (18 000) (18 000)
Bank (A) (1 000) (1 000)
Machine: cost (A) See explanations below 11 000 12 000
Profit on exchange of assets (I) See explanations below N/A (1 000)
Vehicle and cash exchanged for a machine
Comment:
Scenario A: The old asset is removed (derecognised) and the new asset (machine) is recognised at the
fair value of both assets given up (i.e. the vehicle and the cash).
Scenario B: Although the fair value of cash is known, the fair value of the vehicle given up is not available and
thus the fair value of the acquired machine must be used instead. This resulted in a profit on exchange.
Example 5: Asset exchange - with no commercial substance

Machine A is exchanged for machine B. The exchange has no commercial substance.
x Machine A: Cost 50 000
Accumulated depreciation 5 000
Fair value 30 000
x Machine B: Fair value 20 000
Required: Explain how this should be recorded in the general ledger, if at all .
Solution 5: Asset exchange - with no commercial substance

Since the asset exchange has no commercial substance, the acquired asset is not measured at fair value at
all, but rather at the carrying amount of the asset given up. The following journal would be required:
Debit Credit
Machine A: accumulated depreciation (-A) 5 000
Machine A: cost (A) 50 000
Machine B: cost (A) 45 000
Exchange of assets: machine A given up in return for machine B
Comment:
x If the fair value of the asset received is much lower than the value of the asset given up, it may be an
indication that the asset given up was impaired. In this case, before journalising the exchange, we must first
calculate the recoverable amount of the asset given up.
x The recoverable amount of an asset is essentially the higher of the amount expected from either using or
selling the asset (‘ recoverable amount’ is defined in IAS 36 and chapter 11 Impairment of assets).
x If the recoverable amount is lower than its carrying amount, the asset is considered to be impaired and thus
the carrying amount must be reduced before accounting for the exchange.
x More information relating to impairments (damage) can be found in chapter 11 (Impairment of assets).
3.2.3 Item acquired via a government grant (IAS 16.28 and IAS 20)
There are different types of government grant possible:

x low-interest or interest-free loans,
x grants related to income (which actually refers to, for example, cash to be used to help an
entity pay for past, current or future expenses), and
x grants related to assets.
It is the ‘grants related to assets’ that are relevant to this chapter on property, plant and equipment.
Government grants are covered by IAS 20 and are explained in detail in chapter 15 (the
portion of chapter 15 that explains how to account for ‘grants related to assets’ can be found in
section 3.4). In the meantime, the following is a brief overview of grants in the context of
property, plant and equipment.
368 Chapter 7
A grant that an entity is given by a government meets the definition of income (because it is not a
contribution from a holder of an equity claim). This grant income must be recognised in profit or loss
over the same period in which the related costs are recognised in profit or loss. Thus, the receipt of a
grant relating to the acquisition of an item of property, plant and equipment would first be recognised as
deferred grant income and would then be recognised as income in profit or loss over the asset’s useful
life (because the cost of that item is recognised in profit or loss as depreciation over its useful life).
However, if this item of property, plant and equipment is non-depreciable, the transfer from deferred
grant income to profit or loss occurs as and when the conditions to the grant, if any, are met.
A government grant relating to an item of property, plant and equipment could either be received in
the form of the actual non-monetary asset (e.g. a machine) or a monetary asset (e.g. cash) that must be
used to acquire such an asset. Irrespective of how it is received (e.g. whether as a machine or as cash
to be used to acquire a machine), the recognition principles are the same: the grant is income that
must be recognised in profit or loss over the asset’s useful life. However, the form in which it is
received, could affect the measurement of the asset. Let’s look at the impact of these two forms.
x If the grant is received in the form of an actual item of property, plant and equipment (non-monetary
asset), the grant income could either be measured at the item’s fair value or a nominal amount. A
‘nominal amount’ is simply a small amount (e.g. C1) used to record the transaction (e.g. if the entity
cannot determine the item’s fair value or prefers not to use fair value).
Debit property, plant and equipment, and Credit deferred grant income (liability). NOTE 1
This deferred grant income is then recognised as grant income in profit or loss over the item’s useful
life (debit deferred grant income and credit grant income).
x If the grant is received in the form of cash (monetary asset) to be used to acquire an item of
property, plant and equipment, then grant income would be measured at the cash amount.
Debit bank, and Credit deferred grant income (liability). NOTE 1
This deferred grant income is then recognised as grant Government grants
income in profit or loss over the item’s useful life (debit relating to PPE affect
deferred grant income and credit grant income). measurement of cost:
x If we receive PPE for free:
NOTE 1: if the item to be acquired is depreciable, we may choose Measurement of the PPE’s cost is
to credit its carrying amount instead of crediting deferred grant either FV or nominal amount (e.g. C1)
income. The grant would then reach profit or loss as a decreased x If we receive cash to buy PPE:
depreciation charge. This option does not apply if the asset is non- Measurement of the PPE’s cost
depreciable (e.g. land), because otherwise the grant would never could be reduced by this cash
amount (or deferred income could
affect profit or loss. See IAS 20.26-7
t. be credited instead).
Example 6: Government grant is a non-monetary asset
A government gives computer equipment to Beanies Limited, where this equipment is to be
used to train accountants. The equipment has a useful life of 5 years.
Required: Show the journal entries assuming the company chooses to measure the equipment at:
A. its fair value of C50 000
B. a nominal amount of C1.
Solution 6: Government grant is a non-monetary asset Part A Part B

Dr/ (Cr) Dr/ (Cr)
Equipment: cost (A) A: FV of C50 000 B: Nom Amt of C1 50 000 1
Deferred grant income (L) (50 000) -
Grant income (I) - (1)
Recognising the equipment granted by the government
Comment:
x In part A, equipment is expensed as depreciation over its estimated useful life and the deferred
income would be recognised as income in profit or loss over the equipment’s useful life .
x In part B, there would be no further journal entries. We thus credit grant income directly to P/L.
Example 7: Government grant is a monetary asset (to acquire another asset)
The government grants Hothead Limited C50 000 in cash. The cash must be used to buy a
nuclear plant. Hothead subsequently purchases the nuclear plant for C80 000.
Hothead chooses to set the grant off against the cost of the asset.
Required: Show the journals relating to the grant and the subsequent purchase of the nuclear plant.
Chapter 7 369
Solution 7: Government grant is a monetary asset (to acquire another asset)

Comment:
x Since the entity chose to set the grant off against the asset, the nuclear plant is measured at a net cost
of C30 000 (cost of acquisition: C80 000 - government grant: C50 000). The grant is ‘hidden’ in the
cost of the asset and will thus be recognised indirectly as income in profit or loss, through a reduced
depreciation charge (depreciation will be on the net cost of C30 000 instead of on C80 000).
x If the entity had not chosen to set the deferred grant income off against the asset’s cost, the deferred grant
income (a liability) will be recognised as grant income in profit/loss over the useful life of the asset.
x The effect on profit or loss is the same regardless of which option it chooses.
Debit Credit
Bank (A) 50 000
Deferred grant income (L) 50 000
Receipt of government grant to acquire a nuclear plant
Nuclear plant: cost (A) 80 000
Bank (A) 80 000
Purchase of nuclear plant
Nuclear plant: cost (A) 50 000
Government grant recognised as a reduction in the cost of the plant
3.3 Initial costs (IAS 16.16 - 16.22A)

3.3.1 Overview Elements of cost:
The cost of an item of property, plant and equipment x purchase price;

x directly attributable costs; and
comprises three elements: the purchase price, any directly x initial estimates of future
attributable costs (those that are necessary to bring the asset to costs (if the entity has the
a location and condition suitable for the use intended by obligation). See IAS 16.16
management), and the initial estimate of the costs of dismantling and removing the item and
restoring the site on which it is located, if the entity has an obligation to incur these costs. See IAS 16.16
3.3.2 Purchase price (IAS 16.16)
The ‘purchase price’ includes import duties and non-refundable taxes. If the invoiced price includes a
tax that is able to be claimed back from the tax authorities (i.e. refundable, such as VAT), this tax is
excluded from the purchase price.
The purchase price is reduced by trade discounts and rebates received. Although not expressly stated,
cash discounts received and even settlement discounts offered should also be deducted from the
purchase price. If a settlement discount is subsequently forfeited (i.e. because we do not pay in time),
then both the cost of the purchased item and the payable will need to be increased accordingly. (When
initially recognising the purchase transaction, the account payable could be measured at the amount net
of the potential settlement discount or at the gross amount with a separate ‘discount receivable’).
The principles of:
x deducting cash discounts and settlement discounts is not expressly stated in IAS 16 but is an
interpretation based on the methods used to account for these discounts when measuring inventory –
see IAS 2 Inventory (IAS 2.11, educational footnotes 3 and 4)
x increasing the cost of the asset with any forfeited discount, instead of debiting it to a finance cost expense, is
not expressly stated, but is an interpretation based on the concepts used to measure revenue when it involves
discounts offered - see IFRS 15 Revenue from contracts with customers. (IFRS 15.48)
Example 8: Initial costs: purchase price

Nabs Limited (‘Nabs’) bought a machine. The purchase invoice showed the following:
x Marked price: C100 000
x Less discount (on the basis that Nabs is a long-standing customer): C15 000
x Less volume rebate: C5 000
x Less cash discount: C2 000
x VAT is added at 15% on the final amount (assume Nabs is a registered VAT vendor).
Required: Show the journal entry for the acquisition of this machine.
370 Chapter 7
Solution 8: Initial costs: purchase price

Comment: Notice that the machine’s cost must:
x be net of all trade discounts and rebates; and
x not include VAT: since Nabs is a registered VAT vendor, it can claim this back (i.e. it is a
refundable tax) and thus the VAT is debited to a separate asset account: current tax receivable.
Dr/ (Cr)
Machine: cost (A) 100 000 – discounts and rebates: (15 000 + 5 000 + 2 000) 78 000
Current tax receivable: VAT (A) (100 000 – 15 000 – 5 000 – 2 000) x 15% 11 700
Bank (A) (100 000 – 15 000 – 5 000 – 2 000) x 115% (89 700)
Purchase of machine
Example 9: Initial costs: purchase price with settlement discount

Buns Limited bought a machine, with a marked price of C100 000, on 1 April 20X5. The supplier
offered a settlement discount of 5% if the account is paid in full, on or before 31 May 20X5.
Required: Show the journal entries for the acquisition of this machine assuming:
A. the supplier is paid in full on 25 May 20X5 and:
i) the entity does not make use of a deferred discount account.
ii) the entity makes use of a deferred discount account.
B. the supplier is paid in full on 2 June 20X5:
i) the entity does not make use of a deferred discount account.
ii) the entity makes use of a deferred discount account.
Solution 9: Initial costs: purchase price with settlement discount

General comment:
x The machine’s cost must initially be measured net of settlement discount.
x If the settlement discount is forfeited, the discount is added back to the cost of the asset.
Solution 9A: Settlement discount – supplier paid on time

Part A (i) Part A (ii)
1 April 20X5 Dr/ (Cr) Dr/ (Cr)
Machine: cost (A) 100 000 – settlement discounts: 100 000 x 5% 95 000 95 000
Payable (L) (95 000) (100 000)
Discount reeivable Also called Deferred discount/ Right to a discount N/A 5 000
Purchase of machine
25 May 20X5
Payable N/A 5 000
Discount reeivable N/A (5 000)
Payable (L) 95 000 95 000
Bank (95 000) (95 000)
Payment to supplier of machine
Solution 9B: Settlement discount – supplier not paid on time

Part B (i) Part B (ii)
1 April 20X5 Dr/ (Cr) Dr/ (Cr)
Machine: cost (A) 100 000 – settlement discounts: 100 000 x 5% 95 000 95 000
Payable (L) (95 000) (100 000)
Deferred discount N/A 5 000
Purchase of machine
31 May 20X5
Machine: cost (A) 5 000 5 000
Payable (L) (5 000) -
…Deferred discount N/A (5 000)
Discount is forfeited – machine cost increased
2 June 20X5
Payable (L) 100 000 95 000
Bank (100 000) (95 000)
Payment to supplier of machine
Chapter 7 371
3.3.3 Directly attributable costs (IAS 16.16-17 & 16.19–21 & IAS 23)
We include ‘directly attributable costs’ in the cost of an asset. The term 'directly attributable
costs' refers to those costs that we believe were necessary to get the asset into a location and
condition that enabled it to be used as management intended.
Examples of ‘directly attributable costs’ include: Directly attributable
x cost of preparing the site; costs are those
x initial delivery and handling costs; x that were necessary;
x installation and assembly costs; x to get the asset to the
x professional fees; location and condition;
x employee benefits (salaries, wages etc.) relating directly to x that enabled it to be used as
intended by management.
its construction or acquisition; and Reworded IAS 16.16(b)
x cost of testing that the asset is functioning correctly (net of

any proceeds earned from the sale of items produced during testing). See IAS 16.17
Another example is borrowing costs. If we incur costs (e.g. interest) that meet the definition of
borrowing costs and if they ‘are directly attributable to the acquisition, construction or production’ of an
item of property, plant and equipment that meets the definition of a qualifying asset (‘an asset that
necessarily takes a substantial period of time to get ready for its intended use or sale’, e.g. construction
of a factory), then these borrowing costs must be capitalised to the asset’s cost (instead of being
expensed) if certain criteria are met. However, if the asset is measured under the revaluation model (see
chapter 8) instead of the cost model, then capitalisation of these borrowing costs is not a requirement
but a choice. How to account for borrowing costs is covered by IAS 23 Borrowing costs and is
explained in detail in chapter 14. See IAS 23
Any cost that is not a ‘directly attributable cost’ is not included in the cost of the asset.
The following are examples of costs that are not considered to be directly attributable costs:
x administration and other general overheads;
x advertising and other costs relating to introducing a new product or service;
x conducting business in a new location or with a new type of customer;
x cost of training staff, for example, on how to use the newly acquired asset. See IAS 16.19
If a cost was not necessary in bringing the asset to a location and condition that enables it to be
used as intended by management, it is not a ‘directly attributable cost’ and thus not included in
the cost of the asset, for example:
x income and expenses that result from incidental operations occurring before or during
construction of an asset (e.g. using a building site as a car park until construction starts);
x abnormal wastage. See IAS 16.21 and .22
Similarly, costs incurred after the asset was brought into the required location and condition that
enables it to be used as intended by management cannot be referred to as ‘directly attributable’
and thus may not be capitalised (i.e. capitalisation ceases at that point). Examples include:
x staff training and costs of opening new facilities;
x initial operating losses made while demand for an asset’s output increases;
x costs of moving the asset to another location; and
x costs incurred while an asset, which is now capable of being used, remains idle or is being
utilised at below intended capacity. See IAS 16.19 and .20
Example 10: Initial costs: purchase price and directly attributable costs
A Limited (a registered VAT vendor) constructed a factory plant, details of which follow:
Construction costs, including materials (including VAT of 15%) C575 000
Import duties on certain construction materials - non-refundable (no VAT) 100 000
Fuel used to transport construction materials to the construction site (no VAT) 45 000
Fuel destroyed by construction workers during an illegal strike (no VAT) 30 000
Administration costs (no VAT) 10 000
Staff party to celebrate the completed construction of the new plant (no VAT) 14 000
Testing to ensure plant fully operational before start of production (no VAT) 42 123
Borrowing costs (all criteria for capitalisation in terms of IAS 23 were met) (no VAT) 15 000
Advertising of the ‘amazing widgets’ to be produced by the new plant (no VAT) 50 000
Initial operating loss (due to an initial insufficient demand for widgets) (no VAT) 35 000
Required: Calculate the initial costs to be capitalised to the plant account.
372 Chapter 7
Solution 10: Initial costs: purchase price and directly attributable costs
C
Construction costs, including materials (exclude VAT: 575 000 x 100/115) Note 1 IAS 16.16 500 000
Import duties - non-refundable Note 1 IAS 16.16 100 000
Fuel used to deliver construction materials to construction site IAS 16.16 45 000
Fuel destroyed (abnormal wastage) Note 2 IAS 16.22 0
Administration costs Note 2 IAS 16.19(d) 0
Staff party Note 2 IAS 16.19(c) 0
Testing the plant before start of production IAS 16.17(e) 42 123
Borrowing cost IAS 16.22 15 000
Advertising Note 3 IAS 16.19(b) 0
Initial operating losses Note 3 IAS 16.20 0
Initial costs (these will all be debited to the ‘plant: cost’ account) 702 123
Note 1: The VAT paid is not capitalised because the company is registered as a VAT vendor and thus this
VAT is refundable. The import duties are capitalised since they are not refundable.
Note 2: These costs are not capitalised because they were not directly attributable to (not necessary for)
bringing the asset to a location and condition necessary for it to be used as intended by management.
Note 3: This cost is excluded because it is a loss incurred after the asset was brought to a location and
condition that enabled it to be used as intended by management.
Example 11: Initial costs: purchase price, directly attributable costs & significant parts
B Air bought an aircraft on 1 January 20X2, incurring the following related costs in January 20X2:
Purchase price: C’000
Outer-body component 50 000
Engine component 70 000
Internal fittings component 20 000
Other costs:
Delivery costs* 500
Legal costs associated with purchase rights* 200
Costs of safety certificate 1 000
*These costs are incurred in proportion to the purchase price across the 3 components.
x Under local aviation authority regulations, all passenger aircraft must be granted a safety certificate
by the aviation authority, which must be renewed every 2 years.
x All components have a nil residual value. The estimated useful lives of these parts are as follows:
Outer-body 30 years
Engines 10 years
Internal fittings 5 years
Required: Determine the carrying amount of the separate components at 31 December 20X2.
Solution 11: Initial costs: purchase price, directly attributable costs & significant parts
Outer-body Engine Interior fittings Safety certificate
C’000 C’000 C’000 C’000
Initial cost 50 000 70 000 20 000 0
Safety certificate 1 000
Delivery costs 50/140 x 500 179 250 71 0
70/140 x 500
20/140 x 500
Legal costs 50/140 x 200 71 100 29 0
70/140 x 200
20/140 x 200
50 250 70 350 20 100 1 000
Less: depreciation 50 250/30 years (1 675) (7 035) (4 020) (500)
70 350/10 years
20 100/ 5 years
1 000/ 2 years
Carrying amount: 31/12/20X2 48 575 63 315 16 080 500
Total carrying amount 128 470
Chapter 7 373
3.3.4 Future costs: dismantling, removal and restoration costs (IAS 16.16 (c) & 16.18 & IFRIC 1)
3.3.4.1 Future costs: overview
The ownership of an asset may come with obligations to Future costs could
dismantle the asset, remove it and/or restore the site on arise:
which it is located at some stage in the future. This x simply due to an acquisition; or
obligation may arise:
x due to the usage of an asset.
x On acquisition: in other words, simply by having IAS 16.6(c)
purchased the asset; or They are capitalised to PPE unless

the PPE is used to make inventories.
x Over time: in other words, through having used the asset.
If the property, plant and equipment is used to make inventories, then future costs are not
capitalised to the cost of property, plant and equipment but to inventories instead! See IAS 16.16 (c)
3.3.4.2 Future costs: existing on acquisition (IAS 16.16 & 16.18)
If an obligation arises through simply having purchased the Future costs arising
asset (i.e. by having acquired ownership), then the estimated on acquisition are:
future costs must be included in the initial cost of the asset. The x capitalised as an initial cost;
time value of money, if material, must be taken into account in and
calculating the initial amount to be recognised in terms of future x measured at its PV if “FV – PV
dismantling, removal and restoration costs. = a material amount”.
Example 12: Initial cost involving future costs

A Limited bought a plant on 1 January 20X1 for a cash outlay of C704 123, which included
the purchase price and other directly attributable costs. The purchase agreement included the
acceptance of an obligation to rehabilitate a nearby river after 2 years, details below:
x Estimated future amount, payable on 31 December 20X2 C70 031
x Present value of future amount (discounted at rate of 10%) C57 877
The plant has an estimated useful life of 10 years and a nil residual value.
Required: Calculate the initial cost of the plant and show all journals for 20X1 and 20X2.
Solution 12: Initial cost involving future costs

Working 1: Calculation of initial cost to be capitalised
Purchase price and other directly attributable costs 704 123
Future costs (obligation due to ownership): measured at present value 57 877
Debit to the asset account 762 000
Working 2: Effective interest rate table for the provision

Interest @ 10% Payment Balance
1 January 20X1 57 877
31 December 20X1 5 788 0 63 665
31 December 20X2 6 366 (70 031) 0
12 154 (70 031)
1 January 20X1 Dr/ (Cr)
Plant: cost (A) Two separate cost accounts are created for the 704 123
Plant: rehabilitation: cost (A) 2 significant parts – since the useful lives differ 57 877
Bank (A) Given (704 123)
Provision for rehabilitation (L) Present value of future amount: given (57 877)
Purchase of plant – including the related obligation acquired on purchase date
31 December 20X1
Depreciation: plant (E) Balancing 99 351
Plant: accum depreciation (-A) (704 123 – 0) / 10 years x 1 year (70 412)
Plant: rehabilitation: accum deprec. (-A) 57 877 / 2 years x 1 year (28 939)
Depreciation on plant (2 significant parts)
374 Chapter 7
31 December 20X1 continued… Dr/ (Cr)

Interest expense (E) 57 877 x 10% or W2 5 788
Provision for rehabilitation (L) (5 788)
Unwinding of the discount – recognised as an expense (always an expense!)
31 December 20X2
Depreciation: plant (E) 99 351
Plant: accum depreciation (-A) (704 123 – 0) / 10 years x 1 year (70 412)
Plant: rehabilitation: accum deprec. (-A) 57 877 / 2 years x 1 year (28 939)
Depreciation on plant (2 significant parts)
Interest expense (E) (57 877 + 5 788) x 10% or W2 6 366
Provision for rehabilitation (L) (6 366)
Unwinding of the discount – recognised as an expense (always an expense!)
Provision for rehabilitation (L) 70 031
Bank (A) (70 031)
Payment of amount due in terms of the rehabilitation (payment assumed)
Plant: rehabilitation: accum deprec.(-A) 57 877
Plant: rehabilitation: cost (A) (57 877)
De-recognition of the cost of the plant’s part being the related obligation to
rehabilitate the river (now fully depreciated)
3.3.4.3 Future costs: caused/ increases over time (IAS 16.16 (c) & 16.18)
If the obligation for future costs arises as a result of the asset being used (rather than simply an
obligation that already exists on the date of purchase), the present value of the obligation that
arises as the asset is used must also be capitalised to the cost of the asset (i.e. added as a
subsequent cost). However, if the asset is being used to produce inventories, then this present
value would be capitalised to inventories instead.
This means that the cost of the asset will change every time the Future costs arising
due to usage:
usage of the asset leads to an additional obligation.
x are capitalised as a
The fact that cost keeps changing will obviously also affect our subsequent cost;
depreciation calculation. This is because depreciation is the x unless the asset has reached
the end of its UL, in which
expensing of the asset’s ‘depreciable amount’, which is its ‘cost less case the future costs are
residual value’, over the asset’s useful life (see section 4.3). recognised in P/L; and
x are measured at PV if:
If the asset has reached the end of its useful life (i.e. it has been FV – PV = a material amount
fully depreciated), then any changes to the liability from that
point on, would have to be recognised directly in profit or loss.
Example 13: Subsequent costs involving future costs
A coal plant was purchased for C600 000 on 1 January 20X1, at which point its useful life
was considered to be 6 years and its residual value was nil (both unchanged).
x An environmental rehabilitation obligation arose on 31 December 20X4 when a new
law was introduced that affected all companies who were operating coal plants as at
31 December 20X4 (i.e. the law does not affect companies who operated coal plants
before 31 December 20X4 but have ceased to operate such plants).
x The law requires that those affected companies pay for environmental rehabilitation at
the end of the asset’s useful life based on the damage caused by such plants, assessed
from the effective date of 1 January 20X4 (i.e. although the law only affects companies
that were still operating coal plants at 31 December 20X4, these companies would be
required to pay for rehabilitation costs relating to any damage that may have occurred
from an earlier effective date of 1 January 20X4).
x The expected cost of the rehabilitation on 31 December 20X6 due to damage caused
from 1 January 20X4 to 31 December 20X4 was assessed by environmental experts to
be C70 031 (the present value of this amount at 31 December 20X4, using a discount
rate of 10% was C57 877). No additional damage was caused during 20X5.
Chapter 7 375
x The plant had always been used solely to manufacture products for sale to customers,
but from 20X4, some of these products were used to manufacture a machine:
Plant usage/year
The plant was used in the manufacture of products: 20X4 20X5
x that would be sold to customers 70% 70%
x that would be used to manufacture a machine (classified 30% 30%
as property, plant and equipment)
Required: Show the related journals for the years ended 31 December 20X4 and 20X5.
Solution 13: Subsequent costs involving future costs

Depreciation: plant (E) (600 000 – 0) / 6 x 1 year 100 000
Plant: accumulated depreciation (-A) 100 000
Depreciation on plant for 20X4
Inventory (A) 100 000 x 70% 70 000
Machine: cost (A) 100 000 x 30% 30 000
Depreciation on plant capitalised to inventory and machinery
Inventory (A) Present value: 57 877 x 70% 40 514
Plant: cost (A) Present value: 57 877 x 30% 17 363
Provision for environmental restoration: plant 57 877
Recognition of new environmental rehabilitation obligation, measured at
present value, capitalised to inventory & plant
31 December 20X5
Depreciation: plant (E) (600 000/6 yrs + 17 363/2 yrs) or 108 682
Plant: accumulated depreciation (-A) (CA: 217 3631 – RV 0) / 22 x 1 year 108 682
Depreciation on plant for 20X5
Inventory (A) 108 682 x 70% 76 077
Machine: cost (A) 108 682 x 30% 32 605
Depreciation on plant capitalised to inventory and machinery
Interest (E) 57 877 x 10% 5 788
Provision for environmental restoration: plant (L) 5 788
Unwinding of the discount – recognised as an expense
1: Carrying amount on 1 January 20X5: Cost: (600 000 + 17 363) – Acc Depr: (100 000 x 4 years) = 217 363
2: Remaining useful life (RUL) on 1 January 20X5: 6 years – 4 years = 2 years left
Comment: Notice how the amount of the provision was not debited to a separate ‘plant rehabilitation: cost’
account (as it was in the prior example), but was included in the ‘plant: cost’ account (and inventory) instead.
This is because the rehabilitation will take place at the end of the plant’s useful life and thus the rehabilitation
cost and the plant cost (excluding the rehabilitation cost) will be depreciated to P/L at the same rates (unlike
the previous example, where the useful lives differed).
3.3.4.4 Future costs: caused/ increases over time – more detail (IFRIC 1)
The provision for future costs may require adjustment over time, resulting from:
x The unwinding of the discount as one gets closer to the date of the future cost (e.g. getting
closer to the date on which the asset has to be decommissioned);
x A change in the expected outflow of economic benefits (e.g. cash outflows); and
x A change in the estimated current market discount rate.
The unwinding of the discount is expensed in profit or loss as a finance cost. Capitalisation of
these finance costs under IAS 23 Borrowing costs is not permitted. IFRIC 1.8
However, a change in the expected outflows (i.e. a change in the amount of the future cost) or a
change in the estimated current market discount rate would affect the asset’s carrying amount.
376 Chapter 7
The journal adjustments to account for changes expected outflows or changes in discount rates
are detailed in IFRIC 1 and depend on whether property, plant and equipment is measured
using the cost model or revaluation model.
Since IFRIC 1 requires an understanding of both the cost model (explained in this chapter) and
the revaluation model (explained in chapter 8) and also requires an understanding of provisions
(explained in chapter 18), these journals are not covered in this chapter or the chapter on the
revaluation model, but in the chapter relating to provisions (chapter 18).
3.4 Subsequent costs (IAS 16.7; 16.10 & 16.12-14)
Subsequent costs are
After incurring the initial costs of acquiring or constructing an
only capitalised if:
asset, further related costs may continue to be incurred. The
same recognition criteria that apply to these initial costs apply x IAS 16’s recognition criteria are met
equally to these further costs: a cost should only be added to (if not, cost must be expensed)
the asset’s carrying amount if it is reliably measureable and We account for replacement of parts
and major inspections as follows:
leads to probable future economic benefits. Further costs can
x derecognise old carrying amount, and
involve adding to the asset, day-to-day servicing of the asset, x capitalise new cost (generally as a
replacing parts thereof and performing major inspections. separate part).
3.4.1 Day-to-day servicing (IAS 16.12)

It is to be expected that an asset requires certain maintenance. Although maintenance costs
may be material in amount, these should always be expensed. Typically, day-to-day servicing
costs include labour, consumables and small parts.
Example 14: Vehicle repainting
A vehicle acquired for C100 000, is repainted in company colours one month later. The
cost of repainting is C3 000. The vehicle is to be used as a delivery vehicle.
Required: Briefly explain if the C3 000 must be capitalised to the vehicle and provide relevant journals.
Solution 14: Vehicle repainting
The painting cost is reliably measurable. However, the painting in company colours is advertising (and, to an
extent, maintenance), which, although done in the pursuit of future benefits is not able to provide a sufficiently
certain link to specific future benefits. Thus, we conclude that this cost does not lead (directly or indirectly) to
probable future economic benefits. Thus, the recognition criteria are not met and the cost must be expensed.
Debit Credit
Advertising/ Maintenance expense (E) 3 000
Bank/ Payables 3 000
Painting of vehicle
Example 15: Vehicle acquired without engine: engine purchased afterwards

Assume the delivery vehicle acquired in the prior example was acquired without an engine.
After this original acquisition of the vehicle, a new engine is purchased at a cost of C8 000.
Required: Briefly explain if the C8 000 must be capitalised to the vehicle and provide relevant journal/s.
Solution 15: Vehicle acquired without engine: engine purchased afterwards

The cost of the engine is reliably measurable (C8 000). There are no future economic benefits probable if the
vehicle has no engine. Thus, acquiring the engine leads to probable future economic benefits that otherwise
did not exist. Since the recognition criteria are met, the item should be capitalised. For your information:
x If the engine cost is significant in relation to the vehicle purchase cost and, if the engine has a materially
different useful life to that of the vehicle, then it must be capitalised as a separate part of the vehicle.
x Although this cost occurs after the vehicle purchase, we could argue this is technically an ‘initial cost’
rather than a ‘subsequent cost’, but the recognition principle in IAS 16 applies equally to both types of
costs (the item must be reliably measured and must lead to probable future economic benefits).
Debit Credit
Vehicle: cost (or: Vehicle: engine: cost) (A) 8 000
Bank/ Payables 8 000
Purchase of engine for the vehicle
Chapter 7 377
Example 16: Vehicle engine overhaul - extending the useful life

An entity purchases, for C100 000, a second-hand delivery vehicle that has an old worn-out engine.
The entity has the old engine overhauled a few days after acquisition at a cost of C20 000. The
overhaul is performed in order to extend the engine’s useful life.
Required: Briefly explain if the C20 000 must be capitalised to the vehicle and provide relevant journal/s
Solution 16: Vehicle engine overhaul - extending the useful life

The cost of the overhaul is reliably measurable (C20 000). Since the original engine was old and this overhaul
cost was incurred to extend its useful life, there are probable future economic benefits associated with this
item. The recognition criteria are thus met and the overhaul cost should be capitalised.
Debit Credit
Vehicle: cost (A) 20 000
Bank/ trade payables 20 000
Payment for engine overhaul
For interest: If the cost of the overhaul is considered significant in relation to the cost of the vehicle and
now results in the vehicle ‘engine’ having a materially longer useful life than the vehicle ‘body’, then
the carrying amount of the engine and the body should be accounted for as two separate parts of the
vehicle. If the original purchase transaction had been simply recorded as a ‘vehicle’, the carrying amount
of the old engine will now need to be estimated and removed from this ‘vehicle’ account and recorded as
a separate ‘vehicle engine’ account and the cost of the overhaul would need to be added to this account.
For example, if the cost of the old engine in the second-hand vehicle is estimated to be 15% of the cost
of the vehicle purchase, the journals will be as follows:
Debit Credit
Vehicle: cost (A) Given 100 000
Bank/ Payable 100 000
Purchase of second-hand vehicle (this includes the old engine)
Vehicle: engine: cost 100 000 x 15% 15 000
Vehicle: body: cost Balancing: 100 000 – 15 000 85 000
Vehicle: cost (A) Given 100 000
Separation of the significant parts: engine and body (because, after
the overhaul, the engine now has a longer useful life than the body)
Vehicle: engine: cost (A) 20 000
Bank/ Payable 20 000
Payment for engine overhaul
The engine (15 000 + 20 000 = 35 000) and the body (cost: 85 000) will be depreciated separately.
Example 17: Vehicle engine service

The engine in the prior example has its engine serviced 6 months later at a cost of C5 000.
Required: Briefly explain whether this C5 000 must be capitalised to the vehicle.
Solution 17: Vehicle engine service

The cost of the service is reliably measured (C5 000). However, we conclude that the servicing costs will not
lead to a probable inflow of future benefits: although the cost of servicing an engine is incurred in the pursuit of
future benefits, servicing is needed continuously and thus we cannot argue that there is a sufficiently certain link
between the costs and the future benefits. The recognition criteria are thus not met, which means the cost of
servicing may not be capitalised to the vehicle and must be expensed instead (i.e. it is ‘day-to-day servicing’).
3.4.2 Replacement of parts and de-recognition of assets (IAS 16.13)

3.4.2.1 Derecognition of the old part
Some items of property, plant and equipment have parts that regularly need replacing (e.g. an
aircraft may need its seats to be replaced every 3 years). Conversely, a part may unexpectedly
need replacement (e.g. a part may need to be replaced because it was damaged). Where a part
of an asset is replaced, the carrying amount of the old part must be removed from the asset
accounts by expensing its carrying amount in profit or loss (i.e. credit cost, debit accumulated
depreciation and debit/ credit the profit or loss with the carrying amount).
378 Chapter 7
The derecognition is easy if the replaced part had been recognised and depreciated as a
separate part of the asset, but if the replaced part was not originally recognised separately, its
carrying amount will need to be estimated (see Example 18).
If the part needed replacing because it was damaged (as opposed to needing replacing simply
because the part has reached the end of its useful life), we must first check for impairments
before we derecognise its carrying amount.
If this damage caused the value of the part (its recoverable amount) to drop below its carrying
amount, the carrying amount must first be reduced to reflect this impairment (i.e. debit
impairment loss expense and credit accumulated impairment losses), and then be derecognised
(i.e. debit profit or loss with the carrying amount that is being expensed with the contra entry
being a combination of a credit to cost, a debit to accumulated depreciation and a debit to
accumulated impairment losses). Impairments are explained in section 4.4.
3.4.2.2 Capitalisation of a new part

If the property, plant and equipment definition and recognition criteria, given in IAS 16, are met, the
cost of the replacement part must be recognised as an asset. If the cost of this new part is significant
in relation to the value of the asset as a whole and has a useful life and method of depreciation that is
different to the rest of the asset, then this new part must be recorded in a separate asset account.
However, all immaterial replacement parts should be expensed as day-to-day servicing.
Example 18: Replacement of a part
Bigboy Limited owned a car that had a carrying amount of C30 000 on 1 January 20X1.
Details of this car, recorded as two significant parts, were as follows on 1 January 20X1:
x Car structure: C20 000, with a remaining useful life of 10 years and a nil residual value
x Car engine: C10 000, with a remaining useful life of 2 years and a nil residual value.
This old engine (original cost: C12 000) was scrapped and replaced during 20X1 due to the car having
been driven without oil. The engine was replaced on 1 October 20X1 at a cost of C15 000. The new
engine has a useful life of 3 years and a nil residual value. The straight-line method is used.
Required: Show the journal entries relating to the purchase of the new engine in 20X1.
Solution 18: Replacement of a part

Comment: We depreciate the old engine to the date it is scrapped. We then impair it, just before we derecognise it,
to reflect the cost of the damage to the engine, (the damage caused the old engine to have zero value, evidenced by it
being scrapped, so we write off the remaining CA). We then derecognise the engine.
1 October 20X1 Debit Credit

Depreciation: vehicle (E) (10 000 – RV: 0) / RUL 2 years x 9/12 3 750
Vehicle engine: acc. depreciation (-A) 3 750
Depreciation of the vehicle’s engine to date of replacement
Impairment loss: vehicle (E) CA o/b: 10 000 – Depr: 3 750 – 6 250
Vehicle engine: acc. impairment loss (-A) Value after damage: 0 (Scrapped) 6 250
Impairment of vehicle’s engine on date of replacement & derecognition
Vehicle engine: acc. depreciation (-A) (Cost 12 000 – CA o/b 10 000)+ Depr 3 750 5 750
Vehicle engine: acc. impairment loss (-A) See journal above 6 250
Vehicle engine: cost (A) Given 12 000
Derecognition of old engine
Vehicle engine: cost (A) 15 000
Bank/ trade payables 15 000
Purchase of new engine
31 December 20X1
Depreciation: vehicle (E) 3 250
Vehicle engine: acc. depreciation (-A) (15 000 – RV 0) / RUL 3 yrs x 3/12 1 250
Vehicle structure: acc. depreciation (-A) (20 000 – RV 0) / RUL 10 yrs x 12/12 2 000
Depreciation of the vehicle at year end: (old structure & new engine)
Abbreviations used: RUL = remaining useful life RV = Residual value
Chapter 7 379
Example 19: Replacement of a part that was not previously identified

A plant was bought on 1 January 20X1:
x The purchase price was C1 000, paid in cash, (no significant parts were identified).
x The estimated useful life of the plant is estimated to be 10 years on this date.
The engine of this plant seized up, was scrapped and had to be replaced on 1 January 20X2:
x A new engine was installed (on the same day) at a cost of C500 cash.
x The estimated useful life of the new engine is 5 years.
x The cost of the old engine, when originally purchased as part of the plant, is estimated to be C300.
Required: Show the journals in 20X2.
Solution 19: Replacement of a part that was not previously identified

Original Original Asset without
Calculations:
asset engine engine
Cost: 1 January 20X1 1 000 300 700
Accum. depreciation: (1 000/ 10 x 1) and (300/ 10 x 1) (100) (30) (70)
Carrying amount: 31st December 20X1 900 270 630
Journals
Impairment loss: plant (E) 270
Plant: accumulated impairment losses (-A) 270
Impairment of carrying amount of previous engine – part of the plant
Plant: accumulated depreciation (-A) 30
Plant: accumulated impairment losses (-A) 270
Plant: cost (A) 300
De-recognition of engine (engine write-off) – part of the plant
Plant: engine: cost (A) 500
Bank 500
Purchase of new engine (part of plant but separately recognised now)
31 December 20X2
Depreciation: plant (E) 170
Plant: engine: accumulated depr (-A) C500/ 5 years 100
Plant: without engine: acc. depr (-A) C700/ 10 yrs total useful life; Or 70
C630/ 9 yrs remaining useful life
Depreciation of plant: two separate parts
3.4.3 Major inspections (IAS 16.14)
When an asset requires ‘regular major inspections as a condition to its continued use’ (a good
example, given in IAS 16.14, being an aircraft), then the cost thereof (or an estimate thereof),
must be capitalised as soon as the cost is incurred or an obligation arises. This inspection will
be recognised as an asset.
This ‘major inspection’ asset is then depreciated over the period until the date of the next
inspection. If the cost of the inspection is significant and the rate and method of depreciation
of the inspection differs from that applied to the other parts of the related asset, then the cost of
the inspection must be recognised as a separate part.
Example 20: Major inspection performed
New legislation was promulgated on 1 September 20X1 whereby all public transport buses
are required to undergo regular major inspections every 2 years.
Vroom Limited owns a bus that had a carrying amount of C80 000 as at 1 January 20X1.
x A major inspection of this bus was performed on 1 October 20X1 at a cost of C20 000.
x This bus is depreciated on the straight-line method to a nil residual value over its remaining useful
life of 10 years, calculated from 1 January 20X1.
Required:
A Show the journal entry relating to the major inspection.
B Present the bus in Vroom Limited’s statement of financial position at 31 December 20X1.
380 Chapter 7

Comment:
x The inspection is recognised on 1 October 20X1 and not on 1 September 20X1: the pure enactment of the
new law does not create an obligation for Vroom Limited since it can choose simply not to drive the bus
publicly. The obligation thus arises when the inspection is performed.
x The major inspection has a different useful life to that of the physical bus. Its useful life is 2 years after
which a new inspection will have to be performed. The inspection occurred 3 months before year-end and
therefore the inspection was depreciated over these 3 months.
Bus major inspection: cost (A) 20 000
Bank (A) 20 000
Major inspection performed on 1 October 20X1
31 December 20X1
Depreciation: bus (E) 10 500
Bus: acc. depreciation (-A) (80 000 – 0) / 10 years x 1 year 8 000
Bus major inspection: acc. depr. (-A) 20 000 / 2 years x 3 / 12 2 500
Depreciation of bus: physical bus and major inspection of the bus
Solution 20B: Disclosure

Vroom Limited
ASSETS 20X1
Non-current Assets C
Bus 80 000 + 20 000 – 8 000 – 2 500 89 500
If an entity buys an asset that, on the date of purchase, has already been inspected and thus
does not require another inspection for a period of time, the cost must be separated into:
x the cost that relates to the physical asset (or its separate significant parts), and
x the cost that relates to the balance of the previous major inspection purchased.
The cost of the inspection need not be separately identified on the sale documentation i.e. an
estimate of the cost can be made based on the expected cost of future similar inspections.
Example 21: Major inspection purchased as part of the asset

A ship is purchased for C1,3 million cash on 1 January 20X1 when its economic useful life
was estimated to be 10 years.
This ship may only be used if it is inspected for faults every 3 years.
x The 20X0 inspection was done on 31 December 20X0 and is included in the purchase price
(although the exact cost thereof is not known).
x The next inspection is due on 31 December 20X3. The expected cost of this future inspection is
C400 000 and the present value thereof is C300 000 (discounted to 1 January 20X1).
Required: Show how this should be journalised in 20X1.
Solution 21: Major inspection purchased as part of the asset

Comment:
The 20X3 inspection was not recognised as at 31 December 20X1 as no obligation exists for it in 20X1 (no
‘past event’ has occurred yet!). However, we use the expected 20X3 inspection cost to estimate the value of
the 20X0 inspection that had already been performed.
Ship structure: cost (A) 1 300 000 – 300 000 1 000 000
Ship major inspection: cost (A) PV of 20X3 inspection cost 300 000
Bank Given 1 300 000
Purchase of ship: 20X0 inspection costs measured based on the PV of
the estimated 20X3 cost
Chapter 7 381
Journals continued ... Debit Credit

31 December 20X1
Depreciation – ship (E) 200 000
Ship structure: accum. depr. (-A) (1 000 000 – 0)/ 10 years 100 000
Ship major inspection: accum. depr. (-A) 300 000/ 3 years 100 000
Depreciation of ship: structure and major inspection
Example 22: Major inspection derecognised

Use the same information given in the prior example together with the following extra information:
On 31 December 20X3 the first major inspection is performed at a cost of C400 000. New legislation
now requires that major inspections be performed every 2 years starting from 31 December 20X3. The
next major inspection is estimated to cost C600 000.
Required: Show the journals in 20X2, 20X3 and 20X4.
Solution 22: Major inspection derecognised

Comment:
x The estimated cost of the first (20X0) major inspection that was included in the purchase price is fully
depreciated by 31 December 20X3.
x The actual cost of the second major inspection, performed on 31 December 20X3, is capitalised when incurred.
x The cost of the third major inspection, due on 31 December 20X5, may not be provided for (until it is
performed on 31 December 20X5) since there is no present obligation (the ship may be sold before this
date, in which case, the cost of the major inspection would be avoided).

Depreciation: ship (E) 200 000
Ship structure: acc. depreciation (-A) 1 000 000/ 10 years 100 000
Ship major inspection: acc. depreciation (-A) 300 000/ 3 years 100 000
Depreciation of ship and depreciation of major inspection
31 December 20X3
Depreciation: ship (E) 200 000
Ship structure: accum. depreciation (-A) 1 000 000/ 10 years 100 000
Ship major inspection: accumulated depreciation (-A) (20X0) 300 000
Ship major inspection: cost (A) (20X0) 300 000
De-recognition of carrying amount of 20X0 inspection
Ship major inspection: cost (A) (20X3) 400 000
Bank (A) 400 000
Payment: 20X3 major inspection
31 December 20X4
Depreciation (E) 300 000
Ship structure: acc. depreciation (-A) 1 000 000/ 10 years 100 000
4. Subsequent Measurement (IAS 16.29 – .63 and IAS 36)
4.1 Overview
The measurement of an item of property, plant and equipment is reflected in its carrying
amount and is constituted by its initial measurement and subsequent measurement.
Initial measurement of property, plant and equipment is always at cost and thus the
measurement of its carrying amount will initially simply reflect cost.
382 Chapter 7
Subsequent measurement involves:

x using the cost model or revaluation model; Carrying amount is
defined as:
x depreciation: this reflects the usage of the asset; and
x impairments: this reflects any damage to the asset. x the cost (or fair value)
x less accumulated depreciation
Thus, the subsequent measurement of its carrying amount is reflected x less accumulated impairment
by ledger accounts that show its cost, its subsequent accumulated losses (if applicable)
depreciation and its subsequent accumulated impairment losses. IAS 16.6 reworded
This chapter focuses only on the cost model. The revaluation model is explained in the next chapter.
4.2 Cost model
When using the cost model, our cost account reflects the total costs capitalised to the asset (in contrast,
when using the revaluation model, the asset is revalued to a fair value and so its cost account is
adjusted to reflect the fair value instead). These capitalised costs will include both:
x the initial cost (see section 3.3); and
x any subsequent costs (see section 3.4). The cost model
measures PPE as:
When using the cost model, the subsequent measurement of our x the cost (initial + subsequent)
asset (which is initially measured at cost), involves processing x less accumulated depreciation
x subsequent depreciation, if the asset is depreciable (land x less accumulated impairment
may not necessarily be depreciable), and possibly also losses (if applicable) See IAS 16.6
x subsequent impairment losses (all items of property, plant and equipment are subsequently
tested for impairment).
Let us now look at how to measure depreciation and impairment losses.
4.3 Depreciation
Depreciation is
4.3.1 Overview defined as:
x systematic allocation of the
Depreciation reflects the extent to which the asset’s carrying amount x depreciable amount of an asset
has decreased because of having used the asset. All items of x over its useful life. IAS 16.6
property, plant and equipment, with the exception of land in most
cases, must be depreciated. Land is generally not depreciated because it generally cannot be used up:
it always remains there, ready to be used, again and again. Obviously, land that is used, for example,
as a quarry or landfill site, would mean that the land would have a limited useful life (i.e. from the
perspective of the entity, it does get used up) and thus would need to be depreciated.
In measuring depreciation, we simply expense:
x the portion of the cost that will be lost due to usage (called its depreciable amount);
x over its useful life;
x using a method that reflects the pattern in which we expect to use the asset.
The portion of a cost that we believe will not be lost through usage is referred to as its residual
value. We thus exclude the residual value when calculating the depreciation. It is thus only the
depreciable amount (cost less residual value) that is depreciated.
Depreciation is usually recognised as an expense in profit or loss. However, the asset may be used to
produce another asset, in which case the depreciation would be capitalised to that other asset.
Property, plant and equipment is depreciated on a significant parts basis. This means that, if an
asset can be broken down into parts where one (or more) of these parts has a cost that is
considered to be significant relative to the asset's total cost, we must depreciate this part (or
parts) separately from the rest of the asset if it has:
x a different useful life; or
x a different pattern of future economic benefits. See IAS 16.43 - .47
Chapter 7 383
The measurement of depreciation involves estimating three The 3 variables of

variables: residual value (used to calculate the depreciable
depreciation:
amount), useful life and method of depreciation. The
estimation of each of these variables requires professional x Residual value
x Useful life
judgement (which can only come through experience). x Method.
4.3.2 Residual value and the depreciable amount (IAS 16.51 – 16.54)
The depreciable amount is the portion of the asset’s cost that
Depreciable amount is
we believe will be ‘lost’ through usage whereas the residual defined as
value is the portion that will not be lost. This residual value
is simply an estimate and thus we need to reassess our x the cost of the asset (or other
amount, for example its fair value)
estimated residual value at the end of each financial year to
x less its residual value. IAS 16.6 reworded
be sure that it has not changed. See IAS 16.51
The residual value is calculated as follows:
Residual value is defined
x Expected proceeds on disposal: as:
This is the amount for which the entity would currently
x the estimated amount that an entity
be able to sell the asset assuming it had already (i.e. at would currently obtain from disposal
reporting date) reached the end of its useful life; of the asset,
x Less the expected costs of disposal: x after deducting the estimated costs
These are the costs that would be incurred in disposing of disposal,
of the asset in a way that would achieve these proceeds. x if the asset were already of the age
and in the condition expected at the
end of its useful life. IAS 16.6
It can happen that the residual value exceeds the asset’s
current carrying amount. If this happens, simply stop depreciating the asset. Depreciation will
resume (start up again) when the residual value drops below carrying amount again. See IAS 16.54
Since the asset's residual value is just an estimate, it must be reviewed at each year-end. If it
changes, it will be accounted for as a change in accounting estimate. See IAS 16.51 & IAS 8
4.3.3 Method of depreciation (IAS 16.60 – 62A)
A variety of methods of depreciation are possible, including:
x the straight-line method;
x the diminishing balance method; and
x the units of production method (also called the sum-of-the-units method). See IAS 16.62
4.3.3.1 Straight-line method
The straight-line method gives an equal depreciation expense in each of the years of the asset's
useful life and thus is ideal when we expect that the asset will be used to an equal extent during
each of the years of its useful life. The straight-line method is a simple calculation involving
dividing the depreciable amount (i.e. remember to deduct the residual value from the cost) over
the life of the asset. It is calculated as follows:
Depreciable amount Cost – Residual value
Depreciation expense = =
Useful life Useful life
Obviously, the effect of the useful life (e.g. 4 years) could be expressed as a percentage instead
(e.g. (1 ÷ 4) x 100 = 25%), in which case the formula will involve multiplying the depreciable
amount by this straight-line depreciation rate as follows:
Depreciation expense = Depreciable amount x straight-line depreciation rate (%)
= (Cost – Residual value) x straight-line depreciation rate (%)
4.3.3.2 Diminishing balance method

The diminishing balance method results in a decreasing depreciation expense in each of the
years of the asset's useful life and thus is ideal if we expect that the asset will be used the most
during the earlier years of its life and that the usage thereof will diminish as it ages.
384 Chapter 7
The diminishing balance method involves multiplying the carrying amount (which will
obviously be decreasing each year) by a fixed rate of depreciation. It is important to note that
this rate is not applied to the depreciable amount (cost – residual value). This is because the
effect of the residual value is already built into the diminishing balance rate of depreciation. In
the following equation, 'n' represents the useful life in years.
n
Depreciation rate for diminishing balance (%) = 1 – √ (Residual value ÷ Cost)
Once you have calculated the rate of depreciation for purposes of the diminishing balance
method, you simply apply it to the opening carrying amount of the asset.
Depreciation expense = Carrying amount x Depreciation rate for diminishing balance (%)
Worked example: Diminishing balance method

If we wanted to use the diminishing balance method where our cost was C500 000 and the residual value was
C62 500 and the useful life was expected to be 4 years, then our rate of depreciation for purposes of the
diminishing balance would be 40,5%:
4
Depreciation rate for diminishing balance (%) = 1 -
√ (62 500 ÷ 500 000)
= 1 – 0,595
= 0,405 = 40,5% (rounded)
Using this depreciation rate, we then calculate the depreciation expense over the useful life. Notice that after
4 years, the closing carrying amount reflects the residual value of C62 667, close to C62 500 (there is a
rounding error of C167 because the depreciation rate of 40,5% was rounded):
Opening carrying amount Depreciation expense Closing carrying amount
Year 1 500 000 202 500 500 000 x 40.5% 297 500
Year 2 297 500 120 488 297 500 x 40,5% 177 012
Year 3 177 012 71 690 177 012 x 40,5% 105 322
Year 4 105 322 42 655 105 322 x 40,5% 62 667
4.3.3.3 Units of production method

This is possibly the most accurate method of depreciation and can be used assuming it is
possible to estimate the asset's total estimated output and that the actual output achieved in
each period can be determined. It is calculated as follows:
Actual output in the period
Depreciation expense = Depreciable amount x Total estimated output over the useful life
4.3.3.4 Choosing a method

The method chosen should match the way in which we expect to earn the future economic
benefits through use of the asset. See IAS 16.60
The depreciation method
However, it must be emphasised that the depreciation should reflect:
method should reflect the pattern of the consumption of the x the pattern in which,
asset’s expected future economic benefits rather than x the FEB from the asset,
reflect the revenue generated by the asset. The reason for x are expected to be consumed.
IAS 16.60 reworded
this is that revenue that is generated by an activity that
includes the use of an asset is affected by numerous factors that may have no relation to how
the asset is being used up. For example, the revenue generated from the use of an asset would
be affected by factors such as inflation and pricing that is manipulated for marketing purposes.
It would also be affected by sales volumes where the volumes sold would be affected by, for
example, marketing drives and economic slumps. See IAS 16.62A
Worked example: Depreciation method
x An asset is expected to produce 100 000 units in year 1 and 80 000 units in year 2.
x The total expected output of 180 000 units is expected to be sold evenly over a 3-year period (i.e. 60 000
units pa).
x The sales department plans to market the units at C10 per unit in year 1, C12 per unit in year 2 and C15 per
unit in year 3. Thus budgeted sales are: C600 000 in year 1, C720 000 in year 2 and C900 000 in year 3.
Chapter 7 385
Discussion of the example:

x Although the output is expected to be sold evenly over 3 years (60 000 units pa), depreciation on the
straight-line method over the 3 years, or based on average unit sales of 60 000 units pa for 3 years, would
not be appropriate. This is because the unit sales do not reflect the pattern of consumption of the asset’s
future economic benefits. Instead, depreciation based on 100 000 units in the first year and 80 000 units
in the second year as a percentage of the total expected output of 180 000 units is a more appropriate
reflection of how the asset’s future economic benefits are expected to be consumed – in other words, how
the asset is expected to be used up.
x Similarly, basing the depreciation on the sales in ‘currency terms’ would also not be appropriate because
this would not reflect how the asset was actually being used up. The sales in ‘currency terms’ are clearly
affected by the entity’s pricing strategy rather than the pattern in which the asset is being used up.
x The asset is used up after 2 years and its carrying amount should obviously reflect this fact.
See IAS 16.62A
x The sum of the units of output would be the most appropriate method to apply.
Since the depreciation method is based on an expected pattern of future benefits, it is simply an
estimate and must be reviewed at the end of each financial year. If it changes, it will be
accounted for as a change in accounting estimate. See IAS 16.61 & IAS 8
4.3.4 Useful life (IAS 16.51 & 16.55 - .59)
Useful life is defined as:
Depreciation begins when an asset first becomes available
for use (this is not necessarily the same date that it is x the period over which an asset is
expected to be available for use by
brought into use). See IAS 16.55
an entity; or
Depreciation ceases at the earlier of date that the asset is x the number of production or similar
units expected to be obtained from
classified as held for sale in accordance with IFRS 5 and
the asset by an entity. IAS 16.6
the date that the asset is derecognised. This means that an
asset that does not meet the criteria for classification as held for sale but is no longer being
used and is simply awaiting disposal continues to be depreciated! See IAS 16.55
Depreciation does not cease if an asset is idle (unless the units of production method is used to
calculate the depreciation). See IAS 16.55
Determining the useful life involves a careful consideration of many factors, including:
x ‘the expected usage of the asset’ (for example, the total number of units expected to be
manufactured by a plant);
x ‘the expected physical wear and tear’ on the asset (for instance, this would be less in a
company that has a repairs and maintenance programme, than in another company that
does not have such a programme);
x ‘technical or commercial obsolescence’, which may shorten the asset’s useful life. We
should also be on the look-out for an expected reduction in the selling price of the output
produced by the asset because this may suggest imminent ‘technical or commercial
obsolescence’ of the asset and thus may indicate a potential decrease in the asset’s useful
life; and
x other limits on the asset’s useful life, including legal limits (with the result that the useful
life to the company may be shorter than the asset’s actual useful life). IAS 16.56 reworded
Since the asset's useful life is just an estimate, it must be reviewed at the end of each financial
year. If it changes, it will be accounted for as a change in accounting estimate. See IAS 16.51 & IAS 8
4.3.5 Depreciating the whole asset or the parts thereof (IAS 16.43 - .47)
In order for depreciation to be more accurately measured, we may need to recognise and
depreciate each part of an asset separately, rather than as a whole, single asset. This is necessary
if the various parts each have a significant cost and have differing variables of depreciation
(useful life, residual value or method).
For example: a vehicle may have an engine and a body where these two parts have different
useful lives. Similarly, the depreciation method could differ: the engine may need to be
depreciated over the number of kilometres travelled whereas the body may need to be
depreciated over a certain number of years.
386 Chapter 7
4.3.6 Depreciation journal

Depreciation is usually expensed:
Debit Credit
Depreciation: asset name (E) xxx
Asset name: Accumulated depreciation (-A) xxx
Depreciation of PPE is expensed
If an entity uses an existing asset to construct another asset, the depreciation charge must be
capitalised to the cost of the newly constructed asset: IAS 16.48 - .49
Debit Credit
Constructed asset: cost (A) xxx
Depreciation: the name of the other asset that was used (E) xxx
Capitalisation of depreciation to the cost of the constructed asset
Example 23: Depreciation calculation with many dates

Braaimaster Limited bought an asset for C100 000 on 1 January 20X1.
x It was available for use on 1 February 20X1 and brought into use on 1 March 20X1.
x It was temporarily idle for the month of April 20X1.
x Depreciation is estimated using the straight-line method, a 5-year useful life and a nil
residual value.
x The asset was derecognised on 31 October 20X1.
Required: Calculate the depreciation on this asset for the year ended 31 December 20X1.
Solution 23: Depreciation calculation with many dates

x The asset is depreciated from the time that it is available for use, being 1 February 20X1.
x Depreciation must not cease while the asset is temporarily idle in April 20X1.
x Depreciation ceases, however, on 31 October 20X1, when the asset is derecognised.
x Depreciation in 20X1 is therefore = (100 000 – 0) / 5 years x 9 / 12 = C15 000
Example 24: Depreciable amount and straight-line depreciation
An asset is purchased at a cost of C110 000 on 1 January 20X1.
x The asset has a total useful life of 10 years.
x The company expects to sell the asset after 5 years for an estimated C30 000 (present
value), before taking into consideration the present value of the expected costs of
disposal of C20 000.
x The straight-line method of depreciation is to be used for this asset.
Required: Calculate the depreciation for the year ended 31 December 20X1.
Solution 24: Depreciable amount and straight-line depreciation

Comment: Since the asset is depreciated using the straight-line method, the depreciation will remain constant
at C20 000 per annum for each of the remaining 4 years of its useful life.
Residual value: C10 000
Expected proceeds on disposal (in current terms) 30 000
Less expected costs of disposal (in current terms) (20 000)
Depreciable amount: C100 000
Cost 110 000
Less residual value (10 000)
Useful life: 5 years
Being the shorter of:
x Total useful life of the asset 10 years
x The useful life to the business 5 years
Depreciation 20X1: C20 000
Depreciable amount C100 000
Divided by useful life (from the perspective of the entity) 5 years
Chapter 7 387
Example 25: Depreciation using diminishing balance

Koos Limited purchased an asset on 1 April 20X1 for C800 000.
x The rate of depreciation to be used is 20% and the residual value is C327 680.
x The depreciation method appropriate to the use of this asset is the diminishing balance.
Required: Calculate the depreciation expense recognised in each affected year assuming that:
A: the year end is 31 March.
B: the year end is 30 June.
Solution 25: Table showing consumption of the asset over its life
Depreciation calculated per year of Opening Depreciation Closing Calculations
its useful life (UL): balance at 20% balance
1st yr of its UL ending 31/03/X2 12 800 000 160 000 640 000 800 000 x 20% x 12/12
2nd yr of its UL ending 31/03/X3 12 640 000 128 000 512 000 640 000 x 20% x 12/12
3rd yr of its UL ending 31/03/X4 12 512 000 102 400 409 600 512 000 x 20% x 12/12
4th yr of its UL ending 31/03/X5 12 409 600 81 920 327 680 409 600 x 20% x 12/12
Accumulated depreciation: 472 320
Solution 25A: Apportionment of diminishing balance depreciation:

x acquisition date coincides with year-end
Apportionment of depreciation to the financial years:
Depreciation calculated per year of its useful life apportioned to each financial year affected
x to the financial year ended 30 Mar X1 (01/04/X1 – 30/03/X2): 160 000 x 12/12 160 000
472 320
Solution 25B: Apportionment of diminishing balance depreciation:

x acquisition date does not coincide with year-end
Apportionment of depreciation to the financial years:
Depreciation calculated per year of its useful life apportioned to each financial year affected
x to the financial year ended 30 June X1 (01/04/X1 – 30/06/X1): 160 000 x 3/12 40 000
x to the financial year ended 30 June X2 (01/07/X1 – 30/06/X2): 160 000 x 9/12 + 128 000 x 3/12 152 000
x to the financial year ended 30 June X5 (01/07/X4 – 31/03/X5): 81 920 x 9/12 61 440
472 320
Example 26: Depreciation using units of production

A company intends to depreciate its plant using the units of production method:
x The cost of the plant is C100 000 (purchased on 1 January 20X1).
x The asset is expected to be able to produce 100 000 units in its lifetime.
x Production in the year ended 31 December: 20X1 was 10 000 units (20X2 was 15 000 units).
Required: Calculate depreciation for the 20X1 and 20X2 year using the sum-of-the-units method.
Solution 26: Depreciation using units of production

Depreciable amount: Given: 100 000
Depreciation in 20X1 = Depreciable amount C100 000 / 100 000 units x 10 000 units = C10 000
Depreciation in 20X2 = Depreciable amount C100 000 / 100 000 units x 15 000 units = C15 000
Example 27: Depreciation of a self-constructed asset

Terrace Limited was constructing an asset for use in its factory.
x The labour and material costs of construction totalled C100 000 in cash during 20X1.
x Terrace Limited used one of its machines in the process of constructing this asset. The
machine was used for a period of six months in 20X1 on the construction of this asset.
x The depreciation of this machine was C20 000 for the year ending 31 December 20X1.
388 Chapter 7
Required:
Show the journals for the year ended 31 December 20X1 relating to the asset assuming:
A. The constructed asset is a plant that became available for use on 1 October 20X1 and was depreciated
for 5 years to a nil residual value.
B. The constructed asset is inventory, half of which was sold on 1 October 20X1.
Solution 27A: Depreciation involved with a self-constructed plant

Debit Credit
Plant: cost (A) 100 000
Bank (A) 100 000
Payment for construction costs: labour and material
Depreciation: machine (E) 20 000
Machine: accumulated depreciation (-A) 20 000
Depreciation of machine (given)
Plant: cost (A) 20 000 / 12 months x 6 months 10 000
Allocating a portion of the machine’s depreciation (6/12) to the cost of
the plant: the machine was used for 6m in the construction of the plant
Depreciation: plant (E) (100 000 + 10 000 – 0) / 5 yrs x 3/12 5 500
Depreciation of plant
Solution 27B: Depreciation involved with manufacture of inventory

Debit Credit
Bank (A) 100 000
Payment for construction costs: labour and material
Depreciation of machine (given)
Inventory (A) 20 000 / 12 x 6 10 000
Allocation of depreciation of machine to inventory in respect of
6 month usage thereon
Cost of sales (E) (100 000 + 10 000 – 0) x 50% 55 000
Sale of half of the inventory
4.3.7 Change in estimate (IAS 16.51 and IAS 16.61) Changes in accounting
estimates occur if any
If an entity decides that any one of the three variables of of the following are
depreciation (residual value, useful life or method of changed:
depreciation) needs to be changed, this must be adjusted for x estimated useful life
as a change in accounting estimate (in terms of x method of depreciation
IAS 8 Accounting policies, errors and estimates). x the residual value
x estimated costs of dismantling,
removing or restoring items of PPE.
Over and above the possible changes to the estimated
variables of depreciation, we may change our estimate of the present value of the future costs
of dismantling, removing or restoring items of property, plant and equipment. This is
explained in section 3.3.4 and in more depth in the chapter on provisions (chapter 18).
There are two methods that may then be used to calculate the revised depreciation when there
is a change in estimate:
x the reallocation method; and
x the cumulative catch-up method.
Chapter 7 389
These two methods are covered in detail in chapter 26 where further examples are provided
(together with disclosure requirements when there is a change in estimate). The journals for a
change in estimate are really simple and are best explained by way of the following example.
Example 28: Units of production depreciation with a change in total expected
production
An entity purchased a plant for C100 000 on 1 January 20X1 and intended to depreciate its plant
using the units of production method. The estimated residual value (RV) is nil (unchanged).
Production in the year ended 31 December 20X1 was 10 000 units and in 20X2 it was 15 000 units.
It was originally expected that the asset would be able to produce 100 000 units in its lifetime (i.e. original
estimate of total useful life), but in 20X2, this estimated total production was changed to 90 000 units.
Required: Calculate the depreciation for 20X2 assuming the change in estimate is accounted for by:
A adjusting the carrying amount for the cumulative effect on depreciation to date.
B reallocating the carrying amount over the remaining useful life.
Solution 28A: Change in estimate – cumulative catch-up method

Answer: Depreciation in 20X2 = C17 778 (W3)
W1: Acc. depreciation to 31/12/20X2 (new estimate) = (C100 000 – RV: 0) / 90 000 units x (10 000u + 15 000u) = C27 778
W2: Acc. depreciation to 31/12/20X1 (old estimate) = (C100 000 – RV: 0) / 100 000 units x 10 000u = C10 000
W3: Depreciation in 20X2 = Acc. depr. 31/12/20X2 – Acc. depr. 31/12/20X1 = C27 778 (W1) – C10 000 (W2) = C17 778
Abbreviation: RV = residual value.
Solution 28B: Change in estimate – reallocation method

Answer: Depreciation in 20X2 = C16 875 (W3)
W1: Acc. depreciation to 31/12/20X1 (old estimate) = (C100 000 – RV: 0) / 100 000 units x 10 000u = C10 000
W2: CA at 1 January 20X2 (i.e. opening balance) = Cost C100 000 – Acc Depr at 31/12/20X1 C10 000 (W1) = C90 000
W3: Depreciation in 20X2 = (Opening CA: C90 000 (W2) – RV: 0) / RUL: (90 000 – 10 000 units) x 15 000u = C16 875
Abbreviation: RUL = remaining useful life. P.S. we use the ‘remaining useful life’ because, when we use the reallocation
method, our depreciable amount is the ‘opening CA – residual value’ (instead of ‘original cost – residual value’)
4.4 Impairments (IAS 16.63 and IAS 36)

An impairment loss is
4.4.1 Overview defined as:
Items of property, plant and equipment must be tested for x the excess of
x the carrying amount
indications of impairments at the end of every reporting
x over the recoverable amount
period. Impairment testing is governed by IAS 36 and is IAS 16.6 reworded
explained in detail in chapter 11. CA – RA = IL (if the answer is positive)

PS. If the ans. is negative, there is no IL
In a nutshell, an impairment indicator test is one that
tests an asset for evidence of damage of some kind or other.
Please note that damage is not referring exclusively to physical damage. We look for any kind
of damage that reduces the value of the asset (e.g. an economic downturn may reduce demand
for an asset’s output, in which case the asset becomes less valuable to the entity).
Thus, in essence, impairment testing is checking to ensure the asset’s carrying amount is not
overstated. However, if we think the carrying amount may be too high, it may simply be because we
have not processed enough depreciation …the variables of depreciation may need to be re-estimated:
x If we believe that we have not processed enough depreciation, extra depreciation is then
processed (and accounted for as a change in estimate in accordance with IAS 8); but
x If we believe that the depreciation processed to date is a true reflection of past usage, but
yet we are worried that the carrying amount may be too high, we will have to then
calculate the recoverable amount and compare it with the asset’s carrying amount.
Please notice the difference:
x a drop in carrying amount caused by ‘normal usage’ is called depreciation; whereas
x a drop in carrying amount caused by any kind of ‘damage’ is called an impairment loss.
390 Chapter 7
4.4.2 The recoverable amount

The recoverable amount
The recoverable amount is simply an estimate of the is defined as:
highest possible future economic benefits that you expect The higher of an asset’s:
to be able to get from the asset – this may be through using x fair value less costs of disposal; &
the asset (value in use) or selling the asset (fair value less x its value in use. IAS 16.6
costs of disposal). i.e. RA = > of FV-CoD & VIU
The detail regarding how to calculate the value in use and fair value less costs of disposal is set
out in IAS 36 Impairment of assets and is explained in depth in the chapter dedicated to
impairments (Chapter 11).
4.4.3 Comparing the carrying amount with the recoverable amount
If the indicator test suggests that the asset is impaired (i.e. that the accumulated depreciation is
a fair reflection of the usage of the asset and thus a shortage of depreciation is not the reason
for the carrying amount being too high), the carrying amount must be compared with the
asset’s recoverable amount.
Impairment loss reversed
If the carrying amount is greater than this recoverable
amount, the carrying amount is reduced by processing an x If at a subsequent date the RA
impairment loss expense. increases above CA,
x increase the CA,
If circumstances change and the recoverable amount increases
in a future year, the carrying amount may be increased to this x but only to the extent that the CA
does not exceed the depreciated
higher recoverable amount. The increase is recognised in cost (historical CA).
profit or loss as an impairment loss reversal (income).
However, when increasing our carrying amount to this higher recoverable amount, we may not
increase the carrying amount above the carrying amount that it would have had had it never been
impaired. Thus, this means that, when using the cost model, we may not increase the carrying amount
above cost, if the asset is non-depreciable, or above depreciated cost (also called depreciated historic
cost) if the asset is depreciable. In the case of the cost model, you can think of this limit as a ‘magical’
historical carrying amount line, above which the asset may not venture.
In other words, when using the cost model, the carrying amount of an asset may be decreased below
its historical carrying amount (cost or depreciated cost) but may never be increased above it.
Historical carrying amount Actual carrying amount (when using
(depreciated cost/ cost): the cost model):
x original cost x original cost
x less accumulated depreciation (based on x less accumulated depreciation and
the original cost), if any x less accumulated impairment losses
4.4.4 Depreciation in periods following an impairment

The depreciation in future years will be based on the reduced carrying amount. In other words,
the depreciation in the year after the impairment will be calculated by depreciating the asset’s
new revised carrying amount over its remaining useful life to the residual value.
The following diagrams may help you to visualise the effects of the cost model:
Diagram 1: Cost model summarised
Recoverable amount
greater than HCA No adjustments allowed
HCA
Recoverable amount Recognised in P/L
less than HCA
HCA: historical carrying amount (depreciated cost, or just cost in the case of a non-depreciable asset)
Chapter 7 391
Diagram 2: Example adjustments using the cost model – 4 scenarios

Scenario 1 Scenario 2 Scenario 3 Scenario 4
HCA/ HCA HCA RA

ACA
Imp loss Not
(E) allowed
RA ACA RA HCA
Further: Imp loss Imp loss
Imp loss Reversed Reversed
(E) (I) (I)
RA ACA ACA
HCA: historical carrying amount (depreciated cost/ cost) E: expense
ACA: actual carrying amount (which may differ from the HCA) I: income
RA: recoverable amount
Scenario 1: the RA is less than the ACA (which was still the same as the HCA)
Scenario 2: the RA is less than the ACA (the ACA was already less than the HCA due to a prior impairment)
Scenario 3: the RA is greater than the ACA but still less than the HCA (the ACA was less than the HCA due
to a prior impairment)
Scenario 4: the RA is greater than the ACA and greater than the HCA (the ACA was less than the HCA due
to a prior impairment)
The cost model can also be explained by way of a graph. First, plot the ‘magical’ historical
carrying amount line (HCA), otherwise known as the depreciated cost (or cost, if the asset is
non-depreciable). After this, you need to plot your actual carrying amount (ACA) and your
recoverable amount (RA):
Graph: Using a graph for the cost model
Historical carrying amount line

Cost
0 Useful Life
Notice how the line is a diagonal line representing the gradual reduction in the historical carrying
amount as the asset is depreciated over its useful life. It would be a horizontal line if the asset is not
depreciated.
When using the cost model, the asset’s actual carrying amount may be decreased below this diagonal
line (HCA) but may never be increased above it. For example, assume that the recoverable amount is
greater than the historical carrying amount.
x If the actual carrying amount equalled the historical carrying amount, no adjustment will be made
since this would entail increasing the actual carrying amount above its historical carrying amount.
x If the asset had previously been impaired, then the asset’s actual carrying amount would be less
than the historical carrying amount. In this case, the actual carrying amount must be increased, but
only up to the historical carrying amount (reversing a previous impairment loss) but not all the way
up to the recoverable amount (i.e. not above the historical carrying amount).
Let us now try a few examples involving the cost model:

x Example 29: how to calculate and journalise an impairment loss
x Example 30: how to calculate and journalise an impairment loss reversal
x Example 31: impairments and reversals over the life of an asset that is not depreciated
x Example 32: impairments and reversals over the life of an asset that is depreciated.
392 Chapter 7
Example 29: Cost model - impairment loss

Cost of plant at 1/1/20X1: C100 000
Depreciation: 20% straight-line per annum (i.e. 5 yr useful life) to
a nil residual value
Recoverable amount at 31/12/20X1: C60 000
Recoverable amount at 31/12/20X2: C45 000
Required: Provide the journals for both 20X1 and 20X2.
Solution 29: Cost model - impairment loss

W1: Impairment loss: 20X1 C
Cost 1/1/20X1 Given 100 000
Accumulated depreciation 20X1 (100 000 – 0) x 20% x 1 yr
(20 000)
Actual (and historic) carrying amount 31/12/20X1 80 000
Recoverable amount 31/12/20X1 Given (60 000)
Impairment loss 20X1 The RA is less than CA 20 000
Journals: 20X1 Debit Credit
Depreciation: plant (E) (100 000 – 0)/ 5yrs remaining 20 000
Depreciation of asset for year ended 31 December 20X1
Impairment loss: plant (E) W1 20 000
Plant: accumulated impairment losses (-A) 20 000
Impairment of asset as at 31 December 20X1
Graphical depiction: 31/12/20X1
80 000( HCA & ACA)

Cost
20 000 (Debit impairment loss)

60 000(RA)
0 Useful Life
Journals: 20X2 Debit Credit

Depreciation: plant (E) (60 000 – 0)/ 4yrs remaining (5-1)) 15 000
Note: No further impairment loss was required to be journalised at 31/12/20X2 since the new carrying
amount (60 000 – 15 000 = 45 000) equals the recoverable amount.
Example 30: Cost model - reversal of impairment loss

x Cost of plant at 1/1/20X1: C100 000
x Depreciation: 20% straight-line pa to a nil residual value (i.e. over a useful life of 5 years)
x Recoverable amount at 31/12/20X1: C60 000
Required: Show all journals for 20X2, assuming the recoverable amount at 31/12/20X2 is estimated at:
A. C55 000; and
B. C65 000.
For simplicity, you may combine the accumulated depreciation and accumulated impairment loss
account into a single account called the ‘accumulated depreciation and impairment loss account’.
Chapter 7 393
Solution 30: Cost model - reversal of impairment loss

W1: Historical carrying amount (depreciated cost) 31/12/20X2: A and B
Cost 100 000
Accumulated depreciation (100 000 – 0) x 20% x 2yrs (40 000)
60 000
W2: Actual carrying amount 31/12/20X2 (before the impairment testing): A and B
Cost 100 000
Accum. depr. and imp. losses depr20X1:20 000 + IL20X1: 20 000 + depr20X2: 15 000 (55 000)
45 000
W3: Reversal of impairment loss required: A B

Recoverable amount limited to historical carrying amount 55 000 60 000
A: lower of RA: 55 000 and HCA: 60 000 (W1) = 55 000 (RA not limited)
B: lower of RA: 65 000 and HCA: 60 000 (W1) = 60 000 (RA is limited)
Less actual carrying amount (W2) 45 000 45 000
10 000 15 000
Journals: 20X2 A B
Dr/ (Cr) Dr/ (Cr)
Depreciation: plant (E) (60 000 – 0) / 4yrs remaining 15 000 15 000
Plant: accumulated depreciation (-A) (15 000) (15 000)
Plant: accumulated depreciation and impairment losses (-A) 10 000 15 000

Impairment loss reversed: plant (I) (10 000) (15 000)
Reversal of impairment loss journal on 31/12/20X2
Graph depicting A: 31/12/20X2
60 000( HCA)
Cost
55 000(RA)
10 000 (Credit reversal of impairment loss)
45000( ACA)
0 Useful Life
Graph depicting B: 31/12/20X2
65 000(RA)
(No increase allowed)
60 000( HCA)
Cost
15 000 (Credit reversal of impairment loss)

45 000( ACA)
0 Useful Life
394 Chapter 7
Example 31: Cost model – a summary example (the asset is not depreciated)
x Cost of land at 1/1/20X1: C100 000
x Depreciation: This land is not depreciated
Recoverable amount
x 31/12/20X1 120 000
x 31/12/20X2 70 000
x 31/12/20X3 90 000
x 31/12/20X4 110 000
Required:
A. Show the ledger accounts for the years ended 31 December.
B. Draft the statement of financial position for the years ended 31 December.
Solution 31A: Cost model – a summary example (the asset is not depreciated)
Ledger accounts:
Land: cost (asset) Land: accumulated impairment losses (asset)

(1)
1/1/ X1 Bank 100 000 31/12/X2 IL (2) 30 000
Balance c/f 100 000 Balance c/f 30 000
100 000 100 000 30 000 30 000
Balance b/f 100 000 31/12/20X2:
Balance b/f 30 000
31/12/X3 ILR(3) 20 000
Balance c/f 10 000
30 000 30 000
31/12/X3:
Balance b/f 10 000
Bank 31/12/X4 ILR(4) 10 000

(1)
1/1/X1 Land 100 000 Balance c/f 0
10 000 10 000
31/12/X4
Balance b/f 0
Impairment loss expense Reversal of impairment loss income

31/12/X2 AIL (2) 30 000 31/12/X2 P/L 30 000 31/12/X3 P/L 20 000 31/12/X3 AIL(3) 20 000
31/12/X4 P/L 10 000 31/12/X4 AIL(4) 10 000
Solution 31B: Cost model – a summary example (the asset is not depreciated)
Disclosure in the SOFP:
Company name
As at 31 December (extracts)
20X4 20X3 20X2 20X1
C C C C
ASSETS
Non-current Assets
Land 20X1: Cost: 100 000 – AIL: 0 100 000 90 000 70 000 100 000
20X2: Cost: 100 000 – AIL:30 000
20X3: Cost: 100 000 – AIL:10 000
20X4: Cost: 100 000 – AIL:0
Comment: As this asset is not depreciated, its actual carrying amount remains unchanged, at original cost.
In other words, its actual carrying amount (ACA) always equals is historical carrying amount (HCA) of cost.
Chapter 7 395
Solution 31A and B: Cost model – a summary example (the asset is not depreciated)
W1: Land: carrying amount Jnl 20X1 20X2 20X3 20X4
No. Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Opening balance 1 100 000 100 000 70 000 90 000
Depreciation Land not depreciated (0) (0) (0) (0)
Adjustment:
x above HCA Not allowed above HCA 0 0
x below HCA Dr: Impairment loss 2 (30 000)
x up to HCA Cr: Impairment loss reversed 3; 4 20 000 10 000
Closing balance: Lower of RA or HCA 100 000 70 000 90 000 100 000
x Recoverable amount (RA) 120 000 70 000 90 000 110 000
x Historical carrying amount (cost) 100 000 100 000 100 000 100 000
Example 32: Cost model – a summary example (the asset is depreciated)

Cost of machine at 1/1/20X1: 100 000
Depreciation: 25% per annum to a nil residual value
Recoverable amount at each of the 31 December financial year-ends:
x 31/12/20X1 120 000
x 31/12/20X2 40 000
x 31/12/20X3 60 000
x 31/12/20X4 0
Required:
Show the statement of financial position and the ledger accounts for each financial year-end.
Solution 32: Cost model – a summary example (the asset is depreciated)

Ledger accounts:
Machine: Cost (A) Bank
1/1/ X1: Bank (1) 100 000 Balance c/f 100 000 1/1/ X1 M: Cost (1) 100 000
100 000 100 000
Balance b/f 100 000
Depreciation (E) Machine: Acc. depr. & impair. losses (-A)

(2)
31/12/X1 AD&IL 25 000 31/12/X1 Depr (2) 25 000
31/12/X1 P/L 25 000 Balance c/f 25 000
31/12/X2 AD&IL (3) 25 000 25 000 25 000
31/12/X2 P/L 25 000 31/12/X2:
31/12/X3 AD&IL (5) 20 000 Balance b/f 25 000
31/12/X3 P/L 20 000 Depr (3) 25 000
31/12/X4 AD&IL (7) 25 000 Imp loss (4) 10 000
31/12/X4 P/L 25 000 Balance c/f 60 000
60 000 60 000
31/12/X3:
Impairment loss (E) Balance b/f 60 000
31/12/X2 AD&IL (4) 10 000 Depr (5) 20 000
31/12/X2 P/L 10 000 ILR (6) 5 000
Balance c/f 75 000
80 000 80 000
31/12/X4:
Impairment loss reversed (I) Balance b/f 75 000
31/12/X3 AD&IL (6) 5 000 Depr (7) 25 000
31/12/X3 P/L 5 000 Balance c/f 100 000
100 000 100 000
Balance b/f 100 000
396 Chapter 7
Disclosure:
Company name
ASSETS 20X4 20X3 20X2 20X1
Non-current Assets C C C C
Machine 20X1: Cost: 100 000 – AD&IL: 25 000 0 25 000 40 000 75 000
20X2: Cost: 100 000 – AD&IL:60 000
20X3: Cost: 100 000 – AD&IL:75 000
20X4: Cost: 100 000 – AD&IL:100 000
Workings:
W1: Machine: carrying amount and adjustments
Jnl 20X1 20X2 20X3 20X4

Opening balance 1 100 000 75 000 40 000 25 000
Depreciation X1: (100 000 – 0) / 4 x 1 2,3,5,7 (25 000) (25 000) (20 000) (25 000)
X2: (75 000 – 0) / 3 x 1
X3: (40 000 – 0) / 2 x 1;
X4: (25 000 – 0)/ 1 x 1
Adjustment:
x above HCA Not allowed above HCA 0 0
x up to HCA Cr: impairment loss reversed 6 5 000
x below HCA Dr: Impairment loss 4 (10 000)
Closing balance: (lower of RA or CA) 75 000 40 000 25 000 0
x Recoverable amount (RA) 120 000 40 000 60 000 0
x Carrying amount (cost – acc depr) 75 000 50 000 25 000 0
5. Derecognition (IAS 16.67 - .72)
An item of property, plant and equipment must be derecognised: Derecognition

x on disposal; or means to:
x when no future economic benefits are expected from its use remove the item
or disposal. IAS 16.67 from the accounting records.
To derecognise an asset means to remove its carrying amount from the accounting records. To
remove a carrying amount you need to remove all its related accounts. In other words, one side
of the entry requires us to credit its cost account and debit its accumulated depreciation and
accumulated impairment loss accounts. The other side of the entry (i.e. the contra entry) is to
recognise an expense in profit or loss (i.e. you are essentially processing an entry that credits
the carrying amount and debits an expense).
If, when derecognising the asset, the entity earned proceeds on the disposal, these proceeds would be
recognised as income in profit or loss. The amount of these proceeds is measured in the same way that
a transaction price is measured in terms of IFRS 15 Revenue from contracts with customers.
The expensed carrying amount is then set-off against the proceeds to reflect any gain or loss. If
it results in a gain, this gain may not be classified as revenue (i.e. it is simply classified as
income in profit or loss).
Since we are allowed to offset the expense (i.e. the expensed carrying amount) and the income
(i.e. the proceeds), the process of recognising the carrying amount as an expense and
recognising the proceeds as income is generally processed in one account, generally called a
‘profit or loss on disposal’ account.
Chapter 7 397
Disposals occur if, for example, the asset is sold, leased to someone else under a sale and
leaseback agreement or donated. The date on which the disposal must be recorded depends on
how it is disposed of.
x The disposal of an asset by way of a sale and leaseback agreement is explained in the
relevant chapter on leases (chapter 16).
x If a disposal occurs in any other way (e.g. by way of a sale or donation), the asset is
derecognised on the date that the recipient obtains control of the item (the recipient is said
to have obtained control when the IFRS 15 criteria for determining when a performance
obligation has been satisfied are met). See IAS 16.69
Please note: although the performance obligation criteria in IFRS 15, (the standard on
revenue), are used to determine when to derecognise an item of property, plant and equipment
that is disposed of in any manner other than by way of sale and leaseback, any gain on de-
recognition (e.g. profit on sale of plant) may not be classified as revenue. Any gain that may be
made would thus simply be classified as part of ‘other income’.
Sometimes entities, as part of their ordinary activities, rent items of property, plant and
equipment to third parties, after which they sell these second-hand items. In such cases:
x after the entity has stopped renting the item of property, plant and equipment to third
parties and decides to sell it, the carrying amount of this item is transferred to inventory;
x the inventory is derecognised when the revenue recognition criteria are met; and
x the sale of the asset is then classified as part of revenue because it would be a sale of
inventory and not a sale of property, plant and equipment: the related revenue would thus
be accounted for in terms of IFRS 15 Revenue from contracts with customers. See IAS 16.68A
6. Deferred Tax Consequences (IAS 12)
6.1 Overview
Deferred tax balance
Temporary differences will arise if the tax authorities do not =
measure the tax base of the item of property, plant and x Temporary difference x tax rate
equipment in the same way that the carrying amount is (unless TD is exempt)
measured in terms of IFRSs. x Nil if TD is exempt:
Exemption may occur if a TD
Deferred tax should be recognised on temporary differences
arises on initial acquisition
unless the temporary difference is:
x exempt from deferred tax; or
x a deductible temporary difference (i.e. causing a deferred tax asset) where sufficient taxable
profits to absorb the entire tax deduction are not probable (i.e. the deferred tax asset is only
recognised to the extent that the related future tax saving is probable). See IAS 12.15 & .24
This section merely revises some of the deferred tax consequences of property, plant and
equipment because these deferred tax effects have previously been explained thoroughly in
Chapter 6: Deferred Tax. If you are unsure of the deferred tax consequences arising from
property, plant and equipment, please revise the following:
x Deductible assets: chapter 6: section 4.2;
x Non-deductible assets (and the exemption): chapter 6: section 4.3 and section 5;
x Sale of property, plant and equipment: chapter 6: section 4.5.
6.2 Comparing the carrying amount and tax base

The carrying amount of an item of property, plant and equipment changes if and when:
x the asset is acquired;
x the asset is depreciated;
x the asset is impaired (or a prior impairment is reversed); and
x the asset is sold.
398 Chapter 7
The tax base of an item of property, plant and equipment changes if and when:
x the asset is acquired;
x deductions are allowed on the cost of the asset; and
x the asset is sold.
Carrying amount of PPE represents: Tax base of PPE represents:

See IAS 12.7
x cost x future tax deductions
x less accumulated depreciation, and
x less accumulated impairment losses
Essentially, when the carrying amount and tax base are not the same, it means that the rate at
which the cost of the asset is expensed (depreciated) is different to the rate at which the cost of
the asset is allowed as a tax deduction (e.g. through a wear and tear deduction).
The following examples show the effect of deferred tax on property, plant and equipment that
is measured under the cost model:
x Example 33: shows us how to account for deferred tax resulting from basic transactions
involving property, plant and equipment (purchase, depreciation and derecognition through
sale).
x Example 34: shows us how to account for deferred tax when the property, plant and
equipment involves an impairment loss.
x Example 35: shows us the deferred tax implications (i.e. a deferred tax exemption) when
accounting for property, plant and equipment that the tax authorities do not allow a tax
deduction on (i.e. where the tax authorities do not allow its cost to be deducted).
Example 33: Deferred tax caused by purchase, depreciation and sale of PPE
x An entity buys plant on 2 January 20X0 for C100 000 in cash. Depreciation on the
plant is calculated:
- using the straight-line basis
- to a nil residual value
- over 4 years.
x The plant is sold on 30 June 20X2 for C80 000.
x The tax authorities allow the cost of plant to be deducted from taxable profits at 20%
per annum.
x The tax authorities apportion the tax deduction for part of a year.
x The company’s year-end is 31 December.
Required: Show all related journal entries possible from the information provided.
Solution 33: Deferred tax caused by the purchase, depreciation and sale of PPE
Comment:
x It is not necessary to know how much the asset is sold for when calculating the deferred tax balance!
This is because the selling price has no impact on either the asset’s carrying amount or its tax base: both
are reduced to zero, no matter how much it was sold for.
x The selling price is only used in calculating profit before tax and taxable profits, which leads to the
calculation of the current tax charge (chapter 5 explains the calculation of current tax).
x The only effect that a sale of an asset has on the asset account is that its carrying amount is reduced to
zero. If you recall from earlier years of study, when disposing of an asset, you:
- transfer the carrying amount of the asset to the disposal account (debit the disposal account);
- record the proceeds on sale, if any (and credit the disposal account); and then
- transfer the net amount in the disposal account to either profit on disposal (if the proceeds exceeded
the carrying amount) or loss on disposal (if the carrying amount exceeded the proceeds).
Chapter 7 399

Bank (A) 100 000
Purchase of plant for cash
31 December 20X0
Depreciation: plant (E) (100 000 – 0) / 4 years x 12 / 12 25 000
Plant: acc. depreciation (-A) 25 000
Deferred tax: income tax (A) W1 or (25 000 – 20 000) x 30% 1 500
Tax expense (P/L) 1 500
Deferred tax adjustment due to plant
31 December 20X1
Plant: acc. depreciation (-A) or: (75 000 – 0) / 3 years x 12 / 12 25 000
Deferred tax: income tax (A) W1 or (25 000 – 20 000) x 30% 1 500
Tax expense (E) 1 500
30 June 20X2
Plant: acc. depreciation (-A) or: (50 000 – 0) / 2 years x 6 / 12 12 500
Depreciation of plant to date of sale (30 June 20X2)
Plant: acc. depreciation (-A) 25 000 + 25 000 + 12 500 62 500
Asset disposal 37 500
Carrying amount of plant transferred to asset disposal account
Asset disposal 80 000
Proceeds on sale of plant
Asset disposal 80 000 – 37 500 or 42 500
Profit on sale of plant (E) 62 500 + 80 000 – 100 000 42 500
Profit on sale of plant
31 December 20X2
Tax expense (E) W1 or [AP: (12 500 - 42 500) – TP: 3 000
Deferred tax: income tax (A) (10 000 - 50 000)] x 30% 3 000
Deferred tax adjustment due to plant:
(AP = Accounting profits & TP = Taxable profits)
W1: Deferred tax: Plant Carrying Tax base Temp Deferred Details
amount difference taxation
(TB – CA)
Balance: 1/1/20X0 0 0 0 0
Purchase: 02/01/20X0 100 000 100 000
Depreciation 100 000 / 4 yrs; (25 000) (20 000) 1 500 Dr DT (SOFP)
100 000 x 20% Cr Tax (SOCI)
Balance: 31/12/20X0 75 000 80 000 5 000 1 500 Asset
Depreciation 75 000 / 3 yrs; (25 000) (20 000) 1 500 Dr DT (SOFP)
100 000 x 20% Cr Tax (SOCI)
Balance: 31/12/20X1 50 000 60 000 10 000 3 000 Asset
Depreciation 50 000 / 2 yrs x 6/12; (12 500) (10 000)
100 000 x 20% x 6/12 Cr DT (SOFP)
(3 000)
37 500 50 000 Dr Tax (SOCI)
CA/ TB: Sale of plant: 30/06/X2 (37 500) (50 000)
Balance: 31/12/20X2 0 0 0 0
400 Chapter 7
Example 34: Deferred tax involving the impairment of PPE

A company buys plant on 2 January 20X1 for C100 000 in cash.
x Depreciation on the plant is calculated using the straight-line basis to a nil residual value
over 4 years.
x The tax authorities allow the deduction of the plant’s cost from taxable profits at 20% pa.
x The recoverable amount of the plant was estimated to be as follows:
- 31 December 20X1: C60 000
- 31 December 20X2: C45 000
- 31 December 20X3: C30 000
Required:
Calculate the deferred tax balance and adjustments using the balance sheet approach for all the affected
years ended 31 December and prepare all journal entries.
Solution 34: Deferred tax involving the impairment of PPE
Journal entries Debit Credit
2 January 20X1
Bank (A) 100 000
31 December 20X1
Depreciation: plant (E) (100 000- 0) / 4 years 25 000
Plant: acc depr & imp losses (-A) 25 000
Impairment loss: plant (E) CA: (100 000 – 25 000) – RA: 60 000 15 000
Impairment of plant
Deferred tax: income tax (A/L) W1 or 6 000
Tax expense (E) [(25 000 + 15 000) - 20 000] x 30% 6 000
31 December 20X2
Plant: acc depr & imp losses (-A) CA: (60 000 – 20 000) – RA: 45 000 5 000
Impairment loss reversed (I) (not limited by HCA of 50 000) 5 000
Previous impairment of plant now reversed
Tax expense (E) W1 or 1 500
Deferred tax: income tax (A/L) [(20 000 – 5 000) – (20 000)] x 30% 1 500
31 December 20X3
Plant: acc depr & imp losses (-A) CA: (45 000 – 22 500) – RA: 30 000 2 500
Impairment loss reversed (I) limited to HCA: 25 000 2 500
Previous impairment of plant now reversed
31 December 20X4
Deferred tax: income tax (A/L) W1 or 1 500
Tax expense (E) (25 000 – 20 000) x 30% 1 500
Chapter 7 401

Tax expense (E) W1 or 6 000
Deferred tax: income tax (A/L) (0 – 20 000) x 30% 6 000
Workings:
W1: Deferred tax on plant Carrying Tax base Temporary Deferred Details
amount difference taxation
(TB – CA) TD x 30%
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000
Dr DT (SOFP)
Depreciation / tax deduction (25 000) (20 000) 6 000
Cr Tax (SOCI)
Impairment loss (15 000) 0
Balance: 31/12/20X1 60 000 80 000 20 000 6 000 Asset
Depreciation (20 000) (20 000) Cr DT (SOFP)
(1 500)
Impairment loss reversed 5 000 0 Dr Tax (SOCI)
Balance: 31/12/20X2 45 000 60 000 15 000 4 500 Asset
Depreciation (22 500) (20 000)
0 No adjustment
Impairment loss reversed 2 500 0
Balance: 31/12/20X3 25 000 40 000 15 000 4 500 Asset
Dr DT (SOFP)
Depreciation (25 000) (20 000) 1 500
Cr Tax (SOCI)
Balance: 31/12/20X4 0 20 000 20 000 6 000 Asset
Cr DT (SOFP)
Depreciation (0) (20 000) (6 000)
Dr Tax (SOCI)
Balance: 31/12/20X5 0 0 0 0
Calculations:
Tax deduction:
x Each year (20X1 – 20X5): 100 000 x 20% = 20 000
Depreciation:
x 20X1: (100 000 - 0) / 4 yr = 25 000
x 20X2: (60 000 - 0) / 3 yr = 20 000
x 20X3: (45 000 - 0) / 2 yr = 22 500
x 20X4: (25 000 - 0) / 1 yr = 25 000
x 20X5: nil (fully depreciated)
Impairment loss:
x 20X1: CA 75 000 – RA 60 000 = 15 000 impairment loss
x 20X2: CA: 40 000 – RA: 45 000 = 5 000 impairment loss reversed (not limited since HCA: 100 000 x 2 / 4 = 50 000)
x 20X3: CA: 22 500 – RA: 30 000 = 7 500 impairment loss reversed but limited to 2 500 because the CA of
22 500 must not exceed the HCA and the HCA is 25 000 (100 000 x 1/4)
6.3 Deferred tax exemptions (IAS 12.15)
You may recall from chapter 6 (see chapter 6: section 4.3 and section 5) that an interesting
situation arises when you own an asset that is depreciated, but the tax authorities do not allow
its cost as a tax deduction. Core to understanding how to deal with this situation is that:
x the carrying amount represents the cost less accumulated depreciation; and
x the tax base represents the future tax deductions.
If the tax authorities do not allow the deduction of the cost of the asset (i.e. do not allow a wear
and tear or similar allowance), the tax base will be zero from the date of purchase because the
future deductions are nil. Since the carrying amount will start off at the asset’s cost (which is
clearly not zero), the purchase of such an asset will cause a taxable temporary difference
immediately on acquisition that will gradually decrease to zero as the asset is depreciated.
402 Chapter 7
A problem arises, however, in that recognising the deferred tax liability on this temporary
difference means that we will need to know where to process the debit side of the adjustment:
x It can’t be debited to tax expense, because the journal that causes the deferred tax is the
purchase journal and this does not affect accounting profit (debit asset and credit bank or
creditors) and clearly does not affect taxable profit (it is not allowed as a deduction);
x You might therefore try to argue that it is balance sheet-based deferred tax and should
therefore be debited to the account that caused the temporary difference, but this can’t be
done either since this would mean increasing the value of the asset simply because of a
deferred tax liability (which does not reflect a true cost).
Since this question couldn’t be solved in certain cases, the temporary difference is exempted in
terms of IAS 12.15 where it relates to:
x goodwill; or
x the initial recognition of an asset or liability which
- is not a business combination, and
- at the time of the transaction, affects neither accounting profit nor taxable profit.
Thus, any expense relating to the initial cost (e.g. depreciation) is also exempt. See IAS 12.22
Example 35: Deferred tax involving exempt temporary differences
An entity buys an asset on 1 January 20X1 with the following particulars:
x Cost: C100 000
x Depreciation: straight-line to a nil residual value over 4 years.
x The tax authorities do not allow the cost of this asset to be deducted.
x The entity’s year-end is 31 December.
Required: Calculate the deferred tax balance and adjustments in 20X1 – 20X4.
Solution 35: Deferred tax involving exempt temporary differences

Comment: Since the movement in temporary differences is exempted, there are no deferred tax journals and
since the cumulative temporary differences are exempt, the deferred tax balances are nil.
W1: Deferred tax calculation
Asset: Carrying Tax Temporary Deferred Details
x Depreciable amount base difference taxation
x Non-deductible
Balance: 1/1/20X1 0 0 0 0
Purchase: 1 January 20X1 100 000 0 (100 000) 0 Exempt: IAS 12.15
Depreciation Note 1 (25 000) 0 25 000 0 Exempt: IAS 12.15
Balance: 31/12/20X1 75 000 0 (75 000) 0 Exempt: IAS 12.15
Depreciation (25 000) 0 25 000 0 Exempt: IAS 12.15
Balance: 31/12/20X4 0 0 0 0 Exempt: IAS 12.15
1) (100 000 – 0) / 4 years
7. Disclosure (IAS 16.73 - .79)
7.1 Overview
The disclosure of property, plant and equipment involves various financial statements:
x the statement of comprehensive income;
x the statement of financial position;
x the notes (for accounting policies, extra detail on statement of financial position and
statement of comprehensive income items including any changes in estimates); and
x the statement of changes in equity.
Chapter 7 403
Remember that the topic of property, plant and equipment has been split over two chapters.
The disclosure requirements listed below are therefore not complete. Certain items that should
also be disclosed have been ignored for the purposes of this more basic chapter. The complete
disclosure requirements are provided in the next chapter.
7.2 Accounting policies and estimates
For each class of property, plant and equipment (e.g. land, Accounting policies note:
buildings, machinery, etc.) the following policies should
x depreciation methods
be disclosed: x rates (or useful lives)
x depreciation methods used (e.g. straight-line method);
x useful lives or depreciation rates used (e.g. 5 years or 20% per annum); and
x the measurement model used (i.e. the cost model or the revaluation model: the revaluation
model is explained in the next chapter). See IAS 16.73
The nature and effect of a change in estimate must be disclosed in accordance with IAS 8 (the
standard governing ‘accounting policies, changes in accounting estimates and errors’).
7.3 Statement of comprehensive income disclosure
Property, plant and equipment can affect the statement of
comprehensive income by either: SOCI Disclosure
x Decreasing profit: depreciation, impairments and
losses on disposals; or x Other income line item: profit on
sale of PPE may be included in ‘other
x Increasing profit: reversals of depreciation (changes income’
in estimate), reversals of impairments and profits on
x Profit before tax note:
disposals. - depreciation,
- impairment losses/ reversals,
Assuming that one were to present the statement of - profit or loss on disposal
comprehensive income using the function method,
depreciation and losses on disposal of assets would be included in one of the categories of
expenses (for example: depreciation on an asset used to manufacture inventories would be
included in the cost of inventories, which would then eventually be included in the cost of sales
line-item; depreciation on office computers would be included directly in the administration
costs line-item).
Similarly, profit on disposal of items of property, plant and equipment would generally be
included under ‘other income’.
In other words, aspects of property, plant and equipment generally do not appear as separate
line items in the statement of comprehensive income but in the notes instead (a good idea is to
include these in a note that supports the ‘profit before tax’ line item in the statement of
comprehensive income).
The standard requires that the following be disclosed in the notes to the financial statements
and should be shown per class of property, plant and equipment:
x depreciation (whether recognised in profit or loss or as part of the cost of another asset);
x impairment losses (and the line item of the statement of comprehensive income in which it
is included);
x impairment losses reversed (and the line item of the statement of comprehensive income in
which it is included);
x profits or losses on the realisation, scrapping or other disposal of a non-current asset.
The nature and effect of a change in estimated depreciation must be disclosed in accordance
with IAS 8 Accounting policies, changes in accounting estimates and errors.
IAS 1 requires that the depreciation that is expensed be separately disclosed. If part of the total
depreciation is capitalised to another asset, this depreciation expense will be smaller than the
amount disclosed as the total depreciation in the asset note (see section 7.4).
404 Chapter 7
7.4 Statement of financial position disclosure

SOFP Disclosure
IAS 1 requires that property, plant and equipment appears
as a line item on the face of the statement of financial
x One line-item: Property, plant & equip
position.
x PPE note: Reconciliation between
opening and closing balances; Break-
IAS 16 requires that the following main information be down of these balances into
disclosed in the ‘property, plant and equipment’ note, - gross carrying amount and
which is the note that supports the ‘property, plant and
- accumulated depreciation
equipment’ line item.
For each class of property, plant and equipment (e.g. land, buildings, machinery etc.) the
following should be disclosed:
x ‘gross carrying amount’ and ‘accumulated depreciation and impairment losses’ at the
beginning and end of each period;
x a reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable (this reconciliation effectively
shows the users the movements that occurred during the period in the cost, accumulated
depreciation and accumulated impairment loss accounts):
additions;
disposals;
depreciation;
impairment losses/ impairment losses reversed;
acquisitions through business combinations;
assets transferred to ‘non-current assets held for sale’ in accordance with IFRS 5;
other movements (e.g. currency translation differences);
x the existence and amounts of restrictions on title;
x the existence and amounts of property, plant and equipment pledged as security for a
liability;
x the costs capitalised in respect of property, plant and equipment being constructed;
x the amount of any contractual commitments to acquire property, plant and equipment in
the future. See IAS 16.73 - .74
7.5 Further encouraged disclosure
The following disclosure is encouraged:

x the carrying amount of property, plant and equipment that is temporarily idle;
x the gross carrying amount of property, plant and equipment that is still in use but that has
been fully depreciated;
x the carrying amount of property, plant and equipment that is no longer used and is to be
disposed of (but not yet classified as held for sale in accordance with IFRS 5); and
x the fair value of the asset, in the event that the cost model is adopted and the difference
between fair value and carrying amount is material. See IAS 16.79
7.6 Disclosure regarding fair value measurements
Although this chapter focuses on the cost model, you may need to disclose the asset’s fair
value in the note (see ‘further encouraged disclosure’ above), in which case there are further
minimum disclosures required by IFRS 13 Fair value measurement.
These disclosure requirements are summarised in chapter 25.
Chapter 7 405
7.7 Sample disclosure involving property, plant and equipment
ABC Limited
2. Accounting policies
2.1 Property, plant and equipment

Property, plant and equipment is shown at cost less accumulated depreciation and impairment
losses. Depreciation is not provided on land. Depreciation is provided on all other property, plant
and equipment over the expected economic useful life to their expected residual values.
Depreciation is provided on the following assets using the following rates and methods:
- Plant: straight line over 5 years.
3. Property, plant and equipment

20X2 20X1
Total net carrying amount: C C
Land c b
Plant f e
c+f b+e
Land: Plant:
20X2 20X1 20X2 20X1
C C C C
Net carrying amount: 1 January b a e d
Gross carrying amount
Accumulated depreciation & impairment losses
Add additions
Less disposals
Less depreciation
Less impairment losses
Add impairment losses reversed
Other
Net carrying amount: 31 December c b f e
Accumulated depreciation and impairment losses
24. Profit before tax

20X2 20X1
Profit before tax is stated after taking the following into account: C C
Depreciation on plant
Impairment losses on plant
Reversals of previous impairment losses on plant
Profit / (loss) on sale of plant
ABC Limited
20X2 20X1
ASSETS Note C C
Non-current assets
Property, plant and equipment 3 X X
406 Chapter 7
Example 36: Cost model disclosure – no impairment

Flowers Limited owns a variety of assets, the carrying amounts of which were as follows at
1/1/20X0:
x Land: C50 000 (cost: C50 000 on 1 January 19X7, being Lot XYZ comprising 4 000
square metres, situated in Durban North, South Africa)
x Plant: C1 800 000 (cost C3 000 000)
x Machines: C400 000 (cost: C500 000, consisting of 5 identical machines)
The only movements in property, plant and equipment during 20X0 was depreciation.
The only movements in property, plant and equipment during 20X1:

x Plant purchased on 1 June 20X1 for C100 000
x Machine sold on 30 June 20X1 for C70 000 on which date the following was relevant:
o cost: C100 000,
o accumulated depreciation: C35 000
Depreciation is provided as follows:

x Land is not depreciated.
x Plant is depreciated at 20% per annum to a nil residual value.
x Machines are depreciated at 10% per annum to a nil residual value.
The company pledged both plants as security for a loan. Details of the loan will be provided in note 16.
The company used one of its machines on the installation of the new plant.
x This machine was used for one month (June 20X1) in this process.
x The plant was installed and ready to use from 1 July 20X1.
x Depreciation on machines is usually classified as ‘other costs’ in the statement of comprehensive
income.
x Plant is used to manufacture inventories.
Required:
Disclose the plant and related information in the financial statements for the year ended
31 December 20X1 in accordance with the International Financial Reporting Standards.
Ignore deferred tax
Solution 36: Cost model disclosure – no impairment
ABC Limited
20X1 20X0
ASSETS Note C C
Non-current Assets
Property, plant and equipment 4 980 750 1 600 000
ABC Limited
Property, plant and equipment is measured at cost less accumulated depreciation.
Depreciation is provided on all property, plant and equipment over the expected economic useful life
to expected residual values using the following rates and methods:
Land: is not depreciated
Machines: 10% per annum, straight-line method
Plant: 20% per annum, straight-line method.
Chapter 7 407
ABC Limited
Notes to the financial statements (extracts) continued....
20X1 20X0
4 Property, plant and equipment C C
Property, plant and equipment comprises:
x Land 50 000 50 000
x Machine 240 000 350 000
x Plant 690 750 1 200 000
980 750 1 600 000
4.1 Land
Land was purchased for C50 000. Land is not depreciated.
4.2 Machine
Net carrying amount – opening balance 350 000 400 000
Gross carrying amount: 500 000 500 000
Accumulated depreciation 20X0: 500 000 – 400 000 (150 000) (100 000)
Depreciation 20X0: (500 000 – 0) x 10% (45 000) (50 000)
20X1: (500 000 – 100 000 – 0) x 10% +
(100 000 – 0) x 10% x 6/12
Disposals 20X1: 100 000 – 35 000 (65 000) 0
Net carrying amount – closing balance 240 000 350 000
Gross carrying amount 20X1: 500 000 – 100 000 disposal 400 000 500 000
Accumulated depreciation 20X1: 150 000 + 45 000 – 35 000 disposal (160 000) (150 000)
4.3 Plant
Net carrying amount – opening balance 1 200 000 1 800 000
Gross carrying amount: 3 000 000 3 000 000
Accumulated depreciation 20X0: 3 000 000 – 1 800 000 (1 800 000) (1 200 000)
Additions 100 000 0
Capitalised depreciation 20X1: (500 000 – 0)/ 5 x 10% x 1/12 833
Depreciation 20X0: (3 000 000 – 0) x 20% (610 083) (600 000)
20X1: (3 000 000 – 0) x 20% + (100 000 +
833 – 0) x 20% x 6/12
Net carrying amount – closing balance 690 750 1 200 000
Gross carrying amount (3 000 000 + 100 000 + 833) 3 100 833 3 000 000
Accumulated depreciation (1 800 000 + 610 083) (2 410 083) (1 800 000)
Plant was pledged as security for a loan. Details of the loan liability are provided in note 16.

Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
x Depreciation on machine 44 167 50 000
- total depreciation See PPE note 45 000 50 000
- less capitalised to plant (500 000 – 0) / 5 x 10% x 1/ 12 (833) (0)
x Depreciation on plant 0 0
- total depreciation See PPE note 610 083 600 000
- less capitalised to inventory (610 083) (600 000)
x Profit on sale of machine Proceeds: 70 000 – CA: 65 000 (5 000) 0
Example 37: Cost model disclosure with impairments

Plant, with a cost of C100 000, was purchased on the 1/1/20X1. It is depreciated at
25% p.a to a nil residual value. There are no other items of property, plant or
equipment. The entity measures its assets under the cost model.
408 Chapter 7
The following recoverable amounts were calculated:

x Recoverable amount at 31 December 20X1 is C60 000
x Recoverable amount at 31 December 20X2 is C55 000
Required:
A. Disclose the plant and all related information in the financial statements for the years ended
31 December 20X1, 20X2, 20X3 and 20X4 in accordance with the IFRSs, ignoring deferred tax.
B. Show the journals and all additional or revised related disclosures assuming that:
x Deductible allowance (wear and tear) granted by the tax authorities 25% straight-line per year
x Income tax rate 30%
x The entity intends to keep the plant. There are no other temporary differences other than those
Solution 37A: Cost model disclosure with impairments

x deferred tax ignored
ABC Ltd
As at 31 December 20X4 (extracts)
20X4 20X3 20X2 20X1
Note C C C C
ASSETS
Non-current Assets
Property, plant and equipment 4 0 25 000 50 000 60 000
ABC Ltd
x Plant is measured using the cost model: cost less accumulated depreciation & impairment losses.
x Depreciation is provided on all property, plant and equipment over the expected economic useful
life to expected residual values using the following rates and methods:
4. Property, plant and equipment 20X4 20X3 20X2 20X1
C C C C
Plant
Net carrying amount: 1 January 25 000 50 000 60 000 0
Gross carrying amount: 100 000 100 000 100 000 0
Accum depreciation and imp losses: (75 000) (50 000) (40 000) 0
x Additions 0 0 0 100 000
x Depreciation (25 000) (25 000) (20 000) (25 000)
x Impairment loss 0 0 0 (15 000)
x Impairment loss reversed 0 0 10 000 0
Net carrying amount: 31 December 0 25 000 50 000 60 000
Gross carrying amount: 100 000 100 000 100 000 100 000
Accum depreciation and imp losses: (100 000) (75 000) (50 000) (40 000)
25. Profit before tax 20X4 20X3 20X2 20X1

C C C C
x Depreciation on plant 25 000 25 000 20 000 25 000
x Impairment loss 0 0 0 15 000
x Impairment loss reversed 0 0 (10 000) 0
Chapter 7 409
Solution 37B: Cost model disclosure with impairments

x With related deferred tax effects
Journals:
20X1: Dr/ (Cr)

Bank/ Liability (100 000)
Purchase of asset: (1/1/20X1)
Depreciation: plant (E) (100 000 – 0) / 4 years remaining 25 000
Plant: accumulated depreciation and impairment losses (-A) (25 000)
Impairment loss: plant (E) CA: (100 000 – 25 000) – RA: 60 000 15 000
Impairment loss
Deferred tax: income tax (A) W1 or [(25 000 + 15 000) – (25 000)] x 30% 4 500
Income tax expense (E) (4 500)
Deferred tax caused by plant/ impairment loss
20X2
Depreciation: plant (E) (60 000 – 0) / 3 years remaining 20 000
Plant: accumulated depreciation and impairment losses (-A) 10 000
Impairment loss reversed (I) CA: (60 000 – 20 000) – RA: 55 000, ltd to HCA:50 000 (10 000)
Income tax expense (E) W1 or [(20 000 - 10 000) – (25 000)] x 30% 4 500
Deferred tax: income tax (A) (4 500)
Deferred tax caused by plant/ impairment loss reversed & revised depreciation
20X3:
Depreciation: plant (E) (50 000 – 0) / 2 years remaining x 1 year 25 000
20X4:
Depreciation: plant (E) (25 000 – 0) / 1 year remaining 25 000
Disclosure:
ABC Limited
For the year ended 31 December 20X4 (extracts)
Note 20X4 20X3 20X2 20X1
5. Deferred taxation asset/ (liability) C C C C
The deferred taxation balance comprises:
Capital allowances (the balances in W1) 0 0 0 4 500
0 0 0 4 500
26. Income tax expense/ (income)
- current X X X X
- deferred (the movement in W1) 0 0 4 500 (4 500)
All other notes would remain the same.
410 Chapter 7
ABC Ltd
As at 31 December 20X4 (EXTRACTS)
20X4 20X3 20X2 20X1
ASSETS Note C C C C
Non-current Assets
Property, plant and equipment 4 0 25 000 50 000 60 000
Deferred taxation 5 0 0 0 4 500
Workings:
W1: Deferred tax: plant Carrying Tax Temporary Deferred Details

amount base difference taxation
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000
Depreciation (25 000) (25 000) Movement:
(100 000 – 0) / 4 years 4 500 Dr DT (SOFP)
(100 000 x 25%) Cr TE (P/L)
Impairment loss (15 000) 0
Balance: 31/12/20X1 60 000 75 000 15 000 4 500 Asset balance
Depreciation (20 000) (25 000)
Movement:
(60 000 – 0) / 3 years
(4 500) Cr DT (SOFP)
(100 000 x 25%)
Dr TE (P/L)
Impairment loss reversed 10 000 0
Balance: 31/12/20X2 50 000 50 000 0 0
Depreciation (25 000) (25 000) 0 Movement
(50 000 – 0) / 2 years
(100 000 x 25%)
Balance: 31/12/20X3 25 000 25 000 0 0
Depreciation (25 000) (25 000) 0 Movement
(25 000 – 0) / 1 year
(100 000 x 25%)
Balance: 31/12/20X4 0 0 0 0
Chapter 7 411
8. Summary
PROPERTY, PLANT AND EQUIPMENT
Recognition Measurement Disclosure
RECOGNITION
Definition must be met Recognition criteria must be met

x tangible items that are x probable that future economic benefits will
x held for use in the production or supply of goods flow to the entity AND
or services, for rental to others, or for x cost must be reliably measured
administrative purposes; and Note: The Recognition criteria in IAS 16 has not
x are expected to be used during more than one period been updated for the new 2018 CF
Initial versus subsequent costs

Subsequent costs are only recognised as an asset if the recognition criteria
are met (if not met, cost must be expensed):
x Day-to-day servicing would be expensed (including replacements of small parts)
x Other replacements and major inspections etc. could be recognised as an
asset if the recognition criteria are met. If so, the replaced part must
be derecognised.
MEASUREMENT: PPE
Initial Measurement Subsequent Measurement

PPE is initially measured at cost. Subsequent measurement involves:
Cost comprises: x Model: the choice between the cost model
x its purchase price, including import duties and and the revaluation model
non-refundable purchase taxes, after deducting (this chapter covers only the cost model–
trade discounts and rebates. the revaluation model is explained in chp 8)
x any costs directly attributable to bringing the x Depreciation
asset to the location and condition necessary for
it to be capable of operating in the manner x Impairments and impairments reversed
intended by management. (impairments are governed by IAS 36 and
are explained further in chp 11)
x the initial estimate of the costs of dismantling
and removing the item and restoring the site on
which it is located, the obligation for which an
entity incurs either when the item is acquired or
as a consequence of having used the item during
a particular period, for purposes other than to
produce inventories during that period.
If it is an asset exchange, then cost is:
x FV of A given up, unless
x FV of A received is more clearly evident (or if it’s
the only FV available)
x If no FV available, use CA of A given up
Subsequent Measurement: Depreciation
In general Changes in accounting estimate

The depreciable amount must be depreciated Changes in accounting estimates occur if any of the
on a systematic basis over the estimated useful life following are changed:
of the asset.
x the estimated useful life
The method used should reflect x the method of depreciation
the pattern in which economic benefits are expected
to be generated from the asset (it should never be x the residual value
based on related revenue generated by the asset).
x the estimated costs of dismantling, removing or
The depreciation charge is restoring items of PPE.
expensed unless it is capitalised to another asset.
See IAS 8 for more details (chapter 26)
412 Chapter 7
MEASUREMENT: PPE continued …
Subsequent Measurement: Impairments
Impairment loss Impairment loss reversed

If carrying amount (CA) exceeds recoverable amount If at a subsequent date the RA increases above CA,
(RA), write the CA down to the RA (before doing so, increase the CA, but only to the extent that the CA
check that processing extra depreciation would not does not exceed the historical carrying amount:
be a more appropriate way of reducing the CA, in - if the asset is non-depreciable, the HCA
which case the extra depr would be processed as a = cost
change in estimate, and not as an impairment) - if the asset is depreciable, the HCA
= cost – accumulated depreciation (depreciated cost)
MEASUREMENT: THE RELATED DEFERRED TAX BALANCE

x Temporary difference x tax rate (unless exempted)
x DT = nil if TD is exempted: Exemption may occur if a temporary
difference arises on initial acquisition (see chp 6 for the full story on
deferred tax)
Temporary difference
Carrying amount versus Tax base
Carrying amount Tax base

Represents (if the cost model is used): Represents:
x Future economic benefits, being: x Future tax deductions, being:
Cost Cost
Less accumulated depreciation and Less accumulated tax deductions
Less accumulated impairment losses
DISCLOSURE: PPE
(main points only)
SOFP SOCI NOTES

One line-item: One line-item: profit before
x Property, plant & equip tax includes all income and
expense items. However, the
P/L on sale of PPE could also be
included in the ‘other income’
line item.
Accounting policies note: Profit before tax note: Property, plant and equipment
x depreciation methods x depreciation note:
x rates (or useful lives) x impairment losses/ reversals x Reconciliation between opening
x profit or loss on disposal and closing balances
x Break-down of these balances
into
- gross carrying amount, &
- accumulated depreciation &
impairment losses
Chapter 7 413
Gripping GAAP Property, plant and equipment: the revaluation model
Chapter 8
Property, Plant and Equipment: The Revaluation Model
Reference: IAS 16, IAS 12, IFRS 16, IAS 40 and IFRS 13
(incl. any amendments to 1 December 2018)
Contents: Page
1. Introduction 416
1.1 Overview of the two models 416
1.2 Choosing between the two models 416
2. Recognition and measurement under the revaluation model 417
2.1 Overview 417
2.2 Recognition 417
2.3 Initial measurement 417
2.4 Subsequent measurement 417
2.4.1 Depreciation 417
2.4.2 Impairment testing 418
2.4.3 The choice of models 418
3. Subsequent measurement: revaluation model 418
3.1 Overview 418
3.2 How to account for increases or decreases in fair value 419
Example 1: Carrying amount increases: no prior revaluation recognised in P/L 419
Example 2: Carrying amount decreases: no balance in revaluation surplus 419
Example 3: Carrying amount decreases: there is a balance in the revaluation surplus 420
3.3 Characteristics of a revaluation surplus account 420
3.4 Transfer of the revaluation surplus to retained earnings 420
Worked example 1: Revaluation surplus and a sale of a revalued non-depreciable asset 421
Example 4: Transfer of revaluation surplus to retained earnings 422
3.5 Presentation of the revaluation surplus 423
3.6 Diagrammatic explanation of how the revaluation model works 423
3.7 Upward and downward revaluation involving a non-depreciable asset 425
Example 5: Revaluation model – a summary example (the asset is not depreciated) 425
3.8 Upward and downward revaluation involving a depreciable asset 426
Example 6: Revaluation model – a summary example (the asset is depreciated) 426
3.9 The two methods of accounting for a revaluation 429
3.9.1 Overview 429
3.9.2 Proportionate restatement method (gross replacement value method) 429
Example 7: Revaluation model – using the gross replacement value method 430
3.9.3 Elimination restatement method (net replacement value method) 431
Example 8: Revaluation model – using the net replacement value method 431
Example 9: Revaluation model – increase in value, creating a revaluation
surplus 432
Example 10: Revaluation model – decrease in value, reversing the
revaluation surplus and creating a revaluation expense 434
Example 11: Revaluation model – increase in value, reversing a previous
revaluation expense and creating a revaluation surplus 435
414 Chapter 8

3.10 The revaluation model and impairments 437
Worked example 2: Revaluation model and negligible disposal costs 437
Example 12: A low fair value does not necessarily mean an impairment loss 437
4. Deferred tax consequences 439
4.1 Overview 439
4.2 Deferred tax effects of the revaluation surplus 439
4.3 Deferred tax effects of the revaluation surplus and management intentions 440
4.3.1 Deferred tax and a revaluation that does not exceed cost 440
Example 13: Revaluation surplus and deferred tax: revaluation upwards 440
but not exceeding cost
4.3.2 Deferred tax and a revaluation that exceeds cost 441
4.3.2.1 Deferred tax: Revaluation above cost: intention to keep the asset 442
Example 14: Deferred tax: revaluation above cost: intend to keep – 442
short example
Example 15: Deferred tax: revaluation above cost: intend to keep – 443
full example
4.3.2.2 Deferred tax: Revaluation above cost: intention to sell the asset 446
Example 16: Deferred tax: Revaluation surplus above cost: intend to sell 446
Example 17: Revaluation above cost: deferred tax: intend to sell – 447
short example
Example 18: Revaluation above cost: deferred tax: intend to sell 448
Example 19: Revaluation above cost: Deferred tax: change in intention 451
4.3.3 Deferred tax on revalued assets: depreciable but non-deductible assets 451
Example 20: Revaluation above cost: deferred tax: intend to sell 452
Example 21: Revaluation above cost: deferred tax: intend to keep 453
4.3.4 Deferred tax on revalued assets: non-depreciable and non-deductible 453
Example 22: Revaluation of land above cost: deferred tax: intend to keep 454
5. Disclosure 456
5.1 Overview 456
5.2 Accounting policies and estimates 456
5.3 Statement of comprehensive income and related note disclosure 456
5.4 Statement of financial position and related note disclosure 457
5.5 Statement of changes in equity disclosure 457
5.6 Further encouraged disclosure 458
5.7 Sample disclosure involving property, plant and equipment 458
Example 23: Revaluation model disclosure 460
6. Summary 467
Chapter 8 415
1. Introduction
1.1 Overview of the two models Subsequent measurement

of PPE allows choice
between:
This chapter is a continuation of the previous chapter.
x Cost model:
Both chapters explain how to apply IAS 16 Property, - Cost
plant and equipment but IAS 16 allows entities to choose Less AD
between using the cost model and the revaluation model Less AIL
when subsequently measuring its property, plant and x Revaluation model:
- FV on date of revaluation
equipment. The previous chapter applied the cost model Less subsequent AD
whereas this chapter explains how to apply the Less subsequent AIL
revaluation model. The model chosen must be used for all
assets within a class of PPE (e.g. plant)
The cost model refers to the measurement of an asset’s carrying amount at:
x cost (often referred to as historic cost);
x less subsequent accumulated depreciation;
x less subsequent accumulated impairment losses. See IAS 16.30
The revaluation model refers to the measurement of an asset’s carrying amount at:
x fair value;
x less subsequent accumulated depreciation;
x less subsequent accumulated impairment losses. See IAS 16.31
The carrying amount under the cost model is often called ‘depreciated cost’ and the
carrying amount under the revaluation model is often called ‘depreciated fair value’.
1.2 Choosing between the two models
You can choose either model (cost or revaluation model) but must then apply that model to an entire
class of assets. This means, for example, that an entity may not use the cost model for a machine that
makes bread and the revaluation model for a machine that slices bread. All types of machines are
considered to be a single class of property, plant and equipment and thus machines will have to be
measured using the same model, for example, the cost model. Using the cost model for machines
would not, however, prevent the entity from measuring its vehicles using the revaluation model. This
is because vehicles are a different class of asset to machines. See IAS 16.29 & .37
The cost model is based on the asset’s original cost. The revaluation model requires
revaluation of the asset to its fair value. Both models still involve the principles of
depreciation and impairment testing.
The cost model is easier to apply in practice and research

suggests that it is currently the most commonly used model. Fair value is defined as
Fortunately for students, the difficulty in applying the the:
revaluation model is not due to any real complexity from an x Price that would be received to sell
academic point of view, but is merely a difficulty from a an asset (or paid to transfer a
practical point of view (i.e. revaluations must be performed liability)
regularly, and accounting and computer systems may need to x In an orderly transaction
be updated to enable the revaluation model to be used). Using x Between market participants
the revaluation model requires double the work, since we are x At the measurement date. IAS 16.6
still required to calculate and disclose the carrying amount of the asset had it been measured under
the cost model!
The choice of the model affects only one aspect of subsequent measurement. The principles
that apply to recognition, initial measurement and other aspects of subsequent measurement
(such as depreciation and impairment testing) are identical whether you are applying the cost
model
2. or revaluation model. These principles are revised in the next section, section 2.
416 Chapter 8
2. Recognition and Measurement under the Revaluation Model
2.1 Overview
The recognition and initial measurement principles that apply when using the cost model
(explained in the previous chapter) are exactly the same as those that apply when using the
revaluation model. The use of the revaluation model is a choice that may be applied in the
subsequent measurement of the asset. The following is a very brief overview of the
recognition and measurement principles applicable to property, plant and equipment.
2.2 Recognition (IAS 16.6 - .7)
An asset would be recognised as an item of property, plant and equipment only if it meets the:
x definition of property, plant and equipment; and
x the recognition criteria (reliable measurement and probable future economic benefits).
2.3 Initial measurement (IAS 16.15 - .22 and IAS 23.2 and .4)
Items of property, plant and equipment are always initially
measured at cost. If the asset is acquired via an asset The principles of the
exchange or by way of a government grant, the cost is revaluation model and the
cost model are the same
generally its fair value. In all other cases, cost would in terms of:
include the purchase price, directly attributable costs and x Recognition criteria
the initial estimate of certain future costs. x Initial measurement
x Subsequent measurement:
Examples of directly attributable costs are given in chapter 7.
- Depreciation
One of these examples is borrowing costs. If we incur
- Impairments
‘borrowing costs that are directly attributable to the
acquisition, construction or production’ of our asset, and assuming it meets the definition of a
‘qualifying asset’ (‘an asset that necessarily takes a substantial period of time to get ready for its
intended use or sale’), we are normally required to capitalise these costs. However, if the asset is
measured under the revaluation model, then capitalisation of these borrowing costs is not a
requirement but a choice (see chapter 14 and IAS 23 Borrowing costs). Calculating the amount of
borrowing costs to capitalise can become fairly complex and thus one may be forgiven for thinking
that this advantage to the revaluation model may be a good enough reason to choose to use the
revaluation model (and then choose not to capitalise the borrowing costs). However, the complexity
of calculating the amount of borrowing costs to capitalise cannot be avoided. This is because, if you
choose to use the revaluation model, you are required to disclose the carrying amount of the asset
had it been measured under the cost model. See IAS 23.4 and 8
If the purchase price is paid within normal credit terms, the price paid is called a ‘cash price
equivalent’ and used as the measurement of cost. However, if the payment is beyond normal credit
terms, we must determine this ‘cash price equivalent’. If this cash price is not available, then we will
need to estimate it based on the present value of the future payment/s. The difference between this
‘cash price equivalent’ (present value of the future payments) and the future payments is recognised
as an interest expense, unless it is capitalised in accordance with IAS 23 Borrowing costs.
2.4 Subsequent measurement
2.4.1 Depreciation (IAS 16.43 - .62A)
Items of property, plant and equipment must be depreciated to their residual values on a
systematic basis over their estimated useful lives. The only exception is land, which generally
has an unlimited useful life.
Each significant part of an item (i.e. where the cost of the part is significant in relation to the
total cost of that item) must be depreciated separately.
Depreciation begins when the asset is first available for use and ends when the asset is
derecognised or is classified as held for sale (in terms of IFRS 5), whichever date comes first.
Chapter 8 417
2.4.2 Impairment testing (IAS 36 and IAS 16.63 - .66)

At the end of every reporting period, assets must be assessed for possible impairments. If
there is an indication that an asset may be impaired, the asset’s recoverable amount must be
calculated. If the carrying amount exceeds the recoverable amount, the carrying amount must
be reduced. The reduction in the carrying amount is generally expensed, and termed an
impairment loss expense. However, if the revaluation model is used, part of the reduction may
need to be debited to the revaluation surplus instead (see section 3).
If compensation was received as a result of this impairment (e.g. insurance proceeds), this
compensation is considered to be a separate economic event and must be recognised as
income in profit or loss (it must not be set-off against the impairment loss expense).
2.4.3 The choice of models (IAS 16.29 - .42)
The entity may choose to measure its assets using either the cost model or the revaluation
model. However, the revaluation model may only be used if the fair value of an asset is
reliably measurable. The cost model was explained in the previous chapter. The rest of this
chapter is dedicated to explaining the revaluation model.
3. Subsequent Measurement: Revaluation Model (IAS 16.31 – .42)
3.1 Overview The CA under the

revaluation model is
The revaluation model involves the subsequent measurement measured as:
of the asset’s carrying amount to its fair value. It is important x FV on date of revaluation
to remember that, even when using the revaluation model, x Less subsequent AD
the initial measurement is always at cost. See IAS 16.15 x Less subsequent AIL. IAS 16.31
The revaluation model may only be used if the fair value can be measured reliably.
Revaluations to fair value do not have to occur every year and may be done periodically.
However, they must be performed regularly enough so that the carrying amount of the asset at
year-end does not differ materially from its fair value at that date. See IAS 16.31
If an entity wishes to use the revaluation model for a particular asset, it will have to apply this model
to all items within that class of assets – and all assets within that class will need to be revalued
simultaneously. For example, all land could be measured under the revaluation model and all
equipment could be measured under the cost model. See IAS 16.36 & .38
When using the revaluation model, the asset’s carrying amount is adjusted to whatever its fair value
is, whether this means the carrying amount needs to be decreased or increased. Please note that, if
using the revaluation model, the carrying amount can be increased above depreciated cost whereas,
if using the cost model, the carrying amount may never be increased above depreciated cost.
If we increase the asset’s carrying amount to a fair value that is in excess of its depreciated cost, this
excess will be recognised in revaluation surplus account and shown as an adjustment in other
comprehensive income (not in profit or loss). Thus, the revaluation surplus adjustment will appear in
the other comprehensive income section of the statement of comprehensive income. The revaluation
surplus account is an equity account and will thus also appear in the statement of changes in equity.
Ultimately, if we revalue our asset above depreciated cost, it means that an amount greater than cost
will eventually be expensed through profit or loss (e.g. if the asset is depreciable, then the depreciation
charge will be higher than it would otherwise have been; if the asset is non-depreciable, then the
carrying amount that is expensed on derecognition will be higher than it would otherwise have been).
Thus, if we revalue an asset above depreciated cost (thus creating a revaluation surplus), it will cause
an ‘artificial’ reduction in our profit over time (or an increase in a loss). Profit or loss is accumulated in
retained earnings. In order to offset the ‘artificial’ reduction in our retained earnings, we must
eventually transfer the revaluation surplus balance (equity account) to our retained earnings account
(another equity account). This transfer can be done gradually over the life of the asset, or as one single
adjustment when the asset is derecognised (when it is disposed of or when it is retired). See IAS 16.41
418 Chapter 8
3.2 How to account for increases or decreases in fair value If FV > CA See IAS 16.39
Where an asset is revalued to fair value, its carrying amount x Debit: Asset
either increases or decreases. x Credit:
- P/L: if it reverses a previous
revaluation expense in P/L
If the asset’s carrying amount increases as a result of a - OCI: with any excess
revaluation, the increase is:
x recognised in profit or loss as revaluation income if it reverses a previous revaluation decrease
that had been recognised in profit or loss:
debit carrying amount, and
credit revaluation income (P/L); and
x recognised in other comprehensive income as a revaluation surplus if it does not reverse a
previous revaluation decrease that had been recognised in profit or loss:
debit carrying amount, and
credit revaluation surplus (OCI). See IAS 16.39
In other words, if the asset’s carrying amount increases, the increase would first be recognised in
profit or loss (as a credit to revaluation income) to the extent that it reverses a previous decrease that
was recognised in profit or loss. Any increase that does not reverse a previous decrease recognised in
profit or loss is recognised in other comprehensive income (as a credit to revaluation surplus).
Example 1: Carrying amount increases: no prior revaluation recognised in P/L

Land with a carrying amount (cost) of C100 000 is revalued to a fair value of C120 000.
This asset had not previously been revalued.
Required: Show the journal entry to account for the revaluation. Ignore tax.
Solution 1: Carrying amount increases: no prior revaluation recognised in P/L

Debit Credit
Plant: cost (A) FV: 120 000 – CA: 100 000 20 000
Revaluation surplus (OCI) 20 000
Revaluation of land to fair value: carrying amount increased
If the asset’s carrying amount decreases as a result of a
revaluation, the decrease is: If FV < CA See IAS 16.40
x first recognised in other comprehensive income as a debit to x Credit: Asset
any revaluation surplus balance that may exist on this asset: x Debit:
credit carrying amount, and - OCI: if there is a RS balance
debit revaluation surplus; and then from a prior revaluation
- P/L: with any excess.
x after any revaluation surplus balance that may have existed is
reduced to nil, any further decrease is recognised in profit or loss as a revaluation expense:
credit carrying amount, and
debit revaluation expense. IAS 16.40
In other words, if the asset’s carrying amount is decreased, this decrease must first be debited
to the revaluation surplus account (if any) before being expensed as a revaluation expense.
Example 2: Carrying amount decreases:
x no balance in revaluation surplus
Land with a carrying amount (cost) of 100 000 is revalued to a fair value of C80 000. This
asset had not previously been revalued.
Required: Show the journal entry to account for the revaluation. Ignore tax.
Solution 2: Carrying amount decreases: no balance in revaluation surplus

Debit Credit
Revaluation expense (E) FV: 80 000 – CA: 100 000 20 000
Land: cost (A) 20 000
Revaluation of land to fair value: carrying amount decreased
Chapter 8 419
Example 3: Carrying amount decreases:

x there is a balance in the revaluation surplus
Land with a carrying amount (fair value) of C120 000 is revalued to a fair value of C70 000
on 1 January 20X2. The land had originally cost C100 000 and had been revalued on
1 January 20X1 to C120 000. Since this land is not depreciable, the balance on the
revaluation surplus from this previous revaluation was still C20 000 on 1 January 20X2.
Required: Show the journal entry to account for the revaluation on 1 January 20X2. Ignore tax.
Solution 3: Carrying amount decreases: there is a balance in the revaluation surplus

Revaluation surplus (OCI) The balance in the RS a/c: given 20 000
Revaluation expense (E) Balancing: 30 000
Total devaluation: 50 000 – debit to RS: 20 000
Land: cost (A) FV: 70 000 – CA: 120 000 50 000
Revaluation of land to fair value: carrying amount decreased
Comment: Since we reduced the carrying amount to C70 000, which is below its depreciated cost of C100 000 (being
historic cost in this case, since the land is not depreciable), the amount by which the carrying amount dropped below
historic cost (C30 000) is recognised as a revaluation expense and recognised in profit or loss.
A revaluation that decreases the carrying amount of an asset does not necessarily mean it is impaired.
x This is because when revaluing, we are restating the carrying amount to a fair value
whereas when an asset is impaired, we are restating it to a recoverable amount.
x It is possible for the recoverable amount (higher of fair value less costs of disposal and
value in use) to be greater than the fair value and thus for the asset to be restated
downwards to a lower fair value but yet not be impaired.
x Thus, we will use the term ‘revaluation expense’ for decreases in the carrying amount to
fair value that are expensed in profit or loss (as opposed to the term ‘impairment loss’
when decreasing the carrying amount down to the recoverable amount).
3.3 Characteristics of a revaluation surplus account
If the asset’s carrying amount is increased above its ‘historical carrying amount’, the increase is
reflected as a revaluation surplus account (i.e. debit carrying amount and credit revaluation surplus).
Historical carrying amount (HCA) is either the asset’s cost, if the asset is non-depreciable, or its
depreciated cost, if the asset is depreciable. This revaluation surplus adjustment is an income that is
presented within ‘other comprehensive income’ (OCI) and is accumulated in equity. See IAS 16.39
x IAS 1 Presentation of financial statements (see chapter 3) lists a number of items that are to be
presented as ‘other comprehensive income’ (i.e. not in profit or loss). A revaluation surplus is
one of these items (i.e. it is one of the components of other comprehensive income).
x The revaluation surplus balance is equity because when an asset’s carrying amount
increases as a result of a revaluation, there is no equal increase in liabilities, and thus the
increase results in an increase in equity (equity = assets – liabilities).
3.4 Transfer of the revaluation surplus to retained earnings (IAS 16.41)
If an asset’s carrying amount is increased above its historical carrying amount (cost or
depreciated cost, depending on whether it is a depreciable asset), the contra entry is a credit to
revaluation surplus. It does not make sense for this revaluation surplus to remain in the
accounting records indefinitely and thus the surplus must be removed from the accounting
records by the time that the revalued asset no longer exists.
The revaluation surplus is removed by transferring it to retained earnings. The transfer is
made directly to the retained earnings account (i.e. from one equity account to another equity
account, without being recognised in profit or loss):
Debit Credit
Revaluation surplus (OCI) xxx
Retained earnings (Eq) xxx
Transfer of the revaluation surplus to retained earnings
420 Chapter 8
This transfer makes sense if you consider the effect of the revaluation on profits.
Let us first consider a non-depreciable asset (e.g. land). If an asset that is not depreciated is revalued
upwards, thus creating a revaluation surplus, it will mean that, when that asset is finally derecognised
(through retirement or disposal), an amount larger than its original cost will get expensed.
Worked example 1: Revaluation surplus and a sale of a revalued non-depreciable asset (land)
Land with a cost of C100 000 is revalued to its fair value C150 000:
Debit Credit
Revaluation of land
A few years later, this land is then subsequently sold for C220 000:
x the land’s carrying amount, at FV of C150 000, will be expensed;
x we recognise the proceeds on sale, of C220 000;
x we thus recognise a profit on sale of C70 000.
Debit Credit
Asset disposal (Temporary account) 150 000
Bank 220 000
Profit on sale of land (I) 70 000
Sale of land
However, we know that the ‘real’ profit was actually C120 000 (Proceeds: 220 000 – Cost:
100 000). This means that our retained earnings balance at the end of the year will be
understated by C50 000. Thus, to counter this, we transfer the revaluation surplus balance to the
retained earnings account:
Debit Credit
Revaluation surplus (OCI: Equity) 50 000
Retained earnings (Equity) 50 000
Transfer of revaluation surplus to retained earnings on sale of land
The retained earnings balance will now include the ‘real’ profit of C120 000 (profit on sale: 70 000
+ transfer from revaluation surplus: 50 000).
Now consider an asset that is depreciable (e.g. plant). If a

depreciable asset’s carrying amount is increased, the The RS balance must be
depreciation will increase, thus ‘artificially’ reducing profits. transferred directly to
Obviously, if the asset is sold (or disposed of) before the RE. See IAS 16.41
asset is fully depreciated, the same principle that was This can be done:
explained above will also apply: the carrying amount at the x As the asset is used;
time of derecognition will still be ‘artificially high’ and so the x When the asset is retired; or
x When the asset is disposed of.
profit on sale will be ‘artificially low’. Either way, the
revaluation will cause a larger expense (depreciation or the carrying amount expensed on disposal),
and thus a lower profit or loss and a lower retained earnings balance. Thus, we must transfer the
revaluation surplus to retained earnings to counter this artificial decrease in profits.
This transfer of the revaluation surplus may be performed in one of three ways:
x as the asset is used (i.e. it will be transferred gradually over the useful life of the asset,
often referred to as an annual transfer to retained earnings); or
x when the asset is retired (i.e. it will be transferred as one lump sum); or
x when the asset is disposed of (i.e. it will be transferred as one lump sum). See IAS 16.41
If the asset is non-depreciable (e.g. land), it means the asset does not get used up (i.e. it does
not have a useful life) and thus we will only able to reverse the revaluation surplus balance
when the asset is derecognised: when it is retired or disposed of.
If, in the case of a depreciable asset (e.g. plant), the entity chooses to transfer the revaluation
surplus to retained earnings over the life of the asset (i.e. gradually instead of as a lump sum),
the surplus will decrease at the same rate as the asset’s carrying amount.
Chapter 8 421
This means that, if the asset’s fair value subsequently decreases (i.e. if the asset is devalued) and this
fair value is below its historical carrying amount (cost or depreciated cost, depending on whether
the asset is depreciable or not), the decrease in the asset’s carrying amount:
x down to the historical carrying amount, will be debited against the revaluation surplus
(credit asset and debit revaluation surplus); and If the RS is transferred
x below the historical carrying amount, will be to RE over the asset’s
expensed as a revaluation expense (credit asset and useful life, the amount
transferred each year will be
debit revaluation expense).
the difference between the:
However, please note that, if the revaluation surplus is only x depreciation expense based on the
asset’s fair value; and
transferred to retained earnings when the asset is retired or x depreciation based on the asset’s
disposed of, then the revaluation surplus balance will still historic cost.
reflect the full original amount of the revaluation surplus on
the date of the previous upward-revaluation. This means that, in the case of a depreciable asset, the
portion of the revaluation decrease below historical carrying amount (which, in this case would be
depreciated cost) would not all be debited to profit or loss – some of this would first need to be
debited to the revaluation surplus, to be sure that the revaluation surplus is first reduced to zero.
For the purposes of this text, we will assume that the revaluation surplus is transferred to retained
earnings over the life of the underlying asset unless otherwise indicated. However, the following
example shows you how to transfer the revaluation surplus using each of the above three methods.
Example 4: Transfer of revaluation surplus to retained earnings
An asset with a cost of C100 (1/1/20X1) is revalued to fair value of C120 (1/1/20X2).
x It is depreciated straight-line to a nil residual value over a 4-year useful life.
x It is retired from use at the end of its useful life and is sold on 18/9/20X5.
Required: Ignoring the tax effect, show the journals reducing the revaluation surplus to zero assuming:
A the transfer is done over the life of the asset;
B the transfer is done on retirement of the asset; and
C the transfer is done when the asset is disposed of.
Solution 4: Transfer of revaluation surplus to retained earnings

A B C
31 December 20X2 Dr/ Cr Dr/ Cr Dr/ Cr
Revaluation surplus (OCI) A: Calculation 1 15
Retained earnings (Eq) (15)
Transfer of revaluation surplus to retained earnings
31 December 20X3
Retained earnings (Eq) (15)
31 December 20X4
Revaluation surplus (OCI) A: Calculation 3 15 45
Retained earnings (Eq) B: Balance in RS on date of retirement (15) (45)
18 September 20X5
Retained earnings (Eq) C: Balance in RS on date of disposal (45)
(1) Tfr at 31 Dec 20X2: RS balance: 45 / 3 remaining years; Or Revalued depr: (C120 / 3yrs) – historic depr: C25 = 15
(2) Tfr at 31 Dec 20X3: RS bal: (45 – 15) / 2 remaining years; Or Reval depr: (C120 / 3 yrs) – historic depr: C25 = 15
(3) Tfr at 31 Dec 20X4: RS bal: (45 – 15 - 15) / 1 remaining year; Or Reval depr: (C120 / 3 yrs) – historic depr: C25 = 15
Workings C
Cost: 1/1/X1 Given 100
Acc. depreciation: 31/12/X1 (C100 – 0)/ 4yrs x 1yr (25)
Carrying amount: 31/12/X1 31/12/20X1 75
Revaluation surplus Balancing: FV 120 – CA 75 45
Revalued carrying amount Fair value was given 120
422 Chapter 8
3.5 Presentation of the revaluation surplus (IAS 16.39 & .41, IAS 1.82A & .106)
A revaluation surplus is a component of ‘other comprehensive income’ and is ‘accumulated in
equity’. This means that:
x because a revaluation surplus is ‘other comprehensive income’, an increase or decrease in
the revaluation surplus would be presented in the ‘other comprehensive income’ section
of the statement of comprehensive income; and
x because other comprehensive income is accumulated
in ‘equity’, the revaluation surplus balance is also Reclassification
presented in the statement of changes in equity. adjustments are defined as:
x amounts reclassified to P/L in the
IAS 1 requires that other comprehensive income be current period
presented in the statement of comprehensive income and x that were recognised in OCI in the
that the movement in each component of other current or previous periods. IAS 1.71
comprehensive income be separated into components:
x that may be reclassified to profit or loss (i.e. when
certain conditions are met); and Presentation of the RS:
x that may never be reclassified to profit or loss.
x SOCI:
IAS 16 states that the revaluation surplus may only be - in the OCI section;
transferred directly to retained earnings. This means that - under the heading: ‘items that may
the transfer to retained earnings may not be processed never be reclassified to P/L’
through profit or loss. Thus, movements in the revaluation x SOCIE: in its own column.
surplus are presented in the ‘other comprehensive income section’ of the statement of
comprehensive income under the heading:
x items that may never be reclassified to profit or loss.
3.6 Diagrammatic explanation of how the revaluation model works
Now that you have an overview of all main aspects of the revaluation model (except for the
deferred tax consequences and disclosure), you may find it useful to use the following
diagrams and graphs to visualise the overall ‘bigger picture’.
These diagrams and graphs assume that the entity has chosen to transfer the revaluation
surplus to retained earnings over the life of the asset, in which case the revaluation surplus
would reduce at the same rate as the asset’s carrying amount.
The diagrams use a variety of acronyms:
x HCA: this stands for historical carrying amount. It reflects cost, if the asset is non-
depreciable, or depreciated cost if the asset is depreciable. In other words, it reflects what
the carrying amount would be if it was measured at original cost less accumulated
depreciation (if any) (i.e. the carrying amount assuming no revaluations were processed).
x ACA: this stands for actual carrying amount. This represents what the carrying amount
actually is at a point in time. If had been revalued, then the actual carrying amount would
reflect the fair value at the date of the remeasurement less the subsequent accumulated
depreciation (& impairment losses if applicable) since this remeasurement date. We will
ignore impairment losses for the purposes of understanding the revaluation model.
Diagram 1: Revaluation model summarised (assuming any revaluation surplus is transferred to retained earnings
over the life of the asset)
FV greater than HCA
Recognised in OCI
HCA
Recognised in P/L
FV less than HCA
HCA: historical carrying amount OCI: Other comprehensive income P/L: profit or loss
Please remember: This diagram assumes that the entity has chosen to transfer the revaluation surplus to retained
earnings over the life of the asset.
Chapter 8 423
Diagram 2: Example adjustments using the revaluation model – 3 scenarios

This diagram shows a series of possible situations.
Scenario 1 Scenario 2 Scenario 3

FV ACA
Revaluation
Revaluation surplus
surplus (OCI)
(OCI)
(created/
(reversed/ decreased)
HCA/ increased)
HCA HCA
ACA
Reval expense Reval income
(P/L) (P/L) Reval expense (P/L)
FV ACA FV
HCA: historical carrying amount (depreciated cost, or cost if non-depreciable) OCI: other comprehensive income
ACA: actual carrying amount (which may differ from the HCA) P/L: profit or loss
FV: fair value
Remember: This diagram assumes the revaluation surplus is transferred to retained earnings over the asset’s useful life.
Scenario 1: the FV is less than the ACA (which was still the same as the HCA)
Scenario 2: the FV is greater than the ACA (but ACA was less than the HCA due to a prior decrease in value)
Scenario 3: the FV is less than the ACA and also less than the HCA (the ACA was greater than the HCA due to
a prior increase in value)
Graph approach: Using a graph for the revaluation model

You may find it easier to draw a graph of the situation, plotting the depreciated cost line (HCA):

Cost
0 Useful Life
Notice how the line is a diagonal line reflecting the gradual reduction in the historical carrying amount (depreciated cost) as the
asset is depreciated over its useful life (this would be a horizontal line if the asset is non-depreciable).
Note: This diagram assumes the revaluation surplus is transferred to retained earnings over the asset’s useful life.
For a revaluation to fair value, you would then plot your asset’s actual carrying amount (ACA) and fair value (FV)
onto this graph. Then look at your graph carefully:
x If you are increasing the asset’s actual carrying amount to its fair value, the increase will be accounted for as follows:
- Any increase up to HCA: the previous revaluation expense that was recognised in profit or loss, is now
reversed by recognising this adjustment in profit or loss as a revaluation income; after which
- Any increase above HCA: is recognised in other comprehensive income as a revaluation surplus.
x If you are decreasing the asset’s actual carrying amount to its fair value, the decrease in value would be
accounted for as follows:
- any decrease down to HCA: the previous increase that was recognised in other comprehensive income as a
credit to revaluation surplus is now reversed (or perhaps only partially reversed), where this reversal is also
recognised in other comprehensive income but as a debit to the revaluation surplus; after which
- any decrease below HCA: is recognised in profit or loss as a revaluation expense (in other words: any
balance in the revaluation surplus account (from a previous increase in value) is first reduced to zero, after
which any further decrease is then recognised as an expense in profit or loss).
424 Chapter 8
The prior examples, graphs and diagrams show how to account for a revaluation by simply
debiting or crediting the asset’s carrying amount. However, we need to know exactly how
much to debit and credit to the separate accounts that make up this carrying amount (i.e. the
cost and accumulated depreciation accounts). This is best explained by first doing examples
involving non-depreciable assets and then doing examples involving depreciable assets.
3.7 Upward and downward revaluation involving a non-depreciable asset
To start with, we will look at an example that involves land, since land is an asset that is
generally not depreciated. This will allow us to see the essence of the revaluation model.
From there we will progress to an example that involves a depreciable asset.
Example 5: Revaluation model – a summary example (the asset is not depreciated)

Cost of land at 1/1/20X1: 100 000
Depreciation: This piece of land is not depreciated

Fair value
x 1/1/20X2 120 000
x 1/1/20X3 90 000
x 1/1/20X4 70 000
x 1/1/20X5 110 000
The company’s policy is to leave any balance on the revaluation surplus intact until such time as the
asset is disposed of. The year end is 31 December.
Required: Show the ledger accounts and statement of financial position for 20X1 to 20X5.
Solution 5: Revaluation model - a summary example (asset is not depreciated)

Ledger accounts:
Land: cost (asset) Revaluation surplus
1/1/ 20X1: 1/1/20X2:
Bank (1) 100 000 Bal c/f 100 000 Bal c/f 20 000 Cost (2) 20 000
100 000 100 000 20 000 20 000
31/12/20X1: 1/1/20X3: 31/12/20X2:
Balance b/f 100 000 Cost (3) 20 000 Balance b/f 20 000
20 000 20 000
1/1/20X2: 31/12/20X3/4:
R/ Surp (2) 20 000 Bal c/f 120 000 Balance b/f 0
120 000 120 000
31/12/20X2: 1/1/20X3 1/1/20X5:
Balance b/f 120 000 R/ Surp (3) 20 000 Cost (7) 10 000
Rev Exp (4) 10 000 10 000 10 000
Bal c/f 90 000 31/12/20X5:
120 000 120 000 Balance b/f 10 000
31/12/20X3: 1/1/20X4:
Balance b/f 90 000 RevExp (5) 20 000
Bal c/f 70 000
90 000 90 000 Bank
31/12/20X4: 1/1/ 20X1:
Balance b/f 70 000 Land (1) 100 000
1/1/20X5:
Rev Inc (6) 30 000
Rev Surp (7) 10 000 Bal c/f 110 000
110 000 110 000
31/12/20X5:
Balance b/f 110 000
Chapter 8 425
Solution 5: Continued ...

Ledger accounts: continued ...
Revaluation expense Revaluation income
1/1/20X3: 31/12/20X3 31/12/20X5 1/1/20X5
Cost (4) 10 000 P/L 10 000 P/L 30 000 Cost (6) 30 000
1/1/20X4 31/12/20X4
Cost (5) 20 000 P/L 20 000
Disclosure:
Company name
20X5 20X4 20X3 20X2 20X1
ASSETS C C C C C
Non-current Assets
Land 110 000 70 000 90 000 120 000 100 000
EQUITY AND LIABILITIES
Equity
Revaluation surplus 10 000 0 0 20 000 0
Workings:
W1. Carrying amount and adjustments Jnl 20X2 20X3 20X4 20X5
Opening balance *:Jnl 1: purchase in 20X1 1* 100 000 120 000 90 000 70 000
Depreciation Land not depreciated (0) (0) (0) (0)
Fair value adjustments:
Above HCA Cr: revaluation surplus 2; 7 20 000 10 000
Down to HCA Dr: revaluation surplus 3 (20 000)
Below HCA Dr: revaluation expense 4; 5 (10 000) (20 000)
Up to HCA Cr: revaluation income 6 30 000
Closing balance fair value 120 000 90 000 70 000 110 000
Historical carrying amount: (cost) 100 000 100 000 100 000 100 000
Comments:
x Note that the decrease in CA in 20X3 is accounted for by first debiting RS to the extent that there was a
balance in RS (C20 000) and any further decrease was then debited to the expense (C10 000).
x Note that the increase in CA in 20X5 is accounted for by first crediting the revaluation income to the
extent that it reversed a previous revaluation expense (C30 000), thus first bringing the CA up to HCA.
Thereafter, the increase in CA was credited to RS (C10 000).
3.8 Upward and downward revaluation involving a depreciable asset

Now let us do an example that involves a depreciable asset. To keep things simple, we will
start by combining the cost and accumulated depreciation accounts into one account that
reflects carrying amount. It is not difficult to separate the entries between these two accounts,
but is important to see the big picture before getting bogged down with that detail.
Example 6: Revaluation model – a summary example (the asset is depreciated)
The following information relates to a machine:
x Cost of machine at 1/1/20X1: 100 000

x Depreciation: Straight-line over 10 years to a nil residual value
x Fair values as estimated on: 1/1/20X2: 1/1/20X3: 1/1/20X4: 1/1/20X5:
180 000 60 000 77 000 120 000
The company’s policy is to transfer the realised portion of the revaluation surplus to retained earnings as
the asset is used. The year end is 31 December.
Required:
Show the statement of financial position and ledger accounts for 20X2 to 20X5. Use a carrying amount
account (i.e. do not prepare separate cost and accumulated depreciation accounts). Ignore tax.
426 Chapter 8
Solution 6: Revaluation model - a summary example (asset is depreciated)
Ledger accounts:
Machine: carrying amount (A) Revaluation surplus (Eq)

1/1/ 20X2: 31/12/20X2 31/12/20X2: 1/1/20X2:
Balance b/f 90 000 Depr (2) 20 000 Ret Earn 10 000 CA (1) 90 000
Rev Surp (1) 90 000 (90 000/ 9)
180 000 180 000 90 000 90 000
31/12/ 20X2: 31/12/20X2:
Balance b/f 160 000 Balance b/f 80 000
1/1/20X3: 1/1/20X3:
Rev Surp (3) 80 000 CA (3) 80 000
Rev Exp (4) 20 000 Balance c/f 0
80 000 80 000
31/12/20X3 31/12/20X3
Depr (5) 7 500 Balance b/f 0
Balance c/f 52 500 31/12/20X4: 1/1/20X4
Ret Earn 1 000 CA (7) 7 000
(7 000/ 7)
Balance c/f 6 000
160 000 160 000 7 000 7 000
31/12/ 20X3: 31/12/20X4
1/1/20X4 31/12/20X4 31/12/20X5: 1/1/20X5
Rev Inc (6) 17 500 Depr (8) 11 000 Ret Earn 10 000 CA (9) 54 000
Rev Surp (7) 7 000 (60 000/ 6)
77 000 77 000 60 000 60 000
31/12/ 20X4: 31/12/20X5:
1/1/20X5 31/12/20X5
Rev Surp (9) 54 000 Depr (10) 20 000
Balance c/f 100 000
120 000 120 000
31/12/ 20X5:
Balance b/f 100 000
Depreciation expense (E: P/L) Retained earnings (Eq)

31/12/20X2 31/12/20X2 31/12/20X2
CA (2) 20 000 P/L 20 000 Rev Surp 10 000
31/12/20X3 31/12/20X3 31/12/20X4:
CA (5) 7 500 P/L 7 500 Rev Surp 1 000
31/12/20X4 31/12/20X4 31/12/20X5:
CA (8) 11 000 P/L 11 000 Rev Surp 10 000
31/12/20X5 31/12/20X5
CA (10) 20 000 P/L 20 000
Revaluation expense (E: P/L) Revaluation income (I: P/L)

1/1/20X3: 31/12/20X3 31/12/20X4 1/1/20X4
CA (4) 20 000 P&L 20 000 P/L 17 500 CA (6) 17 500
Chapter 8 427
Disclosure:
Company name
ASSETS 20X5 20X4 20X3 20X2
Non-current assets C C C C
Machine C/ balance per ledger 100 000 66 000 52 500 160 000
Equity
Revaluation surplus C/ balance per ledger 50 000 6 000 0 80 000
Interesting points to note:

x The revaluation surplus balance in this statement of financial position is the difference between the year-
end actual carrying amounts and the carrying amounts had the asset not been revalued:
20X5 20X4 20X3 20X2
C C C C
Carrying amount of asset is: c/ balance per ledger 100 000 66 000 52 500 160 000
(a)
Historical carrying amount: cost – depreciation 50 000 60 000 70 000 80 000
Revaluation surplus c/ balance per ledger 50 000 6 000 0 80 000
a) 100 000 – (100 000 x 10% x 2 years) = 80 000
x Another interesting point is that the annual transfer from revaluation surplus to retained earnings reflects
the effect that the revaluation has had on income in each of the years to date:
Cumulative
Effect on statement of comprehensive income between 20X2 and 20X5
C
Actual effect of using the revaluation model on profit:
Depreciation expense: 20X1-20X5 10 000 (20X1 depr) +20 000 +7 500 +11 000 +20 000 68 500
Revaluation expense (20X3) 20 000
Revaluation income (20X4) (17 500)
Net effect on profit (between 20X1 and 20X5) 71 000
Effect on profit had the cost model been used instead:
Depreciation expense: 20X1-20X5 100 000 x 10% x 5 years (50 000)
Transfer: RS to RE See ledger: 10 000 + 1 000 + 10 000 21 000
Workings:
W1: Carrying amount and adjustments Jnl 20X2 20X3 20X4 20X5
Opening balance 20X2: 100 000 / 10 x 9 yr 90 000 160 000 52 500 66 000
Adjustment:
Above HCA Cr: revaluation surplus 1;7; 9 90 000 7 000 54 000
Down to HCA Dr: revaluation surplus 3 (80 000)
Below HCA Dr: revaluation expense 4 (20 000)
Up to HCA Cr: revaluation income 6 17 500
Fair value 180 000 60 000 77 000 120 000
Depreciation: See calcuations below 2;5;8;10 (20 000) (7 500) (11 000) (20 000)
Closing balance 160 000 52 500 66 000 100 000
HCA (depreciated cost) on date of revaluation 90 000 80 000 70 000 60 000
Depreciation calculations:
X2: 180 000/ 9 yrs X3: 60 000 / 8 yrs X4: 77 000 / 7 yrs X5: 120 000 / 6 yrs
428 Chapter 8
This previous example showed how to account for a revaluation but did not specify the
adjustments that would need to be made to the cost account and accumulated depreciation
account. Instead, these examples made use of a ‘carrying amount’ account. The adjustments
that would be made to the cost and accumulated depreciation accounts depend on which of
the following two methods are used (explained in section 3.9 below):
x the gross replacement value method (or proportional restatement method); or
x the net replacement value method (or net method).
3.9 The two methods of accounting for a revaluation (IAS 16.35)
3.9.1 Overview
As mentioned in the cost model chapter, whether the cost model or the revaluation model is
used, the asset’s carrying amount is represented by the following accounts:
x cost account (disclosed as gross carrying amount: GCA); and
x accumulated depreciation and impairment loss account.
Under the cost model, adjustments to the carrying amount only occur in the accumulated
depreciation and impairment loss accounts. In other words, under the cost model, the cost
account continues to reflect the asset’s cost.
Under the revaluation model, however, if the revaluation involves a depreciable asset,
adjustments to the carrying amount could be made to the cost account and/or to the
accumulated depreciation account. Since adjustments are sometimes made to the cost account,
the cost account would no longer reflect its cost, and thus this account is referred to as ‘gross
carrying amount’ in the financial statements.
When making adjustments to an asset’s carrying amount Two methods to journalise

under the revaluation model, the entity may choose to the effect on the CA:
account for the adjustment using:
x Proportionate restatement method
x the proportionate restatement method (or gross (gross method or gross replacement
replacement value method); or value method)
x the elimination restatement method (or net x Elimination restatement method (net
replacement value method). method or net replacement value
method)
Irrespective of the model used (gross or net method), the carrying amount of the asset would
be the same after processing the revaluation. Immediately after the revaluation, the carrying
amount will reflect its fair value (net replacement value).
However, the balances in the separate accounts that constitute carrying amount will differ
depending on whether the gross or net method was used. Since the balances on these separate
accounts will need to be separately disclosed in the notes, we must know how to process the
journal entries using each of these methods.
3.9.2 Proportionate restatement method (gross replacement value method) (IAS 16.35(a))
The proportionate restatement method is often referred to as the gross replacement value
method (or simply, the gross method). Re-measuring the carrying amount to the fair value on
date of revaluation (i.e. sometimes referred to as the ‘net replacement value’) using this
method requires that we:
x proportionately restate the cost account, and
x proportionately restate the accumulated depreciation account.
Proportionately restating the cost account means adjusting the balance in the cost account to
reflect the gross replacement value. The gross replacement value is the re-estimated original
economic benefits that were embodied in the asset on date of purchase. In other words, the
gross replacement value reflects the estimated fair value on date of purchase (or, simply, the
amount that the valuer thinks you should have paid for the asset on date of purchase).
Chapter 8 429
Proportionately restating the accumulated depreciation

account requires adjusting its balance to reflect how Proportionate restatement:
much of the asset’s re-estimated original economic
benefits would have been earned by now (or, in very x Proportionately restate (adjust):
basic terms, what the accumulated depreciation would - Cost account; and
have been had you bought the asset at the gross - AD account
replacement value instead of at its actual cost). x So that net effect is CA = FV
Thus, when using the proportionate restatement method (i.e. the gross method), the carrying
amount immediately after the revaluation will reflect the fair value on the date of revaluation
(often called the net replacement value), but the cost account will reflect the fair value on
date of original purchase (often called the gross replacement value).
Example 7: Revaluation model – using the gross replacement value method

Plant cost at 1/1/20X1: C100 000 (cash)
Depreciation: straight-line over 5 years to a nil residual value
Fair value at 1/1/20X3 C90 000
Required:
A Calculate the gross replacement value.
B Show all journals for the years ended 31 December 20X1 - 20X3 using the gross replacement value
method. Ignore tax and the transfer from the revaluation surplus.
Solution 7A: Calculation of the gross replacement value

The gross replacement value = (90 000 / 3 remaining years x 5 total years) = C150 000.
Comment:
Since, by definition, an asset represents potential economic benefits, the asset’s carrying amount should
reflect the future economic benefits that are expected from the asset over its remaining useful life.
x This means that a fair value that is estimated as at, for example, 1 January 20X3, is an estimation of the
future economic benefits that are still remaining in this asset calculated as at this date.
x The fair value of C90 000 was determined as at 1 January 20X3, 2 years after it was first available for
use, leaving a remaining life of 3 years. This means that the valuer is expecting future benefits of
C90 000 to be earned over the remaining useful life of 3 years, or C30 000 per year (90 000 / 3 years).
Using this same estimation of C30 000 per year, the total future benefits on the date the asset was
originally purchased (i.e. the fair value as at 1 January 20X1) would have been estimated to be
C150 000 (30 000 pa x 5 total years).
x The valuer is effectively saying the asset was actually worth C150 000 on 1 January 20X1 (i.e. not the
C100 000 that we actually paid) and the accumulated depreciation on 1 January 20X3 should thus have
been C60 000 [(150 000 – 0)/ 5yrs x 2 yrs = 60 000].
x The following working is not necessary in answering the question, but may help you understand it better:
Plant accounts at 1/1/X3 Using cost Using FV Reval. surplus

Cost 100 000 5 years in total 150 000 90 000 / 3 x 5 yrs (GRV)
Acc depr 100K / 5 x 2 (40 000) 2 years used (60 000) 90 000 / 3 x 2 yrs
Carrying amount: 1/1/X3 60 000 3 years left 90 000 Fair value (NRV) 30 000
Solution 7B: Journals using gross replacement value method

20X1 Journals Debit Credit
1/1/20X1
Plant: cost (A) Given 100 000
Bank (A) 100 000
Purchase of asset
31/12/20X1
Depreciation: plant (E) 100 000 / 5 years 20 000
Plant: acc depreciation (-A) 20 000
Depreciation of asset
\
430 Chapter 8
Solution 7B: Continued ...

31/12/20X2
Depreciation: plant (E) 100 000 / 5 remaining years 20 000
20X3 Journals
1/1/20X3
Plant: cost (A) GRV: 150 000 (Part A) – Cost: 100 000 50 000
Plant: acc depreciation (-A) (150 000 – 0) / 5 x 2 yrs – (20 000 + 20 000) 20 000
Revaluation surplus (OCI) FV: 90 000 – CA: 60 000 or balancing 30 000
Revaluation of plant (GRVM): the cost acc now shows GRV of 150 000
31/12/20X3
Depreciation: plant (E) FV/ NRV: 90 000 / 3 remaining years 30 000
3.9.3 Elimination restatement method (net replacement value method) (IAS 16.35(b))
The elimination restatement method is often called the net replacement value method (or just
the net method).
This method involves processing a journal immediately prior to re-measuring the asset’s
carrying amount to its fair value. This journal removes the balance that was in the
accumulated depreciation account and sets it off against the cost account (i.e. debit
accumulated depreciation and credit cost). In other words, the net method means that before
we revalue the asset, we must first eliminate the balance in the accumulated depreciation
account, with the result that the cost account then reflects the carrying amount of the asset
immediately prior to the revaluation.
Elimination
The next journal would be to adjust this cost account
restatement:
(which currently reflects the carrying amount prior to the
revaluation) so that it reflects the asset’s latest fair value x First set off:
- AD account against
(otherwise known as the net replacement value). - Cost account
- so that the cost account
Thus, when using the elimination restatement method (i.e. shows CA before revaluation
the net method), immediately after the revaluation, the x Adjust this cost account (showing
accumulated depreciation account will have a nil balance CA) so that the cost account = FV
and the cost account will reflect the asset’s latest fair value (i.e. the net replacement value).
Example 8: revaluation model – using the net replacement value method
Plant cost at 1/1/20X1: C100 000 (cash)
Fair value at 1/1/20X3: C90 000
Required:
A Calculate the net replacement value.
B Provide the journals for the years ended 31 December 20X1 - 20X3.
Ignore tax and the transfer from the revaluation surplus.
Solution 8A: Calculation of net replacement value
The net replacement value on 1/1/20X3 = the fair value on 1/1/20X3 = C90 000
Comment: The net method means:
x netting (eliminating) the accumulated depreciation account against the cost account (debit acc
depreciation and credit cost); and then restating the balance in the cost account to the fair value: the cost
account then shows the fair value and the accumulated depreciation shows nil.
x The working on the next page is not necessary, but may help you understand the solution.
Chapter 8 431
Solution 8A: Continued ...

Workings:
Plant accounts at 1/1/X3 Using cost Using FV Reval. surplus
Cost 100 000 5 years in total 90 000 Given
Acc deprec 100K / 5 x 2 (40 000) 2 years used (0)
Carrying amount: 1/1/X3 60 000 3 years remaining 90 000 Given 30 000
Solution 8B: Journals using the net replacement value method

1/1/20X1
Bank (A) 100 000
Purchase of asset
31/12/20X1
Depreciation: plant (E) 100 000 / 5 years 20 000
20X2 Journals
31/12/20X2
Depreciation: plant (E) 100 000 / 5 years; OR 20 000
Plant: acc depreciation (-A) CA: 80 000 / 4 remaining years 20 000
20X3 Journals
1/1/20X3
Plant: acc depreciation (-A) 20 000 + 20 000 40 000
Netting off of acc depr immediately before revaluation
Revaluation surplus (OCI) FV: 90 000 - CA: 60 000 30 000
Revaluation of asset (the cost account now shows the FV of 90 000)
31/12/20X3
Depreciation: plant (E) 90 000 / 3 remaining years 30 000
Compare the previous example (example 7) and this example (example 8). Notice that all accounts are the same
as at 31 December 20X3 except for the cost and accumulated depreciation accounts:
GRVM (Ex 7) NRVM (Ex 8) Difference
Carrying amount at 31/12/X3 60 000 60 000 0
- Cost account 150 000 90 000 60 000
- Accumulated depreciation account (90 000) (30 000) (60 000)
Revaluation surplus at 31/12/X3 30 000 30 000 0
Depreciation in 20X3 30 000 30 000 0
The following examples continue to compare the gross and net method, but also show the
transfer of revaluation surplus to retained earnings. These ignore the effects of deferred tax
(the deferred tax effects of revaluations are not difficult but are covered later in the chapter).
Example 9: Revaluation model: increase in value, creating a revaluation surplus

Plant purchased on 1/1/20X1 at a cost of: C100 000
Fair value at 1/1/20X2: C90 000
The revaluation surplus is transferred to retained earnings over the life of the asset.
Required: Show the journals for the years ended 31 December 20X1 and 20X2 using the:
A net replacement value method (NRVM)
B gross replacement value method (GRVM)
432 Chapter 8
Solution 9: Revaluation model – increase creating a revaluation surplus

Journals Ex 9A Ex 9B
NRVM GRVM
1/1/20X1 Dr/ (Cr) Dr/ (Cr)
Plant: cost (A) 100 000 100 000
Bank/ Liability (100 000) (100 000)
Purchase of asset: (1/1/20X1)
31/12/20X1
Depreciation: plant (E) 100 000 / 5 years remaining 20 000 20 000
1/1/20X2: revaluation (increase)
Plant: accumulated depreciation (-A) 20 000 N/A
Plant: cost (A) (20 000) N/A
NRVM: set-off of acc. depreciation before revaluing asset
Plant: cost (A) W2 or 90 000 FV – 80 000 CA 10 000 N/A
Revaluation surplus (OCI) (10 000) N/A
NRVM: Revaluation journal – cost account now reflects fair value
Plant: cost (A) 112 500 (W3) - 100 000 N/A 12 500
Plant: accumulated depreciation (-A) 22 500 (W3) - 20 000 N/A (2 500)
Revaluation surplus (OCI) 90 000 - 80 000; or Balancing N/A (10 000)
GRVM: revaluation of asset: (1/1/20X2)
31/12/20X2: depreciation and transfer of revaluation surplus
Depreciation: plant (E) 90 000 / 4 years remaining 22 500 22 500
Depreciation: new CA over remaining useful life
Revaluation surplus (OCI) 10 000 / 4 years remaining; Or 2 500 2 500
Retained earnings (Eq) Revalued depr: 22 500 – (2 500) (2 500)
Historic depr: 20 000
Transfer of revaluation surplus to retained earnings: over life of asset
(the extra depreciation for 20X2 due to the revaluation above HCA)
Workings: applicable to both (A) and (B)

C
W1: Actual (and historic) carrying amount 1/1/20X2:
Cost: 1/1/20X1 Given 100 000
Accumulated depreciation: 31/1/20X1 100 000 x 20% x 1 yr (20 000)
80 000
W2: Revaluation required at 1/1/20X2:
Fair value Given 90 000
Actual carrying amount W1 (80 000)
10 000
Graph depicting both (A) and (B): 1/1/20X2
90 000 (FV)
10 000 (Credit revaluation surplus)
80 000 (HCA & ACA)
Cost
0 Useful Life
Chapter 8 433

W3: For GRVM only: C
Gross replacement value (GRV): 1/1/20X1 90 000 / 4 years remaining x 5 total years 112 500
Accum. depreciation on GRV: 31/12/20X1 112 500 / 5 total years x 1 year to date (22 500)
Fair value: 1/1/20X2 Given 90 000
Example 10: Revaluation model - decrease in value, reversing the revaluation

surplus and creating a revaluation expense:
Use the same information as that in the last example with the following extra information:
x Fair value at 1/1/20X3: C54 000
Required: Show the journals for the year ended 31 December 20X3 using the:
A net replacement value method (NRVM)
B gross replacement value method (GRVM)
Solution 10: Journals

C
W1: NRVM (A) & GRVM (B): Historical carrying amount at 1/1/20X3:
Cost: 1/1/20X1 Given 100 000
Accumulated depreciation: 31/1/20X2 100 000 x 20% x 2 yr (40 000)
60 000
W2: NRVM (A) & GRVM (B): Actual carrying amount at 1/1/20X3:
Carrying amount at 1/1/20X2 after revaluation to FV 90 000
Depreciation in 20X2 (90 000/ 4yrs) or (112 500/ 5 yrs) (22 500)
67 500
W3: NRVM (A) & GRVM (B): Devaluation required at 1/1/20X3:
Fair value 54 000
Actual carrying amount (67 500)
(13 500)
- reverse revaluation surplus (down to HCA: ACA 67 500 – HCA 60 000) 7 500
- revaluation expense (below HCA: HCA 60 000 – NRV 54 000) 6 000
Graph relevant to both NRVM (A) and GRVM (B): 1/1/20X3:
67 500 (ACA)
7 500 (Debit revaluation surplus)
60 000 (HCA)
Cost
6 000 (Debit revaluation expense)
54 000(FV) Historical carrying amount line
0 Useful Life

Gross replacement value (GRV): 1/1/20X1 54 000 / 3 years remaining x 5 total years 90 000
Accum. depreciation on GRV: 31/12/20X2 90 000 / 5 total years x 2 years to date (36 000)
434 Chapter 8

Ex 10A Ex 10B
Journals: 20X3:
NRVM GRVM
1/1/20X3: revaluation (decrease) Dr/ (Cr) Dr/ (Cr)
Plant: accum. depreciation (-A) From example 9A 22 500 N/A
NRVM: set-off of acc. depreciation before revaluing asset
Revaluation surplus (OCI) The balance in the RS acc from Ex 9A 7 500 N/A
Revaluation expense (E) Further decrease expensed: 13 500 – 7 500 6 000 N/A
Plant: cost (A) CA (Ex 9A or W2): 67 500 – FV: 54 000 (13 500) N/A
Revaluation surplus (OCI) The balance in this account from Ex 9B N/A 7 500
Revaluation expense (E) Further decrease expensed: 13 500 – 7 500 N/A 6 000
Plant: cost (A) GRV (W4) 90 000 – Cost (Ex 9B) 112 500 N/A (22 500)
Plant: accum. depreciation (-A) AD (W4) 36 000 – AD (Ex 9B) 45 000 N/A 9 000
GRVM: Revaluation journal – cost account now reflects GRV, the acc
depr account now reflects AD on GRV to date and the CA now reflects
FV. The first adjustment reduces the revaluation surplus and any excess
thereafter is debited to revaluation expense. Note: the cost dropped
C6 000 below the historical cost of 100 000, thus C6 000 was expensed
31/12/20X3: depreciation
Depreciation: plant (E) FV: 54 000 / 3 years remaining 18 000 18 000
Plant: accum. depreciation (-A) (18 000) (18 000)
Depreciation for 20X3: new carrying amount over remaining useful life
Comment:
x Please note that the difference between the journals using the NRVM and the GRVM are purely for
disclosure purposes. The essence of the above adjustments can be more clearly seen in the
following simplified journal: NRVM and GRVM
Debit Credit
Revaluation surplus 7 500
Revaluation expense 6 000
Plant at net carrying amount 13 500
Revaluation journal: decrease in CA: first debit the revaluation surplus
until it is nil and then debit any further reduction to revaluation expense
x Please also note that in this example, the asset’s carrying amount was reduced to below historical
carrying amount (depreciated cost) and therefore the revaluation surplus had been reduced to zero. There
was therefore no journal transferring revaluation surplus to retained earnings in 20X3.
Example 11: Revaluation model - increase in value: reversing a previous

revaluation expense and creating a revaluation surplus
Assume the same information as that given in the previous example as well as the following:
x Fair value at 1/1/20X4: C44 000
Required: Show the journals for the year ended 31 December 20X4 using the:
A. net replacement value method (NRVM)
B. gross replacement value method (GRVM)
Solution 11: Revaluation model - increase in value, reversing a previous revaluation

expense and creating a revaluation surplus
Workings applicable to both (A) and (B)
W1: Historical carrying amount (depreciated cost) at 1/1/20X4: C
Cost 100 000
Accumulated depreciation (100 000 x 20% x 3yrs) (60 000)
40 000
Chapter 8 435

W2: Actual carrying amount at 1/1/20X4: C
Carrying amount at 1/1/20X3 after revaluation on 1/1/20X3 54 000
Depreciation in 20X3 (FV: 54 000/ 3 rem yrs) or (GRV: 90 000/ 5 total yrs) (18 000)
36 000
W3: Increase in value required at 1/1/20X4:
Fair value on 1/1/20X4 44 000
Actual carrying amount on 1/1/20X4 W2 (36 000)
8 000
- revaluation income (up to HCA: 36 000 – 40 000) 4 000
- revaluation surplus (above HCA: 40 000 – 44 000) 4 000
Graph depicting both (A) and (B): 1/1/20X4
44 000 (FV)
4 000 (Credit revaluation surplus)
40 000 (HCA)
Cost
4 000 (Credit reversal of revaluation expense)

36 000 (ACA)
0 Useful Life

Gross replacement value (GRV): 1/1/20X1 44 000 / 2 years remaining x 5 total yrs 110 000
Accum. depreciation on GRV: 31/12/20X3 110 000 / 5 total years x 3 years to date (66 000)
Journals: 20X4: Ex 11A Ex 11B

NRVM GRVM
1/1/20X4: revaluation (increase) Dr/ (Cr) Dr/ (Cr)
Plant: accum. depreciation (-A)) 18 000 N/A
NRVM: Set off of accumulated depreciation against cost
Plant: cost (A) FV: 44 000 – CA: 36 000 (W2) 8 000 N/A
Revaluation income (I) CA: 36 000 – HCA: 40 000 (W3) (4 000) N/A
Revaluation surplus (OCI) HCA: 40 000 – FV: 44 000 (W3) (4 000) N/A
Plant: cost (A) GRV (W4): 110 000 – Cost (Ex 10B): 90 000 N/A 20 000
Plant: accum deprec. (-A) AD (W4): 66 000 – AD (Ex 10B): 54 000 N/A (12 000)
Revaluation income (I) CA: 36 000 – HCA: 40 000 (W3) N/A (4 000)
Revaluation surplus (OCI) HCA: 40 000 – FV: 44 000 (W3) N/A (4 000)
GRVM: Revaluation journal – cost account now reflects GRV, the acc
depr account now reflects AD on GRV to date and the net reflects FV
31/12/20X4: depreciation and transfer of RS to RE
Depreciation: plant (E) FV 44 000 / 2 remaining yrs 22 000 22 000
Plant: accum deprec (-A) (22 000) (22 000)
Depreciation 20X4: new carrying amount over remaining useful life
Revaluation surplus (OCI) RS 4 000/ 2 remaining yrs; Or 2 000 2 000
Retained earnings (Eq) Revalued depr 22 000 – Historical (2 000) (2 000)
depr 20 000
Transfer of revaluation surplus to retained earnings: over life of asset
(the extra depreciation for 20X4 due to the revaluation above HCA)
436 Chapter 8
3.10 The revaluation model and impairments (IAS 36 and IAS 16.63 - .66)
All property, plant and equipment must undergo an impairment indicator test at the end of
every financial year – even those measured under the revaluation model. The indicator test is
merely a test for indicators that the asset may be impaired and is not the actual test for
impairment. If there is an indication that the asset may be impaired, an impairment test is
carried out. This involves calculating the recoverable amount and comparing it to the carrying
amount. If the recoverable amount is less than the carrying amount, the carrying amount must
be reduced to the recoverable amount.
When using the revaluation
Recoverable amount is measured at the higher of: model, we must still check
x Value in use (VIU); and for impairments unless:
x Fair value less costs of disposal (FV-CoD). x Disposal costs are negligible. See IAS 36.5
As you can see, the calculation of the recoverable amount involves choosing the higher of two
amounts (VIU and FV-CoD). However, if we measure an asset using the revaluation model
and where this asset's costs of disposal are considered to be negligible, there is actually no
need to calculate the VIU. This is because the FV-CoD (i.e. the FV – an amount that is close
to nil) will not be materially lower than the asset's carrying amount (FV) and thus the asset
will not be impaired, and the recoverable amount need not be estimated. See IAS 36.5
Worked example 2: Revaluation model and negligible disposal costs
Remember: If RM is used, the CA that we will be comparing to RA will already reflect the FV.
If CA = FV = 100 and CoD are negligible: FV-CoD = 100. Thus, no matter what the VIU is, there is
no need to calculate it because the asset is automatically not impaired. For example, imagine:
x VIU = 120, the RA = 120 (greater of VIU and FV-CoD) & since RA 120 > CA 100: = no impairment
x VIU = 80, the RA = 100 (greater of VIU and FV-CoD) & since RA 100 = CA 100: = no impairment.
IAS 16 does not provide any guidance as to the naming of the resultant income and expense
accounts when making adjustments to an asset’s carrying amount. However, where the
adjustment is to be recognised in profit or loss, one should differentiate between adjustments
to fair value (a revaluation expense/ income) from adjustments to recoverable amount (an
impairment expense/ impairment reversal income).
This differentiation is relevant, it is submitted, because, if for example we are decreasing an
asset’s carrying amount, a decrease to a lower fair value does not necessarily mean that the
recoverable amount has decreased (the recoverable amount could be higher than the original
carrying amount) and thus decreasing a carrying amount to fair value does not mean that the
asset is impaired. Consider the following example.
Example 12: A low fair value does not necessarily mean an impairment loss
1/1/20X1 Cost of plant (paid for in cash) C100 000
Depreciation 5 years; straight-line; residual value is nil
31/12/20X1 Fair value C70 000
31/12/20X1 Value in use C110 000
31/12/20X1 Costs of disposal C10 000
Required: Provide the journal entries necessary in 20X1. The entity uses the NRVM.
Solution 12: A low fair value does not necessarily mean an impairment loss
W1: Revalue to fair value C
Cost Given 100 000
Depreciation (100 000 – 0) / 5 x 1 (20 000)
Carrying amount As calculated above, unchanged 80 000
Revaluation expense Balancing (10 000)
Fair value Given 70 000
W2: Check for impairment losses or reversals C
Carrying amount Fair value 70 000
Recoverable amount Higher of: FV-CoD (70 000 – 10 000) or VIU 110 000 110 000
Impairment/ reversal Impairment loss: N/A because the RA > CA 0
Impairment reversal: N/A: there are no prior impairments
Chapter 8 437
Comment
x The asset is measured under the revaluation model and thus must first be revalued to fair value. The
decrease in value is called a revaluation expense (or something similar – no guidance is provided in
either of the standards: IAS 16 or IAS 36), but should not be called an impairment loss expense.
x IAS 36 Impairment of assets requires that, at the end of the reporting period, items of property, plant
and equipment be checked for impairments unless the costs of disposal are negligible. In terms of
IAS 36.5(c), when the costs of disposal are not negligible, as it is in this example, an impairment is
possible. However, in this example, although the fair value less costs of disposal (60 000) is less than
the carrying amount (fair value: 70 000), the actual recoverable amount (110 000) is greater than the
carrying amount (because the recoverable amount is the greater of fair value less costs of disposal and
value in use). There is therefore no impairment loss.
x Notice how there was a revaluation expense but the asset is not impaired.

1/1/20X1
Bank (A) 100 000
Purchase of plant
31/12/20X1
Depreciation: plant (E) W1 20 000
Plant: accumulated depreciation (-A) W1 20 000
NRVM: Set-off of acc depreciation against cost before revaluing
Revaluation expense: plant (E) W1 10 000
Revaluation of plant to fair value of C70 000
In summary then:
x If the carrying amount is decreased and part or all of the decrease is to be recognised as
an expense, this expense is referred to as:
- a revaluation expense if the CA is being decreased to a fair value; or
- an impairment loss expense if the CA is being decreased to a recoverable amount.
x If the carrying amount is increased and part or all of the increase is to be recognised as an
income, this income is referred to as:
- a revaluation income if the CA is being increased to a fair value; or
- an impairment loss reversal if the CA is being increased to a recoverable amount.
Examples showing the impairment of an asset measured under the revaluation model are
included in the chapter on impairments.
Please note: irrespective of whether or not you interpret IAS 16 and IAS 36 to require
differentiation, the carrying amount is the same. The most important thing to grasp is whether
an adjustment is recognised in other comprehensive income (OCI) or in profit or loss (P/L).
x Adjustments above historical carrying amount (depreciated cost if the asset is
depreciable, or cost if the asset is non-depreciable) are recognised in OCI.
x Adjustments below historical carrying amount (depreciated cost if the asset is
depreciable, or cost if the asset is non-depreciable) are recognised in P/L.
When using the revaluation model, an impairment loss reversal that exceeds historical
carrying amount (depreciated cost if the asset is depreciable, or cost if the asset is non-
depreciable) is recognised in other comprehensive income as a revaluation surplus. However,
when reversing a previous impairment loss, be careful not to increase the carrying amount
above the carrying amount that the asset would have had, had the asset not been impaired. In
other words, in the case of an asset measured under the revaluation model, this would mean
that the carrying amount should never be increased above the previous fair value less
subsequent accumulated depreciation (also known as the depreciated fair value).
438 Chapter 8
4. Deferred Tax Consequences (IAS 12)
4.1 Overview
Deferred tax consequences arise if the tax authorities do not measure the tax base of the asset
in the same way that IAS 16 measures its carrying amount. Deferred tax should be recognised
on these temporary differences unless:
x the temporary difference is exempt from deferred tax (see chapter 6, section 4.3 and 5); or
x the temporary difference is a deductible temporary difference thus causing a deferred tax
asset but where the inflow of future economic benefits is not probable (chapter 6, section 8).
As explained in chapter 7, deferred tax can arise from basic transactions such as:
x buying the asset;
x depreciating and impairing the asset;
x selling the asset.
When using the revaluation model, the carrying amount could be increased by crediting
revaluation surplus. This increase affects other comprehensive income and does not affect
profit or loss. Thus, the deferred tax effect on the revaluation surplus must also be recognised
in other comprehensive income and is thus called a balance-sheet based deferred tax
adjustment. This is explained in section 4.2.
Similarly, when using the revaluation model, the asset is measured at fair value. If this fair
value exceeds cost, we must remember that the deferred tax balance must reflect the expected
tax consequences from the expected manner of recovery of the economic benefits inherent in
the asset. This is explained in section 4.3.
4.2 Deferred tax effects of the revaluation surplus
A big difference between the cost model and the revaluation model, however, is that when
using the revaluation model, the carrying amount may be increased above its historical
carrying amount (depreciated cost in the case of a depreciable asset, or cost in the case of a
non-depreciable asset). Such an increase is credited to a revaluation surplus account, which is
part of other comprehensive income and therefore does not affect profit or loss.
When deferred tax arises from items that are recognised in
profit or loss (e.g. depreciation and impairments), the deferred A revaluation surplus
reflects extra FEB
tax is also recognised in profit or loss. This means that these which means extra
deferred tax adjustments will be debited or credited to the tax future tax:
expense account in the profit or loss section of the statement of x Thus, the recognition of a RS
comprehensive income. These adjustments are thus often means that we must recognise
called income statement-based deferred tax adjustments. DT on the RS.
If deferred tax arises from items recognised in other comprehensive income (e.g. a revaluation
surplus adjustment), the related deferred tax adjustment is also recognised in other comprehensive
income. This deferred tax adjustment will be debited or credited to the revaluation surplus account
and be presented in the other comprehensive income section of the statement of comprehensive
income (i.e. this deferred tax adjustment is not included in tax expense in the profit or loss section).
These adjustments are thus often called balance sheet-based deferred tax adjustments. IAS 12.61A - .62
In summary, there are two types of deferred tax adjustments: DT caused by the
creation of a RS is
x Income statement-based deferred tax adjustments: journalised as:
adjustments made to the tax expense account as a result x Debit RS
of temporary differences that affected profit or loss;
x Credit DT(L).
x Balance sheet-based deferred tax adjustments:
adjustments made directly to an equity account as a result of temporary differences that
did not affect profit or loss (in other words: where the temporary difference arose from a
revaluation surplus, the deferred tax contra-entry must be recognised in the same
revaluation surplus account).
Chapter 8 439
4.3 Deferred tax effects of the revaluation surplus and management intentions
When using the revaluation model, it is possible for an asset’s carrying amount to be increased to a
fair value that exceeds its historical carrying amount (depreciated cost if the asset is depreciable, or
simply cost if the asset is non-depreciable). Importantly, if the asset’s carrying amount is increased to
a fair value that exceeds cost, we must consider the possible impact of management intentions when
measuring the related deferred tax balance.
The measurement of the
To understand this, we must remember the deferred tax DT on a RS is affected by
liability (or asset) balance arising from an asset must simply whether mgmt intends to:
reflect the future tax payable (or receivable) on the specific x Use the asset:
- measure DT normally
future inflows of economic benefits expected from the asset.
x Sell the asset:
If management intends to recover the asset’s carrying If the CA ≤ Cost:
amount (i.e. the estimated future inflow of economic - measure DT normally
benefits) through the sale thereof rather than through its use, If the CA > Cost,
and if its carrying amount reflects a fair value greater than - measure DT in a way that takes
into account the fact that part
cost, the measurement of the related deferred tax balance will of the potential profit on sale
be affected if the tax authorities tax capital profits from the would be taxed as a capital gain.
sale of an asset differently to any other profit (e.g. at different rate). The effect of managements’
intentions on the measurement of deferred tax is explained in chapter 6, section 4.4.2 and 4.4.3.
Please note, however, that if the item of revalued property, plant and equipment is non-depreciable
(i.e. land), then we ignore management’s actual intentions and presume that the intention of
management is to sell the land. IAS 12.51B Presumed intentions are explained in chapter 6, section 4.4.2.
4.3.1 Deferred tax and a revaluation that does not exceed cost
If we have a revaluation surplus, it means that an asset’s carrying amount has been increased above
its historical carrying amount. However, if this revalued carrying amount does not exceed its original
cost, then there is no expected capital profit possible. This makes the deferred tax calculation easier.
Depending on management’s intentions, an increased carrying amount (that does not exceed cost)
refers to the estimated future inflow of economic benefits expected from:
x sales revenue (e.g. from selling the items manufactured through use of the asset), if the
entity intends to keep the asset: these sales will be taxed at the income tax rate; or
x proceeds on sale of the asset if the entity intends to sell the asset: the proceeds could
result in a recoupment of tax allowances, which will be taxed at the income tax rate; or a
scrapping allowance, being a tax saving, also measured at the income tax rate.
Thus, if the carrying amount does not exceed cost, management intentions may be ignored
because the deferred tax consequences will be measured at income tax rates.
Example 13: Revaluation surplus and deferred tax:
x revaluation upwards but not exceeding cost
A plant (cost: C150 000) is revalued to a fair value of C140 000, on which date it had:
x a carrying amount of C100 000 (historical and actual),
x a tax base on date of revaluation of C100 000.
The tax rate is 30%.
For the purposes of this example, you may combine the cost and accumulated depreciation accounts.
Required:
A Explain whether the intentions of management will affect the measurement of the deferred tax.
B Show the revaluation journal and the journal showing the deferred tax consequences thereof.
Solution 13A: Discussion
Since the revalued carrying amount (C140 000) does not exceed cost (C150 000), the intentions of
management would not affect the measurement of the deferred tax balance.
x If the intention was to keep (use) the asset, the carrying amount would reflect future income from
the sale of the plant’s output: C
Future sales income Carrying amount at fair value 140 000
Future wear and tear deductions Tax base 100 000
Future taxable profits 40 000
Future tax 40 000 x 30% 12 000
440 Chapter 8
x If the intention was to sell the asset, the carrying amount would reflect future income from the
proceeds on sale of the plant: C
Future selling price of plant limited to cost price CA at fair value, limited to cost 140 000
(cost not a limitation in this ex.)
Future tax base Tax base 100 000
Future recoupment on sale Note 1 40 000
Future tax Note 1 40 000 x 30% 12 000
A diagrammatic way of explaining the deferred tax based on the intention to sell the asset is as follows:
Tax base 100 Recoupment: 12

40 x 30%
Revalued carrying amount 140
Original cost 150 Capital gain: 0
N/A Note 1
12
Note 1:The calculation above, which shows the future tax if the management intention was to sell, only shows the future
tax on a future recoupment. There is no calculation of the future tax on a future capital gain. This is because the revalued
carrying amount at FV of C140 is less than the original cost of C150. Thus, if management intended to sell the plant, the
future sale would not lead to a capital gain (capital gains only arise if the selling price exceeds cost).
See chapter 5 section 3.5.3.3 (sale of PPE at a selling price below cost) & 3.5.3.4 (sale of PPE at a selling price above cost).
Solution 13B: Revaluation upwards but not exceeding cost: deferred tax: journals
Journal: Debit Credit
Plant: carrying amount (A) FV 140 000 – CA 100 000 40 000
Revaluation above depreciated cost (historical carrying amount
Revaluation surplus (OCI) W1 * or (40 000 x 30%) 12 000
Deferred tax (A/L) 12 000
Deferred tax on the revaluation surplus – see comment below
W1: Deferred tax: plant Carrying Tax Temporary Deferred

amount base difference taxation Calculations
Balances before revaluation 100 000 100 000 0 0
Revaluation surplus 40 000 0 (40 000) (12 000) Cr DT Dr RS *
Balances after revaluation 140 000 100 000 (40 000) (12 000) Liability: 0-12+0
Historical CA/ TB 100 000 100 000 0 0 (100-100) x 30%
Revaluation surplus - up to cost 40 000 0 (40 000) (12 000) (0-40) x 30%
Revaluation surplus - above cost 0 0 0 0 N/A
Comment:
x When the CA is increased from C100 000 to C140 000, it creates a temporary difference of C40 000.
x Since the extra C40 000 is credited to revaluation surplus (OCI) and not to income (P/L), the deferred tax
contra entry will also be a debit to the revaluation surplus account – not to tax expense.*
4.3.2 Deferred tax and a revaluation that exceeds cost

As already mentioned, if an asset is valued above its historical carrying amount (depreciated
cost if it is a depreciable asset, and cost if it is a non-depreciable asset), it is important to
ascertain whether it has also been increased above its cost.
If the revalued carrying amount exceeds its cost, it is important to ascertain whether
management intends to keep the asset or to sell the asset. This is because the tax legislation
may differ depending on what kind of income we earn. For example, the tax legislation
applicable to income from normal trading (e.g. sales revenue) may be different to the tax
legislation applicable to income from the sale of an asset (e.g. profit on sale of an asset).
Chapter 8 441
In other words, the intention of the entity must be considered when estimating the future tax
liability since the deferred tax balance must reflect how much of tax we are expecting to pay,
and the amount of this future tax may be affected by the type of income we are expecting to
earn. If the intention is to:
x keep the asset, the future economic benefits will be the expected future revenue from
normal trading activities;
x sell the asset, the future economic benefits will be the expected future proceeds on sale;
x keep the asset for a while and then to sell it, the future economic benefits will represent a
mixture of revenue from normal trading activities and proceeds on sale.
An exception occurs when the deferred tax balance relates to revalued non-depreciable assets
(for example, land), in which case we must always presume that management intends to sell
the asset irrespective of management’s actual intention. IAS 12.51 B
4.3.2.1 Deferred tax: Revaluation above cost: intention to keep the asset
If the intention is to keep the asset (i.e. use it rather than sell it), then the entire carrying
amount (the extra future economic benefits) is expected to be earned by way of normal
trading profits. In other words, we expect that the future economic benefits (i.e. inflows)
relating to the asset will come in the form of sales revenue or other related trading activities.
These future economic benefits that are expected to be earned through normal trading
activities will be taxed at the normal rate of income tax. If the asset is revalued upwards, the
extra future economic benefits (represented by the revaluation surplus) will also be taxed at
the income tax rate. Therefore, assuming, for example, that trading profits are taxed at an
income tax rate of 30%, the future tax on the revaluation surplus will be measured at 30%.
Note: when measuring deferred tax relating to land, we ignore management’s actual intention
to keep the land and presume that management intends to sell the land. IAS 12.51B
Example 14: Deferred tax: revaluation above cost: intend to keep –

Short example
A machine is revalued to C140 000 when:
x its carrying amount (actual and historical) is C100 000;
x it original cost was C110 000 (not C150 000 as in the previous example);
x its tax base is C100 000.
The tax rate is 30%.
The intention is to keep the asset.
Required: Calculate the deferred tax balance and show the related journal entries.
Solution 14: Deferred tax: revaluation above cost: intend to keep

Comment:
In this case, there will be no capital profit (since this only occurs on disposal of the asset, and the intention
here is to keep it) and thus, the increase in value represents future profits expected from the use of the asset.

Machine (carrying amount) (A) (140 000 – 100 000) 40 000
Increase in asset value above historical carrying amount (depreciated cost)
Revaluation surplus (OCI) W1 * or (40 000 x 30%) 12 000
Deferred tax on the revaluation surplus
442 Chapter 8

W1: Deferred tax:
Asset – intention to keep CA TB TD DT Calculations
Revaluation surplus 40 000 0 (40 000) (12 000) Cr DT Dr RS * (2)
Balances after revaluation: 140 000 100 000 (40 000) (12 000) Liability (3)
Historical carrying amount/ tax base 100 000 100 000 0 0 (100-100) x 30% (1)
Revaluation surplus - up to cost 10 000 0 (10 000) (3 000) (0-10) x 30% (3)
Revaluation surplus – above cost 30 000 0 (30 000) (9 000) (0-30) x 30% (3)
Notes
1) There are no temporary differences at this point since the historical carrying amount (depreciated cost) and tax
base are the same, and therefore there is no deferred tax.
2) The entire revaluation surplus of 40 000 (10 000 + 30 000) represents future profits from the use of the asset in
excess of those originally expected. Since trading profits are taxed at 30%, deferred tax of 12 000 (40 000 x
30%) must be provided.
3) Although the revalued amount is greater than original cost, this profit is expected to be earned through the use
of the asset – and not through the sale of the asset. Therefore all future profits will be taxed at the income tax
rate of 30%. There is thus no need to show this breakdown of the balances after revaluation into the
components of 100 000, 10 000 and 30 000.
This can be illustrated as follows:
Tax base 100 000 Profits in excess of tax base: 10 000 x 30% 3 000
Original cost (and base cost) 110 000

Further profits: 30 000 x 30% 9 000
Revalued carrying amount 140 000
12 000
Yet another way of explaining the deferred tax balance is to imagine that we intend to keep the asset. If
we revalue the asset to 140 000, it means that we are expecting future sales of 140 000. A tax base of
100 000 means that we will be able to deduct 100 000 against this future revenue:
Future sales revenue 140 000
Less future tax allowances (100 000)
Future taxable profit 40 000
Future tax payable 12 000
Example 15: Deferred tax: revaluation above cost: intend to keep – full example
A machine is purchased for C100 000 on 2 January 20X1.
x The machine is depreciated at 25% per annum straight-line to a nil residual value.
x Machines are revalued to fair value using the net replacement value method.
x The fair values were:
1 January 20X2: C120 000
1 January 20X3: C60 000
x The revaluation surplus is transferred to retained earnings over the life of the asset.
x The tax authorities allow the cost to be deducted at 20% pa and levy income tax at 30%.
x The intention is to keep the asset.
Required: Provide all journals.

20X1 Journals: Debit Credit
2 January 20X1
Machine: cost (A) 100 000
Bank (A) 100 000
Purchase of machine
Chapter 8 443

20X1 Journals continued ... Debit Credit
31 December 20X1
Depreciation: machine (E) (100 000 – 0) / 4 years x 12 / 12 25 000
Depreciation on machine
Deferred tax (A/L) W1 or (25 000 – 20 000) x 30% 1 500
Deferred tax on depreciation versus wear and tear
20X2 Journals:
1 January 20X2
NRVM: accumulated depreciation set-off against cost
Machine: cost (A) 120 000 – (100 000 – 25 000) 45 000
Revaluation of machine (increase in value)
Revaluation surplus (OCI) W1 or 45 000 x 30% 13 500
Deferred tax on revaluation surplus
31 December 20X2
Depreciation: machine (E) (120 000 – 0) / 3 years 40 000
Revaluation surplus (OCI) (45 000 – 13 500) / 3 years 10 500
Retained earnings (Eq) 10 500
A portion of revaluation surplus transferred to retained earnings
20X3 Journals:
1 January 20X3
Revaluation surplus (OCI) FV 60 000 – CA (120 000 – 20 000
Machine: cost (A) 40 000) 20 000
Revaluation of machine (decrease in value)
Deferred tax (A/L) 20 000 x 30% 6 000
Deferred tax on revaluation surplus (decrease in future tax liability
because future benefits decreased)
31 December 20X3
Revaluation surplus (OCI) (45 000 – 13 500 – 10 500 – 3 500
Retained earnings (Eq) 20 000 + 6 000) / 2 years 3 500
A portion of revaluation surplus transferred to retained earnings
444 Chapter 8

Debit Credit
20X4 Journals:
31 December 20X4
Revaluation surplus (OCI) (45 000 – 13 500 – 10 500 – 20 000 + 3 500
Retained earnings (Eq) 6 000 – 3 500)/ 1 year 3 500
Portion of revaluation surplus transferred to retained earnings
Deferred tax on machine: depreciation versus wear and tear
20X5 Journals:
31 December 20X5
Tax expense (E) W1 or (0 – 20 000) x 30% 6 000
Deferred tax on machine: depreciation versus wear and tear
W1: Deferred tax: machines Carrying Tax Temporary Deferred Details Revaluation
amount base difference taxation Surplus
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000
Dr DT (SOFP)
Depreciation/ deduction (25 000) (20 000) 5 000 1 500
Cr TE (P/L)
100 000 / 4 years; 100 000 x 20%
Balance: 31/12/20X1 75 000 80 000 5 000 1 500 Asset
(1) Cr DT (SOFP) (45 000)
Revaluation surplus (increase) 45 000 0 (45 000) (13 500)
Dr RS (OCI) (3) 13 500
120 000 80 000 (40 000) (12 000) Liability (31 500)
Dr DT (SOFP)
Depreciation/ deduction (40 000) (20 000) 20 000 6 000 10 500 (4)
120 000 / 3 years; 100 000 x 20% Cr TE (P/L)

Balance: 31/12/20X2 80 000 60 000 (20 000) (6 000) Liability (21 000)
Dr DT (SOFP) 20 000
Revaluation surplus (decrease) (20 000) 0 20 000 6 000(2)
Cr RS (OCI)(3) (6 000)
60 000 60 000 0 0 (7 000)
Depreciation/ deduction Dr DT (SOFP) (4)

(30 000) (20 000) 10 000 3 000 3 500
60 000 / 2 years; 100 000 x 20% Cr TE (P/L)
Balance: 31/12/20X3 30 000 40 000 10 000 3 000 Asset (3 500)
Dr DT (SOFP)
Depreciation/ deduction (30 000) (20 000) 10 000 3 000 3 500 (4)
30 000 / 1 years; 100 000 x 20% Cr TE (P/L)

Balance: 31/12/20X4 0 20 000 20 000 6 000 Asset 0
Cr DT (SOFP)
Depreciation/ deduction (0) (20 000) (20 000) (6 000)
N/A;100 000 x 20% Dr TE (P/L)
Balance: 31/12/20X5 0 0 0 0 Liability
Notes:
1) Since the intention is to keep the asset, there is no need to separate out any capital profit: the entire increase (or
decrease) in carrying amount is expected to be realised through normal trading activities, which is taxed at 30%:
45 000 x 30% = 13 500
2) The drop in carrying amount reflects a drop in expected trading activities. A drop in trading activities will result in a
corresponding decrease in income tax: 20 000 x 30% = 6 000
3) Also note: the deferred tax contra entry is the revaluation surplus in OCI (not the P/L tax expense account).
4) Transfer from revaluation surplus to retained earnings:
20X2: 31 500 / 3 years = 10 500
20X3: 7 000 / 2 years = 3 500
20X4: 3 500 / 1 year = 3 500
Chapter 8 445
4.3.2.2 Deferred tax: Revaluation above cost: intention to sell the asset
If the intention is to sell the asset, then the fair value is assumed to represent the expected
selling price of the asset. This means that the amount by which the fair value exceeds the historical
carrying amount (depreciated cost if the asset is depreciable or cost if it is non-depreciable)
represents the expected profit on sale. If the asset is revalued to fair value, the revaluation surplus
thus reflects this expected profit on sale.
If the fair value is above its original cost, the amount by which the fair value exceeds original
cost will represent an expected ‘capital profit on disposal’, part of which may be exempt. The
rest of the profit on sale will represent a non-capital profit on sale.
Therefore, this revaluation surplus will reflect a capital profit on sale (part of which may be
exempt from tax) and a non-capital profit on sale.
Example 16: Deferred tax: Revaluation surplus above cost: intention to sell
A plant (carrying amount of C60 000 and original cost of C100 000) is revalued to a fair value
of C110 000.
Required: Calculate the revaluation surplus and analyse it into a capital and non-capital components.
Solution 16: Deferred tax: Revaluation surplus above cost: intention to sell
Comment: the trick here is to see the revaluation surplus being made up of a number of components:
x part of the revaluation surplus brought the asset’s carrying amount back up to cost (i.e. from 60 000 to
100 000, thus reversing previous depreciation); and
x part of the asset’s carrying amount increased the carrying amount above cost (i.e. from 100 000 to 110 000,
thus representing a potential capital profit – if the asset were to be sold).
The deferred tax on each component will be taxed differently.

C
Revaluation surplus: profit on sale FV (SP): 110 000 – HCA: 60 000 50 000
Capital profit FV: 110 000 – Cost: 100 000 10 000
Non-capital profit Cost: 100 000 – HCA: 60 000 40 000
If the tax authorities allow an entity to deduct the cost of its asset by way of annual tax
allowances and the asset is sold, either:
x a taxable recoupment of some or all of the past tax allowances could occur; or
x a further tax allowance (a scrapping allowance) may be deducted if the tax authorities
recognise a loss on the sale.
If, however, the asset is sold at more than its cost, then there will also be a capital profit. No
tax is recognised on this capital profit if it is exempt from tax. On the other hand, tax is
recognised on this capital profit if it is taxable to some degree or other.
For example, in some tax jurisdictions:

x a capital profit is totally exempt from tax, in which case tax is not recognised on the
capital portion;
x a capital profit is completely taxable, in which case tax is recognised on the capital
portion (i.e. the full capital portion x the income tax rate); or
x a capital profit is partially exempt and partially taxable, in which case tax is recognised on
the capital portion that is taxable (i.e. the taxable capital portion x the income tax rate).
The idea is simply that the deferred tax balance should be measured based on the tax that
would be levied if the asset were sold and bearing in mind that this sale may involve a
combination of:
x a recoupment of past tax allowances (taxable) or a further allowance (deductible); and/ or
x a capital gain (exempt or taxable – in full or partially).
446 Chapter 8
The impact of our intention on the deferred tax balance is best understood by way of a
comparative example: an asset where we intend to keep it, and then where we intend to sell it.
Example 17: Revaluation above cost: Deferred tax: Intention to sell
x short example
A machine is revalued to C140 000 when:
x its carrying amount (actual and historical) is C100 000;
x it original cost was C110 000 (equal to its base cost for tax purposes);
x its tax base is C100 000.
The tax rate is 30% and the inclusion rate for taxable capital gains is 80%.
The intention is to sell the asset.
Required: Show the related journal entries.
Solution 17: Revaluation above cost: deferred tax: intention to sell – short example
Comment: Since the intention is to sell the asset, the FV reflects the selling price. Since this exceeds the cost
price, there is an expected capital gain, 80% of which would be taxable. The measurement of the deferred tax
balance must take this into account.
Journals Debit Credit

Machine: carrying amt (A) (140 000 – 100 000) 40 000
Revaluation surplus (OCI) [(SP 140 000 – BC: 110 000) x 80% + 10 200
Deferred tax (A/L) SP ltd to Cost: 110 000 – TB: 100 000] x 30% 10 200
Deferred tax caused by the creation of the revaluation surplus: taxable
capital gain of 24 000 plus recoupment of 10 000
Workings
W1: Deferred tax:
Asset – intention to keep CA TB TD DT Calculations
Revaluation surplus 40 000 0 (40 000) (10 200) Cr DT Dr RS (2)
Balances after revaluation 140 000 100 000 (40 000) (10 200) Liability (3)
Historical CA/ TB 100 000 100 000 0 0 (100-100) x 30% (1)
Revaluation surplus - up to cost 10 000 0 (10 000) (3 000) (0-10) x 30% (3)
Revaluation surplus – above cost 30 000 0 (30 000) (7 200) (0-30) x 80% x 30% (3)
1) There are no temporary differences at this point since the carrying amount and tax base are the same, and
therefore there is no deferred tax.
2) The entire revaluation surplus of 40 000 (10 000 + 30 000) represents future profits on sale of the asset. Part of
the profit that exceeds cost price is a capital profit, part of which is exempt. The measurement of the deferred tax
balance must thus take this into account – meaning that only a portion will be taxed at 30%.
3) The deferred tax balance is calculated based on the intention to sell and the related tax legislation:
x The profit on sale up to cost is a recoupment of past wear and tear and will be taxed at 30%.
x The profit on sale above cost will be taxed as a capital gain: 80% of this gain x 30% (i.e. an effective tax
rate of 24%)
Other workings that may help you understand if you are battling:
W2: Deferred tax balance
Tax base 100 000 Recoupment: 3 000

10 000 x 30%
Taxable capital gain: 7 200
Revalued carrying amount 140 000 30 000 x 80% x 30% (see 3 above)
10 200
Chapter 8 447

W3: Proof: deferred tax using income statement approach Taxable profits Deferred tax
Capital portion
Future selling price Fair value 140 000
Cost and base cost (110 000)
Capital profit 30 000
Taxable capital gain (TCG) 30 000 x 80% 24 000
Tax on TCG 24 000 x 30% 7 200
Non-capital portion
Proceeds limited to cost 140 000 ltd to 110 000 110 000
Tax base Given (100 000)
Taxable recoupment 10 000 10 000
Tax on recoupment 10 000 x 30% 3 000
Future taxable profits and deferred tax 34 000 10 200
Example 18: Revaluation above cost: Deferred tax: Intention to sell

A machine is purchased for C100 000 on 2 January 20X1. The company:
x measures it under the revaluation model and revalued it to C120 000 on 1 January 20X2
x depreciates it at 25% per annum straight-line to a nil residual value
x transfers the entire revaluation surplus to retained earnings on sale of the asset
x uses the net replacement value method to record its revaluations
On date of revaluation (1 January 20X2), the entity’s intention is to sell the asset.
x The criteria for reclassification as a non-current asset held for sale are not met.
x The asset is not sold until 1 January 20X3 (for C80 000).
The tax authorities:
x allow the deduction of the cost of the asset at 20% of the cost per annum
x will use a base cost of C100 000 and apply an 80% inclusion rate if sold at a capital gain
x levy income tax at 30%.
Required: Calculate the deferred tax and provide all related journal entries.
Solution 18: Revaluation above cost: deferred tax: intention to sell

Journals:
20X1 Debit Credit
2 January 20X1
Bank (A) 100 000
Purchase of machine
31 December 20X1
Depreciation: machine (E) (100 000 – 0) / 4 years x 12 / 12 25 000
Machine: acc depreciation (-A) 25 000
Deferred tax on machine: depr vs tax allowance (income-statement based DT)
20X2
1 January 20X2
Machine: cost (A) 120 000 – (100 000 – 25 000) 45 000
NRVM: Revaluation of machine (increase in value)
Revaluation surplus (OCI) W1 or 12 300
Deferred tax (A/L) (20 000 x 24% + 25 000 x 30%) 12 300
Deferred tax on machine: due to revaluation surplus (balance-sheet based DT)
448 Chapter 8
20X2 journals continued ... Debit Credit

31 December 20X2
Depreciation on machine (remember: CA=FV & RUL=3)
Deferred tax (A/L) W1 or comment below 4 800
Deferred tax on machine: depr vs tax allowance (income-statement based DT)
Comment: the income statement based deferred tax adjustment in 20X2 can be easily picked up from the
deferred tax table. If, however, you are battling to understand why this adjustment is not calculated at
30% of the temporary difference of C20 000, remember that from a profit perspective, you need to
consider the tax effect of depreciation of C40 000 in 2 parts:
a) C20 000 brings the CA down to cost (120 000 – 20 000 = 100 000).
The first C20 000 of the depreciation dropped the CA to cost, which means that the previously
expected capital profit is no longer expected to be earned and therefore the tax on the capital profit
won’t be charged either: the tax on this part of depreciation is therefore calculated at the effective rate
of 24%: 20 000 x 24% = 4 800 (the tax on the capital profit that won’t be charged now).
b) C20 000 brings the CA below cost (100 000 – 20 000 = 80 000):
Whereas the first C20 000 of the depreciation dropped the CA down to cost, the rest of the
depreciation (another C20 000) simply dropped the carrying amount below cost. The tax effect of this
depreciation is estimated at 30% of the difference between this ‘normal depreciation’ and the tax
allowance granted: (depreciation below cost: 20 000 – tax allowance: 20 000) x 30% = 0
Journals continued …: Debit Credit

20X3
1 January 20X3
Asset disposal account (Temporary) 80 000
Sale of machine – transfer carrying amount to the disposal account
Bank (A) 80 000
Asset disposal account (Temporary) 80 000
Proceeds on sale (no profit: proceeds equalled carrying amount)
Deferred tax (A/L) W1 or [profit on sale: 0 – recoupment on sale: 6 000
Tax expense (E) (80 000 – 60 000)] x 30% 6 000
Deferred tax effect of sale
Revaluation surplus (OCI) 45 000 – 12 300 32 700
Retained earnings (Eq) 32 700
Transfer revaluation surplus to retained earnings on date of sale of machine
W1: Deferred tax Carrying Tax Temporary Deferred Details Revaluation

amount base difference taxation surplus
O/balance: X1 0 0 0 0
Purchase 100 000 100 000 Dr DT (SOFP)
Depr/ tax deduction (25 000) (20 000) 1 500(5) Cr Tax (P/L)
C/ balance: X1 75 000 80 000 5 000 1 500(1) Asset
Cr DT (SOFP) 45 000
Reval surplus 45 000 0 ( 12 300)(5) Dr RS (OCI) ( 12 300)
Fair value 120 000 80 000 (40 000) ( 10 800)(2) Interim bal
Dr DT (SOFP)
Depr/ tax deduction (40 000) (20 000) 4 800(5) Cr Tax (P/L)
C/ balance: X2 80 000 60 000 (20 000) (6 000)(3) Liability 32 700
Sale (80 000) (60 000) 6 000(5) Dr DT (SOFP) ( 32 700)
Cr Tax (CI)
C/ balance: X3 0 0 0 0 (4) 0
Chapter 8 449

Depreciation calculations:
20X1 = 100 000 / 4 years = 25 000
20X2 = 120 000 / 3 years = 40 000
Tax deduction calculations:
20X1 & 20X2 = 100 000 x 20% = 20 000
Deferred tax calculations:
20X1 & 20X2 = 100 000 x 20% = 20 000
1) 31/12/20X1: The deferred tax balance. Whether the intention is to sell the asset or to keep the asset, the deferred
tax implications will be the same. This is because the carrying amount of the asset does not exceed the cost. The
deferred tax balance is calculated as follows:
Carrying amount 75 000 If we sell: scrapping allowance; or

If we keep: loss from normal trade 1 500
Both: 5 000 x 30%
Tax base 80 000
1 500 A
2) 1/1/20X2: The deferred tax balance (an interim balance immediately after the revaluation). Since we revalued
above cost and since the intention is to sell the asset, the capital profit must be separated out: part of the increase
in carrying amount is expected to be realised through a recoupment of past allowances (taxed at 30%) and the
rest of the increase is an expected capital gain, which will be taxed at an effective rate of 24%:
Tax base 80 000

Recoupment:
(6 000)
20 000 x 30%
Capital gain: (4 800)
Revalued carrying amount 120 000 20 000 x 80% x 30%
( 10 800) L
3) 31/12/20X2: The deferred tax balance. Since the intention is still to sell the asset, any expected capital profit on
sale must be separated out: part of the increase in carrying amount is expected to be realised through a
recoupment of past allowances (taxed at 30%) and any capital gain would be taxed at an effective rate of 24%.
However: now that the carrying amount has dropped below the cost, there is no expected capital profit and
therefore the deferred tax is estimated at 30% on the entire temporary difference:
Tax base 60 000

Recoupment:
(6 000)
20 000 x 30%
N/A: 0
Original cost (and base cost) 100 000 Carrying amount < Cost
(6 000) L
4) 1/1/20X3: The deferred tax balance.

Since the asset has been sold, the carrying amount and the tax base are both zero. There is thus no temporary
difference and therefore no deferred tax.
5) Deferred tax adjustments resulting from the difference between the opening and closing balances of deferred tax.
The adjustment is calculated as a balancing item (what entry is necessary to convert the opening balance into the
closing balance). A summary of the adjustments:
Deferred tax A/ (L) 31/12/20X1 1/1/20X2 31/12/20X2 1/1/20X3 Total
Closing balance 1 500 ( 10 800) (6 000) 0 0
Opening balance 0 1 500 ( 10 800) (6 000) 0
Adjustment **1 500 *(12 300) **4 800 **6 000 0
*The adjustment is the creation of a reval surplus and the contra entries are therefore: RS and DT
** These adjustments relate to the movement in the carrying amount caused by items that affected profit (e.g.
depreciation and profit on sale) and therefore, the deferred tax contra entries must all affect profit/loss
(therefore the contra entry is tax expense): DT and TE.
450 Chapter 8
Example 19: Revaluation above cost: Deferred tax: Change in intention

We own an asset with the following characteristics:
x Cost: 100 000 (this is also the base cost for capital gains tax purposes)
x Fair value: 110 000 (this is the first revaluation: dated 31 December 20X3)
x Carrying amount and tax base: 60 000 (on date of revaluation)
The company intention was originally to keep the asset, but on 1 January 20X4, the company changed its
intention to that of selling the asset.
The criteria for reclassification as a non-current asset held for sale were not met.
The income tax rate is 30%. Only 80% of the capital gain (selling price – base cost) is taxable.
The financial year-end is 31 December.
Required: Show the deferred tax journal on 1 January 20X4 to account for the change in intention.
Solution 19: Revaluation surplus: deferred tax: change in intention
Comment: If we change our intention from keeping the asset to wanting to sell it, our deferred tax balance
will have to be reduced. This is because, if we sell the asset, there will be a capital profit of C10 000, only 80%
of which would be taxable. The exempt portion of C2 000 (20% x 10 000) would thus save us tax of C600
(2 000 x 30%).
Journal: 01/01/20X4 Debit Credit

Deferred tax (A/L) W1 600
Revaluation surplus (OCI) 600
Decrease in the deferred tax liability due to change in intention
W1: Deferred tax adjustment calculation C

Def. tax balance was (FV: 110 000 – TB: 60 000) x 30% Credit balance 15 000
Def. tax balance must now be: (FV:110 000 – BC: 100 000) x 80% x 30% + Credit balance 14 400
(Cost: 100 000 –TB: 60 000) x 30%
Deferred tax balance to be decreased by: 600
4.3.3 Deferred tax on revalued assets: depreciable but non-deductible assets

If you depreciate the cost of your asset but the tax authority does not allow a deduction of the
cost of your asset by way of annual capital allowances, a temporary difference will arise
immediately on the purchase of your asset (because the carrying amount is the cost and, since
there will be no future tax deductions, the tax base will be nil).
As was explained in the previous chapter, deferred tax is not

recognised on temporary differences resulting from such a DT on the revaluation
surplus of a depreciable,
purchase (i.e. the temporary differences that will arise when non-deductible asset:
recognising the cost and when recognising any subsequent
depreciation on this cost) since these temporary differences x Intention to sell:
- FV - Cost: Tax @ CGT rates (24%)
are exempted in terms of IAS 12.15 and 12.24. The
- Cost - HCA: Tax at 0%
exemption does not apply, however, to any subsequent
- HCA – TB: Exempt (0%)
temporary differences caused by a revaluation above the
x Intention to keep:
asset’s historical carrying amount (cost if the asset is non-
- FV - HCA: Tax @ Normal rate (30%)
depreciable, or depreciated cost if the asset is depreciable). In
- HCA – TB: Exempt (0%)
other words, the exemption will not apply to the debit
(increase) to the asset’s carrying amount when processing a revaluation surplus and nor does it apply
to the subsequent increase in the depreciation resulting from this upward revaluation.
If such an asset is revalued and the intention is to keep the asset, the revaluation surplus
represents the future profits expected from the use of the asset in excess of the profits
originally expected. When these profits are earned through use, they will be taxed at 30% and
therefore deferred tax is calculated at 30% of the entire revaluation surplus (and the
subsequent temporary differences that will be caused by the increased depreciation).
Chapter 8 451
Where, however, the intention is to sell the asset, deferred tax should be provided for on the
portion of the revaluation surplus representing the increase in value above original cost to the
extent that the capital profit is taxable under any capital gains tax legislation. If, for example,
only 80% of the capital profit is taxable, and the tax rate is 30%, then deferred tax should be
calculated as follows: deferred tax = capital gain x 80% x 30%.
Example 20: Revaluation above cost: Deferred tax: Intention to sell:
x depreciable,
x non-deductible
A depreciable asset is revalued to C140 000
x Its carrying amount (actual and historical) is C100 000 on date of revaluation
x Its original cost was C110 000 (and the base cost is C110 000).
x do not grant deductible allowances on this building and therefore its tax base is C0;
x levy income tax at 30% but tax capital gains (cost less base cost) using an inclusion rate of 80%.
The company intends to sell this asset.
Required: Show the journal entries relating to the revaluation.
Solution 20: Revaluation: deferred tax: intention to sell
Comment: This situation (a non-deductible, depreciable asset that is to be sold) is also covered in chapter 6’s
example 14, which shows the calculation and disclosure of current and deferred tax.
Journals on date of revaluation: Debit Credit

Property, plant and equipment (carrying amount) (A) 40 000
Revaluation surplus (OCI) W1 7 200
W1: Deferred tax:

PPE – sell: CA TB TD DT Calculations
x Depreciable
x Non-deductible
Balance before revaluation 100 000 0 (100 000) 0 Exempt (0%) (1)
Revaluation surplus 40 000 0 (40 000) (7 200) Balancing adjustment
Balance after revaluation (FV) 140 000 0 140 000 (7 200) Liability (4)
CA before revaluation 100 000 0 (100 000) 0 TD 100 000 = Exempt (1)
Depreciated cost: given
Revaluation surplus - up to cost: 10 000 0 (10 000) 0 TD 10 000 x 0% (2)
CA 100 000 – Cost 110 000
Revaluation surplus – above cost: 30 000 0 (30 000) (7 200) TD 30 000 x 80% x 30% (3)
Cost 110 000 – FV 140 000
1) This temporary difference is exempt in terms of paragraph 15 & 24 of IAS 12.
2) This would normally reflect the tax on the increase in the recoupment (before revaluation, the TD of
C100 000 suggested that, if it were a deductible asset and it was sold, it would render a recoupment
of C100 000, but after the revaluation upwards by C10 000 to original cost of C110 000, it would
result in a recoupment of C110 000 – being an increase in the recoupment of C10 000). However,
there would be no tax charged on this recoupment because no recoupment is possible, on the
grounds that the authorities had not allowed any tax deductions on the asset. We get around this by
simply multiplying the temporary difference (which normally reflects the increase in the
recoupment) by 0%.
3) This portion of the revaluation surplus represents the capital profit that would be earned if the asset
were to be sold. Only 80% of the capital gain is taxable.
4) Notice that the deferred tax does not equal 30% of the temporary difference. This is because:
x temporary differences relating to the cost were exempt in terms of IAS 12.15 &.24; and also
x part of the capital profit was exempt from tax due to the capital gains tax legislation.
452 Chapter 8
Another way of explaining this deferred tax balance is as follows:
Tax base 0
NOTE 1
Recoupment: N/A 0
Taxable capital gain: 30 000 x 80% x 30% 7 200

7 200
Note 1: This portion of the temporary difference is exempt in terms of IAS 12.15. This portion normally
reflects the recoupment that would occur if the asset was sold at C140 000. However, since the tax
authorities did not allow deductions on this asset, there can be no recoupment: if there were no previous
deductions granted, no recoupment of previous deductions is possible.
Example 21: Revaluation above cost: Deferred tax: Intention to keep

x depreciable,
x non-deductible asset
Assume the same information given in the previous example.
Required: Show the journal entries assuming that the intention is to keep the asset.
Solution 21: Revaluation: deferred tax: intention to keep

Comment:
x This is an asset that is revalued in terms of IAS 16’s revaluation model but since the asset is depreciable,
management’s real intention to keep the asset is not over-ridden by IAS 12.51B’s presumed intention to
sell (see chapter 6, section 4.4.2 for more about presumed intentions).
x This situation is also covered in chapter 6’s example 12, where example 13 focuses on how the deferred
tax balance should be measured.

Property, plant and equipment: carrying amount (A) 40 000
Deferred tax (A/L): see calculation below 12 000
Deferred tax on the revaluation surplus – see W1
W1: Calculation of deferred tax:

PPE – keep:
x Depreciable
x Non-deductible CA TB TD DT Calculations
Balance before revaluation 100 000 0 (100 000) 0 Exempt (0%) (1)

Balance after revaluation 140 000 0 140 000 (12 000) Liability (3)
CA before revaluation 100 000 0 (100 000) 0 Exempt (0%) (1)
Depreciated cost: given
Revaluation surplus - up to cost: 10 000 0 (10 000) (3 000) (0-10) x 30% (2)
CA 100 000 – Cost 110 000
Revaluation surplus – above cost 30 000 0 (30 000) (9 000) (0-30) x 30% (2)
Cost 110 000 – FV 140 000
1) This temporary difference of C100 is exempt in terms of paragraph 15 and 24 because the tax authorities did
not allow the deduction of tax allowances on the cost of C110, (this cost has since been depreciated and is
currently reflected at a carrying amount of C100).
2) The entire revaluation surplus of 40 (10 + 30) represents future profits from the use of the asset in excess of
those originally expected. Since these profits are simple trading profits and will thus be taxed at 30%, deferred
tax of 12 (40 x 30%) must be provided for.
Chapter 8 453
3) Since the entire temporary difference relates to the revaluation surplus and since this entire revaluation surplus
represents extra profits that will be taxed at 30%, the deferred tax equals 30% of the temporary difference.
Tax base 0 Profits up to cost:

(1)
100 000 x 0% (exempt) + 3 000
Original cost (and base cost) 110 10 000 x 30%
Profits above cost: 9 000
Revalued carrying amount 140 30 000 x 30% (2)
12 000
(1) This temporary difference is exempt in terms of paragraph 15 & 24.
4.3.4 Deferred tax on revalued assets: non-depreciable and non-deductible

If you do not depreciate the cost of your asset and the tax authority does not deduct the cost of
your asset by way of annual capital allowances, a temporary difference will immediately arise on
the purchase of your asset:
x the carrying amount is the cost and yet
x the tax base will be nil, since there will be no future tax deductions.
As was explained in the previous chapter, deferred tax is not recognised on the related temporary
differences since these are exempted in terms of IAS 12.15.
The exemption does not apply, however, to any further temporary differences caused by a
revaluation above the historical carrying amount (cost if the asset is non-depreciable and
depreciated cost of the asset is depreciable).
The carrying amount of an asset that is not depreciated will remain at cost (unless it is revalued). Thus, if
the asset is not revalued, the exempt temporary difference will always be the same: carrying amount (i.e.
the original cost) less its tax base of zero.
DT on the reval surplus of a
However, if a non-depreciable asset is revalued, its carrying non-depreciable,
non-deductible asset:
amount will no longer reflect cost, but a fair value instead.
The extra temporary difference caused by the revaluation is x Always assume intention to sell:
not exempt from deferred tax and the calculation of the - FV - Cost: Tax @ CGT rates
related deferred tax must always be based on an assumed intention to sell (i.e. the carrying amount is
always assumed to be the expected selling price even if the intention is actually to keep the asset!):
x since a non-depreciable asset (e.g. land) never gets ‘used up’, it is argued that it is not
possible to calculate a fair value based on future use; thus
x the fair value could only have been estimated using its expected selling price. See IAS 12.51B
The result is that the revaluation surplus above historical cost will be subject to deferred tax to
the extent that the capital profit is considered taxable under the capital gains tax legislation.
In summary: when dealing with non-depreciable assets: and non-deductible assets

x The revaluation surplus above cost is not exempt for purposes of calculating deferred tax
x The deferred tax on this revaluation surplus is always based on an assumed intention to
sell, even if your stated intention is to keep the asset.
Example 22: Revaluation of land above cost: Deferred tax: Intention to keep:
x non-depreciable,
x non-deductible asset
x A company owns land that cost C100 000. This land is not depreciated.
x The land is revalued to C140 000.
x The tax authorities do not allow the deduction of capital allowances on land. The tax rate is 30% and
80% of capital gains are included in taxable profits.
Required: Show the journal entries for the revaluation assuming that the intention is to:
A sell the asset
B keep the asset.
454 Chapter 8
Solution 22: Revaluation (land): deferred tax: management’s intention to keep is

overridden by the presumed intention to sell (IAS 12.51B)
Comment:
x This asset is revalued in terms of IAS 16’s revaluation model and since the asset is non-depreciable,
management’s real intention to keep the asset is over-ridden by IAS 12.51B’s presumed intention. The
deferred tax is thus measured on the presumed intention to sell the asset even though management’s
real intention is to keep the asset.
x This situation is also covered in chapter 6’s example 15, which shows the calculation and disclosure of
current and deferred tax.
Solution 22A: Revaluation (land): deferred tax: intention to sell

Revaluation of land: Increase above historical carrying amount (cost)
W1: Deferred tax on land – intention to sell

x Non-depreciable Carrying Tax Temp Deferred Calculations
x Non-deductible amount base difference taxation
Balance before revaluation 100 000 0 (100 000) 0 Exempt(1)
Balance after revaluation 140 000 0 140 000 (9 600) Liability (4)
Historical CA/ TB 100 000 0 (100 000) 0 Exempt (1)
Carrying amount before revaluation
Revaluation surplus – up to cost: 0 0 0 0 (0-0) x 30% (2)
No depreciation was provided
Revaluation surplus – above cost 40 000 0 (40 000) (9 600) (0-40) x 80% x 30% (3)
100 000 – 140 000
1) This temporary difference is exempt in terms of paragraph 15 and 24.

2) Since there is no depreciation, no part of the revaluation surplus reflects an increase in value back up to cost.
3) Since, in the case of land, it is assumed that the fair value must represent the expected selling price (no matter
whether the company intends to keep or sell it), this revaluation surplus is treated as an expected capital profit
which would be taxed at 24% (80% x 30%).
4) Notice that the deferred tax does not equal 30% of the temporary difference since only part of the temporary
difference represents a capital profit, and this part is effectively taxed at 24%.
Tax base 0 Recoupment at 30%: N/A 1
0
Original cost (and base cost) 100
Taxable capital gain at 24%: 9 600
Revalued carrying amount 140 40 000 x 80% x 30%
9 600
Note 1: Comparing the cost and TB suggests there is a recoupment of C100 000, but since no deductions
were granted by the tax authorities, clearly no recoupment of prior deductions is possible.
Solution 22B: Revaluation (land): deferred tax: intention to keep

The answer is the same as in example 22A in that we must apply IAS 12.51B. The reasoning is as follows:
x Since the land is a non-depreciable asset, it is clear that the asset has an indefinite useful life.
x When we revalue such an asset to fair value, we therefore have to assume that the fair value was based on
market values because it would not be humanly possible to calculate it based on its future use (indefinite).
x Therefore, irrespective of our stated intention to keep the land, we need to measure deferred tax as if we are
intending to sell it (since the fair value we used would have been based on the current market price).
Chapter 8 455
5. Disclosure (IAS 16.73 – .79)
5.1 Overview
The disclosure of property, plant and equipment involves various aspects: accounting policies
to be included in the notes to the financial statements, disclosure in the statement of
comprehensive income, statement of financial position and the statement of changes in equity.
5.2 Accounting policies and estimates
For each class of property, plant and equipment (e.g. land, buildings, machinery, etc) the
following should be disclosed:
x the measurement bases used (cost model or revaluation model); IAS 16.73
x depreciation methods used (e.g. straight-line method); See IAS 16.73
x useful lives or depreciation rates used (e.g. 5 years or 20% per annum). See IAS 16.73
The nature and effect of a change in estimate must be disclosed in accordance with IAS 8 (the
standard on ‘accounting policies, changes in accounting estimates and errors’). See IAS 16.76
5.3 Statement of comprehensive income and related note disclosure
The note that supports the ‘profit before tax’ line item in the statement of comprehensive
income should include the following items, disclosed per class of property, plant and
equipment (including all these items in this one note helps to save time in exams):
x depreciation expense (whether in profit or loss or in the cost of another asset); IAS 1.102-104
x impairment losses and the line item in the statement of comprehensive income in which it
is included, (i.e. this loss arises if the recoverable amount is less than carrying amount,
and any revaluation surplus has already been written off);
x reversal of impairment losses and the line item in the statement of comprehensive income
in which it is included (i.e. this reversal arises if the recoverable amount is greater than
carrying amount, but a reversal of an impairment loss only reflects an increase in carrying
amount up to historical carrying amount, being cost or depreciated cost depending on
whether the asset is depreciable or not, and only if it reverses a previous impairment loss);
x revaluation expense (i.e. if the fair value is less than depreciated cost and there is no
balance in the revaluation surplus account, the decrease is a revaluation expense);
x revaluation income (i.e. if the fair value is greater than depreciated cost and the increase
in carrying amount up to depreciated cost reverses a previous revaluation expense);
x profits or losses on the realisation, scrapping or other disposal of a non-current asset.
Where an asset is measured under the revaluation model with the result that a revaluation
surplus has been created or adjusted, this creation or adjustment to the revaluation surplus:
x must be presented as a separate line item under ‘other comprehensive income’, under the
sub-heading ‘items that may never be reclassified to profit or loss’;
x must be presented per class of property, plant and equipment (i.e. if there is a revaluation
surplus on machines and a revaluation surplus on plant, each of these movements in
revaluation surplus must be disclosed as separate line items); and
x may be shown on the face of the statement of comprehensive income either:
- after tax, with the gross and tax effects shown in a separate supporting note; or
- before tax, with the gross and tax effects shown on the face of the statement of
comprehensive income. See IAS 1.90 and .91
Any restrictions on the distribution to shareholders of a revaluation surplus must be disclosed:

this can be shown in the note supporting the other comprehensive income line item in the
statement of comprehensive income or in the property, plant and equipment note. See IAS 16.77(f)
456 Chapter 8
5.4 Statement of financial position and related note disclosure (IAS 16 and IFRS 13)
The following is the primary information that IAS 16 requires to be disclosed in the note to
the ‘property, plant and equipment’ line item in the statement of financial position.
This information must be disclosed separately for each class of property, plant and equipment
(e.g. land, buildings, machinery, etc):
x ‘gross carrying amount’ and ‘accumulated depreciation and impairment losses’ at the
beginning and end of each period; See IAS 16.73(d)
x a reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable:
additions;
disposals;
depreciation;
impairment losses recognised in profit or loss;
impairment losses reversed through the statement of comprehensive income;
revaluation income;
revaluation expense;
revaluation surplus increase, due to a revaluation;
revaluation surplus increase, due to an impairment loss reversed;
revaluation surplus decrease, due to a revaluation;
revaluation surplus decrease, due to an impairment loss;
assets transferred to ‘non-current assets held for sale’ in accordance with IFRS 5;
other movements (e.g. currency translation differences); See IAS 16.73(e)
x the existence and amounts of restrictions on title; See IAS 16.74(a)
x the existence and amounts of assets that have been pledged as security for a liability; IAS 16.74(a)
x the costs capitalised in respect of property, plant and equipment being constructed; IAS 16.74(b)
x the amount of any contractual commitments to acquire assets in the future; See IAS 16.74(c)
x when the revaluation model is adopted, then disclose:
the effective date of the latest revaluation;
whether or not the valuer was independent;
the carrying amount of the property, plant and equipment had the cost model been
adopted (per class of revalued property, plant and equipment). See IAS 16.77
The standard also requires that the accumulated depreciation be disclosed (as opposed to the
aggregate of the accumulated depreciation and accumulated impairment losses that is given in
the reconciliation of the carrying amount of the asset) at the end of the period.
IFRS 13 Fair value measurement requires certain minimum disclosures relating to how the
fair value was measured (the following is a brief outline of these requirements: details are
provided in chapter 25):
x If the asset is measured using the revaluation model, detailed disclosures are required in
relation to:
the valuation techniques (e.g. market, cost or income approach);
the inputs (e.g. quoted price for identical assets in an active market; an observable
price for similar assets in an active market) and whether these inputs were considered
to be level 1 inputs (most reliable) or level 3 inputs (least reliable). See IFRS 13.91 & .93
x If the asset is measured using the cost model and thus its measurement does not involve
fair value but its fair value still needs to be disclosed in the note (see further encouraged
disclosure, section 5.6 below), the required disclosures are similar but fewer. See IFRS 13.97
5.5 Statement of changes in equity disclosure (IAS 16.77(f); IAS 1.106(d) & IAS 1.106A)
If property, plant and equipment is measured under the revaluation model, there may be a
revaluation surplus which would need to be disclosed as follows:
x increase or decrease in revaluation surplus during the period (net of tax): this will be the
amount per the statement of comprehensive income;
x realisations of revaluation surplus (e.g. transfer to retained earnings as the asset is used); and
x any restrictions on the distribution of the surplus to shareholders.
Chapter 8 457
5.6 Further encouraged disclosure (IAS 16.79)
The following disclosure is encouraged:

x the carrying amount of property, plant and equipment that is temporarily idle;
x the gross amount of property, plant and equipment that is still in use but that has been
fully depreciated;
x the carrying amount of property, plant and equipment that is no longer used and is to be
disposed of (but not yet classified as held for sale in accordance with IFRS 5); and
x the fair value of the asset, if the cost model is adopted and the difference between fair
value and carrying amount is material.
5.7 Sample disclosure involving property, plant and equipment
ABC Limited
Depreciation is not provided on land and buildings since it is considered to be an investment
property. Depreciation is provided on all other property, plant and equipment over the expected
economic useful life to expected residual values using the following rates and methods:
- Plant at 10% per annum, reducing balance method.
Plant is revalued annually to fair values and is thus carried at fair value less accumulated
depreciation and impairment losses. All other property, plant and equipment is shown at cost less
accumulated depreciation and impairment losses.

20X2 20X1
Total net carrying amount: C C
Land and buildings c b
Plant f e
c+f b+e
Land and Buildings: Plant

20X2 20X1 20X2 20X1
C C C C
Net carrying amount: 1 January b a e d
Accumulated depreciation & impairment losses
Additions
(Disposals)
(Depreciation)
(Impairment loss)/ Impairment loss reversed
Revaluation increase/ (decrease) through OCI
Revaluation increase/ (decrease) through P/L
Other
Net carrying amount: 31 December c b f e
Accumulated depreciation and impairment losses
Land was revalued on 1/1/20X1, by an independent sworn appraiser, to its fair value.
The valuation technique used to determine fair value was the market approach and the inputs used
included observable prices for similar assets in an active market. All inputs are level 1 inputs.
The fair value adjustment was recorded on a net replacement value basis.
Revaluations are performed annually.
Had the cost model been adopted, the carrying amount would have been CXXX (20X0: CXXX).
Plant is provided as security for a loan (see note 15: loans).
458 Chapter 8
ABC Limited
Notes to the financial statements Continued ...
27. Profit before tax 20X2 20X1

C C
Profit before tax is stated after taking the following into account:
Revaluation expense (income) on plant
Impairment losses (reversals of losses) on plant
20X2 20X1
28. Other comprehensive income: Revaluation surplus: PPE C C
Increase/ (decrease) in revaluation surplus before tax

Deferred tax on increase/ (decrease) in revaluation surplus
Increase/ (decrease) in revaluation surplus, net of tax
There are no restrictions on the transfer of this revaluation surplus to shareholders.
ABC Limited
20X2 20X1
Note C C
Profit for the year 27
Other comprehensive income for the year
Items that may never be reclassified to profit or loss
- Revaluation surplus, net of tax: Property, plant and equipment 28
Total comprehensive income for the year
ABC Limited
Revaluation Retained Total
surplus: PPE earnings
C C C
Balance at 1 January 20X1
Total comprehensive income
Realised portion transferred to retained earnings
Balance at 31 Dec 20X1
Total comprehensive income
Realised portion transferred to retained earnings
Balance at 31 December 20X2
ABC Limited
20X2 20X1
ASSETS Note C C
Non-current Assets
Property, plant and equipment 4
Chapter 8 459
Example 23: Revaluation model disclosure

An entity purchased plant on 1 January 20X1 at a cost of C100 000. It was immediately
available for use and depreciated at 20% per annum on the straight-line basis to an estimated
nil residual value.
The company revalues its plant on an annual basis and records the fair value adjustments using the net
replacement value basis. The following revaluations were performed:
Fair value at 1/1/20X2 is C90 000
The fair values were all measured using the income approach and inputs included inputs based on market
expectations of future net cash inflows from the use of the asset. All inputs are level one inputs.
Revaluation surplus is recognised in retained earnings over the useful life of the plant.
There are no other items of property, plant or equipment.
Profit for each year is C100 000 (after tax).
There are no components of other comprehensive income other than that which is evident from the
information provided.
Required:
A. Disclose the plant and all related information in the financial statements for the years ended
31 December 20X1, 20X2, 20X3 and 20X4 in accordance with IAS 16 and IFRS 13.91(a).
Ignore deferred tax.
B. Provide the journals (using the net replacement value method) and show all additional or revised
related disclosure assuming that:
x Deductible allowance (wear and tear) granted by the tax authorities 20% straight-line p.a.
x The company intends to keep the plant.
x There are no other temporary differences other than those evident in the information provided.
x Other comprehensive income is presented net of tax in the statement of comprehensive income.
C. Assume the information given in B above except that the company presents other comprehensive
income gross and net on the face of the statement of comprehensive income. Show how the
disclosure would change.
Solution 23A: Revaluation model disclosure - no deferred tax
The journals for part A may be found under examples 9, 10 and 11.
ABC Limited
20X4 20X3 20X2 20X1
C C C C
Plant is revalued annually to fair values and is thus carried at fair value less subsequent accumulated
depreciation and impairment losses.
Depreciation is provided on all property, plant and equipment over the expected economic useful life
to expected residual values using the following rates and methods:
460 Chapter 8
ABC Limited
For the year ended 31 December 20X4 (extracts) continued …
20X4 20X3 20X2 20X1
12. Property, plant & equipment (extract) C C C C
Plant
Net carrying amount: 1 January 36 000 67 500 80 000
Gross carrying amount 54 000 90 000 100 000 0
Acc dep and impairment losses (18 000) (22 500) (20 000) 0
x Additions 0 0 0 100 000
x Depreciation (22 000) (18 000) (22 500) (20 000)
x Revaluation surplus increase/ (decrease) 4 000 (7 500) 10 000 0
x Revaluation income/ (expense) 4 000 (6 000) 0 0
Net carrying amount: 31 December 22 000 36 000 67 500 80 000
Gross carrying amount 44 000 54 000 90 000 100 000
Acc depr and impairment losses (22 000) (18 000) (22 500) (20 000)
The last revaluation was performed on 1/1/20X4 by an independent sworn appraiser to its fair value.
The valuation technique used to determine fair value was the income approach, where the inputs
included the market expectations regarding discounted future cash flows. All inputs are level 1
inputs. The fair value adjustment was recorded on a net replacement value basis. Revaluations are
performed annually.
Carrying amount if the cost model was used: 20 000 40 000 60 000 80 000
x Depreciation on plant 22 000 18 000 22 500 20 000
x Revaluation expense 0 6 000 0 0
x Revaluation income (4 000) 0 0 0
33. Other Comprehensive Income : Revaluation Surplus: Property, plant and equipment
Increase/ (decrease) in revaluation surplus 4 000 (7 500) 10 000 0

Deferred tax on increase/ (decrease) N/A* N/A* N/A* 0
Revaluation surplus movement, net of tax 4 000 (7 500) 10 000 0
There are no restrictions on the distribution of this revaluation surplus to shareholders.
*: Part A ignores tax.
ABC Ltd
Notes 20X4 20X3 20X2 20X1
C C C C
Profit for the period 100 000 100 000 100 000 100 000
Other comprehensive income for the period 4 000 (7 500) 10 000 0
x Items that may not be reclassified to profit/loss
Revaluation surplus increase/(decrease),
33 4 000 (7 500) 10 000 0
net of tax: plant
Total comprehensive income for the period 104 000 92 500 110 000 100 000
Chapter 8 461
ABC Ltd
C C C
Balance at 1 January 20X1 0 X X
Total comprehensive income 0 100 000 100 000
Balance at 31 December 20X1 0 X X
Realised portion transferred to retained earnings (2 500) 2 500
Balance at 31 December 20X2 7 500 X X
Total comprehensive income (7 500) 100 000 92 500
Realised portion transferred to retained earnings (2 000) 2 000
ABC Ltd
20X4 20X3 20X2 20X1
ASSETS Note C C C C
Non-current assets
Property, plant and equipment 12 22 000 36 000 67 500 80 000
Revaluation surplus (from SOCIE) 2 000 0 7 500 0
Solution 23B: Revaluation model disclosure - with deferred tax
Journals Dr/ (Cr)

1/1/20X1
Bank/ Loan (A/L) (100 000)
Purchase of asset
31/12/20X1
Depreciation: plant (E) (100 000 / 5 years remaining) 20 000
Plant: accumulated depreciation (-A) (20 000)
Depreciation
1/1/20X2:
Plant: cost (A) (20 000)
NRVM: set-off of accumulated depreciation before revaluing asset
Plant: cost (A) W1 10 000
Revaluation surplus (OCI) (10 000)
NRVM: revaluation of asset
Deferred tax (A/L) (3 000)
Deferred tax on revaluation surplus
462 Chapter 8

Journals continued ... Dr/ (Cr)
31/12/20X2:
Revaluation surplus (OCI) (7 000 / 4 years remaining) or (22 500 revalued depr – 1 750
Retained earnings (Equity) 000 historic depreciation) x 70% (1 750)
Transfer of revaluation surplus to retained earnings (effectively reverses the artificial
decrease in after-tax profits)
Deferred tax (L is reduced) W1 750
Tax expense (E) (750)
Deferred tax on plant (tax effect of the difference between depr and tax deduction)
1/1/20X3
NRVM: Set off of accumulated depreciation against cost
Revaluation surplus (OCI) W1: balance in revaluation surplus 7 500
Revaluation expense (E) W1: (13 500 - 7 500) 6 000
Plant: cost (A) 67 500 - 54 000 (13 500)
Revaluation of plant downwards to fair value
Deferred tax (L is reduced) W1; or 7 500 x 30% 2 250
Revaluation surplus (OCI) (2 250)
Deferred tax on reversal of revaluation surplus
Deferred tax (A/L) W1 1 200
Tax expense (E) (1 200)
Deferred tax on plant (tax effect of depr & reval expense versus tax deduction)
1/1/20X4
NRVM: Set-off of accumulated depreciation against cost
Plant: cost (A) 36 000 – 44 000 8 000
Revaluation income (I) W1: up to historical carrying amount (depreciated cost) (4 000)
Revaluation surplus (OCI) W1: above historical carrying amount (depreciated cost) (4 000)
Revaluation of plant upwards to an increased fair value
Revaluation surplus (OCI) W1 or 4 000 x 30% 1 200
Deferred taxation (A is reduced) (1 200)
Deferred tax on creation of revaluation surplus
31/12/20X4
Revaluation surplus (OCI) (2 800) / 2 years; OR (22 000 revalued depreciation 1 400
Retained earnings (Equity) 20 000 historic depreciation) x 70% (1 400)
Transfer of revaluation surplus to retained earnings (effectively reverses the artificial
decrease in after-tax profits)
Tax expense (E) W1: 1 200 - 600 600
Deferred tax (A/L) (600)
Deferred tax on plant (tax effect of depr & reval income versus tax deduction)
Chapter 8 463
Disclosure:
ABC Ltd
20X4 20X3 20X2 20X1
ASSETS Note C C C C
Non-current assets
Property, plant and equipment 12 22 000 36 000 67 500 80 000

Equity
Revaluation surplus (from SOCIE) 7 1400 0 5 250 0
ABC Ltd
Notes 20X4 20X3 20X2 20X1
C C C C
Other comprehensive income 2 800 (5 250) 7 000 0
x Items that may not be reclassified to profit/loss
Revaluation surplus increase / 7 2 800 (5 250) 7 000 0
(decrease), net of tax: plant
Total comprehensive income 102 800 94 750 107 000 100 000
ABC Ltd
C C C
Balance at 1 January 20X1 0 X X
Realised portion transferred to retained earnings (1 750) 1 750 0
Total comprehensive income (5 250) 100 000 94 750
Realised portion transferred to retained earnings (1 400) 1 400 0
464 Chapter 8
ABC Limited
20X4 20X3 20X2 20X1
4. Deferred taxation asset/ (liability) C C C C
The deferred taxation balance comprises:
Property, plant and equipment (600) 1 200 (2 250) 0
(600) 1 200 (2 250) 0
Reconciliation:
Opening balance 1 200 (2 250) 0 0
Deferred tax: charged to profit or loss (600) 1 200 750 0
Deferred tax: other comprehensive income (1 200) 2 250 (3 000) 0
Closing balance (600) 1 200 (2 250) 0
6. Income tax expense/ (income)

x current X X X X
x deferred 600 (1 200) (750) 0
7. Other comprehensive income: Revaluation surplus: Property, plant and equipment

Increase/ (decrease) in revaluation surplus 4 000 (7 500) 10 000 0
Deferred tax on increase/ (decrease) (1 200) 2 250 (3 000) 0
Movement in revaluation surplus, net of tax 2 800 (5 250) 7 000 0
There are no restrictions on the distribution of this revaluation surplus to shareholders.
Workings:
W1: Deferred tax calculation:
Carrying Tax Temp Deferred Details Revaluation
Plant amount base diff taxation surplus
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000 0 0
Depreciation 1 (20 000) (20 000) 0 0
Balance: 31/12/20X1 80 000 80 000 0 0
Revaluation surplus 10 000 0 (10 000) (3 000) Cr DT (SOFP) (10 000)
(equity increase) Dr RS (OCI) 3 000
Fair value 90 000 80 000 (7 000)
Depreciation 2 (22 500) (20 000) 2 500 750 Dr DT (SOFP) 1 750
Cr TE (P/L)
Balance: 31/12/20X2 67 500 60 000 (7 500) (2 250) Liability (5 250)
Revaluation surplus (7 500) 0 7 500 2 250 Dr DT (SOFP) 7 500
(equity decrease) Cr RS (OCI) (2 250)
Depreciated cost: HCA 60 000 60 000 0 0
Revaluation expense (6 000) 0 6 000 Dr DT (SOFP)
1 200
Fair value 54 000 60 000 Cr TE (P/L)
Depreciation 3 (18 000) (20 000) (2 000)
Balance: 31/12/20X3 36 000 40 000 4 000 1 200 Asset 0
Revaluation income 4 000 0 (4 000) (1 200) Cr DT (SOFP)
Dr TE (P/L)
Depreciated cost: HCA 40 000 40 000
Revaluation surplus 4 000 0 (4 000) (1 200) Cr DT (SOFP) (4 000)
(equity increase) Dr RS (OCI) 1 200
Fair value 44 000 40 000 (2 800)
Depreciation 4 (22 000) (20 000) 2 000 600 Dr DT (SOFP) 1 400
Cr TE (SOCI)
Balance: 31/12/20X4 22 000 20 000 (2 000) (600) Liability (1 400)
Chapter 8 465

Calculations:
(1) Depreciation 20X1 (100 000/ 5 years)
Solution 23C: Revaluation model disclosure – with deferred tax
Comment:
x The only difference between Part C and Part B is that Part C now shows how to disclose the movement
in other comprehensive income in a way that shows both the gross amount of the movement (i.e. before
tax) and the amount net of tax on the face of the statement of comprehensive income (see below).
x Since the disclosure on the face of the statement of comprehensive income is so detailed, the note
entitled ‘tax on other comprehensive income’ (see 23B, note number 7) is no longer required.
x The journals and workings for Part C are identical to those in Part B.
x There are no other differences between Part B and Part C in terms of any other disclosures.
ABC Ltd
Notes 20X4 20X3 20X2 20X1
C C C C
Other comprehensive income for the period 2 800 (5 250) 7 000 0
x Items that may never be reclassified to profit/loss
Revaluation surplus increase/ (decrease) on 4 000 (7 500) 10 000 0
property, plant and equipment, before tax
Taxation effect of revaluation surplus 7 (1 200) 2 250 (3 000) 0
increase/ (decrease)
Total comprehensive income for the period 102 800 94 750 107 000 100 000
466 Chapter 8
6. Summary
Measurement models: a comparison
Cost model (explained in Ch 7) Revaluation model (explained in Ch 8)

Measurement of the carrying amount: Measurement of the carrying amount:
cost fair value on date of revaluation
less accumulated depreciation less subsequent accumulated depreciation
less accumulated impairment losses less subsequent accumulated impairment
losses
The rule: The rule:

an asset may be written down below HCA, but the asset may be valued to its fair value
may never be revalued above its HCA (HCA is (whether it is greater/ less than its HCA)
cost, in the case of a non-depreciable asset,
Increase in CA:
or depreciated cost, in the case of a
debit: asset (FV – ACA);
depreciable asset)
credit: income (to extent reverses
Increase in CA: previous impairment reversed previous reval expense: HCA – ACA)
debit: asset; credit revaluation surplus (FV – HCA)
credit: reversal of impairment loss (I)
limited to the carrying amount that it would Decrease in CA:
have had, had there never been an x credit: asset (FV – ACA);
impairment loss (i.e. limited to its HCA: cost x debit: RS (to extent reverses previous RS
or depreciated cost, depending on whether increases: ACA – HCA)
the asset is depreciable) x debit: reval expense (HCA - FV)
Decrease in CA: impairment The revaluation surplus:

x debit: impairment loss (E); transferred annually to retained earnings
x credit: asset (amount transferred equals after tax
effect on profits as a result of increased
depreciation); OR
transferred to retained earnings when
the asset is fully depreciated; OR
transferred to retained earnings when
the asset is disposed of.
Deferred tax: measurement

(reminder of the basic principles)

x Temporary difference x tax rate (unless exempted)
x DT = nil if TD is exempted: Exemption may occur if a temporary
difference arises on initial acquisition (see chp 6 for the full story on
deferred tax)
Temporary difference
Carrying amount versus Tax base
Carrying amount Tax base

Represents: Represents:
x Future economic benefits, being: x Future tax deductions, being:
Cost Cost
Less accumulated depreciation Less accumulated tax deductions
Less accumulated impairment losses
Chapter 8 467
Revaluation model: deferred tax
Depreciable Depreciable Non-depreciable

Deductible Non-deductible Non-deductible
Intention to keep: Intention to keep: Intention to keep:
TDs x 30% Split TDs as follows: Measure DT as if your
- 0 to HCA: @ 0% intention is to sell
(because exempt)
- HCA to Cost: @ 30%
- Above cost: @ 30%
Intention to sell: Intention to sell: Intention to sell:

Split TDs as follows: Split TDs as follows: Split TDs as follows:
- 0 - Cost: - 0 to HCA: @ 0% - Up to cost:
@ 30% (because exempt) @ 0% (exempt)
- Above cost: - HCA to Cost: @ 0% - Above cost:
@ 80% x 30% (no recoupment) @ 80% x 30%
- Above cost:
@ 80% x 30%
Revaluation model:
Disclosure (main points only)
Accounting policies
depreciation methods
rates (or useful lives)
cost or revaluation model
Statement of Statement of Statement of

comprehensive income changes in equity financial position
Depreciation Increase or decrease in RS Reconciliation between
Impairment losses Tax effect of creation or opening and closing balances
Reversals of impairments increase in RS Break-down of these balances
Transfers from RS to RE into gross carrying amount
Revaluation expense and accum. depreciation and
Revaluation income Any restrictions on impairment losses
distributions to shareholders
If revaluation model, also show:
- CA using cost model
- Valuation technique and
inputs used for FV
measurement
- Effective date of
revaluation
- Valuer independence
- Reversal of RS
- Imp. loss expensed
- Increase in/ creation of
RS
- Reversal of imp. loss
If cost model used:
- the FV may have to be
disclosed in note
Certain IFRS 13 disclosure
468 Chapter 8
Gripping GAAP Intangible assets
Chapter 9
Intangible Assets and Purchased Goodwill
References: IAS 38, IAS 36, IFRS 13, IFRS 3, IAS 1, IAS 20, IFRIC 12 & SIC 32 (incl. amendments to 1 December 2018)
Contents: Page
1. Introduction 471
2. Scope 471
3. Recognition and initial measurement 471
3.1 Overview 471
3.2 Recognition 471
3.2.1 Overview 472
3.2.2 Definition 472
3.2.3 Recognition criteria 472
3.2.4 Difficulties in meeting the definitions 473
3.2.4.1 The item must have no physical substance 473
Example 1: Physical substance and a fishing licence 473
Example 2: Physical substance and software 473
Example 3: Physical substance and a prototype 473
3.2.4.2 The item must be identifiable 473
Example 4: Identifiability 474
Example 5: Identifiability in a business combination 474
3.2.4.3 The item must be controllable 475
Example 6: Control 475
3.3 Initial measurement – the basics 475
3.3.1 Overview 475
3.3.2 Purchase price 475
3.3.3 Directly attributable costs 475
Example 7: Recognition and initial measurement 476
3.4 The effect of the method of acquisition on recognition and initial measurement 477
3.4.1 Overview of the methods of acquisition 477
3.4.2 The effect of the method of acquisition on the initial measurement 477
3.4.3 Intangible assets acquired through a separate purchase 477
3.4.3.1 Recognition 477
3.4.3.2 Initial measurement 478
3.4.4 Intangible assets acquired through an exchange of assets 478
3.4.5 Intangible assets acquired by government grant 478
3.4.6 Intangible assets acquired in a business combination 479
Example 8: Intangible asset acquired in a business combination 480
3.4.7 Intangible items that are internally generated 480
3.4.7.2 Internally generated goodwill 481
3.4.7.3 Internally generated intangible items other than goodwill 482
3.4.7.3.1 Overview of issues regarding recognition 482
3.4.7.3.2 Certain internally generated items are banned from being capitalised 482
3.4.7.3.3 The stages of internal generation 482
3.4.7.3.4 Recognition of costs in the research phase 483
3.4.7.3.5 Recognition and measurement of costs in the development phase 483
Example 9: Research and development costs 484
3.4.7.3.6 In-process research and development that is purchased 485
Example 10: In-process research and development 486
3.4.7.4 Web site costs 486
3.4.8 Intangible assets acquired through a service concession agreement 487
Chapter 9 469
4. Recognition of subsequent expenditure 488

5. Subsequent measurement: amortisation and impairment testing 488
5.1 Overview 488
5.2 Amortisation 489
5.2.1 Overview 489
5.2.2 Residual value and the depreciable amount 489
5.2.3 Period of amortisation 490
Example 11: Amortisation period and renewable rights 490
5.2.4 Method of amortisation 491
5.2.5 Annual review 492
5.3 Impairment testing 492
5.3.1 Impairment testing in general 492
5.3.2 Impairment testing of intangible assets with finite useful lives 493
5.3.3 Impairment testing of intangible assets with indefinite useful lives 493
5.3.4 Impairment testing of intangible assets not yet available for use 494
5.3.5 Reversing an impairment 494
Example 12: Impairments and reversals of an asset not yet available for use 494
6. Subsequent measurement: the two models 495
6.1 Overview 495
6.2 Cost model 495
6.3 Revaluation model 496
8. Deferred tax 497
9. Disclosure 498
9.1 General 498
9.2 Sample disclosure involving intangible assets (excluding goodwill) 499
10. Goodwill 501
10.1 Overview 501
10.2 Internally generated goodwill 501
10.3 Purchased goodwill 501
10.3.1 Positive goodwill: asset 501
Example 13: Positive purchased goodwill: asset 502
10.3.2 Negative goodwill: income 502
Example 14: Negative purchased goodwill: income 502
10.3.3 Initial recognition measured provisionally 503
Example 15: Provisional accounting of fair values 503
10.3.4 Adjustment in the initial accounting 504
10.3.5 Subsequent measurement of purchased goodwill 504
10.4 Disclosure of goodwill 504
10.4.1 Disclosure: positive goodwill: asset 504
10.4.2 Disclosure: negative goodwill: income 504
10.4.3 Sample disclosure involving goodwill 505
11. Black Economic Empowerment (BEE) transactions 505
Example 16: BEE equity credentials 506
12. Summary 507
470 Chapter 9
1. Introduction
Something that is intangible is simply something that is ‘unable to be touched’. Thus, this chapter is
simply about assets that have no physical substance. Examples of items without physical substance
include research and development, software, patents, trademarks, copyrights, brands, licences and even
things like the cost of training employees.
Intangible items are interesting because although we may know they exist and may know they are
beneficial to the entity, the fact that we can’t see or touch them sometimes makes it difficult to prove
that they are assets. In other words, we are sometimes unable to recognise an intangible item as an
intangible asset, in which case any costs related to this invisible item will have to be expensed instead.
The standard that covers these invisible and untouchable assets is IAS 38 Intangible assets.
2. Scope (IAS 38.2 - .7)
IAS 38 covers all intangible assets unless the asset:

x falls within the scope of another accounting standard, for example, intangible assets that:
are inventories (IAS 2),
are deferred tax assets (IAS 12),
are held under a lease (IFRS 16), See note below
reflect goodwill arising from a business combination (IFRS 3),
are assets related to employee benefits (IAS 19),
are non-current assets held for sale (IFRS 5),
are assets arising from contracts with customers that involve revenue (IFRS 15); and
are financial assets (IAS 32);
x relates to mineral rights and expenditure on the exploration for and evaluation of, or
development and extraction of non-regenerative resources such as minerals and oils.
Note: An intangible asset that is a licencing agreement (involving items such as movies, videos, plays,
manuscripts, patents and copyrights) held under a lease is covered by IAS 38 Intangible assets (i.e. it will not be
accounted for as a leased asset in terms of IFRS 16 Leases)
3. Recognition and Initial Measurement (IAS 38.18 - .71)
3.1 Overview
Recognition:
Before an intangible asset may be recognised, it must meet both:
x the definition of an intangible asset; and Recognise an IA if it meets IAS 38’s:
x the recognition criteria laid out in IAS 38. See IAS 38.18 x IA definition; and
x recognition criteria. See IAS 38.18
If an item meets both the above, it must be recognised as an
intangible asset. The initial measurement thereof will be at cost.
Initial measurement:
Interestingly, due to the intangible nature of the item, it may be
See IAS 38.24
difficult to prove that it should be recognised as an intangible x at cost.
asset. Similarly, even if we successfully prove it should be
recognised as an intangible asset, we may then find it difficult to establish the amount at which it should
be initially measured (cost may be difficult to determine). These difficulties may also be compounded
by the way in which the item is acquired.
Difference between IAS 38 and the 2018 Conceptual Framework: Definition and Recognition criteria
The asset definition in IAS 38 (see section 3.2.2) differs from the asset definition in the ‘2018 Conceptual
Framework’: a present economic resource controlled by the entity as a result of past events. CF 4.3
Similarly, the two recognition criteria given in IAS 38 (see section 3.2.3) differ from the two recognition criteria in
the ‘2018 Conceptual Framework’, which are that an item should only be recognised if it provides relevant information
and would be a faithful representation of the phenomena it purports to present. See CF 5.7
However, the IASB concluded that we should continue to use the definition and recognition criteria in IAS 38 because
these will still achieve the same outcome.
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The following sections explain the recognition of an intangible asset (section 3.2), the initial
measurement thereof (section 3.3) and also how the various methods of acquiring it could affect its
recognition and measurement (section 3.4).
3.2 Recognition (IAS 38.18 - .23)
3.2.1 Overview
As mentioned above, an item may only be recognised as an intangible asset if it meets both the
definition of an intangible asset and the recognition criteria that are provided in IAS 38. Let us
first consider the definition and then the recognition criteria.
3.2.2 Definition Both definiton and recognition
criteria must be met:
An intangible asset is defined as an ‘identifiable, non-
monetary asset without physical substance’. See IAS 38.8 IA definition
x identifiable
This definition makes reference to the word ‘asset’, x non-monetary
which it then defines as being ‘a resource controlled by x asset *:
- a resource controlled by the entity
an entity as a result of past events, and from which future - as a result of past events
economic benefits are expected to flow to the entity’. - from which an inflow of FEB is expected
Note: This ‘asset definition’, given in IAS 38, is not the x without physical substance. Reworded IAS 38.8
same asset definition given in the new ‘2018 CF’. IA recognition criteria *
x the expected inflow of FEB are probable
The ‘asset definition’ refers to there being an expectation x the cost is reliably measured. See IAS 38.21
of future economic benefits. These benefits could come IAS 38 versus ‘2018 CF’
in any form e.g. revenue, other income or even cost The asset definition and recognition
savings. For example: a new recipe may reduce criteria per IAS 38 differ from those
production costs. See IAS 38.17 in the new ‘2018 CF’.
However, due to the nature of intangible assets, it may be difficult to meet certain aspects of
both the ‘intangible asset definition’ and ‘asset definition’. For example:
x If we cannot touch it or see it:
- how can we say the asset is identifiable? (see the intangible asset definition)
- how can we prove that we control it? (see the asset definition)
x We may even have difficulty in deciding that the asset does not have physical substance (see the
intangible asset definition) (interestingly, this is not always as obvious as it may seem!).
Each of these difficulties (identifiability, control and physical substance) is explained in section 3.2.4.
3.2.3 Recognition criteria
Recognition criteria
Before an item that meets the ‘intangible asset definition’ (which (per IAS 38):
includes meeting the ‘asset definition’) may be recognised as an x the inflow of future
intangible asset, it must also meet the following recognition criteria: economic benefits to the
entity must be probable; and
x the expected inflow of future economic benefits from the
x the asset’s cost must be
asset must be probable; and reliably measurable.
x the cost must be reliably measured. See IAS 38.21 See IAS 38.21
Note: These recognition criteria, given in IAS 38, are not the same
recognition criteria given in the new ‘2018 CF’.
The nature of intangible assets can also lead to difficulties in meeting the recognition criteria. Possibly
the greatest difficulty would be in proving that the cost of the asset is ‘reliably measurable’.
For example: A reliable measure of the cost may be possible if the intangible asset was the only
asset purchased as part of a purchase transaction. However, if an intangible asset was purchased
as part of a group of assets, the purchase price would reflect the cost of the group of assets. In
this case we would need to be able to prove that we can reliably measure the portion of the cost
that should be allocated to the intangible asset within this group of assets. To be able to reliably
measure the portion of the cost that should be allocated to an invisible asset is far more difficult
than measuring it for an asset we can see.
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3.2.4 Difficulties in meeting the definitions
3.2.4.1 The item must have no physical substance (IAS 38.4-.7) No physical substance
Costs are frequently incurred on items that have both x If the item has physical and
intangible and tangible aspects. We will need professional non-physical aspects:
judgment to assess which element is more significant: the x apply IAS 38 or IAS 16
tangible (physical) or the intangible (non-physical) aspects. depending on which aspect is
more significant.
The standard that should be applied to the asset depends on x We use judgement to make this
assessment.
which aspect is the most significant, either:
x IAS 38 Intangible Assets; or
x IAS 16 Property, Plant and Equipment or any other appropriate standard.
Example 1: Physical substance and a fishing licence

Dee Limited acquired a fishing licence. The directors insist that it is a physical asset since
it is written on a piece of paper.
Required: Briefly explain whether or not Dee should recognise the licence as an intangible asset.
Solution 1: Physical substance and a fishing licence

Although the fishing licence has a physical form (the related legal documentation), the licence is considered
intangible rather than tangible since the most significant aspect is the licensed ‘ability’ to fish rather than the
physical proof thereof. Such a right (whether documented or not) is always considered to be intangible.
Example 2: Physical substance and software

Fee Limited acquired a machine that incorporates specialised software that monitors core
functions necessary in the operation of the machine, enables product design and manages
output quantity and quality.
Required: Briefly explain whether or not Fee should recognise the software as an intangible asset.
Solution 2: Physical substance and software

The most significant element would be the tangible machine. Since the software is integral to the
machine (i.e. it is not stand-alone software, but is software that has been designed specifically to enable
the operation of this machine), the cost of the software must be recognised as part of the machine and
would thus be accounted for as property, plant and equipment (IAS 16). However, if the software was
‘stand-alone’ software (i.e. the software could be used on a different platform and the machine could
operate without it), it would have been accounted for as an intangible asset (IAS 38).
Example 3: Physical substance and a prototype

Gee Limited has been researching and developing a wallet that is electronically connected
to one’s bank balance. The wallet is programmed to scream if you try to remove a credit
card when the related bank balance has reached a certain limit. If you insist on removing the cash
from the wallet despite the scream, the wallet phones the owner’s parent or partner in order to ‘get
help’. Gee has managed to create the first working prototype for this wallet.
Required: Briefly explain whether Gee should recognise the cost of the prototype as an intangible asset.
Solution 3: Physical substance and a prototype

Research and development is the pursuit of knowledge with the ultimate goal being to create a product that can
be produced and sold. Although a prototype has a physical form, it is the culmination of these years of research
and development, and so is the embodiment of knowledge than the mere physical parts making up its physical
form. Thus, the prototype must be accounted for as an intangible asset (IAS 38).
3.2.4.2 The item must be identifiable (IAS 38.11 - .12)
An important aspect of the ‘intangible asset definition’ is that the item must be identifiable.
Chapter 9 473
An asset is identifiable if either it:

x is separable; or Identifiable: an item is
x arises from contractual or other legal rights. See IAS 38.12 identifiable if it:
x is separable; or
For something to be separable, it must be:
x arises from contractual or legal
x capable of being separated or divided from the entity, and rights. See IAS 38.12
x sold, transferred, licensed, rented or exchanged,

x either individually or together with a related contract,
identifiable asset or liability, If it is not identifiable:
x regardless of whether the entity intends to do so. IAS 38.12(a) x it is not an IA
x it is internally generated goodwill.
Even if the asset is not separable, identifiability can still be
proven through the existence of contractual or other legal rights. These rights must be
considered even if they are:
x not transferrable; and/ or
x not separable from either the entity or other rights and obligations. See IAS 38.12 (b)
If we cannot prove that an individual asset is identifiable, we must not recognise it as a separate asset.
Instead, we account for it as goodwill. However, there are two kinds of goodwill:
x Acquired goodwill: this is recognised as an asset. It arises during business combinations and
reflects the synergies of all those assets acquired but which were not separately identifiable and
thus not able to be separately recognised.
x Internally generated goodwill: this is recognised as an expense. It arises from the synergies of the
assets within a business but where the costs involved in creating it are so similar to the general
running costs of a business, that they are expensed. In other words, these costs were not considered
‘separable’ from the costs of just running the business.
Acquired goodwill is not covered by the standard on ‘intangible assets’ (IAS 38) but rather by the
standard on ‘business combinations’ (IFRS 3). However, since it is linked to intangible assets, it is
briefly explained in section 3.4.6 and section 10.
Example 4: Identifiability
Guff Limited incurred C300 000 on a massive marketing campaign to promote a new
product. The accountant wishes to capitalise these costs.
Required: Briefly explain whether these costs are considered to be identifiable or not.
Solution 4: Identifiability
The cost of the advertising campaign is not separable as it cannot be separated from the entity and
sold, transferred, rented or exchanged.
Further, the advertising campaign does not arise from contractual or legal rights.
Therefore, the cost of the advertising campaign is not identifiable. Even if the other aspects of the
definition and recognition criteria are met, the advertising costs may not be recognised as an intangible
asset. This is because they create internally generated goodwill, which must be expensed.
Example 5: Identifiability in a business combination

Haw Limited acquired valuable business rights when it acquired Hee Limited.
x These rights, valued at C900 000, were acquired by Hee as part of a contract that was
awarded to it by the local government.
x Contractual terms stipulate that they belong exclusively to Hee and may not be
transferred in any way to another entity.
Required: Briefly explain whether these costs are considered to be identifiable or not.
Solution 5: Identifiability in a business combination

The business rights are not separable since the contract expressly states that the rights may not be transferred
by Hee Limited to another entity. However, identifiability of an asset does not require it to be separable – it
can also be proved if it arises from contractual or legal rights. Since the business rights were awarded by way
of a contract, they are contractual rights and are considered to be identifiable. If the other aspects of the
definition and the recognition criteria are met, these rights will be recognised as a separate intangible asset.
474 Chapter 9
3.2.4.3 The item must be controllable (IAS 38.13 - .16)

As mentioned above, the ‘intangible asset definition’ refers to an ‘asset’, which IAS 38 defines
as being a ‘resource controlled by the entity as a result of past events and from which an inflow
of future economic benefits is expected’. This means that for something to meet the ‘intangible
asset definition’, it will need to be controlled by the entity.
Control over an intangible asset is difficult to prove, but it may be achieved if the entity has:
x the ability to restrict accessibility by others to the asset’s future economic benefits; and
x the power to obtain the asset’s future economic benefits. See IAS 38.13
An asset’s future economic benefits can be controlled through legally enforceable rights (e.g.
copyright) but legal rights are not necessary to prove control; it is just more difficult to prove
that control exists if legal rights do not exist. See IAS 38.13
Control
For example, an entity may be able to identify a team of skilled
staff, a portfolio of customers, market share or technical We must be able to control the
asset’s FEB:
knowledge that will give rise to future economic benefits.
However, the lack of control over the flow of future economic We control the FEB if we:
benefits means that these items seldom meet the definition of x can restrict access to the FEB; &
an intangible asset. On the other hand, control over technical x have the power to obtain the FEB.
See IAS 38.13
knowledge and market knowledge may be protected by legal Legal rights: are useful when trying to
rights such as copyrights and restraint of trade agreements, in prove control but are not necessary!
which case these would meet the requirement of control.
Example 6: Control
Awe Limited incurred C200 000 on specialised training to a core team of employees. The
accountant wishes to capitalise these costs.
Required: Briefly explain whether these costs could possibly be recognised as an asset.
Solution 6: Control
Even if this training can be linked to an expected increase in future economic benefits, the training cost
is unlikely to be recognised as an intangible asset as, despite permanent employment contracts, it is
difficult to prove that there is sufficient control over both the employees (who can still resign) and the
future economic benefits that they might generate. If we cannot prove control,
x the item is not an asset – and
x if the item is not an asset, it automatically cannot be an intangible asset either.
3.3 Initial measurement – the basics (IAS 38.24 - .32)
Cost includes:
3.3.1 Overview
x purchase price and
Intangible assets are initially measured at cost. See IAS 38.24 x directly attributable costs. See IAS 38.27
- those that are necessary to
- bring the asset to a condition that
This cost can be broken down into: - enables it to be used in the manner
x the purchase price; and management intended. See IAS 38.31
x any directly attributable costs. See IAS 38.27
3.3.2 Purchase price (IAS 38.27 & .32) Spot the difference!
Costs capitalised to PPE
The purchase price must be calculated after: include:
x Deducting: discounts, rebates, refundable taxes and x Purchase price
interest included due to the payment being deferred x Directly attributable costs
beyond normal credit terms; x Future costs of dismantling,
x Adding: import duties and non-refundable taxes. removal and site restoration.
Ans: The third bullet doesn’t apply to IAs.
3.3.3 Directly attributable costs

Costs are considered to be directly attributable costs, if:
x they were necessary
x to bring the asset to a condition that enables it to be used as intended by management. See IAS 38.30 - .31
Chapter 9 475
Only those costs that were necessary are capitalised to an Quick! Do this…Compare
intangible asset. This also means that any income and x the list of examples of directly
expenses arising from incidental operations occurring attributable costs in IAS 38 with
before or during the development or acquisition of an x the list of examples of directly attributable
costs in IAS 16 (see chapter 7, section 3.3.3).
intangible asset may not be included in the cost of the
Try to explain why these differences exist
recognised asset (i.e. they must be recognised as income
Ans: The directly attributable costs that apply to PPE include a few
or expenses in profit or loss instead). See IAS 38.31 extra examples that cannot apply to IAs due to the nature of IAs (e.g.
it is impossible to install an IA and so the list of directly attributable
The necessary costs that may be capitalised are those that costs given in IAS 38 does not include ‘installation costs’).
bring the asset to a particular condition that enables it to be used as management intended. Thus,
capitalisation of costs ceases as soon as the asset has been brought to that condition. See IAS 38.30
IAS 38 lists examples of directly attributable costs:
a) professional fees arising directly from bringing the asset to its working condition;
b) cost of employee benefits arising directly from bringing the asset to its working condition; and
c) cost of testing whether the asset is functioning properly.
Example 7: Recognition and initial measurement
On 30 June 20X4, Bee Limited discovered that it had been manufacturing a product
illegally because this product was patented and yet Bee did not have the necessary rights.
Bee immediately shut down its factory and hired a firm of lawyers to act on its behalf in the acquisition
of the necessary rights to manufacture this product.
x Legal fees of C50 000 were incurred during July 20X4.
x The legal process was finalised on 31 July 20X4, when Bee was then required to pay C800 000 to
purchase the rights, including C80 000 in refundable VAT.
x During the July factory shut-down:
- overhead costs of C40 000 were incurred; and
- significant market share was lost with the result that Bee’s total sales over August and
September was C20 000 but its expenses were C50 000, resulting in a loss of C30 000.
x To increase market share, Bee spent an extra C25 000 aggressively marketing their product. This
marketing campaign was successful, resulting in sales returning to profitable levels in October.
The accountant wishes to capitalise the cost of the patent at:
Purchase price: C800 000 + Legal fees: C50 000 + Overheads during the forced shut-down in July:
C40 000 + Operating loss in Aug & Sept: C30 000 + Extra marketing required: C25 000 = C 945 000
Required: Briefly explain whether or not each of the costs identified may be capitalised.
Solution 7: Recognition and initial measurement

Calculations C
x Purchase price: The purchase price should be capitalised, 800 000 – 80 000 720 000
but this must exclude refundable taxes.
x Legal costs: This is a directly attributable cost. Directly Given 50 000
attributable costs must be capitalised.
x Overhead costs: This is an incidental cost not necessary to Incidental costs may -
the acquisition of the rights (the shut-down was only not be capitalised
necessary because Bee had been operating illegally).
x Operating loss: The operating loss incurred while demand Costs incurred after the -
for the product increased to its normal level is an example IA is available for use
of a cost that was incurred after the rights were acquired. may not be capitalised
x Advertising campaign: The extra advertising incurred in Costs incurred after the -
order to recover market share is an example of a cost that IA is available for use
was incurred after the rights were acquired. Furthermore, may not be capitalised
advertising costs are listed in IAS 38 as one of the costs
that may never be capitalised as an intangible asset.
IAS 38 also includes a list of examples that may never be capitalised to the cost of an intangible
asset. These include costs related to:
a) introducing a new product or service (including advertising or promotions);
b) conducting business in a new area or with a new class of customer (including staff training); and
c) administration and other general overheads. Reworded from IAS 38.29
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3.4 The effect of the method of acquisition on recognition and initial measurement
3.4.1 Overview of the methods of acquisition
Intangible assets must meet the definition and recognition criteria if they are to be recognised.
If they are to be recognised, they must be initially measured at cost. Both the recognition of the
intangible asset and the initial measurement of its cost may be affected by the manner in which
the intangible asset was acquired or created. It could have been:
x acquired as a separate purchase (i.e. purchased as a separate asset); or
x acquired by way of an exchange of assets; or
x acquired as part of a business combination; or
x acquired by way of a government grant; or
x acquired by way of a service concession agreement (IFRIC 12); or
x internally generated.
3.4.2 The effect of the method of acquisition on the initial measurement
For intangible assets acquired for cash, the measurement of cost is simple. If the intangible asset
was acquired in any other way (e.g. through an exchange of assets or by way of a government
grant) its cost is measured at its fair value. However, IAS 20 Government grants allows an
intangible asset that was received by way of a government grant to be measured at fair value or
the nominal amount paid for it (if any), or simply at a nominal amount used for purposes of
recording the acquisition of the asset, assuming nothing was paid for it (see chapter 15).
IFRS 13 provides guidance on how fair value should be measured and defines fair value as:
x the price that would be received to sell an
asset (or paid to transfer a liability) Method of acquisition and initial
measurement
x between market participants x Initial measurement = cost
x Cost is measured at FV, unless the asset was
x at the measurement date. IFRS 13: Appendix A
purchased as a separate asset (in which case, follow
the normal rules).
IFRS 13’s definition refers to market participants,
and so the fair value is a market-based measurement. IAS 38 emphasises the fact that the fair value is
a market-based measurement when it clarified that the fair value of an intangible asset that is acquired
in a business combination reflects the market participants’ expectations at acquisition-date of the
probability of the inflow of future economic benefits resulting from the intangible asset. See IAS 38.33
Although the definition of fair value requires that market participants exist, the fair value on initial
measurement of the asset does not require that an active market for the asset exists. Of course, an active
market would make it easier to determine the fair value, but where one does not exist, IFRS 13 allows
the fair value for purposes of initial measurement to be determined in terms of valuation techniques
instead. It should be noted, however, that although the initial measurement at fair value does not require
the existence of an active market (i.e. valuation techniques can be used instead), the subsequent
measurement at fair value in terms of the revaluation model does require that the fair value be
determined in terms of an active market. The revaluation model is explained in section 6.3.
3.4.3 Intangible assets acquired through a separate purchase (IAS 38.25 -. 26)
3.4.3.1 Recognition If acquired through a separate
purchase:
In order to recognise an asset that was acquired via a x Recognition: only need to meet the definition
separate purchase, we only need to prove that the (the recognition criteria are always met)
intangible asset definition is met. This is because the x Measurement: cost (follow normal rules:
recognition criteria are met automatically. see section 3.3)
The recognition criteria are considered to be met automatically for the following reasons:
x Since the asset was purchased separately, it clearly has a value that is reliably measured
(being its purchase price);
x The fact that the asset was purchased in the first place indicates that the entity expects the inflow
of future economic benefits from the use of this asset is probable. In other words, in the case of a
purchase, the probability criterion is also automatically met.
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3.4.3.2 Initial measurement

If the asset was acquired separately (i.e. not as part of a ‘bundle of assets’) for cash, the cost is relatively
easy to measure and follows the general rules (see section 3.3):
x its purchase price, calculated after:
- deducting: discounts, rebates, refundable taxes and interest included due to the payment
being deferred beyond normal credit terms;
- adding: import duties and non-refundable taxes
x directly attributable costs.
x If payment is deferred such that there is a difference between the ‘cash cost’ and total
payments made, the difference between these two amounts is recognised as a finance
cost/interest expense in profit or loss. See IAS 38.27 & .32
3.4.4 Intangible assets acquired through an exchange of assets (IAS 38.45 - .47)
3.4.4.1 Recognition
In order to recognise an asset that was acquired via an asset exchange, it must meet both the definition
and recognition criteria. However, the asset acquired will only be recognised and the asset given up
will only be derecognised if the transaction has commercial substance. A transaction is said to have
commercial substance if its future cash flows are expected to change as a result of the transaction.
3.4.4.2 Initial measurement If acquired through an
asset exchange:
Where assets are exchanged, the cost of the intangible x Recognition: only if it meets the definition
asset acquired will be at fair value, measured as the: and recognition criteria & only recognise if
x fair value of the asset given up; or the transaction has commercial substance
x fair value of the acquired asset if this is more x Initial measurement: cost, where cost is:
- FV of asset given up; or
clearly evident; or the
- FV of asset acquired (if more clearly
x carrying amount of the asset given up if neither evident); or
of the fair values are available or the transaction - CA of asset given up (if no FV).
lacks commercial substance. IAS 38.45 & .47
For examples on the exchange of assets, see the chapter on property, plant and equipment.
3.4.5 Intangible assets acquired by government grant (IAS 38.44)
3.4.5.1 Recognition
On occasion, the government may grant an entity an intangible asset, such as a fishing licence. This
asset may be granted either at no charge or at a nominal amount.
If acquired through a
The recognition of an intangible asset that is acquired by way of a government grant:
government grant simply follows the general principles: meet the x Recognition: if it meets the
definition of an intangible asset and the recognition criteria. definition & recognition criteria
(i.e. it follows the normal rules)
3.4.5.2 Initial measurement x Measurement: cost
This cost is measured at:
- FV of asset acquired; or
The initial measurement of intangible assets acquired by way of - Nominal amount plus directly
government grants is at cost. The entity may choose to measure attributable costs
cost at either:
x the fair value of the asset acquired, or
x the nominal amount plus any directly attributable costs (i.e. those necessarily incurred in
order to prepare the asset for its intended use).
Please note that if an intangible asset acquired by way of government grant is measured at fair
value, then any further directly attributable costs that are incurred must be expensed since the
asset would otherwise be overstated.
For further information on intangible assets acquired by way of government grants, please see chapter 15.
478 Chapter 9
3.4.6 Intangible assets acquired in a business combination (IAS 38.33 - .37)

If acquired through a
3.4.6.1 Recognition business combination:
x Recognition: if it meets the definition
When one entity, A, acquires another entity, B, it acquires
(i.e. recognition criteria always met)
all the assets and liabilities of B, including any intangible
x Measurement: cost where cost is
assets previously belonging to B. measured at FV on acquisition date.
The acquirer (A) must recognise each intangible asset acquired on condition that it meets the
intangible asset definition. The recognition criteria are automatically assumed to be met.
The recognition criteria are always assumed to be met in a business combination because:
x We can assume that the ‘reliable measurement’ criterion is met. We assume this because, if
it is possible to identify the intangible asset (to meet the intangible asset definition, the
intangible asset would have to be identifiable), the standard states that there will be sufficient
information available for it to be reliably measured.
x We can assume that the ‘probability’ criterion is met. We assume this because the cost of an
intangible asset acquired in a business combination is its fair value, and the fair value in this
situation always reflects the market's expectation of the probable future inflow of benefits that
will result from the asset. Thus, since the fair value is able to be determined, there is no need
to still have to prove that the future inflow is probable because the fair value is the market
expectation of the probable inflow of these benefits. See IAS 38.33
Interestingly, this means that any intangible assets that the acquiree (B) was unable to recognise
because the recognition criteria were not met, will now be recognised by the acquirer (A) in a
business combination. For example,
x Internally generated goodwill is prohibited from being capitalised by the entity that created it. This
is because the costs of generating goodwill are inextricably mixed up with the costs incurred in
running a business i.e. there is no reliable way of separating the portion of the costs that relate to the
creation of goodwill from the general running costs. (e.g. how much of a teller’s salary relates to (a)
just performing a job, which must be expensed; and (b) a smiling face, which pleases our customers
and generates goodwill?). Since the cost of creating goodwill and the cost of running a business are
so inextricably linked, it means that internally generated goodwill is not reliably measurable.
x Purchased goodwill may, however, be capitalised. This arises when an entity is purchased for
a price that exceeds the fair value of the individual net assets (if the acquirer paid less than
the fair value of these net assets, the acquirer recognises this as a gain on a bargain purchase).
This excess is an asset that is recognised in the acquirer’s books as ‘purchased goodwill’:
Purchase price paid for entity – Fair value of the entity’s net assets = goodwill (purchased).
In other words, the company that created the goodwill will not recognise it as an asset in its own
books (because it is not reliably measurable), but if another company buys it and pays a premium
for it, this premium (purchased goodwill) is recognised as an asset in the purchaser’s books. The
logic is that, by buying a business at a premium over the fair value of its net assets, it means that
a reliable measure of its value has finally been established.
Important comparison!
If an intangible asset does not meet the definition in full
(e.g. it is not identifiable), then its value is excluded from Goodwill that is:
the ‘net asset value of the entity’ and the value of the x internally generated: expensed
unrecognised intangible asset is included and recognised x purchased: capitalised
as part of the purchased goodwill.
Another issue: For an asset to meet the intangible asset definition it must be identifiable. One
way to prove identifiability is to be ‘separable’. However, an intangible asset acquired in a
business combination may be separable from the company that is being acquired but only if it
is grouped with certain other assets (e.g. a trademark for a chocolate may be useless without the
related recipe). In such cases, the group of related intangible assets (trademark and recipe) is
recognised as a single asset, provided that the individual assets have similar useful lives.
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3.4.6.2 Initial measurement

The initial measurement of each intangible asset to be recognised as a result of a business
combination is at cost, where cost is its fair value on acquisition date. This fair value is measured
in terms of IFRS 13 Fair value measurement.
Example 8: Intangible asset acquired in a business combination
Great Limited acquires Stuff Limited for C700 000. Stuff’s net assets and liabilities are:
x Property, plant and equipment C500 000 Fair value
x Patent C100 000 See the required below
x Liabilities C200 000 Fair value
Required: Journalise the acquisition of Stuff Limited in the books of Great Limited assuming:
A The fair value of the patent is reliably measurable at C100 000.
B The fair value of the patent is not reliably measurable, and the value given above (C100 000) is
simply the carrying amount based on the depreciated cost to Stuff Limited.
C The purchase price of Stuff was C300 000 (not C700 000) and all values are fair values.
Solution 8A: Intangible asset acquired in a business combination

Debit Credit
Property, plant and equipment Given 500 000
Patent Given: FV reliably measured at 100 000 100 000
Liabilities Given 200 000
Bank Given 700 000
Goodwill (Asset) Balancing 300 000
Acquisition of Stuff Limited
Solution 8B: Intangible asset acquired in a business combination

Debit Credit
Property, plant and equipment (A) Given 500 000
Bank Given 700 000
Goodwill (A) Balancing 400 000
Comment:
x The patent is not recognised as an intangible asset since its cost (FV) is not reliably measured.
x This results in goodwill increasing from C300 000 (see solution 8A) to C400 000. This means that the
patent was actually recognised, not as an intangible asset, but as part of the goodwill instead.
Solution 8C: Intangible asset acquired in a business combination

Debit Credit
Property, plant and equipment Given 500 000
Patent Given: fair value reliably measured 100 000
Bank Given: revised in part C to 300 000 300 000
Gain on bargain purchase (I) Balancing 100 000
Comment:
x The goodwill is credited: this is called a gain on a bargain purchase (negative goodwill).
x This is recognised immediately as income in P/L (not as an asset as in 8A and 8B).
x It is recognised as income since Great paid less for Stuff than Stuff’s net asset value and thus Great
effectively made a profit on the acquisition.
3.4.7 Intangible items that are internally generated (IAS 38.48 - .67)
3.4.7.1 Overview
An entity may expend resources on the creation of intangible items with the intention to generate future
economic benefits. However, not all costs incurred in creating an intangible item may be recognised as
an intangible asset.
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The intangible items may be very specific items (e.g. patents and trademarks) or could be a bit
‘more vague’ but which, nevertheless, promote the creation of a successful business (e.g.
customer loyalty and efficient staff). Intangible items that promote the creation of a successful
business are contributing to ‘goodwill’. Since the entity is creating goodwill (as opposed to
purchasing another entity’s goodwill) it is referred to as ‘internally generated goodwill’.
Internally generated goodwill does not meet the intangible asset definition or recognition criteria
and so it is always expensed. Other intangible items may meet the intangible asset definition
and recognition criteria, in which case they must be recognised as intangible assets but
sometimes they won’t, in which case they are expensed.
Internally generated items
Internally generated goodwill Internally generated items other than goodwill
IA def. & recog. IA def. &/or recog.

IA def. & recognition criteria: not met
criteria: met criteria: not met
Expense Int. Gen. Asset Expense
3.4.7.2 Internally generated goodwill (IAS 38.48 - .50) Internally generated

goodwill is:
Costs such as those that develop customer loyalty, market
x not an intangible asset!
share, and efficient and happy staff members are costs that x always expensed
lead to the development of a successful business. Thus,
these costs help create internally generated goodwill.
These costs are very difficult to identify and measure separately from the general costs of simply
running the business (as opposed to running a successful business). Although internally
generated goodwill is expected to produce future economic benefits, it may not be capitalised.
This is because it does not completely meet certain aspects of the definition and recognition
criteria per IAS 38:
x it is not an identifiable resource (i.e. it is not separable from the costs of running a business
and it does not arise from any contractual or legal right);
x it may not be possible to control items such as customer loyalty; and more importantly
x it is impossible to reliably measure its value. See IAS 38.49
Important comparison!
As mentioned in the prior section (section 3.4.6),
Goodwill that is:
internally generated goodwill is always expensed by the
entity that creates it, but if this goodwill is then x internally generated: expensed
purchased by another entity in a business combination, it x purchased: capitalised
becomes purchased goodwill, which is capitalised by the purchaser.
This is because internally generated goodwill is not reliably measurable while it is being created
whereas purchased goodwill is reliably measurable, using the following equation:
Purchase price of entity – Fair value of the entity’s recognised net assets.
Some argue that the entity that creates the internally generated goodwill should be allowed to
recognise it by measuring it using an adaptation of the above equation by simply replacing ‘purchase
price’ with the ‘fair value’ of the entity. Problems with this idea include:
x the fair value of the entity would reflect a wide range of factors (including, for instance, the economic
state of the country), not all of which relate to the customer loyalty or other items forming part of
internally generated goodwill and thus would not be a good indicator of cost; and
x there is no control over these factors (e.g. we may be able to influence but we are unable to control the
economic state of the country or customer loyalty) and thus the asset definition would not be met.
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3.4.7.3 Internally generated intangible items other than goodwill (IAS 38.51 - .67)
3.4.7.3.1 Overview of issues regarding recognition
An entity may have an intangible item that has been internally generated. As always, before an
item may be recognised as an intangible asset, it must meet both the definition of an intangible
asset and the recognition criteria.
Recognising an internally generated intangible asset can sometimes be difficult because:

x it may be difficult to identify ‘whether and when there is an identifiable asset that will
generate expected future economic benefits’; and
x it may be difficult to determine the cost of the asset reliably, because the costs incurred in
creating an intangible asset internally are sometimes very similar to costs incurred in
‘maintaining or enhancing the entity’s internally generated goodwill or of running day-to-
day operations’, where these are expensed as internally generated goodwill. See IAS 38.51
IAS 38 bans certain internally generated items from being capitalised (see section 3.4.7.3.2). If
the internally generated item is not banned and it does not relate to internally generated
goodwill, we must consider whether we can capitalise the costs by first assessing at what stage
of the process of internal generation the cost was incurred (see section 3.4.7.3.3).
3.4.7.3.2 Certain internally generated items are banned from being capitalised
Costs incurred on creating certain internally generated Internally generated items

items may never be capitalised (i.e. must always be that are never capitalised:
expensed, such as internally generated goodwill). For the
x goodwill (see section 3.4.7.2);
full list of these items, see alongside.
x brands;
x mastheads;
Interestingly, had these items been acquired in any way
x publishing titles;
other than through internal generation (e.g. through a x customer lists; and
separate purchase) they would have been able to be x other similar items IAS 38.48 & .63
recognised as intangible assets.
The reason why the internal generation of these items results in them being expensed is because
the nature of the costs incurred in the process of creating them is very similar to the nature of
the costs incurred in operating a business. In other words, they are not separately identifiable
from the costs of developing the business as a whole. This means it is impossible to separate the
one from the other and reliably measure the costs to be capitalised. See IAS 38.64
3.4.7.3.3 The stages of internal generation (IAS 38.54 - .62)
There are two distinct stages (phases) that occur during the process of creating an intangible
asset, each of which will be discussed separately: Internal generation is
x research (IAS 38.54 - .56); split between 2 phases:
x development (IAS 38.57 - .62). - research phase;
- development phase.
The research phase is the gathering of knowledge and
understanding. This is then applied to the development phase which is when the entity uses this
knowledge and understanding to create a plan or design.
It is only once the research stage is completed, that the development stage may begin. Once
development is complete, the completed plan or design is available for use or production.
The ability to prove that the future economic benefits are probable (i.e. being one of the two
recognition criteria) differs depending on what phase the item is in (research or development).
In order to assess whether the costs incurred in the internal generation of an intangible asset
meet the criteria to be recognised as an asset or whether they must be expensed, we must separate
the costs into those that were incurred during each of these two phases.
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3.4.7.3.4 Recognition of costs in the research phase (IAS 38.54 - .56)
Research is the first stage in the creation of an intangible item, Research:

where we are merely investigating if there are possible future x Recognition: expense See IAS 38.54
economic benefits to be obtained from the item. There is no x Definition:
guarantee at this stage that the future economic benefits are: - original & planned investigation
x expected (so the definition is not met); or - undertaken with the prospect
- of gaining new
x probable (so the recognition criteria are not met). - scientific/ technical
- knowledge and understanding.
This means that research costs are always expensed. IAS 38.8
Examples of research activities include:
x activities aimed at obtaining new knowledge;

x the search for, evaluation and final selection of, applications of research findings or other knowledge;
x the search for alternatives for materials, devices, products, processes, systems or services;
x the formulation, design, evaluation and final selection of possible alternatives for new or improved materials,
devices, products, processes, systems or services. IAS 38.56
3.4.7.3.5 Recognition and measurement of costs in the development phase (IAS 38.57 - .71)
Development is the second stage in creating an intangible
item. It involves applying the research findings to the creation Development:
of a plan/ design that will then be used or put into production. x Recognition: asset or expense
x Definition:
Since it is a more advanced stage of creation, it may be - the application of research findings
possible to prove future benefits are expected and probable. or other knowledge
- to a plan or design
x Since the research was considered successful enough to - for the production of
have been allowed to progress to the development stage, - new or substantially improved
we conclude that future economic benefits are expected. - materials, devices, products,
processes, systems or services
x However, for us to be able to prove that these expected - prior to the commencement of
future economic benefits are probable, we are given five commercial production or use.
extra recognition criteria to consider. IAS 38.8
Before development costs may be recognised as an intangible asset, we must be able to prove
that six recognition criteria are met (i.e. the first 5 help us prove that the future economic benefits
are probable and the 6th criteria requires that the cost is reliably measurable).
The 6 recognition criteria relating to development costs:

(1) the technical feasibility of completing the asset;
(2) the intention to complete the asset and to either use or sell it;
(3) the ability to use or sell the asset;
(4) how the asset will generate future economic benefits, by , for example, demonstrating that there is a
market to sell to, or if the asset is to be used internally, then its usefulness;
(5) the adequate availability of necessary resources (technical, financial or otherwise) to complete the
development and to sell or use the asset; and
(6) the ability to reliably measure the cost of the development of the asset. See IAS 38.57
If any one of these six criteria is not met, then the related costs must be expensed.
However, if all six criteria are met it is said that the recognition criteria are met. Then, assuming
the definition of an intangible asset was also met, the item must be capitalised.
Examples of development activities include:

x the design, construction and testing of pre-production or pre-use prototypes and models;
x the design of tools, jigs, moulds and dies involving new technology;
x the design, construction and operation of a pilot plant that is not of a scale economically feasible for
commercial production; and
x the design, construction and testing of a chosen alternative for new or improved materials, devices,
products, processes, systems or services. IAS 38.59
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Diagram: Summary of the recognition of research and development costs
Costs incurred creating internally generated assets are split between:
Research phase Development phase
Expense Expense Asset

If any of the 6
Always If all 6 criteria met
criteria are not met
Once an internally generated item meets the definition and recognition criteria (as discussed
above), the next step is to decide which of the related costs may be capitalised.
Only costs that are
Costs that may be capitalised are only those that are: ‘directly attributable’ may be
x directly attributable capitalised. See IAS 38.66
x to creating, producing and preparing the asset
x to be able to operate in the manner intended by management. Reworded from IAS 38.66
Professional judgement is required to decide whether or not a cost is ‘directly attributable’.
x Costs of materials, services, professional fees (e.g. to register a patent) and employee benefits
that were necessary in the creation of the intangible asset are all 'directly attributable'.
x If other patents and licences were used to create the intangible asset, their amortisation
would also be considered ‘directly attributable’.
x If the creation of the intangible asset required money to be borrowed, then the borrowing
costs would be considered ‘directly attributable’ and capitalised on condition that they met
the criteria for capitalisation set out in IAS 23 Borrowing costs. See IAS 38.66
Directly attributable costs never include:

x selling, administrative & other general overheads unless they are directly attributable to preparing the asset for use;
x costs due to identified inefficiencies occurring before the asset reaches its planned performance level.
x costs reflecting initial operating losses because the asset had not yet reached its planned performance level;
Reworded from IAS 38.67
x costs of training staff how to operate the asset.
Costs that were expensed in a prior financial period Development costs that are
because not all 6 recognition criteria were met when expensed:
they were incurred, may never be subsequently x because the RC are not met, may not be
capitalised, even if all 6 criteria are subsequently met. subsequently capitalised when the RC are met,
See IAS 38.71
x due to an impairment, may be subsequently
When development is complete and the development capitalised if and when the reason for the
asset is available for use, capitalisation of costs to this impairment disappears! See IAS 38.71 & IAS 36.114
asset must cease. At this point, the inflow of
economic benefits from the use of the developed asset can begin and thus amortisation begins.
Amortisation is explained in section 5.2.
The development asset must be tested for impairments both during its development and after its
completion. Impairment losses are expensed. If, later, the reason for the original impairment
disappears, the impairment expense may be reversed and capitalised to the asset (debit asset and
credit impairment expense). However, this does not apply to an impairment of goodwill: these
mayy never be reversed. Impairment testing is explained in section 5.3.
Example 9: Research and development costs
Lab Limited began researching and developing a wireless modem – one which truly did not have
any wires – something they planned to call the ‘Less-wire Wireless’. The following is a summary
of the costs that the Research & Development (R&D) Department incurred each year:
20X1: R&D costs C180 000
20X2: R&D costs C100 000
20X3: R&D costs C80 000
x The costs listed above were incurred evenly throughout each year.
484 Chapter 9
x Included in the costs incurred in 20X1 are administrative costs of C60 000 that are not considered
to be directly attributed to the research and development process. The first two months of the year
were dedicated to research. Then development began from 1 March 20X1 but all 6 recognition
criteria for capitalisation of development costs were only met on 1 April 20X1.
x Included in the costs incurred in 20X2 are administrative costs of C20 000 that are considered to be
directly attributed to the research and development process.
x Included in the costs incurred in 20X3 are training costs of C30 000 that are considered to be directly
attributed to the research and development process: in preparation for the completion of the
development process, certain employees were trained on how to operate the asset.
Required: Show all journals related to the costs incurred for each of the years ended 31 December.
Solution 9: Research and development costs

20X1 Debit Credit
Administration expense (E) Given – not directly attributable 60 000
Research expense (E) (180 000 – 60 000) x 2/12 20 000
Development expense (E) (180 000 – 60 000) x 1/12 10 000
Development: cost (A) (180 000 – 60 000) x 9/12 90 000
Bank/ liability 180 000
Research & development costs: all 6 criteria were met on 1/4/20X1. Capitalise costs incurred after this date
& expense costs incurred before this date. Costs not directly attributable to R&D are also expensed.
20X2
Development: cost (A) 100 000
Development costs incurred (the administration costs of C20 000 are capitalised because they are
directly attributable to the R&D project)
20X3
Training expense (E) Given – not directly attributable 30 000
Development: cost (A) (80 000 – 30 000) 50 000
Development costs incurred (training costs of C30 000 are expensed as they are expressly not allowed
to be capitalised to the intangible asset)
Comment:
x Administration costs are capitalised if they are directly attributable (see 20X2), otherwise they are expensed (see 20X1).
x Training costs are always expensed even if they are considered to be directly attributable (see 20X3).
x Research costs are always expensed.
x Development costs that are expensed due to being incurred before the recognition criteria were met may not be
subsequently capitalised, even if the recognition criteria are subsequently met. They remain expensed. Please
also see example 12 in this regard.
3.4.7.3.6 In-process research and development that is purchased
Whereas many companies do their own research and In-process R&D:

development, it is possible for a company to simply buy
another company’s research and development. x Recognised: if it:
- meets the asset definition; and
If a company buys (either separately or as part of a - is identifiable
business combination) another company’s ‘in-process x Measured:
research and development’, the cost incurred must be - Initial cost: FV on acquisition date
(includes research & development!)
recognised as an asset if it:
- Subsequent cost:
x meets the definition of an asset (the basic asset o Research = expense
definition provided in the CF); and o Development = asset/ expense
x is identifiable (i.e. is separable or arises from
contractual or other legal rights). See IAS 38.34
The cost of the asset is measured at the fair value on acquisition date. This is the fair value of both the
research and development. So, when we buy somebody else’s research and development we end up
Chapter 9 485
capitalising not only the cost of development but also the cost of research (whereas research costs are
normally expensed). IAS 38.33 - .34
However, subsequent costs on this purchased ‘in-process research and development’ project
will be analysed and recognised in the normal way:
x costs that relate to research must be expensed;
x costs that relate to development:
- must be expensed if all recognition criteria are not met; and
- must be capitalised if all recognition criteria are met. See IAS 38.43
Example 10: In-process research and development

On 1 January 20X9, Pen Limited bought an incomplete research and development project
from Nib Limited for C300 000 (i.e. fair value).
The purchase price was analysed as follows: C300 000
x Research 50 000
x Development 250 000
Subsequent expenditure has been incurred on this project as follows: C700 000
x Research Further research into possible markets was considered necessary. 100 000
x Development Incurred evenly throughout the year. All recognition criteria for 600 000
capitalisation as a development asset were met on 1 June 20X9.
Required: Show all journals related to the in-process research and development for 31/12/20X9.
Solution 10: In-process research and development

20X9 Debit Credit
In-process R&D project: cost (A) 300 000
Purchase of ‘in-process research and development’ (no differentiation between research and
development is made) when the project was acquired as ‘in-process R&D’ (IAS 38.34)
Research expense (E) Given 100 000
Development expense (E) 600 000 x 5/12 250 000
Development: cost (A) 600 000 x 7/12 350 000
Bank/ liability 100 000 + 600 000 700 000
Subsequent expenditure on an in-process research and development project recognised on the usual
basis: research is expensed and development costs capitalised only if all 6 recognition criteria are met
Comment: Even though the purchased research and development contains research, which is normally never
capitalised, it is capitalised in terms of IAS 38.34 if it meets the definition of an intangible asset. However, further
research costs must be expensed as usual.
3.4.7.4 Web site costs (SIC 32) The 5 stages of

creating a website:
Creating a web site is an example of the internal generation of an x Stage 1: Planning stage
intangible asset. The related costs are categorised into five stages. x Stage 2: Application &
Stage 1: This is the planning stage. It involves preparing feasibility infrastructure
studies, defining hardware and software specifications. x Stage 3: Graphic design
x Stage 4: Content development
Stage 2-4: These 3 stages involve the development of the web site.
x Stage 5: Operating stage.
- Stage 2: the application and infrastructure development
stage involves, for example, obtaining a domain name and developing server software.
- Stage 3: the graphical design stage involves, for example, designing layout & colours.
- Stage 4: the content development stage involves, for example, writing information
about the entity and including pictures of products sold.
Stage 5: The final stage is the operating stage, involving the maintenance and enhancement of aspects
of the site that were developed in stages 2 – 4 (i.e. graphics are enhanced; content is added
and removed etc). Thus, this stage occurs once the web site is ready for use. See SIC 32.1-.3
486 Chapter 9
Irrespective of these 5 stages, if a company’s web site is mainly Accounting for web
involved in advertising, then all the web site costs should be site costs:
expensed as advertising (since it is impossible to reliably x Stage 1 (Planning):
measure the specific future economic benefits that would flow - research expense
from this advertising). On the other hand, if the web site is able
x Stage 2 – 4 (Development):
to take orders, then it may be possible to identify and measure
- development asset; or
the future economic benefits expected from the web site. If the
- development expense
web site is expected to result in an inflow of future economic
benefits, we will need to analyse the costs into the various stages x Stage 5 (Operating):
- operating expense (unless it
and account for them as follows: is a subsequent expense to
x Stage 1 costs (planning): are always expensed as research. be capitalised)
x Stage 2–4 costs (developing): are recognised either as a development asset or development expense:
- development asset if all six recognition criteria are met, or
- development expense if the six recognition criteria are not all met.
x Stage 5 costs (operating): are expensed unless they meet the requirements for capitalisation as
subsequent costs.
The development stages involve many different tasks, some of which may or may not meet the
6 recognition criteria. For example, content development (stage 4) could involve:
x photographing products available for sale, the cost of which would be considered to be a
cost of advertising and would therefore be expensed; or
x the acquisition of a licence to reproduce certain copyrighted information, the cost of which
would probably be capitalised (assuming the six recognition criteria are met).
An entity may incur web site costs relating to the creation of content other than for advertising
and promotional purposes. When this is a directly attributable cost that results in a separately
identifiable asset (e.g. a licence or copyright), this asset should be included within the ‘web site
development asset’ and should not be recognised as a separate asset. See SIC 32.8 - .9
The web site asset must be amortised, because its useful life is considered to be finite. The useful
life selected should be short. See SIC 32.10
3.4.8 Intangible assets acquired through a service concession agreement (IFRIC 12)
A service concession agreement (SCA) is an agreement between a public-sector entity (grantor) and
an operating entity (entity) under which the entity undertakes to provide services to the public and in
return, will receive payments (consideration) from the grantor. The entity would be required to either
use existing infrastructure owned by the grantor, or construct or otherwise acquire the necessary
infrastructure. IFRIC 12 clarifies many aspects regarding how to account for an SCA, but this section
focuses on how an SCA might result in the recognition of intangible asset.
IFRIC 12 applies if we enter into such an agreement and, the terms of which will mean the grantor:
x controls/ regulates what services we provide, who we provide them to and the price we charge; and
x will have a significant residual interest in the infrastructure that we use to provide the services.
See IFRIC 12.7
In terms of IFRIC 12, the consideration an entity is entitled to receive in return for providing services to
the public is accounted for as revenue (IFRS 15). Thus, the agreement itself represents a right to receive
revenue, and a right to receive future revenue (economic benefits) represents an asset. If the agreement
requires the entity to construct or upgrade the infrastructure, this asset may not necessarily be a financial
asset, but may need to be recognised as an intangible asset, or a combination, instead. If the agreement:
x gives us an unconditional contractual right to receive cash or another financial asset from the grantor/
upon the insistence of the grantor, then we recognise a financial asset (e.g. the contract has committed
someone to paying us a certain sum each year of the agreement in return for us providing the service);
x gives us a right to charge users directly (even if the amount we charge is controlled by the grantor),
then we only have a conditional right (conditional upon users using the public services we provide)
and thus it does not meet the definition of a financial asset (it is not a contractual right to receive cash
or other financial assets) and thus we recognise it as an intangible asset.
Chapter 9 487
IFRIC 12 explains that, if such an agreement results in us acquiring an intangible asset, it must be
measured in terms of IFRS 15 Revenue from contracts with customers. Thus, it must be measured at
its fair value (e.g. an entity acquires a licence to operate a state hospital, and measures it at C1 million
since this is the market price for similar licences). Should the entity not be able to reasonably estimate
the fair value of the intangible asset, we then measure the intangible asset at the stand-alone selling
price of the services rendered (i.e. the public services we provide in terms of the agreement).
4. Recognition of Subsequent Expenditure (IAS 38.20 and .42 - .43)
Unlike property, plant and equipment, where subsequent

expenditure is common (e.g. replacement of parts and Capitalisation of subsequent costs
enhancements of parts), subsequent expenditure on x Is unusual (due to the nature of IAs)
intangible assets does not often arise. However, if it does x Occurs if the costs meet the IA:
arise, the nature of intangible assets frequently makes it - definition
so difficult to prove that the subsequent expenditure - recognition criteria (the basic 2)
relates to a specific intangible asset rather than to the x Is not allowed if it relates to internally
generated:
general operation of the business, that subsequent - brands, mastheads, publishing titles,
expenditure on intangible assets is seldom capitalised. customer lists and similar items.
Subsequent expenditure refers to the costs incurred after the intangible asset is acquired or after its
internal generation is complete.
The same criteria that we applied when deciding whether to recognise the initial expenditure as an asset
or expense, is also applied when accounting for this subsequent expenditure. In other words,
subsequent costs are capitalised to the carrying amount of the asset if:
x The definition of an intangible asset is met; and
x The recognition criteria are met (i.e. the recognition criteria provided in IAS 38: probable
inflow of economic benefits and the cost is reliably measurable).
Where an internally generated intangible item was not allowed to be recognised as an intangible
asset (e.g. an internally generated brand), then any related subsequent expenditure is also not
allowed to be capitalised. See IAS 38.20
5. Subsequent Measurement: Amortisation and Impairment Testing (IAS 38.88 - .111)
5.1 Overview
Subsequent measurement of an intangible asset involves amortisation and impairment testing.

x If the intangible asset is available for use, we need to consider both the:
- amortisation requirements, and
- impairment testing requirements;
x If the intangible asset is not yet available for use: we only need to consider the:
- impairment testing requirements (these assets are not amortised, but impairment testing
is more stringent than the impairment testing of assets that are available for use).
An intangible asset that is available for use could have: Subsequent measurement
involves:
x a finite useful life; or
x Amortisation; and
x an indefinite useful life. x Impairment testing.
Whether it has a finite or indefinite life is important because it affects both the amortisation and
impairment testing of that asset: We refer to indefinite
useful lives.
x If it has a finite useful life, it will be amortised and tested
Indefinite ≠ Infinite
for impairment in much the same way that property,
plant and equipment is depreciated and tested for impairment;
x If it has an indefinite useful life, it is not amortised but has more stringent impairment tests
than the impairment tests that apply to assets with finite lives. See IAS 38.108 & IAS 36.10
488 Chapter 9
Please note that indefinite does not mean infinite. If an asset has an indefinite useful life, it means ‘there
is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for
the entity’. In other words, an indefinite useful life means we do not know when its useful life will end.
Infinite would mean there is no limit at all to the asset’s useful life! See IAS 38.91
There are many factors to consider when assessing the useful life of the asset and whether the
useful life is finite or indefinite. Examples of some of these factors include:
x possible obsolescence expected as a result of technological changes;
x the stability of the industry in which the asset operates;
x the stability of the market demand for the asset’s output;
x expected actions by competitors;
x the level of maintenance required to obtain the expected future economic benefits and
management’s intent and ability to provide such maintenance. See IAS 38.90
Summary of the subsequent measurement of intangible assets
Not yet available for use Available for use
Indefinite useful life Finite useful life

Amortisation: N/ A Amortisation: N/A Amortisation: Yes
Impairment test: Yes Impairment test: Yes Impairment test: Yes
Intangible assets refer to

5.2 Amortisation (IAS 38.97 - .107 and .117) amortisation but PPE refers
to depreciation
5.2.1 Overview
An asset reflects expected future economic benefits. As this asset gets used, these future economic
benefits get used up (what was a future benefit becomes realised). This gradual reduction in the asset’s
remaining future economic benefits is reflected through the process of amortisation.
Amortisation is expensed unless the underlying intangible asset is being used to create yet
another asset, in which case it is capitalised to this other asset.
Only intangible assets with finite lives are amortised. Amortisation:
There are three variables that must be estimated when Reflects: the usage of the IA
Recognise: normally as an exp.
calculating the amortisation:
Only applies to IAs that are:
x residual value; x available for use & with a finite life
x period of amortisation; and Does not apply to IAs:
x method of amortisation. x available for use but with indefinite life
x not yet available for use
Amortisation of an intangible asset does not cease when it is x goodwill. IAS 38.97 & IAS 38.107
not being used – unless, of course, it has either been fully amortised or been reclassified as ‘held for sale’
(i.e. and accounted for under IFRS 5 Non-current assets held for sale and discontinued operations).
See IAS 38.117
5.2.2 Residual value and the depreciable amount (IAS 38.100 - .103)
The depreciable amount is: Residual value:
x the cost (or fair value) of the asset Is used to calculate the:
x Depreciable amount
x less its residual value. IAS 38.8 reworded
Should be zero unless:
The residual value is defined as: x A 3rd party has committed to buying the
x the expected proceeds on disposal of the asset IA at the end of its UL; OR
x less expected costs of disposal x The IA has an active market (AM) and
the RV can be measured from this AM and
x where the disposal proceeds and costs are based on the it’s probable that the AM will exist at
assumption that the asset is currently already of the the end of the IA’s UL.
same age and in the same condition as the asset is Should be reassessed at least:
- at the end of every financial year.
expected to be when it reaches the end of its useful life
IAS 38.8 reworded
(i.e. we must use a current value for our residual value).
Chapter 9 489
In the case of intangible assets, the residual value should always be zero unless:
x a third party has committed to purchasing the asset at the end of its useful life; or
x there is an active market (as defined in IFRS 13) for that asset and
- it is possible to measure the residual value using such market and
- it is probable that the market will still exist at the end of the asset’s useful life. IAS 38.100
The residual value must be assessed at every reporting date (e.g. year-end). Any change in the
residual value is accounted for as a change in accounting estimate (per IAS 8). See IAS 38.102
5.2.3 Period of amortisation (IAS 38.88, .94 - .99 and .104) Amortisation period:
Starts:
Amortisation of an intangible asset begins on the date x When available for use
on which it becomes available for use (i.e. which is not Ceases: When the asset is:
x derecognised; or
necessarily when we actually start to use it). See IAS 38.97 x reclassified as a NCA held for sale.
Useful life:
Amortisation must cease at the earlier of the date of: x Measured in years or units
x derecognition of the asset; and x Shorter of:
x reclassification of the asset as a ‘non-current asset - useful life, or
- legal life, unless legal rights are
held for sale’. See IAS 38.97 renewable & evidence suggests renewal
will occur at insignificant cost.
The amortisation period should be the shorter of: Should be reassessed at least:
x the asset’s expected economic useful life; and x at the end of every financial year.
x If indefinite life changes to a finite life:
x its legal life. See IAS 38.94 - process amortisation (as a change in
estimate) and
If an asset has a limited legal life (i.e. its related future - check for impairments.
economic benefits are controlled via legal rights for a
finite period), its expected economic useful life must be limited to the period of the legal rights,
if this is shorter, unless:
x the legal rights are renewable by the entity; and
x there is evidence to suggest that the rights will be renewed; and
x the costs of renewal are not significant. See IAS 38.94
The asset’s expected economic useful life could be estimated either in terms of:
x expected length of time that it will be used (e.g. 5 years); or
x expected number of units of production, or some other similar measure of units (e.g. 50 000 units).
See IAS 38.88
The period of amortisation must be reassessed at every reporting date (e.g. year-end). Any change in
the period is accounted for as a change in accounting estimate. See IAS 38.104
Example 11: Amortisation period and renewable rights
Ace Limited, a radio broadcaster, purchased a 5-year broadcasting licence for C100 000.
Ace expects to renew the licence at the end of the 5-year period for a further 5 years.
The government has indicated that they will grant the licence to Ace Limited again.
Required: Discuss the number of years over which the licence should be amortised, assuming that:
A. the cost of renewing the licence will be C1 000; or
B. the cost of renewing the licence will be C70 000.
Solution 11A: Amortisation period and renewable rights – insignificant cost
The useful life of the licence is 5 years, but since the legal rights are renewable, we must also consider
this fact. The rights are renewable at an insignificant cost (C1 000 versus the C100 000 original cost,
(1%)), and since it is necessary for the continuation of the business and the government has indicated
that it would be renewed, we must amortise this asset over a 10 year useful life (5 yrs + 5 yrs renewal).
Solution 11B: Amortisation period and renewable rights – significant cost

The useful life of the licence is 5 years, but since the legal rights are renewable, we must also consider
this fact. Since the rights are renewable at a significant cost (C70 000 is a significant portion of the
original cost of C100 000, (70%)), we disregard the renewal period. The asset must be amortised over
a 5-year period. (Note: the renewed licence, if and when it is acquired, must be treated as a separate
asset and amortised over a useful life of 5 years).
490 Chapter 9
5.2.4 Method of amortisation (IAS 38.97 - .98C and .104)
The method used should be a systematic one that reflects the pattern in which the entity expects
to use up the asset’s future economic benefits. Various methods are possible, including:
x straight-line
x diminishing balance
x units of production method. See IAS 38.97 - .98
If the pattern in which the asset is expected to be used cannot be reliably estimated, then the
straight-line method must be used. See IAS 38.97
The amortisation method chosen should result in amortisation that reflects the pattern in which
we expect to consume (use up) the economic benefits that are contained in the intangible asset
(i.e. it should reflect the pattern by which we expect the asset will be used up). In other words,
the amortisation expense should reflect how much of these economic benefits have been used
and the asset’s remaining carrying amount should reflect how much of the economic benefits
are still waiting to be consumed. See IAS 38.97
For example: Method of amortisation:
x If our intangible asset comes with a contract that

expires after 5 years, and we are able to use the Methods that may be used include:
x SL method
asset in any way we like during this period, then x RB method
our predominant limiting factor is time. x Units of production method.
In this example, an amortisation method based on The method used should:
time would be most appropriate (e.g. if we plan to x reflect pattern of usage of the FEB
use it evenly over 5 years, then the straight-line x but if you can’t determine the pattern,
you must use SL!
method over 5 years is an appropriate method).
Should be reassessed at least:
x If our intangible asset is a licence giving us the right to x at the end of every financial year.
produce 10 000 units after which the licence expires,
then our predominant limiting factor is units.
In this example, an appropriate amortisation method is the units of production method (i.e. cost of
the licence amortised over the 10 000 units).
Notice that the method used is closely aligned to its useful life.
IAS 38 clarifies that a method of amortisation that allocates the cost of the asset on the basis of
revenue (whether in terms of currency or units) would not normally be suitable. This is because
there is a concern that revenue generated from the asset would be affected by a host of factors
that have no bearing at all on how the asset is being used up (e.g. the number of units actually
sold could be affected by marketing drives or economic slumps and the unit price could be
affected by inflation or competitive pricing – or any combination thereof).
However, the presumption that revenue would be an inappropriate basis for the amortisation
method of an intangible asset is a rebuttable presumption. The fact that this presumption is
rebuttable, means that, under certain limited circumstances, we are able to argue that an
amortisation method based on revenue is, in fact, appropriate. This presumption may be
rebutted (i.e. we will be able to use revenue as the basis for the amortisation method), if:
x the intangible asset is expressed as a measure of revenue; or
x it can be shown that the ‘consumption of economic benefits’ is ‘highly correlated’ with ‘revenue’.
See IAS 38.98A and 13.98C
For example, an entity may own the right to use an asset where this right is limited based on a revenue
threshold. IAS 38 provides the example of a mining concession that expires as soon as a certain amount
of revenue has been generated (instead of expiring as soon as a certain number of tons of raw material
have been mined from the ground). In this case, the ‘predominant limiting factor’ in the contract is
clearly revenue (i.e. not units or time) and so on condition that the contract specifies the total amount
of revenue that may be generated under the mining concession, then an amortisation method that is
based on revenue would be considered appropriate. See IAS 38.98C
Chapter 9 491
Amortisation methods based on revenue – a comparison between IAS 38 Intangible

assets and IAS 16 Property, plant and equipment
Please note! In case you have already studied property, plant and equipment (PPE), you may
remember a similar discussion regarding methods of depreciation based on revenue. However, in the case of
PPE, using a depreciation method that is based on revenue is never allowed whereas in the case of intangible
assets (IAs), it is what is referred to as a rebuttable assumption.
Since the amortisation method is based on an expected pattern of future benefits, it is an estimate
and must be reviewed at the end of each financial year. If the method changes, it must be
accounted for as a change in accounting estimate per IAS 8 (see chapter 26). See IAS 38.104
5.2.5 Annual review (IAS 38.102 and .104 and IAS 36)
Assets that are available for use and have finite useful lives are amortised. The variables of
amortisation must be reassessed at the end of each financial period (i.e. the amortisation period,
amortisation method and residual value). See IAS 38.102 & .104
If any one or more of the amortisation period, Annual review:

amortisation method or residual value is to be changed, Means reassessing the following
the change should be accounted for as a change in at reporting date:
estimate (IAS 8). See IAS 38.102 & .104 x The 3 variables of amortisation:
- amortisation period;
An assessment of an intangible asset’s useful life as being - amortisation method;
indefinite is something that must be reassessed every year to - residual value;
confirm that it is still an appropriate conclusion. x For IAs with an indefinite UL, whether
this is still appropriate or whether it
now has a finite useful life.
If circumstances have changed such that a useful life that
x If any of the above changes, it is
was once thought to be indefinite is now thought to be finite, accounted for as a change in estimate.
we would need to:
x process amortisation as a change in estimate (IAS 8);
x check for a possible impairment and record an impairment loss if necessary (IAS 36).
See IAS 38.109 - 110
5.3 Impairment testing (IAS 36.9 - .12, .80 - .99 and IAS 38.111)
5.3.1 Impairment testing in general

Impairments:
Impairment testing is dictated by IAS 36 Impairment of Reflects: ‘damage’ to an IA
assets and is explained in detail in chapter 11. The following Identified when: CA > RA
gives an overview of the general process of impairment testing Recognise: as an expense
and explains the aspects of impairment testing that relate Applies to: all IAs
specifically to intangible assets.
The impairment testing of intangible assets is very similar to the impairment testing of property, plant
and equipment. In a nutshell, impairment testing involves first searching for evidence that an asset
may possibly have been damaged in some or other way (this is the impairment indicator review).
Generally, this must be done at reporting date (however, see section 5.3.3 and 5.3.4). When we talk
about damage, we are referring to any kind of damage that reduces the value of the asset (e.g. an
economic downturn may reduce demand for an asset’s output, in which case the asset becomes less
valuable to the entity, similarly, new legislation may affect the continued use of the asset). Damage is
different to usage. Both usage and damage reduce an asset’s carrying amount, but usage is called
‘amortisation’ whereas damage is called an ‘impairment’.
Impairment testing is thus essentially a check to ensure that the asset’s carrying amount is not
overvalued. However, if we think the carrying amount may be too high, it may simply be because we
have not processed enough amortisation. If we believe we have not processed enough amortisation,
extra amortisation is then processed (and accounted for as a change in estimate per IAS 8).
492 Chapter 9
If we believe that the amortisation processed to date is a true reflection of past usage, but yet we are
worried that the carrying amount may be too high, and we believe this difference may be material, we
must then calculate the recoverable amount and compare it with the asset’s carrying amount. The
recoverable amount is the higher of:
x Fair value less costs of disposal; and
x Value in use.
Avoiding the recoverable amount calculation: Please note, however, that if the asset’s recoverable
amount was calculated in a prior year and found to be ‘significantly greater’ than the carrying amount
at that time, and if there have been no events since this calculation to suggest that this difference may
have been ‘eliminated’, then we do not need to recalculate the recoverable amount. The ability to use
a prior recoverable amount calculation
x does not apply to intangible assets that are not yet available for use (see section 5.3.4), and
x may not necessarily be allowed in the case of intangible assets with indefinite useful lives (see
section 5.3.3) See IAS 36.15 & .11 &.24
If the asset’s carrying amount exceeds its recoverable amount, the asset is said to be impaired: the
carrying amount must be reduced to reflect its recoverable amount and this adjustment is recognised
as an impairment loss expense in profit or loss.
Impairment testing of an IA
that has a finite useful life
Impairment testing of an intangible asset is affected by (general impairment testing)
whether the intangible item:
x Perform an impairment indicator
x is available for use and: review at reporting date
- has a finite useful life x If there is a possible impairment that:
- has an indefinite useful life; - is material; and
x is not yet available for use; or - cannot be ‘fixed’ by processing
extra amortisation
x is purchased goodwill. See IAS 36.10 we calculate the RA at reporting date
x if the CA > RA = the IA is impaired
Notice that, due to the levels of uncertainty involved, the
impairment testing is more stringent in the case of indefinite useful life assets, assets not yet available
for use and purchased goodwill.
The impairment testing process for each of these categories of intangible assets is explained in the
following sections (although impairment testing of purchased goodwill is covered in section 10).
5.3.2 Impairment testing of intangible assets with finite useful lives
The impairment testing of an intangible asset with a finite useful life follows the same general
impairment testing process described above (i.e. it is the same as the impairment testing used for
property, plant and equipment). See IAS 36.9-10
5.3.3 Impairment testing of intangible assets with indefinite useful lives
The impairment testing of an intangible asset that has an indefinite useful life follows the same
general process described above, with the exception that:
x we must calculate the recoverable amount, even if there is no indication of an impairment
x the recoverable amount calculation need not be done at reporting date, but must be done at least
annually and at the same time each year (although if the
Impairment testing of an IA
asset was acquired during the current year, we must be with an indefinite useful life:
sure to do this calculation in that same year) Note 1
x Calculate RA at least annually, at any
x if it is available, we may use a prior year’s detailed time, but the same time every year
calculation of recoverable amount, but only on x It is possible for a previous calculation of
condition that: RA to be used instead of recalculating the
RA (but 3 criteria must be met)
if this intangible asset is part of a cash-
generating unit, then the carrying amount of the assets and liabilities making up that
unit have not changed significantly; and
Chapter 9 493
the most recent detailed estimate of the recoverable amount was substantially greater
than the carrying amount at the time; and
events and circumstances after calculating this prior recoverable amount suggest that
there would only be a remote chance that the current recoverable amount would now
be less than the carrying amount. See IAS 36.10 & .24
Note 1. For purposes of these ‘annual tests’, IAS 36 clarifies that different intangible assets may be
tested for impairment at different times. See IAS 36.10
Remember: intangible assets with indefinite useful lives must have their useful lives reassessed
annually to confirm that it is still an appropriate assessment. If things have changed and the
useful life is now thought to be finite, it may indicate a possible impairment. See IAS 38.110
5.3.4 Impairment testing of intangible assets not yet available for use
The impairment testing of an intangible asset that is not yet Impairment of IAs that are
available for use is the same as the impairment testing that not yet available for use:
applies to intangible assets that have indefinite useful lives
(see section 5.3.3), with the one exception: we may never x Calculate RA annually, at any time, but
the same time every year
use a prior year’s calculation of recoverable amount. This x This annual calculation may not be
is due to the extreme uncertainty involved in assessing the avoided See IAS 36.10-11
recoverability of the carrying amount of intangible assets
that are not yet available for use (i.e. the recoverable amount must be calculated every year, even if
there is no indication of impairment). The capitalisation of costs incurred while developing a
prototype is an example of an intangible asset that is not yet available for use.
5.3.5 Reversing an impairment Before reversing an

impairment loss:
If the cause of an impairment in one year ‘disappears’ in a x First check whether the amortisation
subsequent year, such that the recoverable amount increases should not simply be decreased (change
or even exceeds the carrying amount, then the impairment in estimate);
may be reversed in that subsequent year. However, the x If the CA is still too low, then process
an impairment reversal;
carrying amount must never exceed amortised cost
x In processing an impairment reversal, be
(historical carrying amount). See IAS 36.114 & .113 & .117 sure that the CA is not increased above
what it would’ve been had the original
However, care must be taken when reversing an impairment never been processed.
impairment expense because the asset’s:
x carrying amount may be lower than the recoverable amount because too much amortisation has
been processed to date (e.g. the residual value, useful life or amortisation method may need to be
re-estimated): in this case, we increase the carrying amount by reducing accumulated amortisation
(i.e. a change in estimated amortisation) instead of reversing a prior impairment expense; and
x carrying amount must never be increased above the carrying amount that it would have had if the
asset had never been impaired in the first place (i.e. it must never increase above amortised cost, also
called ‘historical carrying amount’). See IAS 36.113 & .117
Example 12: Impairments and reversals of an asset not yet available for use
Busy Limited has a 31 December financial year-end. In 20X7, Busy began a project involving
development of a new recipe, incurring the following costs evenly over each year:
20X7: C120 000
20X8: C100 000
20X9: C100 000
Development began on 1 September 20X7, on which date all the recognition criteria for capitalisation
of development costs were met.
Since the development asset is an intangible asset not yet available for use, Busy must calculate its
recoverable amount every year (at any chosen time but the same time every year). Busy decides to
calculate this recoverable amount at reporting date (i.e. at 31 December):
494 Chapter 9
The recoverable amounts were as follows:

31 December 20X7 C90 000
At no stage were the variables of amortisation in need of adjustment.
Required: Show all journals related to the costs incurred for each of the years ended 31 December.
Solution 12: Impairments and reversals of an asset not yet available for use
20X7 Debit Credit
Development expense (E) 120 000 x 8/12 (before 1 Sept) 80 000
Development: cost (A) 120 000 x 4/12 (after 1 Sept) 40 000
Bank/ liability Given 120 000
Research and development costs incurred
Note: All criteria for capitalisation are met on 1 September: all costs before this date
are expensed and may never be subsequently capitalised
Note: The development asset is not impaired: CA 40 000 < RA 90 000
20X8
Development: cost (A) Given 100 000
Development costs incurred
Note: We assume all criteria for capitalisation continue to be met
Impairment loss: development (E) CA: 140 000-RA: 110 000 (given) 30 000
Development: accumulated impairment loss: (-A) 30 000
Impairment loss recognised
20X9
Development: cost (A) Given 100 000
Development costs incurred
Note: We assume all criteria for capitalisation continue to be met
Development: acc. imp. loss: (-A) See calculation in narration 30 000
Impairment loss reversed: development (I) 30 000
CA: (o/b 110 000 + 100 000) –
RA: 250 000 (given), limited to prior development costs capitalised: 240 000
(40 000 + 100 000 + 100 000)
Notice: the development costs expensed in 20X1 are never subsequently capitalised
6. Subsequent Measurement: The Two Models (IAS 38.72 - .87)
6.1 Overview
There are two alternative measurement models that may be used in the subsequent measurement
of intangible assets:
x the cost model; and
x the revaluation model.
These are the same two measurement models that are allowed to be used in the subsequent
measurement of property, plant and equipment (IAS 16). Please see the examples in chapter 7
and 8 to see how these models are applied.
6.2 Cost model (IAS 38.74)

Cost model
If an intangible asset is measured under the cost model it is
initially measured at cost and subsequently measured by This model is identical to the
amortising the asset and testing for impairments. The carrying model used for PPE:
amount of an asset held under the cost model is thus: x Cost
x Less: AA & AIL
x cost at acquisition
x less any accumulated amortisation and
x less any accumulated impairment losses.
Chapter 9 495
6.3 Revaluation model (IAS 38.75 – 87 and IFRS 13: Appendix A)

If the intangible asset is measured under the revaluation
model, it is initially measured at cost but is subsequently Revaluation model
measured at its fair value. The carrying amount of an asset held
under the revaluation model is its: This model is almost identical to
the model used for PPE:
x fair value at date of revaluation x FV at date of revaluation
x less any subsequent accumulated amortisation and any x Less: Subsequent AD & AIL
accumulated impairment losses. The only difference is that:
- the FV used in the RM
When using the revaluation model to subsequently measure an - must be measured with
intangible asset, the fair value that is used must be measured in reference to an active market
terms of an active market. There is no such requirement in if dealing with IAs.
IAS 16 Property, plant and equipment (i.e. the fair value used to
revalue an item of property, plant and equipment may be The revaluation model
determined with reference to an active market or by other means). may never be used for:
the following intangible assets
An active market is defined as: since their uniqueness means that
x A market in which transactions for the asset or liability an active market could not exist:
x brands;
x take place with sufficient frequency and volume x newspaper mastheads;
x to provide pricing information on an ongoing basis. IFRS 13: App A x music and film publishing
rights;
It is interesting to note that due to the unique nature of most x patents; and
x trademarks. IAS 38.78
intangible assets (e.g. a brand is unique by its very definition),
an estimation of fair value in terms of an active market is generally not possible. This is because
market transactions involving these unique assets would not take place with sufficient frequency
and volume for the definition of active market to be met. Thus, the use of the revaluation model
is generally impossible for most intangible assets. Please also note that IAS 38 specifies certain
intangible assets for which the revaluation model may never be used (see pop-up alongside).
See IAS 38.78
Please note that although most intangible assets do not have active markets, some intangible
assets could have active markets. Fishing licences or production quotas are examples of
intangible assets for which active markets may exist.
Important for you to notice!

Although an active market is required for the subsequent measurement to FV under the revaluation model,
this is not a requirement when determining FV for purposes of initial measurement.
For purposes of initial measurement, IFRS 13 allows the FV to be determined in terms of an active market
or in terms of valuation techniques. Thus, even where an intangible asset is so unique that it has no active
market (e.g. a brand), this asset could be initially measured at FV (determined in terms of a valuation
technique) but would then have to be subsequently measured using the cost model.
If the revaluation model is used, revaluations must be performed with sufficient regularity that
the intangible asset’s carrying amount does not differ significantly from its fair value. The
frequency of the revaluations depends on the:
x volatility of the market prices of the asset; and
x the materiality of the expected difference between the carrying amount and fair value.
A downside to adopting the revaluation model for an asset is that all assets in that same class
must be revalued at the same time. This makes it an expensive alternative to the cost model.
If, within a class of assets measured at fair value, there is an intangible asset for which the fair
value is not reliably measurable in terms of an active market, then that specific asset only must
be measured at cost less accumulated depreciation and impairment losses. See IAS 38.81
If the revaluation model is used but at a later stage the fair value is no longer able to be reliably measured
(i.e. there is no longer an active market), this asset should continue to be carried at the fair value
measured at the date of the last revaluation less any subsequent accumulated amortisation and
impairment losses. Thus, we simply leave the fair value at the last known fair value and continue
amortising and testing for impairment. See IAS 38.82
496 Chapter 9
If, at a later date, the fair value can once again be measured in terms of an active market, then a
revaluation is performed at that date: the carrying amount will once again reflect the latest fair
value less any subsequent accumulated amortisation and impairment losses. See IAS 38.84
It is important to note that, if an active market ceases to exist, it is considered to be an indicator

of a possible impairment. Thus, if an active market ceases to exist, we will need to estimate the
asset’s recoverable amount in terms of IAS 36 Impairment of assets. See IAS 38.83
The revaluation of an intangible asset is accounted for by applying the same ‘revaluation model’
contained in IAS 16 Property, plant and equipment, which is explained in detail in chapter 8. See IAS 38.80
An intangible asset must be derecognised: Derecognition means:

x on disposal; or to remove from the accounting
x when no future economic benefits are expected records.
from its use or disposal. IAS 38.112
Notice that this means that, if we are simply not using an asset, it would not qualify for
derecognition and we would thus continue amortising it.
To derecognise an asset means to remove its carrying amount from the accounting records. The
carrying amount is removed (credit cost and debit accumulated amortisation & impairment
losses) and expensed as part of profit or loss (debit the disposal account).
If, when derecognising the asset, the entity earned proceeds on the disposal, these proceeds
would be recognised as income in profit or loss (debit bank and credit disposal account). The
amount of these proceeds is measured in the same way that a transaction price is measured in
terms of IFRS 15 Revenue from contracts with customers. See IAS 38.116
The expensed carrying amount is set off against the proceeds in the asset disposal account. This
account determines whether there is any gain or loss. It is important to note that any gain on disposal
may not be classified as revenue (i.e. it is simply classified as income in profit or loss). See IAS 38.113
If a part of an intangible asset is being disposed of and replaced, we derecognise the carrying amount
of that part and recognise the cost of the replacement part. However, if the carrying amount of the
replaced part cannot be determined, we can use the cost of the replacement part as an indication of what
the cost of the replaced part was when it was originally acquired or internally generated. See IAS 38.115
The date on which the disposal is recorded depends on how it is disposed of:
x If disposed of via a sale and leaseback agreement, we follow IFRS 16 Leases (chapter 16).
x If disposed of in any other way (e.g. by way of a sale), the asset is derecognised on the date
that the recipient obtains control of the item in terms of IFRS 15 Revenue from contracts
with customers (i.e. when the performance obligations are satisfied). See IAS 38.114
8. Deferred tax (IAS 12)
The carrying amount of an intangible asset is measured at cost (which may be fair value) less any
subsequent amortisation and impairments. Its tax base represents the future tax-deductions, if any. Any
difference between an intangible asset’s carrying and tax base will lead to:
x a taxable temporary difference (if the carrying amount exceeds the tax base) and the recognition
of a deferred tax liability, or
x a deductible temporary difference (if the tax base exceeds the carrying amount), in which case it
will lead to the recognition of a deferred tax asset (unless the deferred tax asset is not recoverable).
If an asset’s cost is not deductible when calculating taxable profits, then its tax base is nil and an exempt
temporary difference will arise (i.e. no deferred tax will be recognised on the temporary difference).
Chapter 9 497
9. Disclosure (IAS 38.118 - .128)
9.1 General
Information should be provided for each class of intangible asset, distinguishing between
intangible assets that have been:
x internally generated; and those
x acquired in another manner. IAS 38.118 reworded slightly
The following disclosure is required for all intangible assets:
x Whether the asset has an indefinite or finite useful life; IAS 38.118 (a)
x ‘Gross carrying amount’ and ‘accumulated amortisation and impairment losses’ at the
beginning and end of each period; IAS 38.118 (c)
x A reconciliation between the ‘net carrying amount’ at the beginning and end of the period
separately disclosing each of the following where applicable:
- additions (separately identifying those acquired through internal development, acquired
separately and acquired through a business combination);
- retirements and disposals;
- amortisation;
- impairment losses recognised in the statement of comprehensive income;
- impairment losses reversed through the statement of comprehensive income;
- increases in a related revaluation surplus;
- decreases in a related revaluation surplus;
- foreign exchange differences; and
- other movements. IAS 38.118 (e)
If the asset has a finite useful life, disclosure of the following is also required:
x line item in the statement of comprehensive income in which amortisation is included;
x methods of amortisation; and
x period of amortisation or the rate of amortisation. IAS 38.118 (a); (b) & (d)
If the asset has an indefinite useful life disclosure of the following is also required:
x significant supporting reasons for assessing the life as indefinite; and
x the carrying amount of the asset. IAS 38.122 (a)
The following information is required but need not be categorised into ‘internally generated’
and ‘acquired in another manner’:
x The existence and carrying amounts of intangible assets:
- where there are restrictions on title; or
- that have been pledged as security for a liability; IAS 38.122 (d)
x If an individual intangible asset is material to the entity’s financial statements, the nature,
carrying amount and the remaining amortisation period thereof must be disclosed. IAS 38.122 (b)
x Information relating to impaired intangible assets: should be disclosed in accordance with the
standard on impairment of assets. IAS 38.120
x Information relating to changes in estimates: should be disclosed in accordance with the
standard on accounting policies, estimates and errors. IAS 38.121
x Research and development costs expensed during the period must be disclosed in aggregate. IAS 38.126
x If there are contractual commitments for the acquisition of intangible assets, the amount
thereof must be disclosed. IAS 38.122 (e)
x Where the intangible asset was acquired by way of government grant and initially recorded at
fair value rather than at its nominal value, the following should be disclosed;
- its initial fair value,
- its carrying amount; and
- whether the cost or revaluation model is being used. IAS 38.122 (c)
498 Chapter 9
x Where intangible assets are carried under the revaluation model, the following should be
disclosed by class of asset (unless otherwise indicated):
- a reconciliation between the opening balance and closing balance of that portion of the
revaluation surplus relating to intangible assets, indicating the movement for the period
together with any restrictions on the distribution of the balance to the shareholders;
- the carrying amount of the intangible asset;
- the carrying amount that would have been recognised in the financial statements had the
cost model been applied; and
- the effective date of the revaluation. IAS 38.124
Since the following information is considered to be useful to the users, the disclosure thereof is
encouraged, but it is not required:
x A description of: fully amortised intangible assets that are still being used; and
x A description of: significant intangible assets that are controlled by the entity but which were
not allowed to be recognised as assets. IAS 38.128
9.2 Sample disclosure involving intangible assets (excluding goodwill)
Company name
At 31 December 20X9 (extracts)
Note 20X9 20X8
ASSETS C C
Non-current assets
Property, plant and equipment xxx xxx
Intangible assets 4 xxx xxx
Company name
Revaluation Retained
surplus earnings Total
C C C
Balance at 1 January 20X8 xxx xxx xxx
Total comprehensive income (xxx) xxx xxx
Realised portion transferred to retained earnings (xxx) xxx 0
Balance at 31 December 20X8 xxx xxx xxx
Total comprehensive income xxx xxx xxx
Realised portion transferred to retained earnings (xxx) xxx 0
Balance at 31 December 20X9 xxx xxx xxx
Company name
Notes 20X9 20X8
C C
Other comprehensive income for the year: xxx (xxx)
x Items that may never be reclassified to profit/loss
Revaluation surplus/ (devaluation), net of tax – 24 xxx (xxx)
intangible assets
Total comprehensive income for the year xxx xxx
Chapter 9 499
Company name
2.3 Intangible assets
Amortisation is provided on all intangible assets over the expected economic useful life to an
expected residual values of zero, unless the intangible asset has no foreseeable limit to the period
over which future economic benefits will be generated.
The following rates and methods have been used:
x Patent (purchased): 20% per annum, straight-line method
x Development (internally generated): 10% per annum, straight-line method
x Casino licence (purchased): indefinite
The casino licence is considered to have an indefinite life since the period of the licence is not
limited in any way other than the meeting of certain prescribed targets. These targets have been
adequately met in the past and are expected to continue to be met in the future.
The casino licence is revalued annually to fair value and is carried at fair value less accumulated
impairment losses. All other intangible assets are carried at historic cost less accumulated
depreciation and impairment losses.
At the end of each reporting period the company reviews the carrying amount of the intangible assets
to determine whether there is any indication of an impairment loss. If such an indication exists, the
recoverable amount of the assets is estimated in order to measure the extent of the impairment loss.
4. Intangible assets Patent Development Licence
20X9 20X8 20X9 20X8 20X9 20X8
C C C C C C
Patent xxx xxx xxx xxx xxx xxx
Development xxx xxx xxx xxx xxx xxx
Casino licence xxx xxx xxx xxx xxx xxx
xxx xxx xxx xxx xxx xxx
Net carrying amount - opening balance xxx xxx xxx xxx xxx xx
Gross carrying amount xxx xxx xxx xxx xxx xxx
Accum amortisation & impairment losses (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Additions
- through separate acquisition xxx xxx xxx xxx xxx xxx
- through internal development xxx xxx xxx xxx xxx xxx
- through business combination xxx xxx xxx xxx xxx xxx
Less retirements and disposals (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Add reversal of previous impairment loss/ xxx (xxx) xxx (xxx) xxx (xxx)
Less impairment loss through profit or loss
Revaluation increase/ (decrease):
- through OCI xxx (xxx) xxx (xxx) xxx (xxx)
- through P/L xxx (xxx) xxx (xxx) xxx (xxx)
Less amortisation for the period (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
Other movements (xxx) xxx (xxx) xxx (xxx) xxx
Net carrying amount - closing balance xxx xxx xxx xxx xxx xxx
Gross carrying amount xxx xxx xxx xxx xxx xxx
Accum amortisation & impairment losses (xxx) (xxx) (xxx) (xxx) (xxx) (xxx)
x The patent has been offered as security for the loan liability (see note …).
x The amortisation of the development asset is included in cost of sales.
x The development asset is material to the entity. The following information is relevant:
Nature: Design, construction and testing of a new product
Remaining amortisation period: 7 years
x The amortisation of the casino licence is included in cost of sales.
x The licence is measured using the revaluation model: the last revaluation was performed on 1/1/20X9
by an independent appraiser to the fair value measured in accordance with an active market.
The revaluation was recorded on a net replacement value basis.
Revaluations are performed annually. 20X9 20X8
Carrying amount had the cost model been used instead: xxx xxx
500 Chapter 9
Company name

C C
- Research and development costs expensed xxx xxx
- Amortisation expensed xxx xxx
- Impairment losses xxx xxx
- Reversals of previous impairment losses (xxx) (xxx)
24. Other comprehensive income: revaluation surplus: intangible assets 20X9 20X8
C C
Increase/ (decrease) in revaluation surplus on intangible assets xxx (xxx)
Deferred tax on increase in revaluation surplus (xxx) xxx
Increase/ (decrease) in revaluation surplus, net of tax xxx (xxx)
Revaluation surplus on intangible assets:
Opening balance xxx (xxx)
Increase/ (decrease) in revaluation surplus, net of tax xxx (xxx)
Closing balance xxx (xxx)
There are no restrictions on the distribution of the revaluation surplus to shareholders.
35. Contractual commitments
The company is contractually committed to purchase fishing licences worth Cxxx.
10. Goodwill (IAS 38 and IFRS 3)
10.1 Overview
Goodwill is described as the synergy between the identifiable assets or individual assets that
could not be recognised as assets. There are two distinct types of goodwill:
x purchased goodwill (covered by IFRS 3); and
x internally generated goodwill (covered by IAS 38).
Internally generated
10.2 Internally generated goodwill (IAS 38.48 - .50) goodwill:
x Always expensed
Internally generated goodwill is never capitalised since:
x it is not identifiable (i.e. is neither separable from the business nor does it arise from
contractual rights);
x it cannot be reliably measured; and
x it is not controllable (e.g. can’t control customer loyalty). See IAS 38.49
10.3 Purchased goodwill (IFRS 3.32 and .34)
Purchased goodwill:
Purchased goodwill arises on the acquisition of another
entity. It is measured as follows: x Positive (debit): asset
x Amount paid for the entity x Negative (credit): income
x Less net asset value of the entity = goodwill*
*or gain on bargain purchase if the net asset value of the entity exceeds the amount paid for it.
10.3.1 Positive goodwill: asset (IFRS 3.32)

Positive goodwill:
Positive goodwill arises if the amount paid for the acquiree’s x Recognition: asset
assets exceeds the value of those assets. This is:
x always capitalised; - NEVER amortise; but
x never amortised; and - Test for impairments
x tested annually for impairment. x Impairments may NEVER be reversed.
Chapter 9 501
With regard to the testing of goodwill for impairment:

x The test may occur at any time, as long as it is done at the same time every year;
x Any impairment loss written off against goodwill may never be reversed.
Thus, purchased positive goodwill is:
x recognised as an asset,
x presented in the statement of financial position and
x measured at a carrying amount that reflects ‘cost less accumulated impairment losses’.
Example 13: Positive purchased goodwill: asset

Purchase price of business C100 000
Net asset value of business C80 000
Required: Journalise the acquisition (ignore any tax effects).
Solution 13: Positive purchased goodwill: asset

Debit Credit
Goodwill: cost (A) 20 000
Net assets: cost (A) 80 000
Bank 100 000
Acquisition of a business worth C80 000 for an amount of C100 000
Comment: The recoverable amount of this goodwill must be assessed at year-end and, if found to be less
than C20 000, this goodwill will need to be impaired.
10.3.2 Negative goodwill: income (IFRS 3.34)
When the value of the assets acquired exceeds the amount paid
for these assets, we have what is referred to as a gain on a Negative goodwill:
bargain purchase, also called purchased negative goodwill.
x Recognise as: income
A bargain purchase gain is immediately recognised as income, and presented in profit or loss.
Negative goodwill sounds like a ‘bad thing’ and yet it is treated as income. It will make more sense
if you consider some of the situations in which negative goodwill arises (the first two situations are
‘win situations’ for the purchaser and should help to understand why it is considered to be income):
x the seller made a mistake and set the price too low, or
x the selling price is a bargain price, or
x the entity that was purchased was sold at a low price since it is expected to make losses in the future.
In the third situation above, the negative goodwill is recognised as income in anticipation of the future
losses (i.e. over a period of time, the negative goodwill income will be eroded by the future losses).
Example 14: Negative purchased goodwill: income

Purchase price of business C100 000
Net asset value of business C750 000
Required: Journalise the acquisition (ignore any tax effects).
Solution 14: Negative purchased goodwill: income

Debit Credit
Net assets: cost (A) 750 000
Bank 100 000
Gain on bargain purchase (I) 650 000
Acquisition of a business worth C750 000 for an amount of C100 000
Comment: Negative goodwill is a gain made on the purchase and is thus recognised as income immediately.
502 Chapter 9
10.3.3 Initial recognition measured provisionally (IFRS 3.45 - .50)

When the fair value of certain assets or liabilities acquired in a business combination can only
be provisionally estimated at the date of acquisition, these assets and liabilities must be
measured at their provisional fair values and the goodwill accounted for as the difference
between the purchase price and these provisional fair values.
The provisional fair values must, however, be finalised within twelve months from acquisition date.
When the ‘provisional’ values are finalised, the comparatives must be retrospectively restated from
the acquisition date, as if the asset value was known with certainty at the purchase date.
Example 15: Provisional accounting of fair values
Doc Limited purchased Nurse Limited on the 30 November 20X8 for C80 000, on which
date the following information applied:
x The fair value of Nurse Limited’s plant (its only asset) could not be measured by the independent
appraiser in time for the 31 December 20X8 year end.
x The fair value of the plant was provisionally measured as C36 000.
x The plant’s useful life was estimated on date of acquisition to be 10 years (residual value: nil).
On 30 September 20X9 the plant’s at-acquisition fair value was finally measured to be C42 000.
Required: Discuss how the acquisition should be accounted for in the financial statements of
Doc Limited for the years ended 31 December 20X8 and 20X9.
Provide journal entries where this will aid your explanation.
Solution 15: Provisional accounting of fair values

x In the 20X8 financial statements the plant must be recognised at the provisional valuation of C36 000,
and the goodwill is measured at the balancing amount of C44 000. Depreciation for one month would
be recorded at C300 [(C36 000 – 0)/10 years x 1/12 months].
30 November 20X8 Debit Credit
Plant: cost (A) Given (provisional fair value) 36 000
Goodwill: cost (A) Balancing 44 000
Acquisition of Nurse Limited at provisional fair values
31 December 20X8
Depreciation: plant (E) 36 000 / 10 x 1 / 12 300
Plant: acc. depr (-A) Given 300
Depreciation of plant (acquired through acquisition of Nurse Limited)
The 20X8 financial statements would have included the following year-end balances/ totals:
Goodwill 44 000
Plant Cost: 36 000 – AD: 300 35 700
Depreciation 300
x During September 20X9 the valuation was finalised and thus the asset must be accounted for as if we
knew the true fair value at acquisition date. The following journals would thus be processed in 20X9:
30 September 20X9 Debit Credit
Plant: cost (A) Final FV: 42 000 – Provisional FV: 36 000 6 000
Goodwill (A) 6 000
Adjustment to fair values of the assets acquired through acquisition of Nurse
31 December 20X9
Retained earnings (Eq) (1) Extra depr on extra cost: 6 000 / 10 x 1 / 12 50
Plant: acc. depr (-A) 50
Adjustment to 20X8 depreciation of plant
(1) Notice that retained earnings is debited (not depreciation expense; this is because the adjustment relates to
the 20X8 depreciation which has already been closed off to retained earnings. The adjustment is
retrospective, which means it is an adjustment to that prior year: it must not affect this year’s profit.
The comparative 20X8 financial statements would therefore be restated as follows:
Goodwill (44 000 estimate – 6 000 adjustment) 38 000
Plant 36 000 – 300 depr + Retrospective adj in 20X9 (6 000 – 50) 41 650
Depreciation (42 000/ 10 x 1/ 12) 350
Chapter 9 503
x Plant is depreciated during 20X9. The following journal would therefore be processed:
Depreciation: plant (E) 42 000 / 10 years x 12/12; or 4 200
Plant: acc. depreciation (-A) (42 000 – 350) / (120 – 1) x 12 months 4 200
Depreciation of plant (acquired through acquisition of Nurse Limited)
x The 20X9 financial statements would therefore reflect the following balances/ totals:
Goodwill Assuming no impairment necessary 38 000
Plant O/bal: 41 650 – Depr: 4 200 37 450
Depreciation 4 200
10.3.4 Adjustment in the initial accounting (IFRS 3.50)

Except for the possible need to re-measure fair values on the date of acquisition (see above),
the only other subsequent adjustments to the fair values of any assets, liabilities and goodwill
acquired in a business combination, would be in connection with the correction of errors.
Any correction of errors would need to be adjusted for retrospectively and disclosed in
accordance with the standard on accounting policies, estimates and errors (IAS 8).
10.3.5 Subsequent measurement of purchased goodwill
If purchased goodwill is negative, it is recognised immediately as income and referred to as a
gain on bargain purchase. There is no subsequent measurement relating to this gain.
If the purchased goodwill is positive (a debit), it is Subsequent measurement
recognised as an asset. Subsequent measurement of the of a purchased goodwill
asset:
purchased goodwill asset is as follows:
x it may not be amortised; x Cost (Amt paid – FV of NAs acquired)
x it must be tested for impairment. See IFRS 3.B69(d) x Less accumulated impairment losses
An impairment on goodwill:
Impairment testing of purchased goodwill acquired in a x may NEVER be reversed!
business combination must be done annually but it may be done at any time during the year, as long
as it is done at the same time every year. See IAS 36.96
The entity may be able to use a recent detailed calculation of the recoverable amount of a cash-
generating unit to which goodwill has been allocated, instead of having to measure the
recoverable amount again, assuming that certain specified criteria are met. These specific
criteria are covered in more depth in the chapter on impairment of assets. See IAS 36.99
An impairment of goodwill may never be reversed. IAS 36.124
10.4 Disclosure of goodwill (IFRS 3: Appendix B.64 and .67)
10.4.1 Disclosure: positive goodwill: asset (IFRS 3.B67 (d))
The following information should be disclosed for goodwill:
x a reconciliation between the opening and closing balances of goodwill (separately disclosing
gross carrying amount and accumulated impairment losses),
x the reconciling items would include: additions, disposals, adjustments relating to changes
to the net asset value of the acquired entity, impairment losses, net exchange differences
arising during the year and any other movement during the period.
10.4.2 Disclosure: negative goodwill: income (IFRS 3.B64 (n))
Where we have negative goodwill (gain on a bargain purchase), we must disclose:
x the line item in the statement of comprehensive income in which the negative goodwill is
recognised as income;
x the amount of the negative goodwill; and
x reasons as to why the transaction resulted in a gain.
The negative goodwill income is normally disclosed in the profit before tax note.
504 Chapter 9
10.4.3 Sample disclosure involving goodwill
Company name
At 31 December 20X9 (extracts)
Note 20X9 20X8
ASSETS C C
Non-current Assets
Property, plant and equipment xxx xxx
Goodwill 7 xxx xxx
Intangible assets 8 xxx xxx
Company name

2.5 Goodwill
Goodwill arising from the acquisition of a subsidiary represents the excess of the cost of the
acquisition over the group’s interest in the net fair value of the assets, liabilities and contingent
liabilities of the acquiree. Goodwill is measured at the cost less accumulated impairment losses.
20X9 20X8
7. Goodwill C C
Net carrying amount - opening balance xxx xxx
Gross carrying amount - opening balance xxx xxx
Accumulated impairment losses - opening balance (xxx) (xxx)
Additions
- through business combination xxx xxx
Less: disposals of subsidiary (xxx) (xxx)
Less: Impairment loss (xxx) (xxx)
Net carrying amount - closing balance xxx xxx
Gross carrying amount - closing balance xxx xxx
Accumulated impairment losses - closing balance (xxx) (xxx)

Gain on a bargain purchase (xxx) (xxx)
Impairment loss on goodwill xxx xxx
11. Black Economic Empowerment (BEE) Transactions (FRG 2)
In South Africa, an entity may issue equity instruments to

BEE partners with a fair value higher than the fair value of BEE equity credentials
the identifiable consideration received (cash and non-cash x must be expensed
assets) in exchange for these instruments. This may arise due
to the benefits the BEE partner could provide to the company (e.g. through improving the
entity’s BEE rating) or through providing specific goods and services to the company.
A South African accounting interpretation (FRG 2) was released in order to clarify how to
account for such BEE transactions. The interpretation concluded that the difference between:
x the fair value of the equity instruments granted (e.g. ordinary shares); and the
x the fair value of the identifiable consideration received (cash and non-cash assets)
must be expensed, and not capitalised as an intangible asset.
Chapter 9 505
The reason that they decided that it should be expensed is because the entity cannot fully control
the future economic benefits of the BEE equity credentials. Competitors could also obtain BEE
credentials over which the entity would not have control and which could impact the entity’s
possible future economic benefits from their own BEE credentials.
That being said, the cost of acquiring BEE equity credentials may be indirectly recognised as
an intangible asset in the following two situations:
x if the cost of acquiring the BEE credentials is directly attributable to the acquisition of another
intangible asset, the cost of these BEE credentials may be capitalised to the cost of that other
intangible asset; and
x if the BEE credentials were obtained as part of the net assets acquired in a business
combination, the cost thereof would form part of goodwill (an asset).
Example 16: BEE Equity Credentials

Bee Limited enters into a contract with Mr Partner to improve its BEE rating and thus enable it to
secure certain contracts that it would otherwise not be able to apply for. The contractual terms
gave Mr Partner 3 000 ordinary shares, which were currently trading at a market price of C3 each.
Required: Journalise the above assuming that, in exchange for the shares, Mr Partner provided:
A. cash of C5 000;
B. cash of C5 000 and a valuable patent to a product that he had recently developed and which
Bee Limited would put into production.
Solution 16A: BEE Equity Credentials – cash received

Debit Credit
BEE equity credentials (E) Balancing 4 000
Stated capital (equity) Fair value: C3 x 3 000 9 000
BEE transaction with Mr Partner to acquire BEE credentials
Solution 16B: BEE Equity Credentials – cash and an intangible asset received
Debit Credit
Patent: cost (A) Balancing 4 000
Stated capital (equity) Fair value: C3 x 3 000 9 000
BEE transaction with Mr Partner to acquire BEE credentials & a patent.
506 Chapter 9
12. Summary
Intangible assets
Definitions
Intangible asset definition (per IAS 38) Asset definition (per IAS 38)
(not the same asset definition in CF)
x identifiable x resource
x non-monetary x controlled* by the entity
x asset x from past events
x without physical substance x from which we expect an inflow of future
economic benefits
Recognition criteria
(per IAS 38)
(these are not the recognition criteria per 2018 CF)
x Cost of the asset must be reliably measured
x Inflow of future economic benefits must be probable
Initial measurement
x Initially measure at cost
Internally generated Acquired
Internally generated items that may never be Types of acquisition:

recognised as assets:
Separate acquisition:
x goodwill
x brands x Recognise as an IA if IA definition met (recognition
x mastheads criteria always met)
x publishing titles x Measure at cost: purchase price, import duties, non-
x customer lists refundable taxes, directly attributable costs
If the internal generation relates to some item other Business combination:

than one of the items above, then separate costs into x Recognise as an IA if IA definition met
research and development: (recognition criteria always met)
x Measure at cost: FV on acquisition date
Research:
x Recognise as an expense
Government grant:
Development: x Recognise if IA definition met and recognition
criteria met
x Recognise as an asset if all 6 rec. criteria can be
demonstrated: x Measure at cost: FV or nominal amount plus
other necessary costs
technical feasibility of completing the IA
intention to complete and sell/ use the IA Asset exchange:
ability to sell/ use the IA
x Recognise as an IA if transaction has
how the IA will generate future economic
commercial substance
benefits (e.g. prove that there is a market if the
intention is to sell; or prove its usefulness if the x Measure at cost:
intention is to use) FV of the asset given up adjusted for C & CE; or
availability of necessary resources to complete the FV of IA acquired if more clearly evident; or
development and to sell/ use the IA CA of asset given up if both FV not available
the ability to reliably measure the costs of
developing the IA. Service concession agreement:
x Recognise if the SCA gives us the right to
charge customers directly (and other criteria
are met…)
x Measure at FV of the IA or at the SASP of the
goods and services
Chapter 9 507
Subsequent measurement: amortisation
Finite useful lives Indefinite useful lives
x Amortise and x Don’t amortise

x Perform an impairment indicator test annually x Calculate the RA at the same time every year
(in accordance with IAS 36)
Amortisation
Depreciable amount Method Period

Cost; or x straight-line or Start from date available for use.
FV less RV, where RV is zero unless: x other method if Shorter of its
x 3rd party committed to purchase more appropriate x UL or
the IA at the end of its UL; or x legal life unless
x An AM exists and the RV can be legal rights renewable AND
measured using this AM and
probable that AM will exist at the evidence suggests renewal will
occur at insignificant cost
end of IA’s UL
Subsequent measurement: impairments
Finite lives Indefinite lives Not yet available for use

x Perform an impairment x Calculate RA at least annually x Calculate RA at least
indicator test annually (in (anytime but at the same time) annually (anytime but at the
terms of IAS 36) x A situation exists where a same time)
x Where there is a possible previous calculation could be
impairment that is: used instead of recalculating
material; and is the RA
not ‘fixed’ by
processing extra
amortisation
calculate the RA at
reporting date
Subsequent measurement: the two models
Cost model Revaluation model

x Calculation of carrying amount: x Calculation of carrying amount:
- cost - fair value
- less accumulated amortisation - less accumulated amortisation
- less accumulated impairment losses - less accumulated impairment losses
x Revaluations to fair value are performed after initial
recognition at cost
x The RM may only be used if a FV is reliably measurable
in terms of an active market
x An active market is defined as
- a market in which transactions for the A/L take place
with sufficient frequency & volume
- giving pricing information on an ongoing basis.
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Goodwill
Purchased Internally generated

x Positive: recognise as an asset and test for x Always expense
impairments annually and more often if an
impairment is suspected
x Negative: recognise as income in P/L
Measurement Disclosure
Positive = Asset Positive = Asset
Initial amount (cost): x reconciliation of opening and closing balances
x Amount paid (same as for PPE)
x less value of net assets acquired
Subsequent amount:
x Cost
x Less accumulated impairment losses
Negative = Income
Negative = Income x amount recognised as income
x Amount paid
x Less value of net assets acquired
Abbreviations:
A/L = Asset or liability
FV = fair value
C and CE = cash and cash equivalents
CA = carrying amount
IA = intangible asset
RV = residual value
RA = recoverable amount
AM = active market
PPE = property, plant and equipment
RC = recognition criteria
RD = reporting date
NCA = non-current asset
Chapter 9 509
Gripping GAAP Investment properties
Chapter 10
Investment Properties
Reference: IAS 40, IAS 12, IFRS 13, IFRS 15 and IFRS 16 (including any amendments to
10 December 2018)
Contents: Page
1. Introduction 512
2. Classification as investment property 512
2.1 Overview 512
2.2 Classification in general 512
2.3 Classification of joint use properties 513
Example 1: Joint use properties 514
2.4 Classification of properties leased in a group context 515
Example 2: Group investment properties 515
2.5 Classification of properties involving ancillary services 516
Example 3: Ancillary services 516
3. Recognition of an investment property 517
3.1 Overview 517
3.2 Investment property that is owned 517
3.3 Investment property that is held under a lease 517
4. Measurement 518
4.1 Overview 518
4.2 Initial measurement: cost 518
4.2.1 Overview 518
4.2.2 Initial cost of owned investment property 518
4.2.2.1 Owned property that was not acquired in an asset exchange 518
4.2.2.2 Owned property that was acquired in an asset exchange 519
4.2.3 Initial cost of investment property held as a right-of-use asset 519
4.2.4 Subsequent costs 520
Example 4: Subsequent expenditure 520
4.3 Subsequent measurement: the cost model 521
4.3.1 Overview 521
4.3.2 Property that is owned 521
4.3.3 Property that is owned, but is to be reclassified as held for sale 521
4.3.4 Property held under a lease 521
4.4 Subsequent measurement: the fair value model 522
4.4.1 Overview 522
4.4.2 Property that is owned 522
4.4.3 Property that is owned, but meets the criteria as held for sale 522
4.4.4 Property that is held under a lease 523
4.4.5 Fair value model: What is a fair value? 523
4.4.6 Fair value model used, but unable to measure fair value 524
4.4.6.2 Investment property that is not under construction 524
510 Chapter 10
Contents continued:
4.4.6.3 Investment property under construction 525
Example 5: Fair value cannot be reliably measured 526
5. Transfers 526
5.1 Change in use 526
Example 6: Transfers in and out of investment property 527
5.2 Measurement of transfers due to a change in use – an overview 528
5.3 Measurement of the transfer: investment property under the cost model 528
5.4 Measurement of the transfer: investment property under the fair value model 528
5.4.1 Change from owner-occupied property to investment property (FVM) 528
Example 7: Change from owner-occupied to investment property 529
5.4.2 Change from inventories to investment property 530
Example 8: Change from inventory to investment property 531
5.4.3 Change from investment property to owner-occupied property or 531
inventories
Example 9: Change from investment property to owner-occupied property 532
Example 10: Disposal 533
7. Deferred tax 533

Example 11: Deferred tax: fair value model (depreciable and deductible) 534
Example 12: Deferred tax: fair value model (depreciable and non-deductible) 536
Example 13: Deferred tax: fair value model (land and building) 538
8. Current tax 540
Example 14: Current tax: intention to keep and use (including land) 540
9. Disclosure 541
9.1 General disclosure requirements 541
9.1.1 An accounting policy note for investment properties 541
9.1.2 An investment property note 541
9.1.3 Profit before tax note 541
9.1.4 Contractual obligations note 542
9.2 Extra disclosure when using the fair value model 542
9.2.1 Investment property note 542
9.3 Extra disclosure when using the cost model 542
9.3.1 An accounting policy note for investment properties 542
9.3.2 Investment property note 543
9.4 Sample disclosure involving investment properties 543
10. Summary 544
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1. Introduction
This chapter deals with property, which is a term that refers to both land and/or buildings that
are classified as investment property. IAS 40 Investment properties, requires that the entity
differentiate between investment properties and other properties, such as:
x owner-occupied property (classified as property, plant and equipment),
x property held for sale in the ordinary course of business (classified as inventory), and
x property leased out under a finance lease to a third party (property, plant and equipment).
For an item to be classified as investment property, it must meet the definition of investment
property. Investment property is essentially property from which the entity intends to earn
capital appreciation or rental income or both. Once an item has been classified as investment
property, we must decide whether it meets the criteria for recognition as an asset. If it does,
we will need to know what amount it will be recognised at – this is called initial measurement
(initial measurement is at cost) (section 4.2). We will then need to know how to measure it on
an ongoing basis thereafter – this is called subsequent measurement (the subsequent
measurement of an investment property involves the choice between the cost model and fair
value model) (section 4.3 and 4.4). If we have investment property at reporting date, this will
need certain disclosures. Each of the aspects of classification, recognition, measurement and
disclosure will now be discussed. See IAS 40.5
2. Classification as investment property (IAS 40.7 - .15)
2.1 Overview Investment Property is

defined as:
For property to be classified as an investment property,
x land/buildings (or both, or part of a
it must meet the definition of investment property. building);
Deciding whether or not the definition is met is x held by:
generally simple but not always. For example, - an owner or
- a lessee as a right-of-use asset
complications may arise when a property (a) has a dual x to earn rentals or for capital
purpose (i.e. a joint use property), (b) is held by an appreciation or both;
entity within a group context, (c) has ancillary services x rather than for use in the
production or supply of goods or
provided by the entity (e.g. security services) and also services or for administrative
if (d) its use has changed (e.g. from using it to earn purposes or sale in the ordinary
rentals, in which case it was investment property, to course of business. See IAS 40.5
using it as the company head office, in which case it is
property, plant and equipment).
All these classification issues will now be considered, with the exception of a change in use.
Issues involving change in use are explained in section 5.
2.2 Classification in general (IAS 40.7 - .9)
To classify a property as an investment property, we simply have to ensure that it meets the
definition of an investment property (see grey block above).
When deciding whether the investment property definition is met, we basically need to decide what
the entity’s intention is for acquiring or holding the property: if the intention is to earn rentals or
capital appreciation or both, then land and / or buildings are classified as an investment property.
The following are examples of property that are not classified as investment property:
x property that is owner-occupied or held with the intention of being owner-occupied (this is
covered by IAS 16 Property, plant and equipment or IFRS 16 Leases);
x property that is leased out to an entity under a finance lease (covered by IFRS 16 Leases); and
x property held for sale in the ordinary course of business (this is IAS 2 Inventory). IAS 40.9
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Owner-occupied property is essentially land or buildings that are

Owner occupied
either owned or are held by a lessee as a right-of-use asset and property is defined
are used to produce goods or services or used for administration as:
purposes. Examples include: x land or buildings (or both,
x Property that is owner-occupied and awaiting disposal; or part of a building)
x Property held for future use as owner-occupied property; x held by an owner, or by a
lessee as a right-of-use
x Factory buildings or shops; asset,
x Employee housing (even if the employees pay market-related x for use in the production or
rentals); supply of goods or services,
or for administration use.
x Administration buildings. See IAS 40.7 & 40.9 IAS 40.5 reworded
Now that you have an idea of what would not be classified as investment property, take a look
at the following examples of property that are classified as investment property:
x property held for long-term capital appreciation (i.e. not a short-term sale);
x a building (owned by the entity or held as a right-of-use asset) that is leased out under an
operating lease;
x a vacant building that is held with the intention to lease it out under an operating lease;
x a property being constructed or developed for future use as an investment property;
x a property that is being redeveloped for continued use as an investment property; and
x land held for an undetermined future use (i.e. land is regarded as held for capital
appreciation) See IAS 40.8 & IAS 40.58
It is also possible that a property that was classified as investment Transfers in /
property could cease to be classified as an investment property, in out of investment
which case it would need to be transferred out of investment property occur if:
property (e.g. investment property to inventory). Conversely, a x there is evidence
property that was classified as something else other than x of a change in use,
investment property (e.g. inventory) could become classified as x with the result that the:
- IP definition is now met
investment property, in which case it would need to be transferred (transfer into IP)
into investment property (e.g. inventory to investment property). - IP definition is not met
This happens when there is a change in use that results in the (transfer out of IP)
investment property definition subsequently failing to be met or
being met, as the case may be. This is discussed in more detail in section 5.
2.3 Classification of joint use properties (IAS 40.10 & .14) Joint use
properties are
It sometimes happens that property (i.e. land and buildings) is properties where:
used for a variety of purposes with the result that a portion of the x part appears to be IP
property meets the definition of investment property and a (e.g. used to earn rent); &
portion of the property meets the definition of property, plant x part appears to be PPE
and equipment. These properties are called joint use properties. (e.g. used in production of
goods/ services)
Joint use properties occur when:

x a portion of the property is used to earn capital appreciation and/or rental income (an
investment property); and
x a portion of the property is used in the production or supply of goods or services and/or
for administration purposes (an owner-occupied property). IAS 40.10 (reworded)
These two portions may need to be classified separately.

Whether to classify each portion separately is determined as follows:
x if each portion can be sold or leased out separately (under a finance lease), then each portion is
classified separately (one as an investment property and the other as an owner-occupied
property);
x if each portion cannot be sold or leased out separately, then:
if the owner-occupied portion is an insignificant portion, then the entire property is
investment property; and
if the owner-occupied portion is the significant portion, then the entire property is
property, plant and equipment. IAS 40.10 (reworded)
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IAS 40 does not provide a quantitative guideline on how to assess whether a portion is
significant or not (i.e. it does not state, for example, that if an owner-occupied portion
represents 60% or more of a property, this portion would be a significant portion). The IASB
deliberately decided not to provide any such guidance as this could lead to ‘arbitrary
decisions’. IAS 40 is also silent on whether significance should be based on a relative
percentage in terms of the physical area occupied by each of the portions or whether it should
be based on the relative significance, in monetary terms, of the business carried out in each of
the portions – or both. See IAS 40.10 and .B39
Thus, it is clear that the decision as to whether an owner-occupied portion is significant or not
will require professional judgement. In this regard, an entity is required to develop criteria so
that it can exercise its judgement consistently. See IAS 40.14 and .B39
Example 1: Joint use properties

Stunning Limited owns properties in Durban, Port Elizabeth, Cape Town and D’Aar.
Required: Briefly explain how Stunning Limited should classify its properties in each of these areas,
details of which are as follows:
A Durban: Stunning Limited owns two freestanding buildings on adjoining but separate sites in
Durban, South Africa: one is used by Stunning Limited for administration purposes and the other is
leased to Runofdamill Limited under an operating lease.
B Port Elizabeth: Stunning Limited owns a twenty-storey building in Port Elizabeth: it leases out
nineteen floors (each operating lease agreement includes an option to purchase) and uses the top
floor as its head office.
C Cape-Town: Stunning Limited owns an eight-room house in Cape Town: six rooms are used for
administration purposes and two rooms are leased to Unpleasant Limited under an operating lease.
The layout of the house makes it impossible for the rooms to be separately sold or leased under a
finance lease.
D D’Aar: Stunning Limited owns a two-storey house in D’Aar: one floor houses Stunning’s entire
business and one floor is leased to S. Kwatter under an operating lease. A single set of title deeds
exists for the house, prohibiting both the piecemeal sale of the house and the piecemeal transfer of
ownership by way of finance lease.
Solution 1: Joint use properties

Comment: This example explains how to identify joint use properties and how to classify land and
buildings that are joint use properties (IAS 40.10).
A. There are two distinct and separate buildings: owner-occupied and leased out. Since each building
is on a separate site, it is assumed that they can be sold and/ or leased out separately. These
buildings, being so separate from one another would not be considered joint-use properties. The
building used for administrative purposes falls within the definition of owner-occupied property
and must therefore be disclosed as property, plant and equipment. The building leased out under
an operating lease must be disclosed as an investment property.
B. There are two portions within a single property: owner-occupied and leased out. This is thus a
joint-use property. Since each of the nineteen tenants have also been offered options to purchase,
it is clear that each of these nineteen floors are separable. Since the property is separable, the
nineteen floors that are leased out must be classified as an investment property and the remaining
one floor used as the company head office must be classified as property, plant and equipment.
C. There are two portions within a single property: owner-occupied and leased out. Since these two
portions are in one property, this is a joint-use property. The layout of the property means that the
two portions cannot be sold separately or leased out separately under a finance lease. Thus, we
must consider if the portion used as owner-occupied is significant or insignificant.
Six of the eight rooms are owner-occupied. It is submitted that this is a significant portion and
thus Stunning Limited must classify the entire house as owner-occupied (i.e. as property, plant and
equipment).
D. There are two portions within a single property: owner-occupied and leased out. This is thus a
joint-use property. The title deeds prevent the building from being sold in parts and from being
leased out separately under a finance lease. Thus, we must consider if the portion used as owner-
occupied is insignificant or not.
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One floor is owner-occupied (property, plant and equipment) and the other floor is leased out
under an operating lease (investment property). The physical split between owner-occupied and
leased is 50:50 and thus we cannot determine ‘significance’ purely on physical area. However,
since the 50% owner-occupied portion houses the entire business, it is submitted that the owner-
occupied portion must be considered significant and thus the entire building is classified as owner-
occupied (i.e. as property, plant and equipment).
2.4 Classification of properties leased in a group context (IAS 40.15)
A property leased out within a group (i.e. the lessee is a How entities in a group
subsidiary and the lessor is the parent company, or vice account for investment
versa), is classified: properties that are held
under leases:
x in the lessor’s financial statements: as an investment
x Lessor: Investment property (as
property (reminder: only if it is leased out under an it earns rental income)
operating lease); x Lessee: Right-of-use asset or
x in the lessee’s financial statements: either an expense (if lessee elects to
recognise the lease as an
as a right-of-use asset (with a lease liability); or expense)
as an expense: if the lessee elects this option, the x Group: PPE (as it is owner-
cost of leasing the property is recognised as an occupied)
expense on the straight-line basis or another systematic basis (this election is available
in the case of short-term leases, where the election is made by class of asset, or when
the underlying asset is of low value, where this election is made on a lease-by-lease
basis); See IFRS 16.5; .8 & .22
x in the group financial statements: as property, plant and equipment (since, from a group
perspective, it is owner-occupied). IAS 40.15 (reworded)
Please note: with the introduction of IFRS 16 and the withdrawal of IAS 17, the classification
of the lease as an operating lease is now only ever determined from the perspective of the
lessor. Lessees no longer differentiate between finance leases and operating leases – from a
lessee perspective, all leases are just leases and are accounted for either by recognising a
right-of-use asset with a lease liability or by expensing the lease.
Example 2: Group investment properties

Big Limited leases a building from Small Limited, a subsidiary of Big Limited, under an
operating lease. The following applies:
x Small Limited purchased the building for C20 million on 1 January 20X5.
x Small Limited’s accounting policy for investment properties is the fair value model.
x The operating lease is not classified as a short-term lease and the underlying asset is not
of a low value.
x The fair value as at 31 December 20X5 was C20 million.
x The useful life of the building is expected to be 20 years with a nil residual value.
x Big Limited uses the cost model for its property, plant and equipment.
x Big Limited uses the fair value model to value its investment properties.
x Big Limited uses the building as its head office.
Required: Explain how the building should be accounted for in the financial statements of:
A. Small Limited’s company financial statements.
B. Big Limited’s company financial statements.
C. Big Limited’s group financial statements.
Solution 2: Group investment properties

A. In Small Limited’s financial statements as at 31 December 20X5: The building must be classified
as investment property since it meets the definition of investment property as it is earning rentals
and is not owner-occupied. It should be measured at fair value because the use of the fair value for
investment properties is Small Limited’s chosen accounting policy.
Investment property measured under the FV model, is not depreciated or tested for impairment.
Chapter 10 515
B. In Big Limited’s financial statements as at 31 December 20X5: If an entity holds a property under a
lease, the entity must recognise a right-of-use asset and a lease liability. Right-of-use assets are
measured using the cost model, unless:
x the right-of-use asset meets the definition of investment property and the lessee applies the fair
value model in IAS 40 to its investment property; or
x the right-of-use asset relates to a class of property, plant and equipment to which the lessee
applies the revaluation model in IAS 16. See IFRS 16.34 & .35
Since Big uses the building as its head office, it is owner-occupied from Big’s perspective and thus
Big’s right-of-use asset meets the definition of property, plant and equipment. Since Big measures
its property, plant and equipment using the cost model (not the revaluation model), its right-of-use
asset (the building) must be measured using IFRS 16’s version of the cost model.
C. In the group financial statements as at 31 December 20X5: The building will be classified as
property, plant and equipment, because, from a group perspective, it is owner-occupied. Since Big
uses the cost model to measure its property, plant and equipment, the group financial statements
will also measure its property, plant and equipment using the cost model. Thus, the group financial
statements will reflect the carrying amount of the building at its depreciated historic cost of
C19 million, having been depreciated for one year of its 20 year useful life [Cost: 20 million – AD:
(20 million – 0) / 20 years x 1 year].
2.5 Classification of properties involving ancillary services (IAS 40.11 - .13)

An entity may provide ancillary services to the tenants Classification of investment
properties when ancillary
of its property (e.g. building maintenance or security). services are provided:
In such cases, the property may only be classified as
an investment property if these 'services are x If services are insignificant:
Investment property
insignificant to the arrangement as a whole'. See IAS 40.11 x If services are significant:
Owner occupied property
If the services provided are considered significant and
/ or the entity is exposed to significant variations in cash flows from the property, then the entity
can no longer be considered to be a passive investor and classification as investment property
may no longer be appropriate. See IAS 40.13
As with partly leased out properties, the entity must develop criteria for classification
purposes so that it can exercise its judgement consistently.
Example 3: Ancillary services

Clumsy Limited owns four properties:
A. An office building which it leases out to another company under an operating lease. Clumsy
Limited provides security services to the lessee who occupies this building.
B. Hotel Mystique: Clumsy Limited leases it to Smart-Alec Limited for which it manages for a fee.
C. Hotel D’Africa: Clumsy Limited entered into an operating lease contract with a professional hotel
management company: this contract provided for a fixed monthly rental with a 1% share in hotel
profits, which is expected to be insignificant relative to the fixed rental.
D. Hotel Brizzy: Clumsy Limited entered into an operating lease contract with a professional hotel
management company: this contract provided for a fixed monthly rental with 50% votes regarding
important decisions regarding the running of the hotel and a 25% share in hotel profits, which is
expected to be more significant than the fixed rental.
Required: Briefly explain how Clumsy Limited should account for each of these properties.
Solution 3: Ancillary services (this example explains the concepts in IAS 40.13)
Comment: this example shows how providing ancillary services affects the classification of a property.
A. The office building is classified as an investment property because the security services are
insignificant to the rental arrangement as a whole.
B. Hotel Mystique is classified as property, plant and equipment (i.e. in terms of IAS 16) because the
services provided by Clumsy Limited are significant to the property.
516 Chapter 10
C. Hotel D’Africa is classified as an investment property since the lease contract is such that, in
substance, Clumsy Limited is simply a passive investor.
D. Hotel Brizzy is classified as property, plant and equipment since, whilst there is a lease contract
that outsources the day-to-day functions of running the hotel, Clumsy is still significantly involved
in management decisions and is exposed to significant variations in cash flows from the hotel.
3. Recognition of an investment property (IAS 40.16 - .19A)
3.1 Overview
How and when to recognise an investment property depends on whether it is:
x owned; or
x held under a lease as a right-to-use asset.
3.2 Investment property that is owned (IAS 40.16 - .19)
Owned property that is classified as an investment property An investment property
may only be recognised (i.e. journalised) as an asset if it that is owned may only
meets the basic recognition criteria: be recognised as an
asset (capitalised) if:
x the expected inflow of future economic benefits is
x it meets the recognition criteria:
probable; and
- FEB from the IP is probable; &
x it has a cost or value that is reliably measurable. IAS 40.16
- its cost is reliably measurable
IAS 40.16 (reworded)
We must question whether these recognition criteria are
met whenever a cost is incurred. This means that we would consider whether the recognition
criteria are met when we incur:
x the initial cost to acquire the property, and also when we incur
x any related subsequent costs such as:
- costs of adding to the property (e.g. constructing a second floor to a building);
- cost of replacing parts of a property (e.g. a part of a building may need to be
reconstructed after a fire): the replaced part would need to be derecognised and the
new part would be recognised as an asset if it meets the recognition criteria (failing
which, it would be recognised as an expense); and
- costs of day-to-day servicing of the property (e.g. maintenance and minor repairs): these
costs always fail to meet the recognition criteria for an asset and are thus always
recognised as expenses. See IAS 40.17 - .19
3.3 Investment property that is held under a lease (IAS 40.19A)
A property that meets the definition of investment property, but is held by the entity under a lease (i.e. it
is not owned by the entity) is recognised in terms of IFRS 16 Leases (not in terms of IAS 40
Investment property). However, that this property will still be presented as an investment property.
Applying the general approach in terms of IFRS 16 means that a leased property would be
recognised as a right-of-use asset with a related lease liability. In this case, IFRS 16 requires that
the initial recognition of the investment property (with related lease liability) must happen on
the commencement date of the lease, where this date is the date on which the ‘lessor makes an
underlying asset available for use by a lessee’. See IAS 40.19A; IFRS 16.22 & IFRS 16 App A
There is an exception to IFRS 16’s general approach, where, instead of recognising the property as
a ‘right-of-use asset’ with a related lease liability, the cost of leasing the property would simply be
expensed (generally on the straight-line basis). This is a simplified approach and is referred to as a
recognition exemption. This simplified approach is only allowed in the case of short-term leases (a
lease that, at commencement date, has a lease term of 12 months or less and does not contain a
purchase option) or if the underlying leased asset is a low value asset. An investment property
held by a lessee would not qualify as a low value asset, but the lease of the investment property
could qualify as a short-term lease and could thus be expensed. See IFRS 16.B3 - .B6
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4. Measurement (IAS 40.20 - .56)
4.1 Overview
The initial measurement of investment property is Measurement of IP:
always at cost. This initial measurement and how to x Initial: at cost
calculate cost is explained in section 4.2. x Subsequent:
- Cost model or FV model
The subsequent measurement of investment property involves choosing between two
measurement models, which must then be applied to all its investment property. The two
models allowed are the cost and fair value models. Although there is a choice between these
two models, the standard encourages the use of the fair value model because it increases the
relevance of the financial statements by giving a better reflection of the true value of the
property. The subsequent measurement under each of these models is explained under
sections 4.3 and 4.4, respectively.
Regardless of the model chosen, since the property’s fair value is so useful to users, the fair
value will actually be measured for all investment property:
x if the fair value model is used, fair values will be needed for measurement purposes;
x if the cost model is used, fair values will be needed for disclosure purposes. See IAS 40.32
Although normally the entity may choose between the cost model and fair value model, the
use of the cost model may turn out to be compulsory for
specific individual properties. This happens where, in Fair value must be
measured regardless of
certain scenarios, it is clear that the property’s fair the model used:
value will not be reliably measurable on a continuing
basis. In these specific scenarios, even if the entity has x FV model: Measurement purposes
x Cost model: Disclosure purposes
chosen to measure investment property under the fair
value model, the individual property would have to be measured under the cost model.
Furthermore, we would not be able to subsequently change the measurement of that property
from the cost model to the fair value model. This is explained further under section 4.4.6.
Before choosing to apply the fair value model, it is important to realise that, if the fair value
model is chosen, it may be very difficult to change the accounting policy to the cost model at
a later stage. This is because, although IAS 8 Accounting policies, changes in accounting
estimates and errors allows accounting policies to be changed voluntarily, it only allows
voluntary changes if the change would result in ‘reliable and more relevant’ information. In
this regard, IAS 40 explains that it would be ‘highly unlikely’ that the cost model could
provide more relevant information than the fair value model. See IAS 8.14 and IAS 40.31
4.2 Initial measurement: cost (IAS 40.17-.29A)

Cost is defined as:
4.2.1 Overview
x the amount of cash equivalents paid
An investment property is initially measured at its (or FV of any other consideration
cost, which is a defined term (see pop-up alongside). given) to acquire an asset
The measurement of cost depends on whether the x determined at the time of its
asset is owned or held under a lease (as a right-of-use acquisition or construction; or
asset), and if it was owned, whether or not it was x the amount at which the asset is
initially recognised in terms of another
acquired in an asset exchange. See IAS 40.20; .27 & 29A IFRS. IAS 40.5 (reworded)
4.2.2 Initial cost of owned investment property (IAS 40.20 - .24)
4.2.2.1 Owned property that was not acquired in an asset exchange
In the case of investment property that is owned, and not acquired in an asset exchange, its initial
cost is measured in terms of IAS 40 Investment properties. The cost in this case would comprise its
purchase price and any directly attributable expenditure, including transaction costs. See IAS 40.21
518 Chapter 10
Directly attributable costs include, for example, legal fees Cost of owned IP, not
and would include construction costs, if the investment acquired in an exchange,
property was self-constructed. Another example is includes:
borrowing costs. If we incur ‘borrowing costs that are x the purchase price; and
x any directly attributable costs
directly attributable to the acquisition, construction or (including transaction costs e.g.
production’ of the property, we must capitalise these costs. legal fees and transfer taxes).
However, we only capitalise these costs if the property is a IAS 40.21 (reworded slightly)
qualifying asset, being ‘an asset that necessarily takes a

substantial period of time to get ready for its intended use or sale’ (e.g. a building under construction).
However, if the property is measured under the fair value model (section 4.4), capitalisation of these
borrowing costs is not a requirement but a choice (see chapter 14 and IAS 23 Borrowing costs).
Cost excludes:
x start-up costs (unless they are necessary to bring the property to the condition necessary
for it to be capable of operating in the manner intended by management);
x operating losses incurred before the property achieves the planned level of occupancy;
x abnormal amounts of wasted material, labour or other resources incurred in constructing
or developing the property. IAS 40.23 (extract)
If the purchase price is deferred, the cost is measured at its cash price with the difference
between the cash price and the total that will be paid ‘recognised as an interest expense over
the period of credit’ (i.e. between the date of purchase and date of final payment). See IAS 40.24
4.2.2.2 Owned property that was acquired in an asset exchange (IAS 40.27 - .29)
In the case of an owned investment property that was Cost of owned IP that
acquired by way of an asset exchange, the cost of the is acquired in an
property for purposes of initial recognition is measured at exchange is:
the fair value of the asset given up, unless the fair value of x FV of the asset given up; or the
the asset received is ‘more clearly evident’. x FV of the asset received, if this
is ‘more clearly evident’; or the
If the fair value of neither asset is reliably measurable, then x CA of the asset given up if:
- neither FV is reliably
the initial cost of the investment property must be measured measurable; or
at the carrying amount of the asset that was given up. - the exchange has no commercial
substance. See IAS 40.27 - .29
Similarly, the initial cost of the investment property will be the carrying amount of the asset
given up if the exchange lacks commercial substance. See IAS 40.27 - .29
The fair value is considered to be reliably measurable if:
x the variability in the range of reasonable fair value measurements is not significant for that asset; or
x the probabilities of the various estimates within the range can be reasonably assessed and
used when measuring fair value. IAS 40.29 (reworded)
4.2.3 Initial cost of investment property held as a right-of-use asset (IAS 40.29A & IFRS 16.24)
An investment property that is held by the entity under a Cost of a right-of-
lease, and which will be recognised as a right-of-use asset use asset is the sum
of:
(i.e. instead of the lease costs being expensed), will also be
measured on initial recognition at cost. However, this cost is x lease liability (PV of future pmts);
x lease pmts made before/ at
measured in terms of IFRS 16 Leases. See IAS 40.29A commencement, less any lease
incentives received;
In this case, the leased property’s cost will be: x initial direct costs; and
x the initial measurement of the lease liability, x estimated future costs (e.g.
future dismantling costs).
x any lease payments made at or before the See IFRS 16.24
commencement date, less any lease incentives received;

x any initial direct costs incurred by the lessee; and
x an estimate of costs to be incurred by the lessee in dismantling and removing the
underlying asset, restoring the site on which it is located or restoring the underlying asset
to the condition required by the terms and conditions of the lease, unless those costs are
incurred to produce inventories. IFRS 16.24 (extract)
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The initial measurement of the lease liability is the present value of total lease payments due
at commencement date, discounted at the interest rate implicit in the lease. Please see the
leasing chapter for more information. See IFRS 16.26
4.2.4 Subsequent costs (IAS 40.18 - .19)
Subsequent costs incurred in relation to investment property may only be capitalised to the
cost of the asset if it meets the two recognition criteria which are:
x it is probable that future economic benefits will flow to the entity; and
x the costs are reliably measurable. See IAS 40.16 - .17
Costs incurred after the initial purchase frequently relate to day-to-day servicing (often called
repairs and maintenance). These costs would never meet the recognition criteria and are thus
simply expensed. See IAS 40.18
There may, however, be occasion to incur costs on replacing parts of the property (for
instance replacing damaged walls or roofs, or building interior walls). In this case:
x the replaced part is derecognised (see section on disposals), and
x the replacement part is recognised as part of the original investment property if the
recognition criteria are met. See IAS 40.19
Notice: the method of accounting for subsequent costs on investment property is identical to
the method of accounting for subsequent costs on property, plant and equipment (i.e. the
principles in IAS 40 are the same as those in IAS 16 Property, plant and equipment).
Example 4: Subsequent expenditure

Flower Limited spent the following amounts on its block of flats, an investment property:
x C500 000: to build an extra floor to be rented out as a penthouse flat under an operating lease;
x C10 000: to replace all globes in the building that had blown in the last month;
x The building’s lift was damaged due to vandalism and Flower Limited had to pay C25 000 to
replace it. The fair value of the damaged lift was C10 000.
Required: Explain how Flower Limited should account for the amounts it spent and show the journals.
Solution 4: Subsequent expenditure

Comment: this example highlights the difference between subsequent expenditure that is capitalised
and that which is expensed.
Explanation of the extra floor: The C500 000 for the extra floor is capitalised to the asset, because:
x extra revenue (future economic benefits) is expected by Flower from the rental income; and
x the cost is reliably measurable: C500 000.
Debit Credit
IP: Building: flats (A) 500 000
Bank/ Accounts payable (A/L) 500 000
Cost of building the penthouse (the extra floor)
Explanation of the globes: The replacement of the globes is considered to be day-to-day servicing and
should be expensed.
Debit Credit
Maintenance (E) 10 000
Payment for the replacement of globes (minor parts)
Explanation of the lift: The lift that was destroyed due to vandalism must be impaired to zero as it was
scrapped for a nil return. The new lift must then be capitalised because:
x the replacement lift will restore the expected future economic benefits; and
x the cost is measurable: C25 000.
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Debit Credit
Lift written off (E) 10 000
Write-off of lift destroyed through vandalism (estimated fair value)
Bank/ Creditor (A/L) 25 000
Replacement lift capitalised at cost
4.3 Subsequent measurement: the cost model (IAS 40.56 and IFRS 16)
4.3.1 Overview
If the entity chooses to measure its investment property under the cost model, the version of
the cost model used depends on whether the investment property is:
x owned, or
x held under a lease. See IAS 40.56
The measurement would be further impacted if it is owned but meets the criteria to be
classified as held for sale. See IAS 40.56
Each of these situations are explained below.
4.3.2 Property that is owned
If the entity uses the cost model, and assuming the Investment property measured
investment property is owned and does not meet the under the cost model is:
criteria to be classified as ‘held for sale’, the cost
model to be used is the same as the cost model used x initially measured at cost;
for property, plant and equipment. See IAS 40.56 (c) x depreciated;
x tested for impairments; and
x can be classified as held for sale
This means that this investment property would be
measured initially at cost, depreciated annually and tested for impairments (in terms of
IAS 36 Impairment of assets).
4.3.3 Property that is owned, but is to be reclassified as held for sale
If the entity uses the cost model, and an investment property is owned but meets the criteria to
be classified as held for sale, this property must :
x be measured in terms of this standard, IAS 40 (this requires us to use the same cost model
as described in IAS 16) to the date on which the criteria for reclassification are met,
x then it must be classified as held for sale, and
x then remeasured to the lower of its carrying amount and fair value less costs to sell (in
terms of IFRS 5 Non-current assets held for sale).
This process is explained in detail in chapter 12.
4.3.4 Property held under a lease
If the entity measures its investment property using the cost model, and one of the investment
properties is held under a lease and recognised as a right-of-use asset, this property must be
measured in accordance with the cost model described in IFRS 16 Leases. This version of the
cost model (i.e. per IFRS 16 Leases) is very similar to the cost model described in IAS 16 in
that the asset is measured at cost less any accumulated depreciation and any accumulated
impairment losses. However, there are two important differences, explained overleaf.
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First difference: In the case of an investment property held under a lease, the right-of-use
asset’s carrying amount must be adjusted for any remeasurement made to the related lease
liability (e.g. if the future lease payments change due to a lease modification).
Second difference: When depreciating a leased asset, we must analyse the lease as follows.
x If ownership transfers at the end of the lease or if the lease includes a purchase option
and the asset’s cost was measured based on the assumption that the option will be
exercised, then the asset must be depreciated:
x from commencement date
x to the end of the underlying asset’s useful life;
x In all other cases, the asset must be depreciated:
x from commencement date
x to the earlier of:
- the end of the right-of-use asset’s useful life, and
- the end of the lease term. See IFRS 16.32
4.4 Subsequent measurement: the fair value model (IAS 40.33 - .55, IAS 36.2 & IFRS 13)
4.4.1 Overview (IAS 40.33; .35 & .40A) Investment property

measured under the fair
If the entity chooses to measure its investment value model:
property under the fair value model, the fair value x is initially measured at cost;
model used is the same whether the investment x is re-measured to fair value at the
end of the reporting period;
property is owned or held under a lease and even if it x any gains or losses arising from a
meets the criteria to be classified as held for sale. change in the fair value must be
recognised in profit or loss.
If the fair value model is chosen for a property, all investment properties must be measured
using this model, unless the fair value cannot be reliably measured (see section 4.4.6). See IAS 40.33
4.4.2 Property that is owned (IAS 40.33 & .35)
The fair value model requires that the investment property be initially measured at cost. At the
end of the reporting period the property must be subsequently remeasured to its fair value.
Any subsequent gains or losses resulting from a change in the fair value of the investment
property shall be recognised in profit or loss for the period in which they arise. See IAS 40.35
The fair value model used to measure investment properties differs from the revaluation model
used for property, plant and equipment (see chapter 8). When using the fair value model:
x there is no depreciation;
x there are no impairment tests, as investment property measured using the fair value model
is excluded from the scope of IAS 36;
x investment property may be classified as held for sale, but it will not be measured in terms
of IFRS 5 (i.e. it must continue to be measured in terms of IAS 40’s fair value model);
x fair value adjustments are recognised in profit or loss (not other comprehensive income).
4.4.3 Property that is owned, but meets the criteria as held for sale (IAS 40.33 & IFRS 5.5)
An investment property that meets the criteria to be classified as held for sale would have to
be classified and presented as a ‘held for sale’ asset (in terms of IFRS 5 Non-current assets
held for sale and discontinued operations).
However, if the entity measured its investment properties under the fair value model, then the
investment property would continue to be measured under the fair value model in terms of
IAS 40 Investment properties. Thus, this property would continue to be measured under the
fair value model, where this fair value model is identical to the fair value model used when
measuring a straight-forward ‘owned property’ – see section 4.4.2 above. See IAS 40.33 and IFRS 5.5
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4.4.4 Property that is held under a lease (IAS 40.33 & .40A and IFRS 16.34)
An investment property that is held under a lease and recognised as a right-of-use asset,
would be measured under the same fair value model that is used to measure a straight-forward
‘owned property’ – see section 4.4.2.
It is important, however, that when applying the fair value model to an investment property
that is held under a lease and recognised as a right-of-use asset, we must make sure we
measure the fair value of the right-of-use asset – not the fair value of the property.
See IAS 40.33 & .40A and IFRS 16.34
4.4.5 Fair value model: What is a fair value? (IAS 40.40 - .40A & IFRS 13)
Fair value is a market-based value measured in terms The fair value of a property
of IFRS 13, which must reflect, amongst other things: is defined as:
x rental incomes from current leases; and x the price that would be received to sell
the property in an orderly transaction;
x other assumptions that market participants would x between market participants;
use when pricing investment property under x at the measurement date. IFRS 13.9 (reworded)
current market conditions. IAS 40.40
The emphasis here is that the fair value is an exit price and thus, the assumptions used are
always those that a market participant would use when pricing the asset.
The standard recommends, but does not require, that this fair value be measured by an
independent and suitably qualified valuer. See IAS 40.32
In terms of IFRS 13, fair value is a market-based measurement and can, in fact, be measured
using a variety of valuation techniques (such as the market, cost or income approach) and can
involve a variety of inputs of varying quality.
These inputs are classified into a hierarchy of level 1 inputs through to level 3 inputs.
x Level 1 inputs are ideal, being quoted prices (unadjusted) for identical assets in an active
market. These are unlikely to be found for an investment property.
x Level 2 inputs are directly or indirectly observable prices for the asset. An example would
be a quoted price for a similar asset, when this has to be adjusted for the condition and
location of the asset.
x Level 3 inputs are unobservable inputs. Level 3 inputs enable the entity to use assumptions
in a situation where there is little if any market activity for the asset.
It is important when measuring fair value that we do not double-count the fair value of assets or
liabilities that may have already been recognised as separate assets or liabilities. For example:
x A building that includes a built-in lift would typically have a fair value that is higher than
the fair value of a building that does not have a lift. Thus, generally, the fair value of the
‘building with the lift’ will effectively have included the fair value of the lift and thus we
would need to be careful not to recognise the lift as a separate asset.
x When investment property is let under an operating lease, the lessor (who owns the asset
or holds it as a right-of-use asset) will account for the operating lease income on a
straight-line basis or another systematic basis. Thus, the lessor of the operating lease may
have recognised income received in advance or income receivable. However, the fact that
the fair value of the right-of-use asset would typically reflect the fact that there is an
amount receivable or received in advance, and thus, since the receivable or amount
received in advance will have already been separately recognised, we must adjust the fair
value to avoid double-counting: the fair value should be increased by the amount received
in advance or decreased by the amount receivable. See IAS 40.50 & IFRS 16.81
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4.4.6 Fair value model used, but unable to measure fair value (IAS 40.53 - .55)
4.4.6.1 Overview
As mentioned previously, if the fair value model is chosen, the entity is expected to apply the
fair value to all investment properties. This is based on the presumption that, when dealing
with investment properties, fair values will be reliably measurable on a continuing basis.
However, this is a rebuttable presumption, which means that, in certain ‘exceptional cases’,
one may rebut this presumption where there is clear evidence to prove that the fair values are
not expected to be reliably measurable on a continuing basis.
The method of accounting for situations in which fair values are not reliably measurable on a
continuing basis, or are difficult to measure under the current circumstances will be discussed
under the following categories:
x Investment property that is not under construction
x Investment property that is under construction.
4.4.6.2 Investment property that is not under construction
When dealing with acquired investment property, there is a rebuttable presumption that the
fair value will be able to be reliably determined on a continuing basis. In fact, we always
assume that the fair value is reliably measurable on a continuing basis unless:
x the market for comparable properties is inactive; and
x alternative reliable measurements of fair value are not available. See IAS 40.53
However, if an entity concludes that the fair value of an

If the FV of ‘IP that is
investment property (that is not under construction) is
not under construction’ is
not reliably measurable, the accounting treatment not reliably measurable
depends on whether or not the entity has ever measured and this is determined:
this property at fair value in the past.
x on initial recognition as IP: we can
rebut the presumption and thus use CM
If the entity has managed to measure the property at fair for that property (must use CM until
value in the past, even though it may subsequently find disposal & a RV of nil)
x after initial recognition as IP: since it
it difficult or impossible to measure the property’s fair would have been measured at FV at
value, the entity is forced to continue to measure the least once by this stage, we may not
property at fair value until disposal (using the last rebut the presumption and must thus
use FVM until disposal.
known fair value if no subsequent fair values are ever See IAS 40.53 & .55
determinable). The only time that this property would
cease to be measured at fair value is if it ceases to meet the definition of investment property
and is transferred either to property, plant and equipment or inventory. See IAS 40.55
Note: IAS 40.55 does not actually prohibit a change in accounting policy from the fair value
model to the cost model. It simply provides that the presumption that fair value is reliable on a
continuing basis may not be rebutted if the asset has previously been measured at fair value.
However, a change in accounting policy from the fair value model to the cost model is
unlikely to be possible (Section 4.1).
If on initial acquisition of an investment property – or on the date that an existing property

first becomes classified as investment property (i.e. due to a change in use) – the entity
concludes that the fair value of the property will not be reliably measurable on a continuing
basis, then, despite the fact that the entity may have chosen to use the fair value model for its
investment property, this particular property must be measured under the cost model (we
would use the cost model per IAS 16 Property, plant and equipment if the property is owned
or the cost model per IFRS 16 Leases if it is leased and is thus a right-of-use asset).
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What is important here is that the entity:

x must measure this property using the cost model until disposal – it may never switch to
the fair value model at a subsequent date (even if fair values subsequently become reliably
measurable); and
x must always use a residual value of nil; but
x would still use the fair value model for all other investment properties. See IAS 40.53 & .54
4.4.6.3 Investment property under construction
If an entity that uses the fair value model has an investment property that is currently under
construction and for which a reliable measure of fair value is currently unavailable, but the
entity believes that a reliable measure will be possible on a continuing basis once construction
is complete, the investment property must, in the interim, be measured at cost (this is not the
same as the cost model!). It is measured at cost until either a fair value becomes reliably
measurable, or the construction is completed (whichever happens first).
If the fair value then becomes reliably measurable during construction, the property must be
remeasured from cost to fair value, under the fair value
model (with the difference between the cost and fair If the FV of ‘IP that is
value recognised in profit or loss). under construction’ is not
reliably measurable and
However, being able to determine a fair value during this is determined:
construction means that, when construction is complete, x during construction: measure at cost
we will not be allowed to reassess the situation and until FV becomes measurable or until
rebut the presumption that fair values will be reliably completion date, whichever is earlier
measurable on a continuing basis – we will be forced to x on completion:
continue to use the fair value model until the property is - if still at cost, we can rebut the
disposed of (or transferred out of investment property presumption and use CM for that
due to a change in use). property (must use CM until disposal
& a RV of nil)
In other words, if we are able to reliably measure the - if already at FV, we cannot rebut the
presumption now, so must continue to
property’s fair value during construction and thus began
measure under the FVM until
using the fair value model during construction, but then on
disposal.
completion of construction, we decide that the fair value See IAS 40.53 & .55
will not be reliably measurable on a continuing basis, we

will not be allowed to switch from the fair value model to the cost model. IAS 40.53; .53A & .53B
If the fair value was not reliably measurable during construction, we start by measuring this
under-construction property at cost. Then, on the date that construction is complete, we re-
assess whether we believe the fair value for this property will be reliably measurable on a
continuing basis.
We start with the rebuttable presumption that the fair value will be reliably measurable on a
continuing basis:
x If the presumption is not rebutted, the investment property must now be measured under
the fair value model. Since the property, at this point, would still have been measured at
cost, it must now be remeasured to fair value (the difference recognised in profit or loss).
x If the presumption is rebutted, the investment property must now be measured under the
cost model (per IAS 16 or IFRS 16). Since the property, at this point, would still have
been measured at cost, it must now be measured under the cost model. This means that we
must now start depreciating the property and testing for impairments (the property must
be measured under the cost model until disposal and depreciation must be measured
assuming that the residual value is nil). See IAS 40.53 & .53A
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Example 5: Fair value cannot be reliably measured

Clueless Limited purchased a building that it intended to hold for capital appreciation:
x The building was purchased on 31 March 20X5 for C1 million.
x On 31 March 20X5 it was unclear if the building’s fair value would be reliably
measurable on a continuing basis.
x By the 31 March 20X6, due to a boom in the property industry, the fair value of the
building was estimated to be C15 million.
x The property has an estimated useful life of 20 years.
x The company’s accounting policy is to measure investment property at fair value.
Required: Calculate the carrying amount of the property at the year ended 31 March 20X5 and 20X6.
Solution 5: Fair value cannot be reliably measured

Comment: this example illustrates the measurement (initial and subsequent) of an investment property
where at the time of purchase, clear evidence can be provided that the fair value of the property will
probably not be measurable on a continuing basis.
Because it was established at the acquisition date that the fair value of the building could not be
reliably measured on a continuing basis, IAS 40.53 requires that the building be measured under the
cost model (i.e. at depreciated historic cost) throughout its life.
Even though the fair value can be measured at the next financial year end, the building must remain at
depreciated historic cost and must never be revalued to fair value.
When we are forced to use the cost model, (because the FV could not be reliably measured), then
depreciation must be calculated using a nil residual value, even if the entity estimates another amount
for the residual value.
The carrying amounts of the property would therefore be:
x 31 March 20X5: 1 000 000 – [(1 000 000 – 0) / 20 years x 0 yrs] = C1 000 000
x 31 March 20X6: 1 000 000 – [(1 000 000 – 0)/ 20 years x 1 yr] = C950 000
5. Transfers (IAS 40.57 - .65)
5.1 Change in use (IAS 40.57 - .58)
When there is change in use of a property, it may result in the Transfers in / out
investment property definition: of investment
x ceasing to be met, in which case the property would need property occur if:
to be transferred out of investment property into another x there is evidence
classification (e.g. inventory); or x of a change in use,
x with the result that the:
x becoming met, in which case the property would need to - IP def is now met :
be transferred into investment property from another tfr into IP
classification (e.g. inventory). - IP def is no longer met:
tfr out of IP
A transfer into or out of investment property is only processed if management has clear
evidence that there has been a change in use. Evidence of a change in use would not be
considered sufficient if it was based solely on a change in management’s intentions.
Examples of evidence of a change in use that would thus require a transfer into or out of
investment property could include the following, amongst others:
x A property, which was previously rented out under an operating lease (thus meeting the
definition of investment property), could subsequently become used by the entity as its
head office (i.e. subsequently becoming owner-occupied and thus no longer meeting the
definition of investment property but meeting the definition of property, plant and
equipment instead). In this case, the property would need to be transferred out of
investment property and into property, plant and equipment. See IAS 40.57 (a)
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x A property, which was previously rented out under an operating lease (thus meeting the
definition of investment property), could become available for sale in the ordinary course
of business, thus suggesting that it is now inventory instead (i.e. the investment property
definition fails to be met and the inventory definition is met instead). However, as we
know, the standard is clear that evidence of a change in use may not simply be based on
management’s change in intention. Thus, in this ‘hazier’ situation involving a transfer
from investment property to inventories, IAS 40 states that evidence must exist that
construction or development of the property, with a view to making it saleable, has
commenced. Thus, an investment property that management contends will now be sold in
the ordinary course of business, but which will be sold without undergoing construction or
development to ensure its sale, must remain classified as an investment property until
disposal – it would not be transferred to inventory. See IAS 40.57(b) & .58
x A property, which was owner-occupied (thus meeting the definition of property, plant
and equipment), could subsequently cease to be occupied by the owners and become
rented out to third parties under an operating lease instead (i.e. no longer meeting the
definition of property, plant and equipment but meeting the definition of investment
property instead). In this case, the property would need to be transferred from property,
plant and equipment and into investment property. See IAS 40.57 (c)
x A property that was previously available for sale in the ordinary course of business (thus
meeting the definition of inventories), could subsequently be rented out under an
operating lease instead (i.e. thus no longer meeting the definition of inventories but
meeting the definition of investment property instead). In this case, the property would
need to be transferred out of inventories and into investment property. See IAS 40.57 (d)
Example 6: Transfers in and out of investment property

Pillow Limited was in the process of constructing a building to be used to earn rental income
when, due to financial difficulties, it could not complete the construction thereof.
Required: Explain how Pillow Limited should account for the building if its intention is now to:
A. sell the building ‘as is’ (Pillow Limited sometimes sells buildings as part of its business activities);
B. hold the building ‘as is’ for capital appreciation; or
C. borrow from the bank and complete the building, then use it as the entity’s head office.
Solution 6: Transfers in and out of investment property

Whilst the property was being developed, it should be classified as investment property since the
entity’s intention was to earn rental income from the property. However, the recent turn of events and
change in intention would result in the following accounting treatment going forward:
A. This change in use suggests there should be a transfer out of investment property to inventories
(since it is no longer held for rent income but is now to be sold as part of its ordinary activities).
However, IAS 40 clarifies that a change in use cannot be based purely on management intentions
and thus clarifies that a transfer to inventories can only occur if there is a change in use ‘evidenced
by commencement of development with a view to sale’ and that an investment property that is to
be disposed of ‘without development’ must remain classified as investment property until disposal.
Thus, this property must not be reclassified to inventories (i.e. it remains investment property)
because it is being sold ‘as is’ (i.e. it is not being developed with the intention to sell it).
B. If the intention is to keep the building for capital appreciation, the building will remain classified
as investment property because it still meets the definition of investment property. Pillow Limited
will then have the option to measure this building under the fair value model (preferred by IAS 40)
or the cost model. (See section 4.3 and 4.4)
C. If there is sufficient evidence that the intention is to borrow from the bank and complete the
building for future owner-occupation, the building will no longer meet the definition of investment
property and would, instead, meet the definition of property, plant and equipment. It would then be
transferred to property, plant and equipment. Borrowing costs must be capitalised if the building is
a qualifying asset. If it is not a qualifying asset, the borrowing costs must be expensed (in
accordance with IAS 23 Borrowing Costs)
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5.2 Measurement of transfers due to a change in use – an overview
Obviously, if a property is transferred into investment property, it will become measured in

terms of the principles contained in IAS 40 Investment property. Conversely, if a property is
transferred out of investment property, it will cease to be measured in terms of the principles
contained in IAS 40 Investment property and will be measured in terms of another relevant
standard. The issue, however, is how to measure the property at the time of the transfer.
The measurement of the property at the point of the transfer depends on whether the entity
measures its investment properties using the cost model or the fair value model.
A summary of the situation is contained in table 1 below, and is explained in more detail in
section 5.3 (where the entity measures investment property using the cost model) and
section 5.4 (where the entity measures investment property using the fair value model).
Table 1: How to measure the transfers in and out of investment property:
From To Transfer measured depending on model
used for investment property:
Cost model Fair value model
PPE: Owner-occupied Investment property Carrying amount Fair value *
(IAS 16) (IAS 40)
Inventories Investment property Carrying amount Carrying amount
(IAS 2) (IAS 40)
Investment property PPE: Owner-occupied Carrying amount Fair value
(IAS 40) (IAS 16)
Investment property Inventories Carrying amount Fair value
(IAS 40) (IAS 2)
* if the property is to be measured using the fair value model, the transfer is done at fair value even if
the property was previously carried under the cost model in terms of IAS 16. This complication is
explained in section 5.4.
5.3 Measurement of the transfer: investment property under the cost model (IAS 40.59)
If the entity uses the cost model, a change in use that results in a transfer into or out of
investment property will not involve a change in the carrying amount of the property at the
date of transfer:
x For a transfer into investment property, the property will first be measured in terms of the
previous relevant standard (e.g. IAS 16/ IFRS 16 or IAS 2) to the date of change in use. It
will then be transferred into investment property and be measured in terms of IAS 40 (i.e.
using the cost model in IAS 16 or IFRS 16 or will be measured in terms of IFRS 5).
x For a transfer out of investment property, the property will be measured in terms of
IAS 40 (i.e. using the cost model in IAS 16 or IFRS 16 or using IFRS 5) to the date of
change in use. It will then be transferred out of investment property and be measured in
terms of the relevant standard (e.g. IAS 16 or IFRS 16 or IAS 2).
The transfer will not alter the cost for measurement or disclosure purposes. See IAS 40.59
5.4 Measurement of the transfer: investment property under the fair value model (IAS 40.60 - .65)
If the entity uses the fair value model, then there may be measurement implications when
there is a transfer in or out of investment property due to a change in use.
5.4.1 Change from owner-occupied property to investment property (FVM) (IAS 40.61-.62)
Owner-occupied property is accounted for in terms of IAS 16 Property, plant and equipment
or accounted for as a right-of-use asset in terms of IFRS 16 Leases.
528 Chapter 10
When owner-occupied property is to be

reclassified to investment property that will then Transferring from
owner-occupied property
be measured under the fair value model (FVM), to investment property (FVM):
the entity must revalue the property to its fair
x account for any depreciation and impairment
value immediately before making the transfer to losses until the date of change in use and;
investment property: x revalue the property to fair value (even if the
x any change from the carrying amount to fair cost model has been used to measure PPE)
value is accounted for in the same way that a
revaluation is accounted for under the revaluation model in IAS 16, and
x this revaluation is done even if the property had been measured using the cost model. See IAS 40.61
The steps to follow before making the transfer of property from the property, plant and
equipment classification (IAS 16) to the investment property classification (IAS 40) are as
follows:
x Depreciate and check the property for impairments up to the date of change in use;
x Then revalue to fair value where:
x a decrease in the carrying amount:
is first debited to other comprehensive income (to the extent that the revaluation
surplus account has a balance in it from a prior revaluation); and
is then debited as an expense in profit or loss (impairment loss/ revaluation
expense);
x an increase in the carrying amount:
is first credited as income in profit or loss (to the extent that it reverses a previous
impairment loss/ revaluation expense – thus, this step should not increase the
carrying amount above the historic carrying amount); and
is then credited to other comprehensive income (i.e. revaluation surplus). See IAS 40.62
Once a property becomes investment property measured using the fair value model, it is no
longer depreciated. This creates an interesting situation if the property was previously
classified as property, plant and equipment under the revaluation model and had a revaluation
surplus at the time of reclassification to investment property. The reason it is interesting is
that, when this property becomes classified as investment property, it is no longer possible for
this revaluation surplus to be transferred to retained earnings over the life of the asset, since
the asset is longer depreciated. Thus, any revaluation surplus relating to a property that
subsequently becomes classified as investment property can only be transferred to retained
earnings on disposal of the property.
As always, this transfer from revaluation surplus to retained earnings may not be made
through profit or loss: the transfer must be made directly to retained earnings (i.e. debit
revaluation surplus and credit retained earnings). IAS 40.62(b) (ii) (reworded)
The revaluation surplus relating to an investment property can only be transferred to

retained earnings on:
x the disposal of the asset.
Example 7: Change from owner-occupied to investment property

Fantastic Limited had its head office located in De Rust, South Africa. During a landslide on
30 June 20X5, a building nearby, which it owned and was renting to Sadly, was destroyed.
As Sadly Limited was a valued tenant, Fantastic Limited decided to move its own head-office to another
under-utilised building nearby, which was currently also used for administrative purposes and to lease
this original head-office building to Sadly Limited as a ‘replacement’. The move was effective from
30 June 20X5.
Other information:
x The head office was purchased on the 1 January 20X5 for C500 000 (total useful life: 5 years)
x The fair value of the head office building was:
- C520 000 on 30 June 20X5 and
- C490 000 on 31 December 20X5.
Chapter 10 529
x Fantastic Limited uses the:

- the cost model to measure its property, plant and equipment, and
- the fair value model to measure its investment properties.
Required: Show the journals relating to Fantastic’s head-office for the year ended 31 December 20X5.
You may use a single account to record movements in the head office’s carrying amount (i.e. do not use
a cost and accumulated depreciation account). Ignore tax.
Solution 7: change from owner-occupied to investment property

Comment: Despite the property being measured using IAS 16’s cost model, the property must be
revalued to fair value in terms of IAS 16’s revaluation model before being transferred to investment
property. This is because the entity uses the fair value model for its investment properties.
PPE: Office building: carrying amount (A) 500 000
Purchase of head-office building(owner-occupied)
30 June 20X5
Depreciation (E) (500 000 - 0) / 5 x 6 / 12 months 50 000
Depreciation to date of change in use
Revaluation surplus (OCI) 520 000 – (500 000 – 50 000) 70 000
Revaluation of head office to fair value on date of change in use
IP: Office building: fair value (A) 520 000
Transfer head office building from PPE to IP on date of change in use
31 December 20X5
Fair value adjustment on investment property (P/L) 30 000
Remeasurement of investment property to fair value at year-end
Notes:
1. The adjustment to the fair value of the building occurs before the transfer to investment property
thus the adjustment is credited to other comprehensive income – not to profit or loss.
2. The revaluation surplus is not reduced when the fair value drops. This revaluation surplus will only
be reversed when the property is disposed of. See IAS 40.62(b) (ii)
5.4.2 Change from inventories to investment property (IAS 40.63 - .64)
If property is held for sale in the ordinary course of business, it would be classified as
inventory. However, if there is evidence of a subsequent change in use such that the property
no longer meets the definition of inventory but meets the definition of investment property
instead, the property must be transferred from inventories to investment properties.
Property that was classified as inventories would have been measured at the lower of cost and
net realisable value. If this property is transferred to investment property, where the entity
measures its investment property under the fair value model (FVM), it will mean that an
adjustment to the carrying amount of the property will be required on date of transfer.
The standard is not clear on whether this

Transferring from inventories to
adjustment should be made immediately before or investment property (FVM):
after the transfer. However, it makes sense to
process the adjustment after the transfer. In other x transfer at the CA of the inventory; and then
words, transfer the inventory to investment x revalue the property to fair value.
property at the carrying amount of the inventory x Recognise difference between CA & FV in P/L.
(i.e. lower of cost or net realisable value) and then remeasure the investment property to fair value.
The difference between the property’s previous carrying amount and its fair value is
recognised immediately in profit or loss. See IAS 40.63
530 Chapter 10
Example 8: Change from inventory to investment property

Chess Limited purchased a building on 1 January 20X5 for C250 000 that it intended to sell
in the ordinary course of business.
Player Limited asked Chess Limited to lease the building to them for a period of time:
x An operating lease agreement was then entered into and became effective from 1 March 20X5.
x On 1 March 20X5, the building’s:
- fair value was C300 000 and
- net realisable value was C290 000.
x On 31 December 20X5, the building’s fair value had grown to C340 000.
x Chess Limited uses the fair value model for its investment properties.
Required: Provide the journals for Chess Limited’s year ended 31 December 20X5. Ignore tax.
Solution 8: change from inventory to investment property

Comment: this example shows how to account for a change from inventory to investment property.
Building purchased with the intention of selling
1 March 20X5
IP: Building: fair value (A) 250 000
Building (previously inventory) transferred to investment property
since leased out in terms of an operating lease (no adjustment to NRV
required since the NRV is 290 000, being greater than cost)
IP: Building: fair value (A) FV: 300 000 FV – Cost: 250 000 50 000
Fair value adjustment of investment property (P/L) 50 000
Remeasuring of investment property to fair value at date of transfer
31 December 20X5
IP: Building: fair value (A) (340 000 – 300 000) 40 000
Investment property remeasured to fair value at year-end
5.4.3 Change from investment property to owner-occupied property or inventories (IAS 40.60)
Investment property that was measured under the fair value model but is now being
reclassified as an owner-occupied property or inventory must first have its carrying amount
adjusted to fair value on the date of change. This fair value adjustment must be recognised in
profit or loss. The fair value on date of transfer, measured in accordance with IAS 40, will
then be deemed to be the initial cost of the owner-occupied property or inventory. See IAS 40.60
If the investment property:
x is now classified as inventory, it will then be measured in terms of IAS 2 Inventories at
the lower of cost (i.e. fair value on date of transfer) and net realisable value.
x is now classified as ‘owned’ owner-occupied, it will then be measured in terms of
IAS 16 Property, plant and equipment (using either the cost model or revaluation model)
and will be depreciated over its remaining useful life.
x is a leased property that that is now classified as owner-occupied, it will then be
recognised as a right-of-use asset and measured in terms of the cost model in
IFRS 16 Leases, (which is very similar to the cost model in IAS 16), or in terms of the
revaluation model in IAS 16 Property, plant and equipment.
The standard only permits a transfer from investment property to inventories if there is a change in
use that is evidenced by commencement of development with a view to sale (see example 6, part A).
If an entity decides to dispose of an investment property without development, it continues to treat the
property as investment property (although we must obviously consider whether the investment
property meets the criteria to be classified as held for sale in terms of IFRS 5 Non-current assets held
for sale). See IAS 40.57(b) & 58
Chapter 10 531
Example 9: Change from investment property to owner-occupied property

Super Limited owned and leased out a building in Pretoria (South Africa), which was
correctly classified as an investment property on 31 December 20X4.
During a ‘freak’ earthquake Super Limited’s head office was destroyed, forcing them to relocate to the
building in Pretoria, which forced the tenants of this building to move out from 30 June 20X5.
Super Limited’s head office moved into these premises on 1 July 20X5.
On 31 December 20X4, the fair value of the building was C200 000.
On the 30 June 20X5 the building:
x had a fair value of C260 000, and
x had a remaining useful life of 10 years and a nil residual value.
Super Limited uses:
x fair value model for its investment property, and
x cost model for its property, plant and equipment.
Required: Show the journals for Super Limited for the year ended 31 December 20X5. Ignore tax.
Solution 9: Change from investment property to owner occupied property

Comment: This example explains which accounts are affected by a change in use when an investment property
(IAS 40) becomes an owner-occupied property (IAS 16).

IP: Office building: fair value (A) (260 000 – 200 000) 60 000
Investment property revalued to fair value on date of transfer
PPE: Office building: cost (A) 260 000
Transfer of investment property to property plant and equipment
Depreciation (E) (260 000 / 10 x 6/12) 13 000
PPE: Office building: accumulated depreciation (-A) 13 000
Depreciation for the year
An investment property (or a part thereof) must be derecognised (i.e. eliminated from the
statement of financial position) on:
x disposal (by way of sale or finance lease); or Investment property is
x permanent withdrawal from use (e.g. abandonment) derecognised on:
and where no future economic benefits are expected
x Disposal; or
from its disposal. IAS 40.66 (reworded) x Permanent withdrawal from use.
The date on which the disposal must be recorded depends on how it is disposed of.
x If the investment property is disposed of by way of entering into a finance lease, the date
will be determined in accordance with IFRS 16 Leases (see chapter 17).
x If the investment property is disposed of by way of a sale, the date of disposal is the date
on which the recipient obtains control of the investment property (the recipient obtains
control when the criteria in IFRS 15 Revenue from contracts with customers are met and
indicate that the performance obligation has been satisfied). See IAS 40.67
If, when derecognising the investment property, the entity earned proceeds on the disposal,
these proceeds must be recognised as income in profit or loss. The amount of these proceeds
(also called ‘consideration’) is measured in the same way that a transaction price is measured
in terms of IFRS 15 Revenue from contracts with customers. See IAS 40.70
532 Chapter 10
When we retire a property (i.e. withdraw from use) or when we dispose of it, we will
generally have made a gain or incurred a loss. This gain or loss is:
x measured as the difference between the net proceeds we receive for the property (if any)
and its expensed carrying amount; and
x recognised in profit or loss (unless IFRS 16 Leases requires an alternative treatment in the
case of a sale and leaseback). See IAS 40.69
As mentioned above, proceeds on disposal are measured in the same way that we determine
the transaction price in terms of IFRS 15. Thus, if property is disposed of by way of a sale
but the receipt of these proceeds is to be deferred, and if this deferral gives the purchaser a
significant financing benefit, these proceeds must be measured at the price that the customer
would have paid for the investment property had it been disposed of for cash. The difference
between the price that the property would have been sold for had it been sold for cash (i.e. the
notional cash price) and the actual agreed selling price must be recognised separately over the
payment period as interest revenue measured using an appropriate discount rate. See IFRS 15.60 - .65
It can also happen that only a part of the investment property is disposed of (for example a
roof destroyed in a storm, a lift that needs to be replaced etcetera). The carrying amount of
this replaced part needs to be derecognised.
The following guidance is provided for cases where you find it difficult to establish the
carrying amount of the replaced part:
x if the cost model is used and this part was not recognised and depreciated in a separate
account: the cost of the replacement part may be used to estimate the cost of the part on
the date that the property was purchased;
x if the fair value model is used, you may either decide to:
remove an estimated fair value of the replacement part and then add the cost of the
replacement part; or
not bother removing the estimated fair value of the replacement part and add the cost of
the replacement part and then revalue the investment property as a whole to its fair
value: this option is available only if it is believed that the fair value will reflect the
changes owing to the part requiring replacement. See IAS 40.68
Compensation receivable from claims made following an impairment or giving up of a

property are considered to be separate economic transactions and are therefore accounted for
separately when the compensation becomes receivable. The compensation is recognised in
profit or loss. See IAS 40.73
Example 10: Disposal

Ashley Limited sells an investment property, with a fair value of C75 000, for C100 000.
Ashley Limited uses the fair value model.
Required: Show the journal entries for the disposal.
Solution 10: Disposal
Comment: This example shows a disposal where the fair value is known.
Debit Credit
Bank/ debtor 100 000
Investment property (A) 75 000
Profit on sale of investment property (P/L) 100 000 – 75 000 25 000
Sale of investment property
7. Deferred tax (IAS 12.15 and .51 - .51D)
If the cost model is used, the deferred tax implications are the same as those arising from
property, plant and equipment measured in terms of the cost model in IAS 16 (see chapter 7).
Chapter 10 533
If the fair value model is used, the carrying amount of the investment property changes each time
it is fair valued, but the tax base doesn’t change for these adjustments. The tax base will simply
reflect the tax deductions allowed, if any. The difference between the carrying amount and the tax
base will cause temporary differences. So far, this is no different to the calculation of temporary
differences when accounting for a property classified as property plant and equipment in IAS 16.
Please note that if an asset is not deductible for tax purposes, its tax base will be nil (because the
tax base of an asset is a reflection of the future tax deductions) and the resulting temporary
difference that arises on initial recognition (i.e. the difference between the carrying amount of
cost and the tax base of nil) is exempt from deferred tax. This exemption from deferred tax is
covered in more depth in chapter 6, section 4. So far, this is also no different to the calculation of
exempt temporary differences when accounting for a property classified as property plant and
equipment in IAS 16.
However, there is a fundamental difference in the deferred tax journal entries when accounting
for deferred tax on a property classified as an investment property and measured under the fair
value model in terms of IAS 40 and accounting for deferred tax on a property classified as
property plant and equipment and measured under the revaluation model in terms of IAS 16:
x fair value adjustments on property, plant and equipment may create a revaluation surplus
(which is recognised in other comprehensive income: equity): any related deferred tax
journal will be debited or credited to the revaluation surplus account (OCI); whereas
x fair value adjustments on investment properties are all recognised in profit and loss: any
related deferred tax journal will be debited or credited to the tax expense account (P/L).
The general rule when measuring the deferred tax balance is to measure it based on how
management intends to recover the carrying amount of the asset (i.e. whether the entity intends to
make money from using the asset or selling the asset). See IAS 12.51
Management intentions affect the measurement of deferred tax assuming that the way in which
the tax authorities levy tax is affected by whether income is earned through the use or sale of the
asset. In other words, if the tax authorities tax normal operational income (e.g. rent income) at
30% but tax capital profits differently (e.g. in SA, although a capital gain is taxed at the same
income tax rate that is levied on other income such as rent income, only 80% of it is taxable in the
case of companies), we must build this into the estimate of our deferred tax balance.
In the case of investment property measured using the fair value model, however, there is a
rebuttable presumption that the carrying amount of the investment property will be recovered
entirely through the sale of the property rather than through the use of the property. However,
this presumption of sale is rebutted if the investment property is:
x depreciable; and
x held within a business model whose objective is to consume substantially all of the
economic benefits embodied in the property over time rather than through a sale. IAS 12.51C
In other words, if an investment property measured using the fair value model is land, the related
deferred tax is always based on the presumed intention to sell because the presumption is not able
to be rebutted. It is not able to be rebutted because land is an asset that is typically not
depreciable. However, if the investment property was a building, the presumed intention to sell
would be rebutted if it is held within a business model whose objective it is to recover most of the
carrying amount through use (because the building would have been depreciated had it been
measured under the cost model).
Example 11: Deferred tax: fair value model (depreciable and deductible)
Tiffiny Limited owns a building which it leases out under an operating lease.
This building originally cost C1 500 000 (1 Jan 20X2).
The total useful life of the building is 10 years.
Tiffany intends to continue leasing this property for the foreseeable future and uses the fair value model
to account for investment properties. Fair value was C3 000 000 on 31 December 20X5 (31 December
20X6: C3 600 000).
534 Chapter 10

x allow the cost of the building to be deducted at 5% per annum;
x levy income tax on taxable profits at a rate of 30%;
x include all rent income in taxable profits; and
x include capital gains in taxable profits at a 80% inclusion rate (the base cost equals the cost price).
Required:
A. Calculate the deferred tax balance at 31 December 20X6 and provide the deferred tax adjusting
journal for the year ended 31 December 20X6.
B. Show how your answer would change, if at all, if the building falls with a business model the objective of
which is to obtain substantially all of the property's economic benefits through use rather than sale.
Solution 11: Overview of question

x This question involves presumed intentions (IAS 12.51C) and deferred tax exemptions (IAS 12.15)
x This is an investment property measured under the fair value model and thus we must consider the
presumed intention to sell that is included in IAS 12.51C and whether is to be rebutted.
x As the fair value model is used, the building is not depreciated and thus the useful life is ignored.
Solution 11A: Presumed intention to sell

Comment:
x In this scenario, the presumed intention to sell may not be rebutted:
- it is a building and thus considered to be a depreciable asset, but
- although the intention is to use this building, there is no evidence to suggest that it falls within a
business model the objective of which is to obtain substantially all of the economic benefits
embodied in the property through use rather than sale.
x The deferred tax balance is thus measured based on the presumed intention to sell.
The deferred tax balance at 31 December 20X6: C616 500, liability (see W1)
The deferred tax journal during 20X6 will be as follows:
Income tax expense (E) (616 500 – 450 000) 166 500
Deferred tax on investment property (W1)
W1: Deferred tax calculation on investment property: intention to sell
CA TB TD DT
Balance: 1/1/20X2 0 0 0 0
(1)
Purchase: 1/1/20X2 1 500 000 (4) 1 500 000 0 0
FV adj’s/ tax deductions:X2/3/4/5 (3) 1 500 000 (3) (300 000) (1 800 000) (3)
(450 000) Cr DT Dr TE
(2)
Balance: 1/1/20X6 3 000 000 (4) 1 200 000 (1 800 000) (5)
(450 000) Liability
(3)
FV adj’s/ tax deductions: X6 600 000 (3) (75 000) (675 000) (3)
(166 500) Cr DT Dr TE
(2)
Balance: 31/12/20X6 3 600 000 (4) 1 125 000 (2 475 000) (5)
(616 500) Liability
(1) Cost (given) (2) Fair value (given) (3) Balancing
(4) Tax base: 01/01/20X2: 1 500 000 (future deductions that will be allowed)
Tax base: 01/01/20X6: (1 500 000 – 1 500 000 x 5% x 4 years) = 1 200 000
Tax base: 31/12/20X6: (1 500 000 – 1 500 000 x 5% x 5 years) = 1 125 000
(5) Future tax on future economic benefits (intention to sell):
31/12/20X5 31/12/20X6
Taxable capital gain:
Selling price 3 000 000 3 600 000
Base cost (1 500 000) (1 500 000)
Capital gain 1 500 000 2 100 000
Multiplied by: X X
Inclusion rate 80% 80%
Taxable capital gain 1 200 000 1 200 000 1 680 000 1 680 000
Recoupment:
Selling price (3 000 000 or 3 600 000),
limited to cost price (1 500 000) 1 500 000 1 500 000
Tax base (1 200 000) (1 125 000)
Recoupment 300 000 300 000 375 000 375 000
Total future taxable profits 1 500 000 2 055 000
Total future tax @ 30% 450 000 616 500
Chapter 10 535
Solution 11B: Presumed intention to sell is rebutted

Comment:
x In this scenario, the presumption is rebutted since:
- it is a depreciable property and
- the property falls within a business model the objective of which is to obtain substantially all
of the economic benefits embodied in the property through use rather than sale.
Thus, the deferred tax balance must be measured based on the actual intention to use the property.
x As the fair value model is used, the building is not depreciated. Thus, the useful life was irrelevant.

Income tax expense (E) W1: (742 500 – 540 000) 202 500
Deferred tax on investment property (W1)
W1: Deferred tax calculation: Investment property: intention to keep

Carrying Tax Temporary Deferred
(1)
Balance: 1/1/20X6 3 000 000 (2) 1 200 000 (1 800 000) (4)
(540 000) Liability
(6)
Movement 600 000 (6) (75 000) (675 000) (6)
(202 500) Cr DT Dr TE
Balance: 31/12/20X6 (1) 3 600 000 (3) 1 125 000 (2 475 000) (5)
(742 500) Liability
(1) Fair value (given)
(2) (1 500 000 – 1 500 000 x 5% x 4 years) = 1 200 000
(3) (1 500 000 – 1 500 000 x 5% x 5 years) = 1 125 000
(4) 1 800 000 x 30% (rental income would be taxed at income tax rates) = 540 000
(5) 2 475 000 x 30% (rental income would be taxed at income tax rates) = 742 500
(6) Balancing
Example 12: Deferred tax: fair value model (depreciable and non-deductible)
Cowie Limited owns a building which it leases out under an operating lease. This building
originally cost: C1 500 000 (1 January 20X2) and had a total useful life of 10 years and a nil
residual value. Cowie intends to keep the building. Cowie uses the fair value model to account for
investment properties. The fair values of the building were measured as follows:
x 31 December 20X5: C3 000 000
x 31 December 20X6: C3 600 000.
Tax related information:
x Taxable profit will include all rent income but only 80% of a capital gain.
x The base cost for purposes of calculating any taxable capital gain is equal to cost.
x The cost of the building is not allowed as a tax deduction.
Required:
A. Calculate the deferred tax balance at 31 December 20X6 and provide the deferred tax adjusting
journal for the year ended 31 December 20X6.
B. Show how your answer would change, if at all, if the building falls with a business model the
objective of which is to obtain substantially all of the economic benefits embodied in the property
through use rather than sale.
Solution 12: Overview of question

Comment:
x This question involves:
- presumed intentions (IAS 12.51C) and
- deferred tax exemptions (IAS 12.15).
x This is an investment property that is measured under the fair value model and thus we must
consider the presumed intention to sell that is included in IAS 12.51C.
x This is a property the cost of which is not deductible for tax purposes, with the result that certain of
the temporary differences are exempt from deferred tax.
536 Chapter 10
Solution 12A: Presumed intention to sell and an exemption

The deferred tax balance at 31 December 20X6: C504 000 liability (see W1)
Income tax expense(E) W1 144 000
Deferred tax on investment property
Investment property: Carrying Tax Temporary Deferred taxation
intention to sell amount Base difference
Balance: 1/1/20X2 0 0 0 0
(1) (4) (5)
Purchase: 1/1/20X2 1 500 000 0 (1 500 000) 0 Exempt
(3) (4) (3)
FV adj’s: 20X2 – 20X5 1 500 000 0 (1 500 000) (360 000) Cr DT Dr TE
(2) (4) (6)
Balance: 1/1/20X6 3 000 000 0 (3 000 000) (360 000) Liability
x Original cost (1)
1 500 000 (4)
0 (1 500 000) (5)
0 Exempt
x FV adj’s: 20X2 – 20X6 (3)
1 500 000 (4)
0 (1 500 000) (6)
(360 000) Liability
(3) (4) (3)
FV adj’s: 20X6 600 000 0 (600 000) (144 000) Cr DT Dr TE
(2) (4) (7)
x Original cost (1)
1 500 000 (4)
0 (1 500 000) (5)
0 Exempt
x FV adj’s: 20X2 – 20X6 (3)
2 100 000 (4)
0 (2 100 000) (7)
(504 000) Liability
(1) Cost (given)
(3) Balancing
(4) Tax base is nil as no tax future tax deductions (e.g. wear and tear) are granted. Remember that the tax base of
an asset is defined as its future tax deductions.
(5) The temporary difference caused by the initial cost is exempt from deferred tax by IAS12.15 (see chp 6). The
exemption makes sense because there would be a nil tax liability if we sold this asset for C1 500 000:
x FV, limited to cost price: 1 500 000 – Tax base: 0 = Recoupment: 1 500 000 BUT
x a recoupment is impossible: because there were no deductions given that the tax-authority can recoup.
(6) (FV: 3 000 000 – Base cost: 1 500 000) x inclusion rate: 80% = Taxable capital gain: 1 200 000
The taxable capital gain is included in taxable profits and therefore taxed at 30%.
The tax is therefore 1 200 000 x 30% = 360 000
(7) (FV: 3 600 000 – Base cost: 1 500 000) x inclusion rate: 80% = Taxable capital gain: 1 680 000
The taxable capital gain is included in taxable profits and therefore taxed at 30%.
The tax is therefore 1 680 000 x 30% = 504 000
Comment:
x In this scenario, this presumed intention to sell was not able to be rebutted:
it is a building and thus considered to be a depreciable asset, but
although the intention is to use the building, there is no evidence to suggest it falls within a
business model the objective of which is to obtain substantially all of the economic benefits
embodied in the property through use rather than sale. Thus, the deferred tax balance is
measured based on the presumed intention to sell it.
x Since the building is not deductible for tax purposes, the temporary difference that arises on initial
recognition of this cost is exempt from deferred tax, as are all temporary differences arising from
adjustments made to this cost, other than an adjustment that increases the carrying amount above
cost. Deferred tax will thus only arise on temporary differences caused by adjustments above cost.
x Given that we must measure deferred tax based on the presumed intention is to sell and since the
carrying amount has been adjusted to a fair value that exceeds cost, we must consider the tax effect
of capital gains and exempt capital gains.
Solution 12B: Presumed intention to sell is rebutted and an exemption

Comment:
x In this scenario, this presumed intention to sell is rebutted:
- it is a building and thus considered to be a depreciable asset, and
- it falls within a business model the objective of which is to obtain substantially all of the
economic benefits embodied in the property through use rather than sale.
x The deferred tax is thus measured based on the actual intention to use this asset.
Chapter 10 537
Solution 12B: Continued …

x Since the building is not deductible for tax purposes, the temporary difference that arises on initial
recognition of this cost is exempt from deferred tax, as are all temporary differences arising from
adjustments made to this cost, other than an adjustment that increases the carrying amount above
cost. Deferred tax will thus only arise on temporary differences caused by adjustments above cost.
x Since the carrying amount has been adjusted to a fair value that exceeds cost, we must consider the
deferred tax effect of normal income in excess of cost being expected.
Income tax expense (E) W1 180 000

Investment property: Carrying Tax Temporary Deferred
intention to keep amount base difference taxation
Balance: 1/1/20X2 0 0 0 0
(1) (4) (5)
Purchase: 1/1/20X2 1 500 000 0 (1 500 000) 0 Exempt
(3) (4) (3)
FV adj’s: 20X2 – 20X5 1 500 000 0 (1 500 000) (450 000) Cr DT Dr TE
(2) (4) (6)
x Original cost (1)
1 500 000 (4)
0 (1 500 000) (5)
0 Exempt
x FV adj’s: 20X2 – 20X6 (3)
1 500 000 (4)
0 (1 500 000) (6)
(450 000) Liability
(3) (4) (3)
(2) (4) (7)
x Original cost (1)
1 500 000 (4)
0 (1 500 000) (5)
0 Exempt
x FV adj’s: 20X2 – 20X6 (3)
2 100 000 (4)
0 (2 100 000) (7)
(630 000) Liability
(1) Cost (given)
(3) Balancing
(4) Tax base is nil as no tax deductions (e.g. wear and tear) are granted
(5) The temporary difference caused by the initial cost is exempt from deferred tax (see IAS12.15 &/or chp 6).
(6) FV: 3 000 000 – Cost: 1 500 000 = Extra future economic benefits: 1 500 000
These extra FEB will be taxed as normal income since the intention is to keep the asset.
The future tax will therefore be: 1 500 000 x 30% = 450 000
(7) FV: 3 600 000 – Cost: 1 500 000 = Extra future economic benefits: 2 100 000
These extra FEB will be taxed as normal income since the intention is to keep the asset.
The future tax will therefore be: 2 100 000 x 30% = 630 000
Example 13: Deferred tax: fair value model (land and building):
x Non-depreciable and non-deductible; and
x Depreciable and deductible
Faith Limited owns a property which it is holding for rent income. The property originally cost
C1 500 000 (1 January 20X2) and had a total useful life of 10 years. The property, which is classified
as investment property and which is measured using the fair value model, consists of a building and a
large empty tract of land. The estimated split is:
x 40% of the cost and the fair values relate to the land, and
x 60% of the cost and the fair values relate to the building.
The fair values of the property were estimated as follows:
x 31 December 20X5: C3 000 000
x 31 December 20X6: C3 600 000.
This property falls within a business model the objective of which is to obtain substantially all of the
The profit before tax and before any adjustments relating to fair value adjustments, rental income and
depreciation, is C500 000. The property earns an annual rental of C300 000.
538 Chapter 10
Tax-related information:
x Taxable profit will include all rent income but only 80% of a capital gain.
x The base cost is equal to its original cost.
x The tax authorities allow the deduction of an annual building allowance equal to 5% of the cost of
the building but do not allow deductions against the cost of land.
There are no temporary differences, no exempt income and no other non-deductible items other than
those evident from the above.
Required: Calculate the deferred tax balance as at 31 December 20X6 and show the deferred tax
adjusting journal for the year ended 31 December 20X6.
Solution 13: Presumed intentions (rebutted and not rebutted) and exemption
The deferred tax balance at 31 December 20X6: C647 100 liability (W1: 445 500 L + W2: 201 600 L)
Income tax expense (E) (W1: 121 500 + W2: 57 600) 179 100
W1: Deferred tax calculation: Investment property: Building (keep)
(1)
Balance: 1/1/20X6 1 800 000 (3) 720 000 (1 080 000) (5) (324 000) Liability
Movement 360 000 (45 000) (405 000) (7) (121 500) Cr DT Dr TE
(2)
Balance: 31/12/20X6 2 160 000 (4) 675 000 (1 485 000) (6) (445 500) Liability
Calculations:
(1) Fair value (given): 3 000 000 x 60% = 1 800 000
(2) Fair value (given): 3 600 000 x 60% = 2 160 000
(3) (1 500 000 x 60% – 1 500 000 x 60% x 5% x 4 years)= 720 000
(4) (1 500 000 x 60% – 1 500 000 x 60% x 5% x 5 years) = 675 000
(5) 1 080 000 x 30% (all future benefits are expected to be fully taxed as rent income) = 324 000
(6) 1 485 000 x 30% (all future benefits are expected to be fully taxed as rent income) = 445 500
(7) 445 500 (L) – 324 000 (L) = 121 500 (increase in deferred tax liability)
W2: Deferred tax calculation: Investment property: Land (assume sell)

Balance: 1/1/20X2 0 0 0 0
(1) (4) (5)
Purchase: 1/1/20X2 600 000 0 (600 000) 0 Exempt
(3) (4) (3)
FV adj’s: 20X2 – 20X5 600 000 0 (600 000) (144 000) Cr DT Dr TE
(2) (4) (6)
x Original cost (1)
600 000 (4)
0 (600 000) (5)
0 Exempt
x FV adj’s: 20X2 – 20X5 (3)
600 000 (4)
0 (600 000) (6)
(144 000) Liability
(3) (4) (3)
(2) (4) (6)

x Original cost (1)
600 000 (4)
0 (600 000) (5)
0 Exempt
x FV adj’s: 20X2 – 20X6 (3)
840 000 (4)
0 (840 000) (6)
(201 600) Liability
Calculations:
(1) Cost (given): 1 500 000 x 40% = 600 000
(2) Fair value 31/12/20X5: 3 000 000 x 40% = 1 200 000
Fair value 31/12/20X6: 3 600 000 x 40% = 1 440 000
(3) Balancing
(4) No future tax deductions and thus the tax base is nil.
(5) The temporary difference arising on the initial recognition is exempt from deferred tax
(6) Future tax on future economic benefits (intention to sell): See calculation on the next page.
Chapter 10 539

(6) Future tax on future economic benefits (intention to sell):
31/12/20X5 31/12/20X6
Taxable capital gain:
Selling price (FV per W1) 1 200 000 1 440 000
Base cost: 1 500 000 x 40% (600 000) (600 000)
Capital gain 600 000 840 000
Multiplied by: X X
Inclusion rate 80% 80%
Taxable capital gain 480 000 480 000 672 000 672 000
Recoupment: not applicable (no 0 0
deductions had been given)
Total future taxable profits 480 000 672 000
Total future tax @ 30% 144 000 201 600
Comments:
x The details regarding the profit before tax and rent income that were provided in the question are
irrelevant when calculating deferred tax.
x It is important to account for land and buildings separately wherever material. In this regard, the land
portion is considered material enough to be recognised separately.
x This question involves:
- presumed intentions (IAS 12.51C) and
- deferred tax exemptions (IAS 12.15).
x We must consider the presumed intention to sell (IAS 12.51C) since this is an investment property
that is measured under the fair value model.
x Certain of the temporary differences relating to land will be exempt from deferred tax because the
land is not deductible for tax purposes.
x When considering the presumed intention, we apply the principle to each of the components of the
investment property: the land and the building.
x In the case of the land, the presumed intention to sell may not be rebutted:
- although it falls within a business model the objective of which is to obtain substantially all of the
economic benefits embodied in the property through use rather than sale ,
- it is land and is thus not a depreciable asset.
The land thus fails the criteria for the presumption to be rebutted and thus the deferred tax must be
measured based on the presumed intention to sell this asset.
x In the case of the building, this presumed intention to sell is rebutted:
- it is a building and thus considered to be a depreciable asset, and
- it falls within a business model the objective of which is to obtain substantially all of the
The deferred tax is thus measured based on the actual intention to use this asset.
8. Current tax
In most countries (including SA) the fair value gains and losses recognised in profit or loss
are not taxable for income tax purposes until they are actually realised through a sale. In
other words, when converting profit before tax to taxable profits, unrealised fair value
adjustments must be reversed.
Depreciation on a building would also be ignored for tax purposes and would be replaced by
the actual tax deduction granted, if any. In other words, when converting profit before tax to
taxable profits, you need to add back the depreciation and subtract any tax deduction.
Example 14: Current tax: intention to keep and use (including land)
This example uses the same information that was provided in the prior example (dealing
with Faith Limited). In this example, we focus only on calculating the current income tax.
Required: Calculate and journalise the current income tax payable as at 31 December 20X6.
540 Chapter 10
Solution 14: Current tax: intention to keep and use (including land)
Comment: This example focussed only on the current income tax effects - the deferred tax consequences were
calculated in the prior example (example 13).

Income tax (E) W1 226 500
Current income tax payable (estimated)
W1. Current income tax Calculations C
Profit before tax and before adjustments 500 000

Add rental income 300 000
Add fair value gain - land See Ex 13: W2 (3 600 000 – 3 000 000) x 40% 240 000
Add fair value gain - building See Ex 13: W1 (3 600 000 – 3 000 000) x 60% 360 000
Less depreciation Property held under fair value model 0
Profit before tax 1 400 000
Differences between accounting profit and taxable profit:
Less fair value gain - land Taxable in future (240 000)
Less fair value gain - building Taxable in future (360 000)
Add back depreciation Not applicable: fair value model used 0
Less tax allowance on building Cost: 1 500 000 x 60% (building portion) x 5% (45 000)
9.1 General disclosure requirements (IAS 40.75 - .76 & .79)

General disclosure requirements (i.e. irrespective of whether the cost model or fair value
model is used) include:
9.1.1 An accounting policy note for investment properties
The accounting policy note should disclose:
x whether the fair value model or cost model is used;
x where it was difficult to decide, the criteria that the entity used to determine whether a
property was an investment property, owner-occupied property or inventory. IAS 40.75 (a); (c)
9.1.2 An investment property note

The investment property note should disclose:
x whether the fair value was measured by an independent, suitably qualified valuer with
relevant experience in the location and type of property; IAS 40.75 (e)
x any restrictions on the property (i.e. in terms of selling the property or on receiving the
income or proceeds on disposal); IAS 40.75 (g)
x a note for investment property that shows the opening balance of the property reconciled
to the closing balance. IAS 40.76 and IAS 40.79 (d)
9.1.3 Profit before tax note
The profit before tax note should include disclosure of:
x rental income earned from investment property;
x fair value adjustments
x direct operating expenses related to all investment property, split into:
- those that earned rental income, and
-
those that did not earn rental income. IAS 40.75 (f)
Chapter 10 541
9.1.4 Contractual obligations note
Contractual obligations relating to investment property must be categorised into those:

x related to capital expenditure (e.g. purchase, construction or development thereof); or
x general expenditure (e.g. repairs and maintenance). IAS 40.75 (h)
9.2 Extra disclosure when using the fair value model (IAS 40.76- .78 & IFRS 13.91)
9.2.1 Investment property note
The investment property note should, if the fair value model was used, also disclose:
x the reconciliation between the opening balance and closing balance of investment
property, showing all:
- additions (either through acquisition or a business combination);
- subsequent expenditure that was capitalised;
- assets classified as held for sale or included in a disposal group classified as held for
sale in accordance with IFRS 5;
- transfers into and out of investment property (i.e. from and to inventories and owner-
occupied property e.g. property, plant and equipment);
- fair value adjustments;
- exchange differences;
- other changes. IAS 40.76 (reworded slightly)
x if a specific property is measured using the cost model because the fair value could not be
reliably measured then the reconciliation above must be presented separately and the
following must be disclosed in relation to that property:
- a description of the property; IAS 40.78(a)
- a separate reconciliation from opening balance to closing balance;
- an explanation as to why the fair value could not be measured reliably; IAS 40.78(b)
- the range of estimates within which the fair value is highly likely to lie; IAS 40.78(c)
- if such a property is disposed of, a statement to this effect including the carrying
amount at the time of sale and the resulting gain or loss on disposal. IAS 40.78 (d)
x if the valuation obtained had to be significantly adjusted to avoid double-counting assets
and liabilities recognised separately in the financial statements, then include a
reconciliation between the valuation obtained and the adjusted valuation. IAS 40.77
IFRS 13 also requires certain minimum disclosures relating to fair value. If the asset is
measured using the fair value model, IFRS 13.91 requires disclosure of how the fair value
was measured:
x the valuation techniques (e.g. market, cost or income approach); and
x the inputs (e.g. quoted price for identical assets in an active market or an observable price
for similar assets in an active market).
Further minimum disclosures relating to this measurement of fair value are listed in
IFRS 13.93 and are covered in the chapter on Fair value measurement (IFRS 13).
9.3 Extra disclosure when using the cost model (IAS 40.79)
9.3.1 An accounting policy note for investment properties
If the cost model had been used, then the accounting policy note should also disclose the:
x depreciation method and rates / useful lives. IAS 40.79 (a)-(b)
542 Chapter 10
9.3.2 Investment property note
If the cost model had been used, then the investment property note should also disclose the:
x the reconciliation between the opening balance and closing balance of investment
property must show all:
- the gross carrying amount and accumulated depreciation (at the beginning and end of
the year);
- additions (either through acquisition or a business combination);
- subsequent expenditure that was capitalised;
- assets classified as held for sale or included in a disposal group classified as held for
sale in accordance with IFRS 5 and other disposals;
- transfers into and out of investment property (i.e. from and to inventories and owner-
occupied property e.g. property, plant and equipment);
- depreciation for the current year (and in the profit before tax note);
- impairments (and reversals) for the current year (and in the profit before tax note);
- exchange differences;
- other changes. IAS 40.79 (c) – (d)
x the fair values of the property unless, in exceptional circumstances, these cannot be
measured, in which case also disclose:
- a description of the property
- the reasons why the fair value was considered to not be reliably measurable;
- the range of estimates within which the fair value is highly likely to lie. IAS 40.79 (e)
IFRS 13 also requires certain minimum disclosures relating to fair value:

x If the asset is not measured at fair value but the fair value is disclosed in the note, certain
minimum disclosures are required. These minimum disclosures are listed in IFRS 13.97
and are covered in the chapter on Fair value measurement.
9.4 Sample disclosure involving investment properties
Company Name
ASSETS 20X5 20X4
Non-current assets Note C C
Investment property 27 xxx xxx
Company Name
1. Statement of compliance … 20X5 20X4

.... C C
2.1 Investment property:
Investment properties are land and buildings held by the group to earn rentals and/or for
capital appreciation. Properties held for resale or that are owner-occupied are not included in
investment properties. Where investment property is occupied by another company in the
group, it is classified as owner-occupied.
Investment properties are measured using the fair value model (or the cost model).
The company uses the following criteria to identify investment properties from inventory:
x …..
Chapter 10 543
Company Name
27 Investment property (fair value model) 20X5 20X4

Opening balance xxx xxx
x Capitalised subsequent expenditure xxx xxx
x Transfers from/(to) investment property:
- from property, plant and equipment (as no longer owner-occupied) xxx xxx
- to property, plant and equipment (as it became owner-occupied) (xxx) (xxx)
- from inventory (as the property is now leased under an op. lease) xxx xxx
- to inventory (as the property is being re-developed for resale) (xxx) (xxx)
- to (or from) non-current assets held for sale (xxx) xxx
x fair value adjustments xxx (xxx)
Closing balance
The investment property has been fair valued by suitably qualified and independent valuator with
recent experience in similar property in similar areas.
The valuation technique used when measuring fair value was the market approach and the inputs
involved level one inputs (quoted prices for similar properties, adjusted for condition and location).
Included in the above is a property measured at … that has been offered as security for a loan (see
Note … Loan obligations)
Included in the above is a property situated in Zimbabwe: income from rentals earned may not be
received due to exchange controls and the property may not be sold to anyone other than a
Zimbabwean national.

Profit before tax is stated after:
Income from investment properties: rental income
Fair value adjustments for the period
Investment property expenses:
- Properties not earning rentals
- Properties earning rentals
10. Summary
Property
Owner-occupied Investment property

x Land/ buildings/ both x Land/ buildings/ both
x Held by owner or held by lessee as a right-of- x Held by owner or held by lessee as a right-of-
use asset use asset
x For use in supply of goods/ services or for admin x To earn rentals or for capital appreciation
purposes
Follow IAS 16 Follow IAS 40
544 Chapter 10
Investment property
Recognition and measurement
Recognition Measurement
Owned property x Initial measurement: cost.
x Cost is different for
Same principle as for PPE (IAS 16): the - Owned property
property needs to meet the: - Property held as right-of-use asset
x definition and x Subsequent measurement:
choose between 2 models (cost & FV models)
x recognition criteria x Subsequent expenditure:
Held under a lease (as a right-of-use asset) normal capitalisation rules (IAS 16)
Same principles as in IFRS 16 x Transfers in / out (when evidence of change
in use)
x Disposals / purchases (IAS 16)
x Impairments (IAS 36) – cost model only
Initial measurement
Initial costs:
x Acquisition: Purchase price
x Construction: IAS 16 costs
x Right-of-use asset: IFRS 16 cost
x Exchange:
o FV of asset given up/ received (if more clearly evident) or
o CA of asset given up (if no FV’s or lack of commercial substance)
Includes:
x transaction costs,
x directly attrib. costs, professional fees etc
Excludes:
x wastage
x start-up costs
x initial operating losses
If payment deferred:
x PV of future payments
Subsequent costs:
x Same as above but often expensed – must meet the usual recognition criteria
Subsequent measurement
The models
Do we have a choice or is there no choice?

Generally you have the choice between:
x Cost model (CM) (IAS 16 if IP is owned or IFRS 16 if IP is held under a lease)
x Fair value model (FVM) (IAS 40)
But must use same model for all
Exceptions: p53
Investment property not under construction
x if on acq. date, you think FV not reliably measurable on a continuing basis: use CM for this particular
property until disposal – all other investment property can still be measured using FVM.
Investment property under construction:

x During construction: measure at cost if FV not measurable but switch to FVM if FV becomes measurable
during construction or at completion
x On completion: If FV not reliably measurable on continuing basis on completion date, use CM until disposal
(but if FV was used during construction, we may not switch to CM – we must continue using FVM)
No choice in models if:

x p53B and 55: properties previously measured using FV model: always measure using FVM
Chapter 10 545
Fair value model

x Measure at: Fair value
x FV adjustments: recognised in P/L
x FV is measured in terms of IFRS 13 Fair value measurement using:
- valuation techniques (e.g. market, cost or income approach) and
- inputs varying between Level 1 and Level 3 quality (ideally level one inputs, such as quoted prices for
identical assets but more likely to be level two input, such as a quoted price (adjusted) for a similar
asset, adjusted for its location and condition)
x FV is an exit price based on assumptions that would be made by market participants
x Fair value is ideally measured by qualified valuator with relevant experience
FV is not:
x FV – CtS
x VIU (i.e. not entity-specific!)
Careful of double-counting! For example:

x building: equipment that is integral (e.g. a lift) is generally included in the IP
x if leased out as a furnished building: furniture is generally included in the IP
x if leased out and FV = DCF: lease rentals receivable/ received in advance must be excluded from the DCF
calculation because these are already reflected as assets or liabilities, respectively
If FV no longer able to be reliably measured, leave CA at the last known FV (do not change to CM)
Change in policy:
x generally only possible if policy changes from CM to FVM
Cost model
Measure in terms of:
x IFRS 16: if the property is a right-of-use asset. Apply:
- Depreciation requirements in IAS 16 (slight variations!)
- Impairment requirements in IAS 36
x IFRS 5: if it meets all criteria in IFRS 5 to be classified as 'held for sale'; or
x IAS 16: for all other assets, in which case measure at:
- Cost
- Less acc depreciation
- Less acc imp losses
Must still determine FV for disclosure purposes
Transfers in/ out of IP

These occur when there is evidence of a change in use that
results in the IP definition no longer being met or being met
for the first time, examples below:
Inventories IP PPE
If cost model used for IP:

No measurement complications
when transferring from one account to another
If fair value model used for IP:
Specific measurement rules
when transferring from one account to another
Examples of transfers in/ out of IP: Transfer measured at:

From To Cost model Fair value model
x PPE (IAS 16/ IFRS 16) x IP (IAS 40) Carrying amount Fair value
x Inventories (IAS 2) x IP (IAS 40) Carrying amount Carrying amount
x IP (IAS 40) x PPE (IAS 16/ IFRS 16) Carrying amount Fair value
x IP (IAS 40) x Inventories (IAS 2) Carrying amount Fair value
546 Chapter 10
Measurement
Deferred tax
Cost model Fair value model

Deferred tax is the same as for property, plant and Deferred tax is measured based on the
equipment: deferred tax balance is measured on all presumption that the intention is to sell the
temporary differences (at income tax rates) unless investment property (IAS 12.51C)
the asset is not tax deductible, in which case the
This presumption is rebutted if the investment
temporary differences will be exempt from
property:
deferred tax (IAS 12.15)
x Is depreciable; and
x Is held within a business model, the objective
of which is to recover substantially all its
carrying amount through time (use) rather
than through a sale.
Land is not depreciable and thus the presumption is

always that it will be sold.If the asset is not tax
deductible, the temporary differences arising from
the initial recognition of the asset are exempt
from deferred tax (IAS 12.15)
Summary: examples involving recognition (classification)
Property owned or held under a lease as a right-of-use asset that is currently

x Held for sale as ordinary business activity Inventories
x Held for capital appreciation Investment property
x Leased out under op. Lease Investment property
x Leased out to 3rd party under finance lease Lease (as a lessor) (can’t be IP!)
x Owner-occupied PPE
x Occupied by employees PPE
x Land held for unknown use Investment property
x Vacant: future use = invest property Investment property
x Vacant: future use = owner occupation PPE
Property owned or held under a lease (from a 3rd party) as a right-
of-use asset where intended use is:
x Future use = investment property Investment property
x Future use = owner-occupation Property, plant and equipment
x Future use = for a third party Construction contracts
x Future use = for sale Inventories
Property rented by a subsidiary (or parent) under an operating lease

x In the lessee’s books (i.e. the subsidiary) Right-of-use asset (or lease expense if elected)
x In the lessor’s books (i.e. the parent) Investment property
x In the group’s books (i.e. consolidated) Owner-occupied (property, plant and equipment)
Chapter 10 547
Main disclosure
General
x Accounting policies
Rental income from investment properties
Direct expenses re IP’s that earn rental income
Direct expenses re IP’s that do not earn rental income
Depreciation, impairment loss & reversals (if cost model)
x Investment property note:
Reconciliation between opening and closing balance
Fair value (if CM used, this must still be disclosed)
How fair value measured
IP: Disclosure – for both models

x which model used
x what criteria used to identify IP from PPE/ Inventories what criteria used to identify IP from PPE/ Inv
x how FV was measured:
Based on mkt evidence or other factors (list)
Methods and significant assumptions applied
Based on a valuation by professional valuer with relevant experience?
If FVM used, a recon between such a valuation and the valuation used for FS’s
(e.g. adjustments to avoid double-counting)
Rental income
Direct op expenses on IP generating rent income
Direct op expenses on IP with no rent income
x Restrictions on remittance of rent income/ sale-ability
x Contractual obligations
IP: Disclosure – for FV model

Recon between CA at beginning and end of period
x Additions – acquisitions
x Additions – subsequent expenditure
x +/- assets classified as held for sale
x Gain/ loss from FV adjustments
x Transfers (to)/ from inventories/ PPE
x Other
Show a separate recon for any property that HAD to be measured using CM and also:
x Describe this property
x Explain why the FV could not be measured reliably
x The range of estimates in which FV is highly likely to be
x When it is sold:
Indicate that it was sold
The CA at time of sale
G/L recognised on sale
IP: Disclosure – for Cost model

Recon between CA at beginning and end of period
x Additions – acquisitions
x Additions – subsequent expenditure
x +/- assets classified as held for sale
x Depreciation
x Impairments or impairments reversed
x + - transfers (to)/ from inventories/ PPE
x Other
FV of the properties
548 Chapter 10
Gripping GAAP Impairment of assets
Chapter 11
Impairment of Assets
Reference: IAS 36 and IFRS 13 (including amendments to 10 December 2018)
Contents: Page
1. Introduction 551
2. Indicator review 552
2.1 Overview 552
2.2 External information 552
2.3 Internal information 552
2.4 Materiality 552
2.5 Reassessment of the variables of depreciation 553
Example 1: Indicator review 553
Example 2: Indicator review 555
3. Recoverable amount 556
3.1 Overview 556
Example 3: Recoverable amount and impairment loss: basic 556
3.1.1 Recoverable amounts: indefinite useful life intangible assets 557
3.1.2 Recoverable amounts: all other assets 557
3.2 Fair value less costs of disposal 558
Example 4: Recoverable amount: fair value less costs of disposal 558
3.3 Value in use 559
3.3.1 Cash flows in general 559
3.3.1.1 Relevant cash flows 559
3.3.1.2 Assumptions 560
3.3.1.3 Period of the prediction 560
3.3.1.4 Growth rate 560
3.3.1.5 General inflation 561
3.3.2 Cash flows from the use of the asset 561
3.3.2.1 Cash flows from use to be included 561
3.3.2.2 Cash flows from use to be excluded 561
3.3.3 Cash flows from the disposal of the asset 561
Example 5: Recoverable amount: value in use: cash flows 562
3.3.4 Present valuing the cash flows 563
Example 6: Value in use: discounted (present) value 563
3.3.5 Foreign currency future cash flows 564
Example 7: Foreign currency future cash flows 564
4. Recognising and measuring an impairment loss 564
4.1 Overview 564
4.2 Impairments and the cost model 565
Example 8: Impairment loss journal: basic 565
4.3 Impairments and the revaluation model 566
Example 9: Impairment loss journal: with a revaluation surplus 567
Example 10: Fair value and recoverable amount – disposal costs are negligible 568
Example 11: Fair value and recoverable amount – disposal costs are not negligible 568
Chapter 11 549
Contents continued ...: Page

5. Recognising a reversal of a previous impairment loss 569
5.1 Overview 569
5.2 Impairment reversals and the cost model 569
5.3 Impairment reversals and the revaluation model 570
Example 12: Revaluation model and impairment loss reversed 570
6. Impairment of cash-generating units 573
6.1 Overview 573
Example 13: Scrapping of an asset within a cash-generating unit 574
6.2 Allocation of an impairment loss to a cash-generating unit 574
Example 14: Allocation of impairment loss (no goodwill) 575
Example 15: Allocation of impairment loss (no goodwill): multiple allocation 576
Example 16: Allocation of impairment loss (with goodwill) 577
6.3 Reversals of impairments relating to a cash generating unit 579
6.3.1. Calculating impairment loss reversals relating to CGUs 579
6.3.2. Impairment loss reversals relating to CGUs – cost model 580
Example 17: Impairment and reversal thereof (no goodwill) – cost model 580
Example 18: Impairment and reversal thereof (with goodwill) – cost model 581
6.3.3. Impairment loss reversals relating to CGUs – revaluation model 582
Example 19: Impairment reversal of a CGU (with goodwill) – cost model 582
and revaluation model
6.4 Corporate assets 585
Example 20: Corporate assets 586
7. Deferred tax consequences of impairment of assets 587
Example 21: Deferred tax consequences relating to impairment 587
8. Disclosure 588
8.1 In general 588
8.2 Impairment losses and reversals of previous impairment losses 588
8.3 Impairment testing: cash-generating units 589
9. Summary 591
550 Chapter 11
1. Introduction
IAS 36 Impairment of assets is designed to ensure that an The purpose of IAS 36:
asset’s carrying amount does not exceed its recoverable amount. To ensure an asset’s CA is not
overstated. See IAS 36.1
The carrying amount of an asset should reflect the economic
benefits an entity expects that asset to produce. However, an asset’s carrying amount could, for
many reasons, end up being overstated. For example: a vehicle costing C100 000, that is depreciated
to a nil residual value over 5 years, would have a carrying amount of C80 000 at the end of year 1.
However, if it was damaged during a storm in year 1, this could
be an indication that its carrying amount is no longer a Carrying amount is
reasonable measurement of the economic benefits expected. In defined as:
this case, we must assess the amount we could truly obtain from x the amount at which an asset is
this vehicle. There are only two options for an asset: dispose of it recognised
or continue using it. Thus, we calculate the net amount we could x after deducting any:
- accumulated depreciation
obtain from disposing of it (fair value less cost of disposal) and (amortisation) and
the amount expected from continuing to using it (value in use). - accumulated impairment losses.
See IAS 36.6
The higher of these two amounts is the recoverable amount (we
use the higher amount since we assume the entity would choose the most advantageous outcome).
If the recoverable amount is found to be lower than our asset’s Recoverable amount is
defined as:
carrying amount, it means the asset’s carrying amount is
overstated and must be reduced. In other words, our asset has x the higher of an asset’s:
been impaired. This reduction is called an impairment loss and - fair value less costs of disposal
(FV-CoD); and
is an expense that is generally recognised in profit or loss. - value in use (VIU). See IAS 36.6
However, after reducing an asset’s carrying amount due to an impairment, the unfavourable
conditions that originally caused this impairment loss may subsequently reverse (e.g. damage is
repaired). If this happens, the recoverable amount may now exceed the asset’s carrying amount and
require us to increase the carrying amount. This increase would be an impairment loss reversal and
is an income that is generally recognised in profit or loss.
Entities must perform an ‘annual indicator review’, at reporting date, to assess whether an asset
might be impaired. It is generally only if this review suggests an asset may be impaired that the
recoverable amount is calculated. IAS 36.9 (reworded) Scope of IAS 36
The annual indicator review and recoverable amount calculation IAS 36 applies to all assets
except for:
(when necessary), are helpful (although time consuming), as it x inventories (IAS 2)
forces businesses to assess the most profitable future for the x contract assets & costs to obtain/
asset concerned (i.e. whether to use or dispose of the asset). fulfil a contract that are
recognised as assets (IFRS 15)
IAS 36 does not apply to all assets. All assets excluded from the x deferred tax assets (IAS 12)
scope of IAS 36 (see grey box) are measured in terms of their x employee benefit assets (IAS 19)
own standards, specifically designed to cater for each of these x financial assets (IFRS 9)
asset types. IAS 36 affects all other assets (e.g. property, plant x investment properties measured
at fair value (IAS 40)
and equipment and intangible assets). x biological assets measured at FV
less costs to sell (IAS 41)
The term ‘asset’ in this chapter refers to both ‘individual assets’ x insurance contracts (IFRS 17)
and to ‘cash-generating units’ (i.e. a group of assets that cannot x non-current assets classified as
produce cash inflows independently of one another, but only as held for sale (IFRS 5). See IAS 36.2
a part of a group). We will start with how to account for
impairments and impairment reversals in terms of individual assets and then apply these principles in
the context of cash-generating units. We will now discuss the following issues in more detail:
x what is entailed by an indicator review?
x how does one calculate the recoverable amount?
x how does one process an impairment loss?
x how does one calculate and process an impairment loss reversal?
x how does this change if we are dealing with a cash-generating unit instead of an asset?
x what are the disclosure requirements when there is an impairment loss or reversal thereof?
Chapter 11 551
2. Indicator Review (IAS 36.8 - .17)
2.1 Overview (IAS 36.8 - .17) An indicator review is:

a procedure that involves
An ‘indicator review’ must be performed at the end of the looking for evidence that
reporting period in order to assess whether an impairment an asset’s CA may be overstated
may have occurred. An asset is impaired if its carrying amount is greater than its recoverable
amount. The recoverable amount is essentially a measure of how much we can still recover from
the asset through either its use or the sale of the asset (see section 3 for the definition and full
discussion of the recoverable amount). If the asset is impaired, its carrying amount must be
adjusted downwards to reflect its recoverable amount. See IAS 36.1 & 9
The indicator review should take into consideration the
The recoverable
following factors: amount is only
x external information; calculated if:
x internal information; x the indicator review suggests a
x materiality; and possible material impairment
x reassessment of the variables of depreciation. See IAS 36.12, 15 &17 x unless the asset is
- an intangible asset with an
The recoverable amount only needs to be calculated if: indefinite useful life / not
x the indicator review suggests that the asset may be impaired; yet available for use
- goodwill
x the asset is an intangible asset with an indefinite useful life; in which case the RA must
x the asset is an intangible asset not yet available for use; or ALWAYS be calculated.
x the asset is goodwill acquired in a business combination. See IAS 36.9 & .10
See IAS 36.9 & .10
2.2 External information (IAS 36.12 - .14)
There are many examples of external information that could indicate an asset is impaired, including:
x a decrease in the value of the asset that is significant relative to normal usage over time;
x a significant adverse change in the market within which the asset is used (e.g. where a
new competitor may have entered the market and undercut the selling price of the goods
that the machine produces); and
x the net asset value per share is greater than the market value per share. See IAS 36.12
2.3 Internal information (IAS 36.12 - .14)
As with external information, there are countless examples of internal information that could
indicate that an asset may be impaired, including knowledge of:
x significant changes adversely affecting the use of the asset, including planned changes;
for example:
- a plan to dispose of the asset at a date earlier than previously expected,
- a plan that will result in the asset becoming idle,
- a plan to cease manufacturing a product line or close a factory that uses the asset, and
- the reassessment of the useful life of an asset from ‘indefinite’ to ‘finite’;
x future unexpected maintenance costs that will reduce the value in use;
x unusually low budgeted cash flows and profits/ losses relating to the use of the asset; and
x physical damage or obsolescence. See IAS 36.12
2.4 Materiality (IAS 36.15)
We must calculate the estimated recoverable amount if the annual indicator review suggests
that an asset may be impaired, but only if the potential impairment is expected to be material.
However, this does not apply to intangible assets with indefinite useful lives, intangible assets not yet
available for use and goodwill - their recoverable amounts must be calculated annually, even if there
is no indication of an impairment and even if a possible impairment would not be material. See IAS 36.10
552 Chapter 11
2.5 Reassessment of the variables of depreciation (IAS 36.17)
If an indicator (internal or external) suggests that the asset’s carrying amount is materially overstated,
this could mean that it may be materially impaired. If so, we would adjust the carrying amount down
to the recoverable amount and call this adjustment an ‘impairment loss’. However, an impairment
loss is only processed after first verifying that the possibly over-stated carrying amount is not simply
the result of past accumulated depreciation that was under-estimated.
In order to assess the reasonableness of the depreciation to If the CA appears

date, we must re-evaluate the three variables of depreciation: overstated:
x estimated remaining useful life, x before processing an impairment
x residual value (used to calculate depreciable amount), & loss; we
x depreciation (or amortisation) method. IAS 36.17 (reworded) x first check that our depreciation
variables do not need to be re-
estimated (e.g. we may need to
Any change in the above three variables must be adjusted in process extra depreciation)
accordance with the statement governing that type of asset.
For example, a change in the depreciation of property, plant and equipment will be accounted
for as a change in accounting estimate (IAS 8), since this is how IAS 16 Property, plant and
equipment requires a change in depreciation to be accounted for.
Example 1: Indicator review

Lilguy Limited owns a plant, its largest non-current asset, which:
x originally cost C700 000 on 1/1/20X4; and
x has a carrying amount of C350 000 at 31/12/20X8; and
x is depreciated straight-line to a nil residual value over a 10-year estimated useful life.
Lilguy Limited performed an indicator review at its financial year end (31/12/20X8) to assess whether
this asset might be impaired. Initial information collected for the purpose of review includes:
x Budgeted net cash inflows: these are slightly reduced because a decrease in the market demand for
the plant’s output is expected during 20X9 after which demand is expected to cease altogether.
x The present value of the future net cash inflows from the plant: C230 000.
x The market price per share in Lilguy Limited: C2,20 (there are 100 000 issued shares).
A summary of the totals in the statement of financial position is as follows:
x Assets: 400 000
x Liabilities: 100 000
x Equity: 300 000
Required: Discuss whether the recoverable amount must be calculated at 31 December 20X8.
Solution 1: Indicator review

x The net asset value of the company as presented in the statement of financial position is C300 000
(Assets: 400 000 – Liabilities: 100 000) and this works out to a net asset value of C3 per share
(300 000 / 100 000 shares). The fact that the market perceives the value of the company to be only
C2,20 per share, or C220 000 in total, suggests that the total assets in the statement of financial
position may be over-valued. This difference in value appears to be material and thus suggests that
there may be a possible impairment.
x The future cash flows from this specific asset (plant) will be reduced over the next year which
suggests a possible impairment, but the fact that the reduction is expected to be ‘slight’ suggests
that the impairment would be immaterial and therefore this fact alone does not require a
recoverable amount to be calculated.
x The present value of the future cash inflows from the use of the plant is C230 000. This appears to
be significantly less than the carrying amount of the plant of C350 000. This difference appears to
be material and therefore suggests that there may be a possible impairment.
x On balance, there appears to be overwhelming evidence that suggests that there may be a possible
impairment and if, as in this case, the possible impairment appears likely to be material, the
recoverable amount would need to be calculated. Before doing this though, one must first reassess
the variables of depreciation, and adjust the carrying amount for any changes in estimate.
Chapter 11 553

x The entity expects the demand to cease entirely after 20X9. Since the asset is only expected to
produce cash inflows (economic benefits) for one more year (20X9), it means that the estimated
useful life of 10 years that is currently being used to calculate depreciation, is too long. By
changing the useful life to a shorter period, the depreciation will increase and the carrying amount
of the plant will decrease and may possibly decrease sufficiently such that there is no need to
calculate the recoverable amount.
Total useful life – original estimate 10 years
Used up to end of 31 December 20X8 5 years
Remaining useful life at 31 December 20X8 – original estimate 5 years
Remaining useful life at 31 December 20X8 – according to latest budget 1 years
Remaining useful life at 31 December 20X8 – reduction (from 5 yrs to 1 yr) 4 years
The decrease in useful life must be recorded as a change in accounting estimate (IAS 8). The useful life
decreases by 4 years, whether we look at the total life or remaining life. At 31 December 20X8, it is a:
decrease in total life, from 10 years to 6 years (5 past years to the end of 20X8 + 1 more year: 20X9)
decrease in remaining life from 5 years to 1 year (working above).
These calculations at 31 December 20X8 establish that there is a change in useful life. However, since the
20X8 financial statements are not yet finalised, we account for this change from the beginning of 20X8.
Assuming one uses the reallocation approach to calculate the effect of the change in estimate, the change to
the carrying amount, calculated and accounted for from the beginning of 20X8, is as follows:
10-year 6-year Drop in carrying
W1 Change in estimate useful life useful life amount
Cost: 1/1/20X4 Given 700 000
Acc depr: 31/12/20X7 700 000 / 10 x 4 (280 000)
Carrying amount: 1/1/20X8 420 000 420 000
Remaining useful life 10 – 4; 1 + 1 6 2
Depreciation: 20X8 420 000 / 6; (70 000) (210 000) (140 000)
420 000 / 2
Carrying amount: 31/12/20X8 350 000 210 000 (140 000)
After processing the extra depreciation (of C140 000) in 20X8, the plant’s carrying amount at
31 December 20X8 will now be C210 000 instead of C350 000. This means that the net asset value
will decrease, and this revised net asset value must now be compared with the market value:
Assets per the SOFP before the change in useful life Given 400 000
Less reduction in carrying amount of plant due to extra depr. See W1 above (140 000)
Assets per the SOFP after the change in useful life 260 000
Less liabilities Given 100 000
Net asset value 160 000
The revised net asset value is now less than the company’s market value of 220 000 (2.2 x
100 000) and therefore the market value no longer suggests a possible impairment.
x The new reduced carrying amount is now also more in line with the present value of the future net
cash inflows per the management accountant’s budget:
Carrying amount of plant – revised See W1 above 210 000
Present value of budgeted future cash inflows from plant Given 230 000
As the carrying amount is now less than the present value of the expected future cash inflows, the
budgeted future cash flows no longer suggest an impairment.
Conclusion: Although the review initially suggested there were possible impairments and that these
impairments were possibly material, no recoverable amount needed to be calculated since the revised
depreciation resulted in the carrying amount being reduced.
Debit Credit
Depreciation – plant (P/L: E) 140 000
Plant: Acc depr (-A) 140 000
Extra depreciation due to a reduction in useful life (change in
estimated depreciation)
554 Chapter 11
Example 2: Indicator review

Lilguy Limited owns a plant, its largest non-current asset, that:
x originally cost C700 000 on 1/1/20X1;
x has a carrying amount of C350 000 at 31/12/20X5; and
x is depreciated straight-line to a nil residual value over a 10-year useful life.
Lilguy Limited performed an indicator review (at 31/12/20X5) to assess if this asset may be impaired.
Initial information collected for the purpose of this review included:

x The management accountant budgeted that net cash inflows will be slightly reduced over the next 3
years of usage, due to a decrease in the market demand for the plant’s output, and that there will be
no market for the plant’s output after 31/12/20X8.
x The estimated fair value less costs of disposal of the plant is C250 000.
x The market price per share in Lilguy Limited was C3,50 (there are 100 000 issued shares).
A summary of the totals in the statement of financial position is as follows:
x Assets: 400 000
x Liabilities: 100 000
x Equity: 300 000
Required: Discuss whether the recoverable amount must be calculated.
Solution 2: Indicator review

x The future cash flows will be reduced over the next three years which suggests a possible impairment,
but the fact that the reduction is expected to be slight suggests that the impairment would be immaterial
and therefore this fact alone does not require a recoverable amount to be calculated.
x The net asset value of the company is presented in the statement of financial position as C300 000
(Assets: 400 000 – Liabilities: 100 000) and this works out to a net asset value of C3 per share
(300 000 / 100 000 shares).
However, the market perceives the value of the company to be C3.50 per share or C350 000 in total
(C3,50 x 100 000 shares), which is more than the value reflected in the statement of financial
position (C300 000). This suggests that the assets in the statement of financial position are not
over-valued and therefore that there is possibly no impairment required.
x The fact that the management accountant believes that there are only 3 years of usage left in the
plant suggests that the 10 years over which the plant is being depreciated is too long.
By revising the useful life to a shorter period, the carrying amount of the plant will be reduced and
may be reduced sufficiently such that there is no need to calculate the recoverable amount.
Total useful life – original estimate 10 years
Used up to end 31 December 20X5 5 years
Remaining useful life – original estimate 5 years
Remaining useful life according to latest budget 3 years
Reduction in remaining useful life (from 5 years to 5 – 3 = 2 years) 2 years
This change in useful life (total life of 10 years decreased to 5 + 3 = 8 years; or change in remaining life
changed from 5 years to 3 years) must be accounted for as a change in accounting estimate (IAS 8).
Assuming that one uses the reallocation approach to account for the change in estimate, the change to
the carrying amount is as follows: 10 year 8 year Drop in
useful life useful life CA
Cost: 1/1/20X1 Given 700 000
Accum deprec: 31/12/20X4 700 000 / 10 x 4 (280 000)
Remaining useful life (10 – 4); (1 + 3) 6 4
Depreciation: 20X5 420 000/ 6; (70 000) (105 000) (35 000)
420 000/ 4
Carrying amount: 31/12/20X5 350 000 315 000 (35 000)
Chapter 11 555
x The new carrying amount will adjust the net asset value downwards and the revised net asset value
must be compared again with the market value:
Assets per the statement of financial position before the change in useful life 400 000
Less reduction in carrying amount of plant (35 000)
Assets per the statement of financial position after the change in useful life 365 000
Less liabilities 100 000
Net asset value 265 000
The revised net asset value is still lower than the company’s market value of 350 000 (3.5 x 100 000
shares) and therefore the market value still does not suggest a possible impairment.
x The new carrying amount will have brought the carrying amount downwards to be more in line with
the estimated fair value less costs of disposal.
Carrying amount - revised 315 000
Fair value less costs of disposal 250 000
Although the carrying amount is reduced, it is still materially greater than the fair value less costs of
disposal, and thus these budgeted future cash flows still suggest that the asset may be impaired.
x Conclusion: The depreciation journal needs to be processed:
Debit Credit
Depreciation – plant (P/L: E) 35 000
Plant: Acc depr (-A) 35 000
Extra depreciation processed due to a reduction in useful life
Although this extra depreciation will be processed (see above journal), there is still evidence of a
possible material impairment and therefore the recoverable amount must be calculated.
This recoverable amount must then be compared with the revised carrying amount (i.e. after
deducting the depreciation per the journal above). If the recoverable amount is less than the carrying
amount, an impairment journal would need to be processed, as follows:
Debit Credit
Impairment loss – plant (P/L: E) xxx
Plant: Acc imp losses (-A) Xxx
Impairment of plant
3. Recoverable Amount (IAS 36.18 - .57)
3.1 Overview
Recoverable amount is
defined as:
The recoverable amount is a calculation of the estimated
economic benefits that the entity expects to obtain from the x the higher of an asset’s:
asset. It is measured at the higher of the expected benefits - fair value less costs of disposal
(FV-CoD); and
from the entity using the asset or the entity disposing of the
- value in use (VIU). See IAS 36.6
asset. It is important to note that recoverable amount is
thus an entity-specific measurement.
Example 3: Recoverable amount and impairment loss – basic

A company has an asset with the following details at 31 December 20X9:
Fair value less costs of disposal C170 000
Value in use C152 164
Required:
A. Calculate the recoverable amount of the asset at 31 December 20X9.
B. Calculate whether or not the asset is impaired if its carrying amount is:
i. C200 000
ii. C150 000.
556 Chapter 11
Solution 3A: Recoverable amount – basic

C
Recoverable amount is the higher of the following: 170 000
Value in use 152 164
Solution 3B: Impairment loss – basic

i. If the carrying amount is C200 000, the asset is impaired, because CA exceeds RA: C
Carrying amount 200 000
Less recoverable amount 170 000
Impairment (carrying amount exceeded the recoverable amount) 30 000
ii. If the carrying amount is C150 000, the asset is not impaired, because RA exceeds CA: C
Less recoverable amount 170 000
Impairment (carrying amount less than the recoverable amount) N/A
3.1.1 Recoverable amounts: indefinite useful life intangible assets (IAS 36.24)
The recoverable amount of an intangible asset with an indefinite useful life must be estimated
annually (i.e. not only when an indicator review suggests an impairment). There is one
exception to this rule, being when there is a recent detailed estimate of recoverable amount
that was made in a previous year and on condition that certain criteria are met.
If a recent detailed estimate of the recoverable amount was made in a preceding year, this
estimate may be used instead of re-calculating the recoverable amount, on condition that:
x if this intangible asset is part of a cash-generating unit, the assets and liabilities making
up that unit have not changed significantly; and
x the most recent detailed estimate of the recoverable amount was substantially greater
than the carrying amount at the time; and
x events and circumstances subsequent to the calculation of the previous recoverable
amount suggest that there is only a remote chance that the current recoverable amount
would now be less than the carrying amount. IAS 36.24 (reworded)
3.1.2 Recoverable amounts: all other assets (IAS 36.18–22)
When faced with calculating recoverable amounts, remember that the recoverable amount
should be measured for each individual asset, unless the asset produces cash inflows in
tandem with a group of inter-dependent assets.
In this case, the recoverable amount for the group of assets is calculated rather than for an
individual asset. This group of assets is referred to as a cash-generating unit. This will be
covered later in this chapter. See IAS 36.22
Although the recoverable amount is the higher of value in use and fair value less costs of
disposal, it is not always necessary (or possible) to calculate both of these amounts:
x it may be impossible to measure the fair value less costs of disposal, in which case only
the value in use is calculated;
x if one of these two amounts is calculated to be greater than the carrying amount, the other
amount does not need to be calculated, since this will automatically mean that the
recoverable amount is greater than the carrying amount, and the asset is not impaired;
and
x if there is no indication that the value in use materially exceeds the fair value less costs of
disposal, only the fair value less costs of disposal need be calculated (this is generally
easier to calculate than value in use). See IAS 36.19 - .21
Chapter 11 557
Summary:
Normal approach x calculate FV-COD; and then

x if FV-COD is less than CA then also: calculate
VIU (because this may be higher than CA)
But if you know that the:
x VIU> FV-COD only calculate VIU
x FV-COD > VIU only calculate FV-COD
x VIU = FV-COD only calculate FV-COD (easier!)
x If calculation of FV-COD impossible calculate VIU
VIU = value in use FV-COD = fair value less costs of disposal CA = carrying amount
3.2 Fair value less costs of disposal (IAS 36.28 and IAS 36.53A)
Fair value is
Fair value less costs of disposal is a measurement of the estimated net defined as:
proceeds that would be received if we were to sell the asset, after x the price that would be
taking into account disposal costs that we expect would be incurred. x received to sell an asset (or
It is important to notice that the definition of fair value is a market- paid to transfer a liability)
based measurement, taking into consideration only those assumptions x in an orderly transaction
that market participants would use when pricing the asset. x between market
participants
The costs of disposal are the costs directly associated with the x at the measurement date.
disposal (other than those already recognised as liabilities) and IAS 36.6
may include, for example:

x legal costs;
x costs of removal of the asset; Costs of disposal
x costs incurred in bringing the asset to a saleable condition; are defined as:
x transaction taxes. x incremental costs
x directly attributable to the
disposal of an asset or
Termination benefits (as defined in IAS 19) and costs to cash-generating unit,
restructure (re-organise) a business may not be included as a x excluding finance costs and
disposal cost. IAS 36.28 (reworded) income tax expense. IAS 36.6
Example 4: recoverable amount – fair value less costs of disposal

Apple Limited (a VAT vendor) has an asset with the following details on 31 December 20X9:
x Expected selling price (incl. VAT at 15%) C230 000
x Costs of delivery to potential buyer C20 000
x Legal costs involved in sale agreement C10 000
x Costs to re-organise the production layout of the factory due to C15 000
disposal of asset
x If Apple were to sell the asset, it will result in a taxable recoupment of C45 000
C150 000 on which tax of C45 000 will be incurred (tax rate 30%).
Required: Calculate the fair value less costs of disposal of the asset at 31 December 20X9.
Solution 4: recoverable amount – fair value less costs of disposal

Expected selling price C230 000
Less the costs of disposal (C20 000 + C10 000 + C30 000) (60 000)
Comment:
x VAT is a transaction tax (not an income tax) and thus is included in disposal costs (230 000 x 15/115 = 30 000).
x The cost of reorganising the factory after disposal of the asset is excluded from the costs of disposal
because this is not a cost that is directly attributable to the disposal (it is indirectly related).
x The sale of the asset results in cost represented by an income tax expense of C45 000 (recoupment:
150 000 x 30%). This is excluded from the costs of disposal since IAS 36 specifically excludes this the
definition of ‘costs of disposal’. IAS 36.28
558 Chapter 11
3.3 Value in use (IAS 36.30 – .57)

Value in use is defined
Value in use includes the net cash flows from an asset’s: as:
x the present value of the
x use, and
x future cash flows expected to be
x disposal after usage. derived from
x an asset or cash-generating unit.
Value in use is an entity-specific measurement (whereas fair IAS 36.6
value is a market-based measurement). This means that,
for example, a legal right or restriction that applies only to the entity and which would not
apply to market participants:
x would be taken into consideration in the measurement of value in use; but
x would not be taken into consideration in the measurement of fair value (since it is an
assumption that would not generally be available to the market participants).
The measurement of value in use involves calculating a present value, as follows:

x estimate all future cash flows relating to the asset; and
x discount the cash flows using an appropriate discount rate (i.e. multiply the cash flows by
the present value factor relevant to the discount rate).
There are five elements involved in this process (IAS 36 Appendix A: A1):
a) estimate of future cash flows (inflows and outflows);
b) time value of money;
c) uncertainties regarding the amount and timing of the cash flows;
d) the cost of bearing the uncertainties; and
e) other factors that may affect the pricing of the cash flows (e.g. illiquidity).
The time value of money is represented by an appropriate discount rate, which is the market risk-
free rate (element b). The last three elements (elements c-e) may either be considered when
estimating the future cash flows or be considered together with the time value of money when
estimating the discount rate. Considering these elements (c-e)
Value in use equals:
when estimating the future cash flows and when estimating
the discount rate would be double-counting. These elements (FCF1/(1+Disc. Rate)) +
(c-e) may only be considered when estimating the future cash (FCF2/(1+Disc. Rate)2) + ... +
(FCFn/(1+Disc. Rate)n)
flows or estimating the discount rate - not both.
Where FCF1 = future cash flows
We will now discuss the calculation of the value in use in year 1 etc
under the following headings:
x cash flows in general;
x cash flows from the use of the asset;
x cash flows from the disposal of the asset; and
x present valuing the cash flows.
3.3.1 Cash flows in general (IAS 36.33–54)

General factors to bear in mind when estimating the future cash flows include the:
x relevant cash flows (cash flows to be included and excluded);
x assumptions made;
x period of the prediction;
x growth rate used;
x general inflation.
3.3.1.1 Relevant cash flows: (IAS 36.39)
The cash flows that should be included in the calculation of value in use are:
x From usage: the cash inflows from continuing use as Relevant cash flows
well as those cash outflows that are necessary to create include inflows &
these cash inflows; and outflows from:
x From eventual disposal: the net cash flows from the x Usage &
eventual disposal of the asset. See IAS 36.39 x Disposal.
Chapter 11 559
3.3.1.2 Assumptions: (IAS 36.33 (a), .34 and .38)

The assumptions used when making the projections should be:
x reasonable;
x justifiable (e.g. an entity could justify a projection of, Assumptions must be:
for example, 1 000 units p.a. despite its normal output
being only 800 units, if it had already expended cash x Reasonable
x Justifiable
outflows, before year-end, on upgrading its plant); x Mgmt’s best estimate
x management’s best estimate (i.e. not the most x Based on past cash flows
optimistic or most pessimistic) of the future economic x Based mainly on external evidence.
conditions that will exist over the useful life of the asset;
x considerate of the past cash flows and past accuracy (or lack thereof) in projecting cash
flows; and be
x based on mainly external evidence rather than internal evidence, wherever possible (since
external evidence is considered to be more objective).
3.3.1.3 Period of the prediction: (IAS 36.33(b) and .35)
The projected cash flows:

x should be based on the most recent budgets and forecasts that have been approved by
management (therefore budgets produced and approved after year-end would be favoured
over budgets produced and approved before year-end); and
x should not cover a period of more than five years unless this can be justified (because
budgets covering longer periods become more inaccurate). See IAS 36.35
Projected cash flows should ideally not extend beyond five
Period of prediction:
years since projections usually become increasingly unreliable.
However, they may extend beyond five years if: x should ideally be 5 years/ shorter
x management is confident that these projections are x should be based on most recent &
reliable; and approved budgets and forecasts.
x it can demonstrate its ability, based on past experience, to forecast cash flows accurately
over that longer period. See IAS 36.35
3.3.1.4 Growth rate: (IAS 36.33(c); .36 and .37)
If the projected cash flows cover a period that exceeds the period covered by the most recent,
approved budgets and forecasts (or indeed beyond the normal five-year limit), then the
projected cash flows for these extra years should be estimated by:
x extrapolating the approved budgets and forecasts;
x using either a steady or a declining growth rate (i.e. this would be more prudent than
using an increasing growth rate), unless an increasing growth rate is justifiable, for
example, on objective information regarding the future of the product or industry; and
x using a growth rate that should not exceed the long-term average growth rate of the
products, industries, market or countries in which the entity operates, unless this can be
justified (prudence once again).
For example: Imagine that our current year’s growth rate is 15%, which is significantly higher than our
average growth rate over the past 10 years, of 10%.
x In this case, even if we feel certain that the future growth rate will be 15%, it would be inadvisable to use 15% as
the projected future growth rate in our calculations of value in use.
x This is because it is difficult to justify a growth rate that exceeds the long-term average growth rate. A
projected growth rate that exceeds the past long-term average growth rate is obviously based on favourable
conditions that the entity is either currently experiencing, or expects to experience in the future. However, when
experiencing – or expecting to experience – favourable conditions, it means we should also expect competitors to
enter the market to take advantage of these same favourable conditions. If this happens, the higher than normal
projected growth rate of 15% would be reduced over this longer term.
x The effects of future unknown competitor/s are obviously impossible to estimate and thus, to be prudent, one
should use a growth rate of 10%, and not 15%. See IAS 36.37
560 Chapter 11
3.3.1.5 General inflation: (IAS 36.40)

If the discount rate:
If the discount rate used:
x reflects the effect of general inflation, then projected cash x includes general inflation:
- use nominal cash flows
flows must be the ‘nominal’ cash flows (i.e. the current
x excludes general inflation:
values are increased for the effects of inflation). - use real cash flows
x does not reflect the effects of general inflation, then
projected cash flows must be the ‘real’ cash flows and must only include future specific
price increases or decreases. IAS 36.40 (reworded)
3.3.2 Cash flows from the use of the asset (IAS 36. 39–51)
3.3.2.1 Cash flows from use to be included: (IAS 36.39(a) and (b); .41 and .42)
Cash inflows include:

x the inflows from the continuing use of the asset.
Cash outflows include all those cash outflows that are expected to be necessary:
x for the continuing use of the asset in its current condition (and which can be directly
attributed, or allocated on a reasonable and consistent basis, to the asset); and
x to bring an asset that is not yet available for use to a usable condition. See IAS 36.39 & .41
Cash flows represent the economic benefits resulting from a single asset. However, it may be difficult
to estimate the expected cash inflows from a single asset in which case it may become necessary to
evaluate the cash inflows and outflows of a group of assets (cash-generating unit – see section 6).
3.3.2.2 Cash flows from use to be excluded: (IAS 36.43 - .48, .50 and .51)
Future cash flows are estimated based on the asset’s current condition. The following
expected cash flows are thus excluded:
x cash inflows that relate to other assets, (since these will be taken into account when
assessing the value in use of these other assets);
x cash outflows that have already been recognised as liabilities (for example, a payment of an
accounts payable) since these outflows will have already
been recognised (either as part of the asset or as an
expense); See IAS 36.43 Cash flows from use:
x cash inflows and outflows relating to future expenditure x Includes: cash flows relating to
to enhance the asset in excess of its current standard of continuing use in its existing
performance at reporting date; See IAS 36.44 & .45 condition (plus costs needed to
get asset to a useable condition)
x cash inflows and outflows relating to a future restructuring
See IAS 36.44 & .45 x Excludes: cash inflows re other
to which the entity is not yet committed; assets; cash outflows already
x cash inflows and outflows from financing activities recognised as liabilities, cash
(since cash flows will be discounted to present values flows relating to enhancements,
using a discount rate that takes into account the time- financing, tax.
value of money);
x cash flows in respect of tax receipts and tax payments (because the discount rate used to
discount the cash flows is a pre-tax discount rate). See IAS 36.50
3.3.3 Cash flows from the disposal of the asset (IAS 36.43(c); .52 and .53)
The net cash flows from the future disposal of an asset is estimated
as follows: Cash flows
from disposal:
x the amount the entity expects to receive from the disposal of the
asset at the end of the asset’s useful life in an arm’s length x Expected proceeds
transaction between knowledgeable, willing parties; x Less expected disposal
costs
x less the estimated costs of the disposal. IAS 36.52 (slightly reworded)
Chapter 11 561
The net cash flow from the future disposal of an asset is estimated based on prices currently
achieved from the disposal of similar assets that are already at the end of their useful lives and
have been used under similar conditions. These prices are then adjusted up/down:
x for general inflation (if general inflation was taken into account when estimating the cash
flows from use and the discount factor); and
x for specific future price adjustments. See IAS 36.53
Example 5: Recoverable amount – value in use – cash flows

Management’s most recently approved budget shows a machine’s future cash flows as
follows:
20X7 20X8 20X9
Future cash inflows/ (outflows): C’000 C’000 C’000
Maintenance costs (100) (120) (80)
Operational costs (electricity, water, labour etc) (200) (220) (240)
Interest on finance lease (60) (50) (40)
Tax payments on profits (16) (20) (28)
Cost of increasing the machine’s capacity (0) (220) (0)
Depreciation (80) (80) (80)
Expenses to be paid in respect of 20X6 accruals (30) (0) (0)
Basic inflows on machine: see note 1 1 000 1 200 1 400
Extra profits resulting from the upgrade 0 20 50
Note 1: Machine Plant
x Cash inflows stem from 40% 60%
The machine is expected to last for 5 years, and management does not expect to be able to sell it at the
end of its useful life. The growth rate in the business in 20X6 was an unusual 15% whereas the average
growth rate over the last 7 years is:
x in the industry 10%
x in the business 8%
Required: Calculate the future net cash flows to be used in the calculation of the value in use of the
machine at 31 December 20X6 assuming that a 5-year projection is considered to be appropriate.
Solution 5: Recoverable amount - value in use – cash flows
20X7 20X8 20X9 20Y0 20Y1

Future cash inflows / (outflows) - Machine C’000 C’000 C’000 C’000 C’000
Maintenance costs (direct cost) (100) (120) (80)
Operational costs (allocated indirect costs) (200) (220) (240)
Interest on finance lease (financing always excluded) - - -
Tax payments (tax always excluded) - - -
Cost of upgrading machine (upgrades always excluded) - - -
Depreciation (not a cash flow) - - -
Payments to settle 20X6 accruals (not a future expense – - - -
already recognised in 20X6 financial statements as liability)
Basic inflows: (only 40% relates to machine) 400 480 560
Extra profits from the upgrade (always exclude) - - -
Net cash inflows (20Y0: 240 x 1.08) (20Y1: 259 x 1.08) 100 140 240 259* 280*
* Rounded
Comment:
x The net cash inflows per year still need to be present valued and the total of the present values per year is then
totalled to give the ‘net present value’ or ‘value in use’.
x It was assumed in this question that the machine would not be able to be sold at the end of its useful life and
the disposal thereof would not result in any disposal costs.
x The current year growth rate of 15% seems unusual given the company’s average growth rate was only 8%.
The industry average of 10% is also greater than the business average of 8%. Prudence dictates that we should
thus use 8%.
562 Chapter 11
3.3.4 Present valuing the cash flows (IAS 36.55 - .57)

The cash inflows and cash outflows relating to the use and eventual disposal of the asset must
be present valued (i.e. discounted). This means multiplying the cash flows by an appropriate
discount factor (or using a financial calculator). The discount rate is a pre-tax discount rate.
The pre-tax discount rate is estimated using the:
Discount rate should
x current market assessment of the time value of money; and be:
x the risks specific to the asset for which the future cash x pre-tax
flows have yet to be adjusted. IAS 36.55 (reworded) x mkt-related risk-free rate
x Adjusted for risks specific to
When an asset-specific rate is not available, a surrogate rate is
the asset for which future cash
used. Guidance for estimating a surrogate rate is as follows: flows haven’t been adjusted for
x Estimate what the market assessment would be of:
- the time value of money for the asset over its remaining useful life;
- the uncertainties regarding the timing and amount of the cash flows (where the cash
flow has not been adjusted);
- the cost of bearing the uncertainties relating to the asset (if the cash flow was not adjusted);
- other factors that the market might apply when pricing future cash flows (e.g. the
entity’s liquidity) (where the cash flow has not been adjusted).
x The weighted average cost of capital of the entity (using the Capital Asset Pricing
Model), the entity’s incremental borrowing rate and other market borrowing rates could
be considered although these rates would need to be adjusted for the following risks
(unless the cash flows have been appropriately adjusted):
- country risk;
- currency risk; and
- price risk. IAS 36 Appendix A, A16 - 18
Example 6: Value in use – discounted (present) value
An asset has the following future cash flows, estimated at 31 December 20X6:
x Expected cash inflows per year (until disposal) C110 000
x Expected cash outflows per year (until disposal) C50 000
x Expected sale proceeds at end of year 3 C7 000
x Expected disposal costs at end of year 3 C3 000
Number of years of expected usage 3 years
Present value factors based on a discount rate of 10%
x Present value factor for year 1 0.909
Required: Calculate the expected value in use at 31 December 20X6.
Solution 6: Value in use – discounted (present) value

Comment: The value in use is calculated as a net present value (NPV):
x The NPV calculation below involved multiplying the net cash flows by the present value factors.
x If a financial calculator had been used instead, the NPV would be C152 216 (rounded off).
x The difference is because the present value factors used below were rounded to 3 decimal places.
20X7 20X8 20X9
Cash inflow for the year 110 000 110 000 110 000
Cash outflow for the year (50 000) (50 000) (50 000)
Sale proceeds 7 000
Disposal costs (3 000)
Net cash flows (NCF) 60 000 60 000 64 000
Present value factor (PVF) (discount factor) 0.909 0.826 0.751
PV of net cash flows (NCF x PVF) 54 540 49 560 48 064
Net present value (NPV) (value in use): (54 540 + 49 560 + 48 064) C152 164
Chapter 11 563
3.3.5 Foreign currency future cash flows (IAS 36.54)
If the future cash flows are generated in a foreign currency, the value in use must be
x the future cash flows must first be estimated in that foreign currency;
x these foreign currency future cash flows must then be discounted to a present value by
using a discount rate that is appropriate for that foreign currency; and
x this foreign currency present value is then translated into the local currency using the spot
rate at the date of the value in use calculation. IAS 36.54 (reworded)
Example 7: Foreign currency future cash flows
An asset belonging to a South African company, with a functional currency of Rand (R)
has the following dollar denominated future cash flows, estimated at 31 December 20X6:
x Expected cash inflows per year (until disposal) $100 000
x Expected cash outflows per year (until disposal) $50 000
x Expected sale proceeds at end of year 3 $7 000
x Expected disposal costs at end of year 3 $3 000
Number of years of expected usage 3 years
Present value factors based on a discount rate of 10% (an appropriate rate for the dollar)
x PV factor for year 1 (1/1.1) 0.909
The Rand : Dollar spot exchange rate:
x 31 December 20X6 R6: $1
Required:
Calculate the expected value in use at 31 December 20X6.
Solution 7: Foreign currency future cash flows

Comment: The PV of cash flows would be $127 348 (rounded) and R764 088, using a financial calculator.
20X7 20X8 20X9
Cash inflows for the year $100 000 $100 000 $100 000
Cash outflows for the year (50 000) (50 000) (50 000)
Sale proceeds 7 000
Disposal costs (3 000)
Net cash flows 50 000 50 000 54 000
Present value factor 0.909 0.826 0.751
PV of net cash flows 45 450 41 300 40 554
Net present value in dollars (value in use) (45 450 + 41 300 + 40 554) $127 304
Net present value in Rand (value in use) ($127 304 x R6) R763 824
4. Recognising and Measuring an Impairment Loss (IAS 36.58 - .64 and IAS 36.5)
4.1 Overview
An impairment loss is
processed when:
When the recoverable amount of an asset (other than a
CA > RA.
cash-generating unit or goodwill) is found to be less than its
carrying amount, the carrying amount must be reduced to the recoverable amount.
After an impairment is processed, depreciation in subsequent periods must be calculated using

the new depreciable amount and using the asset’s remaining useful life.
The new depreciable amount is: An impairment loss is

x the reduced carrying amount of the asset (the defined as:
recoverable amount) x the amount by which the
x less its residual value. x carrying amount exceeds
IAS 36.6
x the recoverable amount.
564 Chapter 11
Please note that it is not uncommon for the residual value to be reduced and/ or for the remaining
useful life to be reduced as a result of the same circumstances that caused an impairment to be
processed. Changes to the residual value and useful life are accounted for as changes in estimate in
terms of IAS 8 Accounting policies, changes in accounting estimates and errors.
Impairments are processed whether the asset is measured using the cost model or revaluation
model. The journal entries will be slightly more complex if the revaluation model is used.
4.2 Impairments and the cost model
To process an impairment on an asset that is measured using the cost model (e.g. in terms of
IAS 16 Property, plant and equipment or IAS 38 Intangible assets), the carrying amount is
not reduced by crediting the asset's cost account but rather by crediting either:
x accumulated impairment loss account; or
Cost model
x accumulated depreciation and impairment loss account impairment journal:
(‘accumulated depreciation’ is not required to be
separately disclosed from ‘accumulated impairment x Dr: Impairment loss
losses’ and thus the two accounts can be combined). x Cr: Accumulated imp loss
Summary: Decreases in carrying amount using the cost model

HCA
HCA/
ACA ACA
Imp loss Imp loss
RA RA
HCA: Historical carrying amount ACA: Actual carrying amount RA: Recoverable amount
Explanation:
x Historical carrying amount (HCA) reflects the asset’s
cost if it is non-depreciable, or
depreciated cost, if it is a depreciable asset.
x If the ACA = HCA (cost less accumulated depreciation) and this ACA must be reduced to a lower
amount in order to reflect RA, this is recognised as an impairment loss expense.
x If the ACA had already been reduced below the HCA and must now be reduced to an even lower RA,
the treatment is the same: the decrease is recognised as an impairment loss expense.
Example 8: impairment loss journal – basic

A plant, measured under the cost model, has the following values at 31 December 20X9:
Cost 150 000
Less accumulated depreciation to 31 December 20X9 (50 000)
Carrying amount: 31 December 20X9 100 000
Recoverable amount 40 000
Required: Journalise the impairment at the year ended 31 December 20X9.
Solution 8: impairment loss journal – basic

Impairment loss (P/L: E) 60 000
Plant: Accumulated impairment losses (-A) 60 000
Impairment of plant (100 000 – 40 000)
For further examples of an impairment loss involving an asset measured under the cost model,
see chapter 7: see example 29, 31 and 32.
Chapter 11 565
4.3 Impairments and the revaluation model

To process an impairment on an asset that is measured using the revaluation model (e.g. in
terms of IAS 16 Property, plant and equipment or IAS 38 Intangible assets) one must:
x credit accumulated impairment losses; and
x debit an impairment loss expense account, but only after first debiting (removing) any
related balance that may exist in the revaluation surplus account.
In other words, if no revaluation surplus existed, then the entire decrease in the carrying
amount is recognised as an impairment loss expense as follows:
Debit Credit
Impairment loss (E) xxx
Plant: Accumulated impairment losses (-A) xxx
Impairment of PPE (no revaluation surplus balance existed)
If there was a balance on the revaluation surplus, we journalise the impairment in two steps:
x Step 1: first reduce the revaluation surplus account (debit revaluation surplus)
x Step 2: once the revaluation surplus account has been reduced to zero, any excess impairment is
recognised as an impairment expense (debit impairment loss expense).
Debit Credit
Revaluation surplus (OCI) xxx
Step 1: Impairment of PPE: first against existing RS balance
Impairment loss (E) xxx

Step 2: Impairment of PPE: excess impairment expensed
Note: The above journal could also be combined to show the total amount credited to
accumulated impairment losses
Notice that we credit the accumulated impairment loss account for both the:
x debit to impairment loss expense, and
x debit to revaluation surplus.
The effect of the above treatment is that the cost account remains reflected at fair value and
the carrying amount of the asset is thus reflected at fair value less subsequent accumulated
depreciation and impairment losses. See IAS 16.31
Summary: Decreases in carrying amount using the revaluation model
ACA ACA HCA

Reversal Reversal
of RS of RS
NOTE 1 NOTE 1
HCA RA ACA
Imp loss Imp loss
NOTE 1
RA HCA RA
Note 1:
x The summary above assumes that any revaluation surplus is transferred to retained earnings over the
life of the asset, in which case, the difference between the ACA and the HCA will reflect the
revaluation surplus balance.
x If the revaluation surplus is not transferred to retained earnings over the life of the asset, the table
above does not apply since the balance in the revaluation surplus account will not be the difference
between ACA and HCA: however, the over-riding principle of first removing whatever balance exists
in the revaluation surplus account and then expensing any further impairment still applies.
566 Chapter 11
x In essence: any impairment is first debited against whatever balance is in the revaluation surplus
account, and any further impairment after having completely reversed the revaluation surplus balance
is then expensed as an impairment loss expense (i.e. first debit revaluation surplus and then debit
impairment loss expense with any excess). This obviously assumes that the ACA already reflected
FV, since the revaluation model is being used. The asset must be measured at its fair value less
accumulated depreciation and subsequent impairment losses. However, in reality, since revaluations
to FV are not required to be performed each year, when 'impairing' ACA to RA, check that the ACA
reflected this FV before assuming the entire decrease is an impairment loss. If not, then one must first
adjust the ACA to FV, accounting for this adjustment as a revaluation.
Example 9: impairment loss journal – with a revaluation surplus

The following balances relate to plant, measured under the revaluation model at 31 December 20X9:
x Carrying amount: 31 December 20X9 C100 000
x Recoverable amount: 31 December 20X9 C85 000
x Revaluation surplus: 31 December 20X9 C10 000
Required: Journalise the impairment at 31 December 20X9.
Solution 9: impairment loss journal – with a revaluation surplus

Comment: This example shows how:
x the carrying amount is first reduced by reducing the revaluation surplus to nil, after which,
x any further reduction in the carrying amount is then expensed as an impairment loss expense.

Revaluation surplus (OCI) Balance in this account: given 10 000
Impairment loss expense (P/L) Total decrease: 15 000 – 10 000 debit to reval surplus 5 000
Plant: Acc imp losses CA: 100 000 – RA: 85 000 15 000
Impairment of plant (CA: 100 000 – RA: 85 000 = 15 000) first set-off against
the reval. surplus balance (10 000), the rest (5 000) is expensed
When processing an impairment loss for an asset that uses the revaluation model, if a
revaluation is due to be performed during the year, we would account for the revaluation
before we account for the impairment. In other words:
x Revalue the asset to fair value following the normal revaluation process (see Chapter 8)
x Calculate the recoverable amount of the asset
x Process an impairment loss (if the new CA exceeds the asset’s RA).
This process is based on the principle that the asset measured under the revaluation model
must be carried at its ‘fair value at the date of the revaluation less any subsequent
accumulated depreciation and impairment losses’. See IAS 16.31
Please also remember that the carrying amount of an asset measured under the revaluation
model, must never differ materially from its current fair value at year-end. See IAS 16.31
Thus, when calculating impairment losses, we should be comparing:

x the carrying amount, which should not differ materially from its current fair value; and
x the recoverable amount: the higher of fair value less costs of disposal and value in use.
The difference between fair value (used in the revaluation model) and fair value less costs of
disposal (used in calculating the recoverable amount) is obviously the ‘cost of disposal’:
x If the costs of disposal are negligible, the fair value less costs of disposal would be almost
the same as the fair value and thus, irrespective of what the value in use is, the asset
cannot be materially impaired (the recoverable amount will be equal to or higher than the
fair value). Thus, if the costs of disposal are negligible, the asset need not be tested for
impairment. See IAS 36.5(a) as amended by IFRS13
x If the costs of disposal are not negligible, then the fair value less costs of disposal will be
less than the fair value, in which case the asset would be impaired unless the value in use
is greater than fair value. See IAS 36.5(c)
Chapter 8: example 12, is another example of the revaluation model with impairment loss.
Chapter 11 567
Example 10: Fair value and Recoverable amount

An asset is revalued to fair value on 31 December 20X5. The following measurements are
provided as at this date:
x Fair value 100 000 100 000 100 000
x Costs of disposal 0 0 0
x Value in use 100 000 60 000 120 000
Required: Determine if the asset is impaired at the financial year ended 31 December 20X5.
Solution 10: Fair value and Recoverable amount

Comment:
x If the revaluation model is used, the carrying amount will reflect fair value.
x This example proves that if the costs of disposal are negligible (this example used an extreme
situation where the costs of disposal were actually nil, but the same principle applies if these costs
are immaterial) then the asset cannot be impaired since the fair value less costs of disposal will
almost equal the fair value and thus the recoverable amount will either be very similar to the fair
value or will be greater than fair value (e.g. if value in use is greater than fair value).
x Where the costs of disposal are negligible, a revalued asset is thus not tested for impairment.

Carrying amount FV: Given 100 000 100 000 100 000
Less recoverable amount, higher of: (100 000) (100 000) 120 000
- Fair value less costs of disposal 100 000 – 0 (100 000) (100 000) (100 000)
- Value in use Given (100 000) (60 000) (120 000)
Impairment loss 0 0 N/A
Example 11: Fair value and Recoverable amount

An asset is revalued to a fair value at 31 December 20X5. The following measurements are
provided as at this date (these costs of disposal are 'not negligible'):
Scenario A Scenario B Scenario C Scenario D
Fair value 100 000 100 000 100 000 100 000
Costs of disposal 10 000 10 000 10 000 10 000
Value in use 100 000 120 000 60 000 92 000
Required: Determine if the asset is impaired at the financial year ended 31 December 20X5, and
calculate the impairment loss, if any.
Solution 11: Fair value and Recoverable amount

Comment:
x This example proves that if the costs of disposal are not negligible then the asset could be
impaired, but only if its value in use is less than its fair value.
- Scenario A: value in use is equal to fair value: no impairment
- Scenario B: value in use is greater than fair value: no impairment.
- Scenario C: value in use is less than fair value: impaired (RA = FV-CoD)
- Scenario D: value in use is less than fair value: impaired (RA = VIU)
x Where costs of disposal are not negligible, a revalued asset must thus be tested for impairment.
Scenario A Scenario B Scenario C Scenario D

Carrying amount FV: Given 100 000 100 000 100 000 100 000
Less recoverable amount, higher of: (100 000) (120 000) (90 000) (92 000)
- FV less costs of disposal 100 000 – 10 000 (90 000) (90 000) (90 000) (90 000)
- Value in use Given (100 000) (120 000) (60 000) (92 000)
Impairment loss 0 N/A 10 000 8 000
568 Chapter 11
5. Recognising a Reversal of a Previous Impairment Loss (IAS 36.109 - .125)
5.1 Overview
If an asset (other than goodwill) was once impaired but, at a later
stage, we find that the recoverable amount is now greater than the An impairment loss
actual carrying amount, the impairment loss previously reversal is
processed when:
recognised may be reversed. This is allowed when the
circumstances that originally caused the impairment are reversed. RA > CA.
An impairment loss relating to goodwill is never reversed. The Impairment losses

reason is that an apparent increase in the recoverable amount of on goodwill:
May never be reversed!
goodwill probably relates to internally generated goodwill
(rather than the purchased goodwill), which is not allowed to be recognised as an asset
according to IAS 38.48 (see chapter 9 which explains Intangible Assets). See IAS 36.124 & .125
Depreciation subsequent to the reversal of an impairment loss will be calculated based on the:
x adjusted carrying amount of the asset (i.e. after the reversal, the carrying amount will
have increased), less its residual value
x divided by the asset’s remaining useful life. See IAS 36.121
Please note that it is not uncommon for the remaining depreciation variables (e.g. useful life), to
be increased as a result of the change in circumstances that caused an impairment to be
reversed. Changes to the variables of depreciation are accounted for prospectively as a change
in estimate in terms of IAS 8 Accounting policies, changes in accounting estimates and errors.
Impairment reversals are processed whether the asset is measured using the cost model or
revaluation model. The journals are slightly more complex if the revaluation model is used.
5.2 Impairment reversals and the cost model (IAS 36.117 & .119)
When reversing an impairment, we must never increase an asset’s Impairment loss
carrying amount above the carrying amount it would have had, reversals under the
had the asset never been impaired. In other words, in the case of cost model:
the cost model, we may not increase the asset’s carrying amount x Up to HCA (depreciated cost):
above depreciated cost (its historical carrying amount): - Dr: Accum. impairment loss
x original cost - Cr: Impairment loss reversal
x less accumulated depreciation. See IAS 36.117 x Above HCA (depreciated cost)
Not allowed (the ACA under the
If the cost model is used, the increase in carrying amount is cost model must never exceed
recognised as an impairment loss reversal (income), and is depreciated cost)
C
Recoverable amount (limited to historical carrying amount) xxx
Less the actual carrying amount (xxx)
Impairment loss reversed xxx
Summary: Increases in carrying amount using the cost model
RA HCA
Not allowed
HCA RA
Imp loss Imp loss
reversed reversed
ACA ACA
Chapter 11 569
For further examples of an impairment loss reversal involving an asset measured under the
cost model, please see chapter 7: examples 30, 31 and 32.
5.3 Impairment reversals and the revaluation model (IAS 36.118 - .120)
When reversing an impairment, one must take care that the carrying amount is not increased
above what the carrying amount would have been had the asset never been impaired. In other
words, in the case of the revaluation model, the carrying amount may not be increased above
its most recent fair value less subsequent accumulated depreciation (depreciated fair value).
If the revaluation model is used, the reversal of an Impairment loss

reversal under the
impairment loss may be recognised in profit or loss, other revaluation model:
comprehensive income or a combination of both.
x Up to HCA:
- Dr Acc impairment loss
Any reversal of an impairment loss that:
- Cr Impairment loss reversal (P/L)
x increases the carrying amount up towards the historical
x Above HCA:
carrying amount (cost less accumulated depreciation) is
- Dr Acc impairment loss
recognised in profit or loss as an impairment loss
- Cr Revaluation surplus (OCI)
reversed (income); and
x increases the carrying amount above historical carrying amount (cost less accumulated
depreciation) is recognised in other comprehensive income as a revaluation surplus.
Example 12: Revaluation model and impairment loss reversed

A plant was purchased on 1 January 20X2 for C200 000.
x The plant is measured under the revaluation model and was revalued to its fair value of
C270 000 on 1 January 20X3. No other revaluations have been necessary.
x The asset’s recoverable amount decreased to C70 000 at 31 December 20X4 due to a
decrease in demand for the product produced by this plant. No other impairments have
been necessary.
x The plant is depreciated straight-line to a nil residual value over 10 years.
x The revaluation surplus is transferred to retained earnings over the asset’s useful life.
Required: Show the journal entries assuming that:
A. The asset’s recoverable amount increased to C160 000 at 31 December 20X5;
B. The asset’s recoverable amount increased to C210 000 at 31 December 20X5.
Solution 12A: Revaluation model and impairment loss reversed

Comment:
x This example involves a situation where:
- the recoverable amount exceeds the historical carrying amount (depreciated cost) of C120 000 and
thus the impairment loss reversed is recognised partly in profit or loss (increasing the CA back up to
HCA) and partly in other comprehensive income (increasing the CA above HCA); but
- the recoverable amount does not exceed the depreciated fair value of C180 000, and thus the
increase will not be limited by this depreciated fair value.
x On 31 December 20X5, the recoverable amount (RA) is C160 000.
On this date, the actual carrying amount (ACA) is C60 000:
- CA at 31/12/X4: 70 000 – Depr in 20X5: (70 000 – 0) / 7 yrs x 1 = 60 000.
The increase in carrying amount of C100 000 (from C60 000 to C160 000) occurs after a previous
impairment loss had been processed (on 31/12/X4). This means that the portion of the increase on
31/12/X5 that increases the actual carrying amount of C60 000 up to the historical carrying amount
(depreciated cost) of C120 000 (see W1) is an impairment reversal (i.e. it is not ‘revaluation income’).
x The recoverable amount of C160 000 exceeds the historical carrying amount (depreciated cost) of
C120 000 (W1: Cost – AD, being the HCA) and thus this part of the increase is recognised in OCI.
x We must be careful not to increase the carrying amount above the depreciated fair value. However,
the recoverable amount of C160 000 does not exceed the depreciated fair value of C180 000 (W2:
FV - AD) and thus none of the increase is disallowed.
570 Chapter 11

Plant: Acc imp loss (-A) 60 000
Impairment loss reversal (P/L) HCA: 120 000 (W1) – ACA: 60 000 60 000
Plant: Acc imp loss (-A) 40 000
Revaluation surplus (OCI) RA: 160 000 (not limited by the FV-AD of 40 000
180 000 (W2)) - HCA: 120 000
Reversal of impairment on plant: RA is C160 000 and ACA is C60 000:
the IL reversal of C100 000 is recognised partly in P/L and OCI
Note: The above journal can also be combined as shown in solution 12B that follows.
Workings:
W1: Cost less accumulated depreciation (Historical carrying amount): 31/12/20X5 C

Cost: 01/01/20X2 Given, as at date of purchase 200 000
Accumulated depreciation: 31/12/20X5 (200 000 – 0) / 10yrs x 4yrs (80 000)
HCA (i.e. depreciated cost): 31/12/20X5 Cost – Accumulated depreciation 120 000
W2: Fair value less accumulated depreciation: 31/12/20X5

Fair value: 01/01/20X3 Given, as at date of last revaluation 270 000
Accumulated depreciation: 31/12/20X5 (270 000 – 0) / 9 remaining yrs x 3yrs (90 000)
Depreciated fair value: 31/12/20X5 Fair value – Accumulated depreciation 180 000
W3: Roll forward from purchase (01/01/X2) to reporting date (31/12/X5) (NOT REQUIRED)
Cost: 01/01/20X2 Given 200 000
Accumulated depreciation: 20X2 (200 000 – 0) / 10 yrs x 1 yr (20 000)
Carrying amount: 31/12/20X2 180 000
Revaluation surplus: 01/01/20X3 Balancing: FV: 270 000 – CA: 180 000 90 000
Depreciation: 20X3 & 20X4 (270 000 – 0) / 9 remaining yrs x 2yrs (60 000)
210 000
Revaluation surplus (OCI): 31/12/20X4 Balancing: 210 000 – HCA: 140 000 (70 000)
HCA (i.e. depreciated cost): 31/12/20X4 HCA: 200 000 – (200 000 – 0) / 10 x 3 140 000
Impairment loss (P/L): 31/12/20X4 Balancing: HCA: 140 000 – RA: 70 000 (70 000)
Carrying amount: 31/12/20X4 Recoverable amount: Given 70 000
Depreciation: 20X5 (70 000 – 0) / 7 remaining yrs x 1 yr (10 000)
Actual carrying amount: 31/12/20X5 ACA before the impairment is reversed 60 000
Imp loss reversed (P/L): 31/12/20X5 Balancing: ACA: 60 000 – HCA: 120 000 60 000
HCA (i.e. depreciated cost): 31/12/20X5 200 000 – (200 000 – 0) / 10 x 4 120 000
Revaluation surplus (OCI): 31/12/20X5 Balancing: HCA: 120 000 – RA: 160 000 40 000
Carrying amount: 31/12/20X5 Lower of: x RA: 160 000 (Given), and 160 000
x Depreciated FV: 180 000 (W2)
Solution 12B: Revaluation model and impairment loss reversed

Comment:
x This example is identical to the previous example, example 12A, except that it involves a recoverable
amount (RA) of C210 000 and not C160 000. This is important since the RA of C210 000 exceeds the
depreciated fair value (under the revaluation model, the asset’s carrying amount may not be
increased above depreciated fair value).
x This example involves a situation where:
- the recoverable amount exceeds the historical carrying amount (depreciated cost) of C120 000 (W1:
Cost – AD) and thus the impairment loss reversed is recognised partly in profit or loss (increasing the
CA back up to HCA) and partly in other comprehensive income (increasing the CA above HCA).
- this recoverable amount exceeds the depreciated fair value of C180 000 (W2: FV – AD) and thus
part of the intended increase is disallowed (under the revaluation model, the carrying amount may
not be increased above its depreciated fair value: so we increase the CA to a maximum of C180 000
and thus may not increase it to the recoverable amount of C210 000).
x On 31 December 20X5, the recoverable amount (RA) is C210 000.
Chapter 11 571
On this date, the actual carrying amount (ACA) is C60 000:

- CA at 31/12/X4: 70 000 – Depr in 20X5: (70 000 – 0) / 7 yrs x 1 = 60 000.
Because the asset’s carrying amount (C60 000) had been reduced in a prior year due to an impairment
loss (on 31/12/X4), the higher recoverable amount on 31/12/X5 (C210 000) means that we will need to
increase the CA but the portion of the increase that reverses the prior impairment must be called an
impairment reversal (i.e. it is not ‘revaluation income’).
x W1 and W2 from Part A apply to this question too.

Plant: Acc imp loss (-A) RA: 210 000, ltd to 180 000 – ACA: 60 000 120 000
Impairment loss reversal (P/L) HCA: 120 000 (W1) – ACA: 60 000 60 000
Revaluation surplus (OCI) RA: 210 000, limited by the FV-AD of 60 000
180 000 (W2) - HCA: 120 000
Impairment reversal of plant: On 31 Dec 20X5, the RA was 210 000, but
was limited to the FV-AD of 180 000, when the ACA was 60 000: an
impairment loss reversal recognised partly in P/L and partly in OCI
Workings:
W1: Cost less accumulated depreciation (Historical carrying amount): 31/12/20X5 C
Cost: 01/01/20X2 Given, as at date of purchase 200 000
Accumulated depreciation: 31/12/20X5 (200 000 – 0) / 10yrs x 4yrs (80 000)
Historical CA: 31/12/20X5 Cost – Accumulated depreciation 120 000
W2: Fair value less accumulated depreciation: 31/12/20X5 C
Fair value: 01/01/20X3 Given, as at date of last revaluation 270 000
Accumulated depreciation: 31/12/20X5 (270 000 – 0) / 9 remaining yrs x 3yrs (90 000)
Depreciated fair value: 31/12/20X5 Fair value – Accumulated depreciation 180 000
W3: Roll forward from purchase (01/01/X2) to reporting date (31/12/X5) (NOT REQUIRED)
Cost: 01/01/20X2 Given 200 000
Accumulated depreciation: 20X2 (200 000 – 0) / 10 yrs x 1 yr (20 000)
Carrying amount: 31/12/20X2 180 000
Revaluation surplus: 01/01/20X3 Balancing: FV: 270 000 – CA: 180 000 90 000
Depreciation: 20X3 & 20X4 (270 000 – 0) / 9 remaining yrs x 2yrs (60 000)
210 000
Revaluation surplus (OCI): 31/12/20X4 Balancing: 210 000 – HCA: 140 000 (70 000)
HCA (i.e. depreciated cost): 31/12/20X4 HCA: 200 000 - (200 000 – 0) / 10 x 3 140 000
Impairment loss (P/L): 31/12/20X4 Balancing: HCA: 140 000 – RA: 70 000 (70 000)
Carrying amount: 31/12/20X4 Recoverable amount: Given 70 000
Depreciation: 20X5 (70 000 – 0) / 7 remaining yrs x 1 yr (10 000)
Actual carrying amount: 31/12/20X5 ACA before the impairment is reversed 60 000
Imp loss reversed (P/L): 31/12/20X5 Balancing: ACA: 60 000 – HCA: 120 000 60 000
HCA (i.e. depreciated cost): 31/12/20X5 200 000 - (200 000 – 0) / 10 x 4 120 000
Revaluation surplus (OCI): 31/12/20X5 Balancing: HCA: 120 000 – RA: 180 000 60 000
Carrying amount: 31/12/20X5 Lower of: x RA: 210 000 (Given), and 180 000
x Depreciated FV: 180 000 (W2)
Summary: Increases in carrying amount using the revaluation model
HCA RA RA
Not allowed or Not allowed or
Creation of RS Increase in RS
(See note 1 & 2) (See note 1 & 2)
RA HCA ACA
Increase Increase
allowed (P/L) allowed (P/L)
(See note 3) (See note 3)
ACA ACA HCA
572 Chapter 11
Note 1: If the revaluation model is used, an increase above HCA (depreciated cost) is allowed but only
to the extent that the new CA does not exceed the CA the asset would have had had it not been
impaired (i.e. it is limited to depreciated fair value under the revaluation model). See IAS 36.117
Note 2: Any increase above HCA that is allowed is recognised as a revaluation surplus. See IAS 36.120
Note 3: An increase up to HCA is recognised in profit or loss. It will be called:
x an impairment loss reversal if it reverses a prior impairment loss (i.e. the asset was
previously impaired to recoverable amount, through an impairment loss expense),
x a revaluation income if it reverses a prior devaluation (i.e. the asset was previously devalued
to a lower fair value, through a revaluation expense). See IAS 36.119 read together with IAS 16.40
6. Impairment of Cash-Generating Units (IAS 36.65 – .108 and IAS 36.122 - .123)
6.1 Overview
A cash generating unit is
defined as:
When testing assets for impairment, the recoverable amount
should ideally be estimated for that individual asset. There are, x the smallest identifiable group of
assets
however, instances where it is not possible to estimate the
recoverable amount of the individual asset. x that generates cash inflows that are
x largely independent of the cash
inflows from other assets or groups
These instances are when:
of assets. IAS 36.6
x its value in use cannot be measured and this value in
use is not estimated to be close to its fair value less costs of disposal; and
x it does not generate cash inflows from continuing use that are largely independent of
those from other assets (i.e. it is a part of a cash-generating unit). See IAS 36.67
Where this is the case we must decide to which cash-generating unit the asset belongs.
A cash-generating unit is a grouping of assets – the smallest group of identifiable assets –

which together as a group of assets, generate cash inflows from continuing use (i.e. not from
disposal) and where these cash inflows are generally not affected by or dependent upon other
assets or groups of assets. IAS 36.6 (reworded)
Please note that we identify separate cash generating units based on the ability of the asset or
group of assets to generate cash inflows that are independent of other assets or groups of
assets. Thus, in identifying a cash generating unit, we do not consider whether the asset or
group of assets’ cash outflows are independent.
Sometimes the output of an asset or group of assets is used partly or entirely by another asset
or group of assets within the entity. In this situation, it would seem that the cash inflows from
this asset, or group of assets, would not be independent.
However, IAS 36 states that if it is possible for the output to be sold on an active market
instead, then this asset or group of assets is still classified as a cash generating unit even
though its output is being used internally by another group of assets. See IAS 36.70
In this case, budgets relating to this asset or group of assets

may need to be adjusted to reflect the market prices that An active market is
would be achievable if the output was sold on the active defined as:
market instead of the internal prices currently achieved by
x A market in which transactions for
using the output internally. See IAS 36.70
x the asset or liability
When checking a cash generating unit for impairment, we x take place with sufficient
frequency and volume
must calculate the recoverable amount for the cash-
generating unit as a whole and compare this to the total net x to provide pricing information on an
ongoing basis. IFRS 13, Appendix A
carrying amount of all the assets and liabilities that make
up the unit.
Chapter 11 573
When calculating the carrying amount and the recoverable amount (greater of fair value less
costs of disposal and value in use) of a cash-generating unit (CGU):
x include the carrying amount of only those assets that can be attributed directly, or
allocated on a reasonable and consistent basis, to the CGU and will generate the future
cash flows used in determining the CGU’s value in use; IAS 36.76 (a)
x exclude all liabilities relating to the group of assets unless the recoverable amount of the
CGU cannot be measured without consideration of this liability. For example, where the
disposal of a group of assets would require the buyer to assume (accept responsibility for)
the liability, (e.g. a nuclear power station where there is a legal requirement to dismantle
it at some stage in the future); IAS 36.76 (b) (reworded) & IAS 36.78
x any asset within the CGU that an entity intends to scrap is tested for impairment
separately from the remaining assets of the CGU. Obviously, if one knows that the asset
is to be scrapped, then both the value in use and fair value less costs of disposal will be
the same: the expected net proceeds from scrapping.
Example 13: Scrapping of an asset within a cash-generating unit

One of the machines (carrying amount of C40 000) in an assembly line suffered damage due
to a power surge and was immediately removed from the assembly line.
x The assembly line is still operating although at 80% capacity.
x The assembly line’s recoverable amount is C300 000 and its carrying amount is C240 000.
Required: Calculate and journalise the impairment of the machine assuming that:
A. the intention is to repair the machine and return it to the assembly line; and
B. the intention is to scrap the machine for C1 000.
Solution 13A: Scrapping of an asset within a cash-generating unit

The machine is part of a cash-generating unit:
x the machine is thus not tested for impairment separately from the cash-generating unit.
x Since the cash-generating unit’s recoverable amount exceeds its carrying amount, the cash-
generating unit is not impaired and therefore the machine is not impaired.
Therefore, no journals are processed.
Solution 13B: Scrapping of an asset within a cash-generating unit

Comment:
Although the machine is part of a cash-generating unit, it is to be scrapped and must therefore be
removed from the cash-generating unit and tested for impairment on its own.
x Given that the machine has already been taken out of use, its value in use will consist of only the
disposal proceeds of C1 000 (there are no future cash flows from continuing use).
x Given that the machine is to be scrapped for C1 000, its fair value less costs of disposal is C1 000
(assuming no costs of disposal).
The machine is therefore impaired as follows: C
Recoverable amount 1 000
Impairment loss 39 000
Debit Credit
Impairment loss (P/L: E) 39 000
Machine: Accumulated impairment loss (-A) 39 000
Impairment of machine
6.2 Allocation of an impairment loss to a cash-generating unit (IAS 36. 104 and 105)
If a cash generating unit is impaired, the impairment loss must be allocated to the individual
assets within the group.
574 Chapter 11
The allocation of an impairment of a cash-generating unit to Allocating an

its individual assets is as follows: impairment loss to
assets in a CGU:
x if the cash-generating unit contains goodwill, then the
x first allocate to goodwill;
impairment loss is first allocated fully to goodwill; and
x any remaining impairment loss is allocated on a pro rata x then allocate to remaining assets
basis based on the relative carrying amounts of the on a pro rata basis based on their
individual assets within the group. IAS 36.104 (reworded) carrying amounts
When allocating an impairment loss, however, the The CA of each asset

individual assets’ carrying amounts may not be reduced can’t be reduced below
below the greater of their individual: the higher of its:
x fair value less costs of disposal; x fair value less costs of disposal
x value in use; or x value in use
x zero. IAS 36.105 (slightly reworded) x zero. IAS 36.105
Example 14: Allocation of impairment loss (no goodwill)

A cash-generating unit, measured under the cost model, which has a recoverable amount of
C10 000, includes the following assets:
Carrying amount Recoverable amount
x Equipment C3 000 unknown
x Vehicles 2 000 unknown
x Plant 6 000 unknown
x Factory building 4 000 unknown
Required: Calculate and allocate the impairment loss to this cash-generating unit and then journalise it.
Solution 14: Allocation of impairment loss (no goodwill)
Comment: In this example, the impairment loss expense is shown separately for each asset. It is possible to
recognise the full expense as one debit entry, but the accumulated impairment loss (-A) needs to be
recognised for each individual asset (i.e. you cannot have one credit entry for the entire CGU).
W1: Impairment loss of cash-generating unit C
Carrying amount 3 000 + 2 000 + 6 000 + 4 000 15 000
Recoverable amount Given 10 000
Impairment loss 5 000
CA before Impairment CA after

W2: Impairment loss allocated to individual assets imp allocated imp
Calculation C C C
Equipment 3 000/ 15 000 x C5 000 impairment 3 000 1 000 2 000
Vehicles 2 000/ 15 000 x C5 000 impairment 2 000 667 1 333
Plant 6 000/ 15 000 x C5 000 impairment 6 000 2 000 4 000
Factory building 4 000/ 15 000 x C5 000 impairment 4 000 1 333 2 667
15 000 5 000 10 000
Journals at year-end Debit Credit
Impairment loss: equipment (P/L: E) 1 000
Equipment: accumulated impairment loss (-A) 1 000
Impairment loss: vehicles (P/L: E) 667
Vehicles: accumulated impairment loss (-A) 667
Impairment loss: plant (P/L: E) 2 000
Plant: accumulated impairment loss (-A) 2 000
Impairment loss: building (P/L: E) 1 333
Building: accumulated impairment loss (-A) 1 333
Impairment of assets within the cash-generating unit
If one (or more) of the individual assets within a cash-generating unit show signs of being
impaired, the entity will need to try to calculate its recoverable amount. If this individual
asset's recoverable amount is determinable and found to be less than its carrying amount, this
individual asset will be impaired.
Chapter 11 575
If the cash-generating unit does not contain goodwill, it is not essential to process the
impairment on this individual asset before allocating any impairment loss on the cash-
generating unit. However, if the cash-generating unit does contain goodwill, it becomes
essential to process the impairment on this individual asset before allocating any impairment
loss on the cash-generating unit. Thus, for consistency, the solutions to the following
examples will show individual asset impairments (if any) being processed first, before any
impairment on the cash-generating unit is allocated. See IAS 36.97-98
The nature of cash-generating units means that the value in use is often not determinable on
an individual asset basis. However, the measurement of an individual asset's fair value less
costs of disposal may be possible.
If an individual asset's fair value less costs of disposal is known, the portion of the cash-
generating unit's impairment loss that is allocated to this individual asset must not reduce its
carrying amount below its fair value less costs of disposal.
This may require us to limit the amount of the impairment loss that was going to be allocated
to this asset, resulting in a portion of the cash-generating unit's impairment loss remaining
unallocated. In this case, a second round of allocation (or even a third/ fourth round etc) must
be performed until the entire impairment loss is re-allocated to those assets within the cash-
generating unit that have not yet reached their minimum value (i.e. higher of value in use, fair
value less costs of disposal and zero). See IAS 36.105
Example 15: Allocation of impairment loss (no goodwill)

– some individual recoverable amounts known - multiple allocation
The following details apply to a cash- generating unit, measured under the cost model:
Carrying amount Recoverable amount
x Equipment 3 000 unknown
x Vehicles 2 000 unknown
x Plant 6 000 5 000
x Factory building 4 000 unknown
15 000 12 000
Although the recoverable amount of the building is unknown, we know that its fair value less costs of
disposal is C3 600.
Required: Allocate the impairment loss to the assets within the cash-generating unit and show the final
carrying amounts of each.
Solution 15: Allocation of impairment loss (no goodwill)

– some individual recoverable amounts known – multiple allocation
Comments:
x The RA of the plant was known and was less than its CA and is thus impaired. Since this CGU does
not contain goodwill, we are not required to impair this plant first. However, in the interests of
applying a consistent approach to all examples, we have impaired the plant before calculating and
allocating the impairment on the CGU.
x We are given the building's FV-CoD. We will thus need to make sure that the building's CA does not
drop below its FV-CoD. This limitation led us to have a second round of allocations.
Workings
CA RA Impairments of
W1: Impair individual assets where necessary individual assets
Plant C6 000 C5 000 C1 000
W2: Impairment loss on CGU C

CA of CGU after individual asset impairments 15 000 – 1 000 14 000
RA of CGU Given (12 000)
Impairment loss of CGU 2 000
576 Chapter 11
W3: Allocation of the CGU impairment loss (2 000) to the individual assets
CA before Impairment loss CA after

First round of allocation IL on CGU allocation IL on CGU
CGU impairment to be allocated (W2) 2 000
Assets already fully impaired / not impaired 5 000 N/A 5 000
5 000 NOTE 1
x Plant (6 000 – 1 000… see W1) N/A 5 000
Other assets possibly not yet fully impaired 9 000 (1 511) 7 489
x Equipment (3 000 / 9 000 x 2 000) 3 000 (667) 2 333
x Vehicles (2 000 / 9 000 x 2 000) 2 000 (444) 1 556
4 000 NOTE 2
x Factory (4 000 / 9 000 x 2 000; but limited to 400) (400) 3 600
14 000 (1 511) 12 489
Second round of allocation
CGU impairment still to be allocated (2 000 – 1 511) 489
Assets already fully impaired / not impaired 8 600 N/A 8 600
5 000 NOTE 1
x Plant (6 000 – 1 000 … see W1) N/A 5 000
3 600 NOTE 2
x Factory (4 000 – 400 … see allocation above) N/A 3 600
Other assets possibly not yet fully impaired 3 889 (489) 3 400
x Equipment (2 333 / 3 889 x 489) 2 333 (293) 2 040
x Vehicles (1 556 / 3 889 x 489) 1 556 (196) 1 360
12 489 (489) 12 000
CGU impairment still to be allocated (489 – 489) 0
Notes:
1. We know the RA of the plant and thus impair this individual asset first – see W1. See IAS 36.97-8
Thus, once the plant has been impaired, its CA will have been reduced to its RA and thus plant may not be
impaired further. See IAS 36.105
2. Although we did not know the RA of the factory, we knew that its FV-CoD was C3 600. Thus, we must be
careful not to reduce its CA below C3 600. See IAS 36.105
Therefore, although the impairment allocation was supposed to be C889 (4K/9K x 2 000), this would have
reduced its CA to C3 111 (C4 000 – C889), but yet we know we may not reduce its CA to below C3 600, and
thus we limit the IL allocation to C400.
As a result of this limitation, there will need to be a second round of allocations to allocate the remaining
unallocated impairment loss of C489 (C889 – C400).
After processing the C400 impairment loss to the factory, the factory is fully impaired and thus the second
round of allocations will now also exclude the factory (i.e. the plant and the factory are excluded in the
second round of allocations).
As discussed earlier, where a cash-generating unit includes A CGU may include

goodwill, any impairment of this cash-generating unit must scoped-out assets.
first be allocated to this goodwill. Any remaining x A CGU's CA and RA includes any
impairment loss is then allocated to the remaining assets scoped-out assets; but
within the cash-generating unit on a pro rata basis. x A CGU impairment is never
allocated to a scoped-out asset
Example 16: Allocation of impairment loss (with goodwill) – cost model
- with scoped out assets; some individual RAs known
A cash-generating unit (CGU) is measured under the cost model. It includes a vehicle with
a recoverable amount of C2 800, but the recoverable amounts of the other assets in the
CGU are unknown. The CGU has a recoverable amount of C8 000 and a carrying amount
of C12 000, constituted by the following individual carrying amounts:
x Inventory C1 000
x Vehicle C4 000
x Building C5 000
x Goodwill C2 000
Required: Calculate and allocate the impairment loss to this cash-generating unit
Chapter 11 577
Solution 16: Allocation of impairment loss (with goodwill) – cost model

– with scoped out assets; some individual RAs known
Comments:
x The RA of the plant was known and was less than its CA and is thus impaired. This CGU contains goodwill, and
thus it is essential that we impair this plant first.
x This CGU was impaired and contained goodwill. Since it contained goodwill, we first allocate the CGU's
impairment against goodwill, and only if there is a remaining unallocated CGU impairment do we allocate it
against the remaining assets in the CGU.
x This CGU included scoped-out asset (inventory). Although the CA and RA of a CGU is calculated by including
scoped-out assets, we do not allocate a CGU's impairment loss to scoped-out assets.
Workings
Impairments of
W1: Impair individual assets where necessary CA RA individual assets
Vehicle C4 000 C2 800 C1 200
W2: Impairment loss on CGU C
CA of CGU after individual asset impairments 12 000 – 1 200 10 800
RA of CGU Given (8 000)
Impairment loss of CGU 2 800
W3: Allocation of the CGU impairment loss (2 800) to the individual assets
CA before Impairment loss CA after
First round of allocation: IL on CGU allocation IL on CGU
CGU impairment to be allocated W2 2 800
x Goodwill 2 000 (2 000) NOTE 1 0
Second round of allocation:
CGU impairment still to be allocated 800
x Goodwill 2 000 – 2 000 0 0 NOTE 2
0
x Inventory 1 000 0 NOTE 2
1 000
x Vehicle W1 2 800 0 NOTE 3
2 800
x Building 5 000 / 5 000 x 800 5 000 (800) 4 200
8 800 (800) 8 000
CGU impairment still to be allocated 0
Notes:
1. If a CGU contains goodwill, the first round of impairment allocations is always against this goodwill.
2. The second round of impairment allocations did not allocate a portion against goodwill, because it was already
fully impaired, and did not allocate a portion against inventory, because it is a scoped-out asset (see the pop-up
in section 1 for a list of scoped-out assets).
3. The vehicle has already been impaired to its recoverable amount (see W1). Thus, its carrying amount may not
be reduced any further. The remaining impairment is thus allocated to the building.
It should be noted that goodwill must be tested every year for possible impairments, even if
there is no indication that it is impaired. Whereas most other assets must be tested at year-end,
goodwill may be tested at any stage during the year so long as it is tested at the same time
every year (where goodwill is allocated across various cash-generating units, these cash-
generating units may be tested for impairment at different times). See IAS 36.10
The most recent detailed calculation made in a preceding period of the recoverable amount of
a cash-generating unit to which goodwill has been allocated may be used in the impairment
test of that unit in the current period provided all of the following criteria are met:
x the assets and liabilities making up the unit have not changed significantly since the most
recent recoverable amount calculation;
x the most recent recoverable amount calculation resulted in an amount that exceeded the
carrying amount of the unit by a substantial margin; and
x based on an analysis of the events that have occurred and the circumstances that have
changed since the most recent recoverable amount calculation, the likelihood that the unit’s
current recoverable amount is less than its current carrying amount is remote. IAS 36.99
578 Chapter 11
6.3 Reversals of impairments relating to a cash generating unit (IAS 36.119 & 122 - .125)
6.3.1 Calculating impairment loss reversals relating to CGUs
If we find we need to reverse an impairment loss relating to a cash-generating unit (CGU), we start
by calculating the total impairment loss reversal that we think we Allocating an
need to recognise. We do this by subtracting the recoverable impairment loss
amount of the CGU from the carrying amount of the CGU (we reversal:
may not necessarily be able to recognise this total impairment loss x Allocate first to all assets on a
pro rata basis (but making sure
reversal due to the limitation, which will be explained below). that the new CA doesn’t exceed
the lower of HCA & RA)
After calculating the total impairment loss reversal that we x Never allocate to goodwill!
expect to recognise, we then allocate this total to each of the
assets within the CGU, (except to goodwill, because any impairment once allocated to
goodwill may never be reversed). This allocation is done on a pro rata basis using the
carrying amounts of the individual assets relative to the carrying amount of the CGU in total.
Since an impairment of goodwill may never be reversed, we leave goodwill out of this
allocation calculation entirely. See IAS 36.124 - .125
Now, when allocating the total impairment loss to the individual assets in the CGU, we must
be careful because the amount of the impairment loss reversal allocated to each of these assets
may be limited. This is because the carrying amount of each of the assets in the CGU may
not be increased above the lower of its:
x Recoverable amount; and
An IL reversal is
x Carrying amount, had no impairment loss been recognised recognised:
in prior years.
- if the cost model is used, this is historical carrying x in P/L if cost model is used;
x in P/L, and possibly also in OCI
amount (depreciated cost); and (RS), if revaluation model used
- if the revaluation model is used, this is depreciated
fair value. See IAS 36.123
Notice that the limitation described above means that, when using the cost model, the carrying
amounts of the individual assets may not increase above the historical carrying amount
(depreciated cost)), but if the revaluation model is used, the carrying amounts can be.
However, when using the revaluation model, the carrying amounts of the individual asset may
never increase above depreciated fair value.
The difference between the impairment loss reversals relating to CGUs under the cost model
and revaluation model are described in section 6.3.2 and section 6.3.3 respectively.
If an impairment loss reversal to be allocated to a particular asset is limited (i.e. the portion of the
impairment loss reversal to be allocated to this asset could not be allocated at all or could only be
partially allocated), then the excess reversal that could not be allocated to the asset must be allocated to
the remaining assets. This is done as a ‘second round allocation’ (which may need to be followed by a
third and fourth round allocation etc). For example, if we have a total impairment loss reversal of
C2 000, of which C100 is to be allocated to a particular asset, but due to the upper limit on this asset’s
carrying amount, we could only allocate an impairment reversal of C80, then the excess reversal of
C20 that could not be allocated to the asset must be allocated to the remaining assets. See IAS 36.123
The basic principles applied when reversing an impairment loss for an individual asset also
apply to a CGU (explained in the sections below). These principles are that, when we use the:
x cost model
- the impairment reversal is always recognised in profit or loss as income.
x revaluation model
- the impairment reversal is recognised as income in profit or loss only to the extent that it
increases the carrying amount up to historical carrying amount (depreciated cost).
- Any remaining impairment reversal is recognised as income in other comprehensive
income (i.e. the portion that increases the carrying amount above depreciated cost).
Chapter 11 579
6.3.2 Impairment loss reversals relating to CGUs – cost model

When allocating an impairment loss reversal to the individual Important summaries
assets in a CGU, we must not allow the carrying amount of each of about IL reversals:
these assets in the CGU to increase above the lower of its: x Cost model: section 5.2
x Recoverable amount; and x Reval. model: section 5.3
x Carrying amount had no impairment loss been recognised in prior year (historical
carrying amount): in the case of the cost model, this carrying amount is depreciated cost.
The effect of the limitation, when using the cost model, is that the carrying amounts of the individual
assets in the CGU may not increase above historical carrying amount (depreciated cost). For example, if
our actual carrying amount before the reversal is C80 and the recoverable amount is C110, then:
x if our historical carrying amount (depreciated cost) is C100, the impairment reversal would be
limited to C20: the CA would be increased from C80 to C100 (i.e. the impairment reversal is C20).
x if our historical carrying amount (depreciated cost) was C120, the impairment reversal would not be
limited: the CA would be increased from C80 to C110 (i.e. the impairment reversal would be C30).
If using the cost model, impairment loss reversals are recognised as income in profit or loss:
x Debit accumulated impairment losses (i.e. increasing the asset) &
x Credit impairment loss reversal income (P/L).
Example 17: Impairment and reversal thereof (no goodwill) – cost model
On 31 December 20X4, as a result of a government ban on a product produced by Banme Limited, a
cash-generating unit had to be impaired to its recoverable amount of C2 000 000. On this date, the
details of the individual assets in the unit (each measured using the cost model) were as follows:
Remaining Residual Carrying Recoverable
useful life value amount amount
31 December 20X4: C C C
x Equipment 5 years Nil 1 000 000 unknown
x Plant 5 years Nil 3 000 000 unknown
4 000 000 2 000 000
One year later, on 31 December 20X5, the ban was lifted and the cash-generating unit was brought
back into operation. Its revised recoverable amount is C3 000 000:
31 December 20X5: Historical CA * RA
x Equipment 800 000 unknown
x Plant 2 400 000 unknown
*: the carrying amount had the assets not been impaired C3 200 000 C3 000 000
Required: Calculate and allocate the impairment losses and reversals thereof to the cash-generating unit.
Solution 17: Impairment and reversal thereof (no goodwill) – cost model
W1: 31 December 20X4: Impairment loss of cash-generating unit C
Carrying amount Given 4 000 000
Less: Recoverable amount Given (2 000 000)
Impairment loss 2 000 000
W2: 31 December 20X4: Allocation of impairment loss to individual assets
impairment loss impairment
Equipment 1mil/ 4mil x C2mil impairment 1 000 000 (500 000) 500 000
Plant 3mil/ 4mil x C2mil impairment 3 000 000 (1 500 000) 1 500 000
4 000 000 (2 000 000) 2 000 000
W3: 31 December 20X5: Carrying amount (before reversal of impairment) C
Equipment 500 000 – (500 000 / 5 x 1 year) 400 000
Plant 1 500 000 – (1 500 000 / 5 x 1 year) 1 200 000
1 600 000
W4: 31 December 20X5: Reversal of impairment loss of cash-generating unit C
Carrying amount W3 1 600 000
Less recoverable amount Given (3 000 000)
Impairment loss reversed not limited: HCA of 3 200 000 is greater than the RA* (1 400 000)
580 Chapter 11
W5: 31 December 20X5: Allocation of reversal of impairment to individual assets

impairment reversed impairment
Equipment 0.4mil/1.6mil x 1 400 000 imp. reversal 400 000 350 000 750 000
Plant 1.2mil/1.6mil x 1 400 000 imp. reversal 1 200 000 1 050 000 2 250 000
1 600 000 1 400 000 3 000 000
*The impairment loss reversed is limited on an individual asset basis to what its carrying amount would have been if it had
not previously been impaired (e.g. HCA(depreciated cost). However, the limits were not exceeded in this example because
the reversal did not increase the carrying amount above the HCA (depreciated cost):
x Equipment’s HCA (depreciated cost) is C800 000 (given), but the CA after the imp. reversal was only C750 000 (W5)
x Plant’s HCA (depreciated cost) is C2 400 000 (given), but the CA after imp. reversal was only C2 250 000 (W5).
Example 18: Impairment and reversal thereof (with goodwill) – cost model
On 31 December 20X4, due to a government ban on a product produced by Banme Limited,
the affected cash-generating unit must be impaired to its recoverable amount of C2 000 000.
On this date, the details of the individual assets in the unit (each measured using the cost model) were:
Remaining Residual Carrying Recoverable
useful life value amount amount
On 31 December 20X4: C C C
x Goodwill 5 years Nil 2 000 000 unknown
x Plant 5 years Nil 3 000 000 unknown
x Building 5 years Nil 5 000 000 unknown
10 000 000 2 000 000
One year later, the ban was lifted and the cash-generating unit was brought back into operation. On this date,
the CGU's and individual asset's carrying amounts and recoverable amounts were recalculated – as follows:
Historical Carrying Recoverable
carrying amount amount amount
On 31 December 20X5: C C C
x Goodwill 2 000 000 0 Unknown
x Plant 2 400 000 600 000 Unknown
x Building 4 000 000 1 000 000 Unknown
8 400 000 1 600 000 4 000 000
Required: Perform the allocation of the impairment and the reversal thereof.
Solution 18: Impairment and reversal thereof (with goodwill) – cost model
W1: 31 December 20X4: Impairment loss of cash-generating unit C
Carrying amount Given 10 000 000
Less: Recoverable amount Given (2 000 000)
Impairment loss 8 000 000
W2: 31 December 20X4: Allocation of CGU impairment loss to individual assets

impairment loss impairment
First round of allocation:
Impairment to be allocated (W1) 8 000 000
x Goodwill The entire goodwill is first removed 2 000 000 (2 000 000) 0
Second round of allocation:
Impairment still to be allocated (balancing) 6 000 000
x Goodwill 2 000 000 – IL: 2 000 000 0 - 0
x Plant 3mil/ (3mil + 5mil) x 6 mil impairment 3 000 000 (2 250 000) 750 000
x Building 5mil/ (3mil + 5mil) x 6 mil impairment 5 000 000 (3 750 000) 1 250 000
8 000 000 6 000 000 2 000 000
Impairment still to be allocated (balancing) 0
Chapter 11 581
W3: 31 December 20X5: Carrying amount (before reversal of impairment) (given) C

Goodwill Given 0
Plant Given 750 000 – (750 000 / 5 x 1 year) 600 000
Building Given 1 250 000 – (1 250 000 / 5 x 1 year) 1 000 000
Please note: W3 is unnecessary as amounts are given: shown for completeness 1 600 000
W4: 31 December 20X5: Reversal of impairment loss of cash-generating unit
Carrying amount Given or W3 1 600 000
Less recoverable amount Given (4 000 000)
Impairment loss reversal (income) not limited since the HCA of C6 400 is greater than the RA* (2 400 000)
W5: 31 December 20X5: Allocation of CGU's impairment reversal to individual assets
reversal reversed reversal
Goodwill Prior goodwill impairments may never be reversed 0 0 0
Plant 0.6mil/1.6mil x 2 400 000 impairment reversal 600 000 900 000 1 500 000
Building 1.0mil/1.6mil x 2 400 000 impairment reversal 1 000 000 1 500 000 2 500 000
1 600 000 2 400 000 4 000 000
*The impairment loss reversed is limited on an individual asset basis to what its CA would have been if it had not previously
been impaired (e.g. HCA/ depreciated cost ). However, the limits were not exceeded in this example because the reversal did
not increase the CA above the HCA (depreciated cost) . However, impairments of goodwill may never be reversed.
x Plant’s HCA (depreciated cost) was: 3 000 000 / 5 x 4 = 2 400 000, but the CA after imp. reversal was only C1 500 000
x Building’s HCA (depreciated cost) was: 5 000 000 / 5 x 4 = 4 000 000, but the CA after imp. reversal was only C2 500 000.
6.3.3 Impairment loss reversals relating to CGUs – revaluation model

When allocating the impairment loss reversal to each of the individual assets in the CGU, we
must be careful not to allow the carrying amount to increase above the lower of its:
x Recoverable amount; and
x Carrying amount, had no impairment loss been recognised in prior year: in the case of the
revaluation model, this carrying amount is the depreciated fair value. See IAS 36.123
The effect of the limitation, if the revaluation model is used, is that the carrying amounts may be
increased above historical carrying amount (i.e. depreciated cost), but the carrying amounts of the
individual asset may never increase above depreciated fair value. Depreciated fair value may be
higher than historical carrying amount (depreciated cost).
When using the revaluation model, an impairment loss reversal will be recognised as income in
profit or loss to the extent that it increases the asset’s carrying amount (actual carrying amount) up to
its historical carrying amount (depreciated cost), but increases in a carrying amount above its
historical carrying amount (depreciated cost) must be recognised as income in other comprehensive
income – in other words, in the revaluation surplus account:
x Increasing the carrying amount up to historical carrying amount (depreciated cost):
Debit accumulated impairment losses & Credit impairment loss reversal income (P/L).
x Increasing the carrying amount above depreciated cost:
Debit accumulated impairment losses & Credit revaluation surplus (OCI).
Any increase above historical carrying amount (i.e. depreciated cost) is recognised in other
comprehensive income as a revaluation surplus. Please note that we would not debit the cost
account because the cost account would currently reflect the asset’s fair value and thus a debit
to this account would result in it reflecting an arbitrary balance.
Example 19: Reversal of impairment of a CGU (with goodwill)
– some individual RAs known: cost model and revaluation model
A CGU was impaired (for the first time) to C750 000 on 31/12/20X4, details of which are as follows:
CA before impairment CA after impairment Remaining useful life
x Goodwill 100 000 0
x Machine 200 000 190 000 5 years
x Factory 300 000 240 000 6 years
x Equipment 400 000 320 000 4 years
1 000 000 750 000
582 Chapter 11
The recoverable amount of the CGU is C900 000 on 31/12/20X5 and the recoverable amounts of the
following individual assets on this date are known: Recoverable amount
x Machine 220 000
x Factory 240 000
All depreciation recognised was calculated using nil residual values and using the straight-line method.
The assets in the CGU are measured as follows:
x goodwill, machine, equipment: cost model;
x factory building: revaluation model.
The factory building:
x was originally purchased on 1/1/20X1 for 450 000.
x had an original useful life of 10 years (residual value = 0) and was depreciated straight-line.
x was revalued to a fair value of 350 000 on 1/1/20X4.
x was revalued using the net replacement value method (see chapter 8).
The revaluation surplus is transferred to retained earnings over the asset’s useful life.
Required:
A. Calculate the impairment reversals per individual asset at 31 December 20X5.
B. Show the impairment reversal journal entries.
C. Show all journals relating to the factory from date of purchase to 31 December 20X5 (ignore tax).
Solution 19A: Impairment reversal – calculations

CA: Depreciation CA:
W1: 31/12/20X5: Carrying amount – IS 31/12/20X4 20X5 31/12/20X5
Goodwill 0 0 N/A 0
Machine 190 000 (38 000) 190K/5yrs 152 000
Factory 240 000 (40 000) 240K/6yrs 200 000
Equipment 320 000 (80 000) 320K/4 yrs 240 000
750 000 (158 000) 592 000
W2: 31/12/20X5: Impairment loss reversed – CGU in total
Carrying amount: CGU W1 592 000
Less recoverable amount: CGU Given (900 000)
Impairment loss reversal expected * (308 000)
*This is the IL reversal we are going to try to recognise – we may not be able to recognise all of it (and if you
look ahead at W4, you will see that we only manage to recognise C108 000 of this).
W3: Limitations per asset: lower of historical carrying amount and recoverable amount
HCA: Depreciation HCA: RA: Lower
31/12/20X4 31/12/20X5 31/12/20X5
Goodwill N/A (1& 2) 0 N/A (1) N/A (1) ? N/A (1)
Machine 200 000 (2) 40 000 200K/5yrs 160 000 220 000 160 000
Factory 300 000 (2) 50 000 300K/6yrs 250 000 240 000 240 000
Equipment 400 000 (2) 100 000 400K/4yrs 300 000 ? 300 000 (3)
900 000 190 000 710 000

(1) The impairment on goodwill may never be reversed, so it is excluded from this calculation.
(2) We know that the CA given before the impairment on 31/12/20X4 is also the HCA on this date because
we are told that the impairment that then took place on 31/12/20X4 was the first impairment ever.
(3) We do not know this recoverable amount and therefore we must go with the HCA at 31/12/20X5.
W4: Allocation of the CGU impairment reversal (W2) to the individual assets in the CGU
Carrying amount Imp reversal Carrying amount
before impairment allocation after impairment
reversal reversal
(W1)
1
Goodwill N/A N/A N/A
6 2
Machine (152/592 = 25.7% ) 152 000 8 000 160 000
3
Factory (200/592 = 33.8% 6) 200 000 40 000 240 000
4
Equipment (240/592 = 40.5% 6) 240 000 60 000 300 000
5
592 000 108 000 700 000
Chapter 11 583
Notes:
(1) The impairment is never reversed to goodwill, so we leave goodwill out of the calculation entirely.
(2) 25.7% x 308 000 = 79 156. This would increase the CA to 231 156 (152 000 + 79 156). But, the maximum CA is
160 000 (W3), thus the allocation is limited to 160 000 – 152 000 = 8 000
(3) 33.8% x 308 000 = 104 104. The CA would increase to 304 104 (200 000 + 104 104), but the maximum CA is 240 000
(W3), thus the allocation is limited to 240 000 – 200 000 =40 000
(4) 40.5% x 308 000 = 124 740. The CA will increase to 364 740 (240 000 + 124 740). But the maximum CA is
300 000(W3), thus the allocation is limited to 300 000 – 240 000 = 60 000
(5) The impairment reversal of 308 000 was limited to 108 000. The excess (C200 000) cannot be re-allocated pro-rata, since
the CA of each asset in the CGU (other than goodwill) has already being increased to its upper limit (the lower of its RA
and HCA/ depreciated fair value). If this were not the case, a second-round of allocation would be necessary.
(6) These percentages have been rounded. The notes above use these rounded percentages. You could work with the exact
percentages instead, which would mean that your calculations would be slightly more accurate than the calculations
shown in the notes above.
Solution 19B: Impairment reversal – journals (cost and revaluation model)

31/12/20X5 Debit Credit
Machine: Accumulated impairment losses (-A) 8 000
Impairment loss reversed – machine (P/L: I) 8 000
Impairment of machine in 20X4 reversed (cost model)
Factory building: Accumulated impairment losses (-A) 40 000
Impairment loss reversed – factory building (P/L: I: ) (1) 25 000
Revaluation surplus – factory building (OCI: I: ) (1) 15 000
Impairment of factory building in 20X4 reversed (revaluation model)
Equipment: Accumulated impairment losses (-A) 60 000
Impairment loss reversed – equipment (P/L: I) 60 000
Impairment of equipment in 20X4 reversed (cost model)
Note 1: The calculations of how much of the impairment loss reversal income is recognised in profit or loss (i.e. presented as
an impairment loss reversal income in P/L) and how much is recognised in other comprehensive income (presented
as a revaluation surplus in OCI) can be found in solution 19C
Solution 19C: Impairment reversal – journals for factory building (revaluation model)
Comment:
x The reversal of the impairment loss relating to the machine and the equipment involved the cost model. This
means that the related carrying amounts are not allowed to increase above the historical carrying amount (i.e. cost
less accumulated depreciation; also known as depreciated cost).
x The reversal of the impairment loss relating to the factory involved the revaluation model. This means that its
carrying amount is allowed to increase above the historical carrying amount (depreciated cost). The increase
above this historical carrying amount is recognised in other comprehensive income as a revaluation surplus.
x To understand the building’s imp. Reversal journal, we must understand the revaluation model.

Factory: Cost (A) Given 450 000
Bank (A) 450 000
Factory building purchased
31/12/20X1; 31/12/20X2 and 31/12/20X3 (Jnl repeated x 3 yrs)
Depreciation – factory (P/L: E) (450 000 – 0) / 10yrs 45 000
Factory: Accumulated depreciation (-A) 45 000
Factory building depreciated annually
1/1/20X4
Factory: cost (A) 45 000 x 3 years 135 000
Accumulated depreciation netted off against cost, before revaluing (NRVM)
Factory: Cost (A) FV: 350 000 – HCA: 315 000 35 000
Revaluation surplus (OC1: I) (Cost: 450 000 – AD: 135 000) 35 000
Revaluation of factory
584 Chapter 11

Depreciation – factory (P/L: E) (CA: 350 000-0) / 7 remaining yrs x 1 50 000
Revaluation surplus (OCI) 35 000 / 7 remaining yrs x 1 5 000
Transfer of revaluation surplus to retained earnings over the building’s life
Revaluation surplus (OCI) CA: 300 000 – HCA: 270 000 30 000
Impairment loss (E) HCA: 270 000 – RA: 240 000 30 000
Factory: Acc imp loss (-A) CA: 300 000 – RA: 240 000 60 000
Factory building impairment
1st step: Reduce asset’s CA to HCA (depreciated cost);
impairment recognised in OCI (revaluation surplus)
2nd step: Reduce asset’s CA further, reducing from HCA to the lower RA;
impairment recognised in P/L (impairment loss expense)
CA: (FV: 350 000 – AD: 50 000) = 300 000
HCA (depreciated cost): Cost: 450 000 – AD: (450 000 - 0) / 10 x 4yrs = 270 000
RA: given = 240 000
31/12/20X5
Depreciation (P/L: E) (CA: 240 000-0) / 6 remaining years x 1 40 000
Factory: Acc imp loss (-A) CA: 200 000 – HCA: 225 000 25 000
Impairment loss reversed (P/L: I) (450 000 – 450 000 / 10 x 5years) 25 000
Previous impairment reversed: 1st step: increase CA back up to HCA –
reversal recognised in profit or loss (impairment loss reversal income)
Factory: Acc imp loss (-A) HCA: 225 000 – RA: 240 000 15 000
Previous impairment reversed: 2nd step: increase CA above HCA to RA:
240 000 (check not limited to depreciated FV: FV: 350 000 - AD (350 000 –
0)/7 x 2 = 250 000). Reversal above HCA is recognised in OCI (reval surplus)
Note: If you scribble down t-accounts showing the processing of the above journals, you can do a quick check:
x The cost account must reflect the fair value of C350 000 (notice we did not debit any part of the impairment loss reversal
to ‘cost’, even though part of the reversal is credited to revaluation surplus – the entire reversal is debited to ‘Acc IL’).
x The revaluation surplus reverses to zero at end 20X5.
x The total of the AD account and AIL account on 31 December 20X5 is C110 000 (AD: 90 000 + AIL: 20 000 = 110 000).
This correctly reflects the total of the AD and AIL that would have been processed had we not impaired on
31 December 20X4. We would have depreciated the fair value by C50 000 in both 20X4 and in 20X5 (i.e.by total
of C100 000) thus reducing the CA from C350 000 to C250 000 and would have then found that we have a RA of
C240 000, so would have impaired the CA by C10 000.
So, the total of the AD and AIL accounts would have been C110 000 (AD: 100 000 + AIL: 10 000).
6.4 Corporate assets (IAS 36.100 - .102) Corporate assets

are defined as:
When testing a cash-generating unit (CGU) for impairment, one x assets other than goodwill
must include any corporate assets that are capable of being x that contribute to the
future cash flows
allocated on a reasonable and consistent basis to that unit. x of both the:
- cash generating unit under
The primary characteristics of corporate assets (e.g. head office review and
buildings) are that: - other cash generating units.
IAS 36.6
x ‘they do not generate cash flows independently of other
assets or groups of assets; and
x their carrying amounts cannot be fully attributed to the CGU under review’. IAS 36.100 (extract)
It may be possible to allocate the corporate assets to the CGUs on a reasonable basis, using, for
example, the carrying amounts of the various CGUs to pro-rata the corporate assets to these units.
Impairment tests are performed by comparing the carrying amount of the CGU, including the
portion of the carrying amount of the corporate asset allocated to the unit, with its recoverable
amount. IAS 36.102 (reworded)
Chapter 11 585
If the entity owns corporate assets that are unable to be allocated to its cash-generating units
on a reasonable basis, further impairment test/s are performed from the bottom-up.
Essentially this means that we must:

x first step: test the smallest CGU for impairment (excluding the corporate assets);
x second step: test a group of CGUs to which the corporate assets (or portion thereof) can
be allocated on a reasonable and consistent basis for impairment (example: two CGUs
with one corporate asset);
x third step: test a bigger group of CGUs for impairment; and so on until the corporate
assets are completely included in a CGU/s (example: 3 CGUs with 2 corporate assets).
The final group of CGUs is often the business as a whole. See IAS 36.102
Example 20: Corporate assets

The reporting entity has 3 cash-generating units (toothpaste, wire brushes and rubber tyre
production lines) and 3 corporate assets (a building, phone system and a computer platform).
The building and phone system support all cash-generating units while the computer platform supports
the toothpaste and wire-brush units only. The following are measurements as at 31 December 20X5:
CA RA
Cash-generating units excluding corporate assets: C C
x Toothpaste unit 1 000 000 600 000
x Wire-brush unit 2 000 000 1 500 000
x Rubber tyre unit 4 000 000 3 200 000
7 000 000 5 300 000
Corporate assets:
x Building 700 000
x Phone system 350 000
x Computer platform 1 050 000
2 100 000
Summary of carrying amounts:
x Cash generating units excluding corporate assets 7 000 000
x Corporate assets 2 100 000
Total carrying amount 9 100 000
Required: Calculate the amount of the impairment to be allocated to the entity’s assets, assuming that:
A. the corporate assets can be allocated to the relevant cash-generating units. The appropriate method
of allocation is based on the carrying amount of the cash-generating unit’s individual assets as a
percentage of cash-generating unit’s total assets excluding corporate assets to be allocated.
B. the corporate assets cannot be allocated to the relevant cash-generating units.
Solution 20A: Corporate assets are able to be allocated

W1. Calculation of impairment loss per unit Cash-generating units
Toothpaste Wire-brushes Rubber tyres
Without corporate assets 1 000 000 2 000 000 4 000 000
Building 1 000K / 7 000K x 700 000 * 100 000 200 000 400 000
2 000K / 7 000K x 700 000 *
4 000K / 7 000K x 700 000 *
Phone system 1 000K / 7 000K x 350 000 * 50 000 100 000 200 000
2 000K / 7 000K x 350 000 *
4 000K / 7 000K x 350 000 *
Computer platform 1 000K / 3 000K x 1 050 000 ** 350 000 700 000 0
2 000K / 3 000K x 1 050 000 **
Total 1 500 000 3 000 000 4 600 000
Recoverable amount 600 000 1 500 000 3 200 000
Impairment 900 000 1 500 000 1 400 000
*: 1 000 000 + 2 000 000 + 4 000 000 = 7 000 000
**: 1 000 000 + 2 000 000 = 3 000 000
Note: these three impairment losses are then allocated and journalised to the individual assets within each cash
generating unit (as has been done in the previous CGU examples).
586 Chapter 11
Solution 20B: Corporate assets not able to be allocated

The impairment testing of this entity’s assets, where its corporate assets were incapable of being
allocated to its three cash-generating units, involves three levels of testing, as follows:
Cash-generating units
W1: First test: without any corporate assets: Toothpaste Wire-brushes Rubber tyres
Carrying amount before first impairment 1 000 000 2 000 000 4 000 000
Recoverable amount 600 000 1 500 000 3 200 000
First impairment 400 000 500 000 800 000
W2: Second test: toothpaste and wire-brush units with computer platform C
Cash-generating unit toothpaste 1 000 000 – 400 000 first impairment 600 000
Cash-generating unit wire-brushes 2 000 000 – 500 000 first impairment 1 500 000
Computer platform (supports only the toothpaste and wire-brush unit) 1 050 000
Carrying amount before level 2 impairment 3 150 000
Recoverable amount 600 000 + 1 500 000 (2 100 000)
Second impairment 1 050 000
W3: Third test: all cash-generating units with all corporate assets: C
Toothpaste, wire-brushes and computer platform 3 150K – 1050K second impairment 2 100 000
Cash-generating unit: rubber tyres 4000K – 800K first impairment 3 200 000
Building (supports all 3 units) 700 000
Phone system (supports all 3 units) 350 000
Carrying amount before level 3 impairment 6 350 000
Recoverable amount 600 000 + 1 500 000 + 3 200 000 (5 300 000)
Third impairment 1 050 000
W4: Total impairment: C

First impairment 400 000 + 500 000 + 800 000 1 700 000
Second impairment 1 050 000
Third impairment 1 050 000
Total impairment allocated 3 800 000
W5: Total revised carrying amount of all assets: C

Carrying amount before impairment 9 100 000
Impairment 3 800 000
Carrying amount after impairment 5 300 000
7. Deferred Tax Consequences of Impairment of Assets
Chapter 6 dealt extensively with the concept of deferred tax. Let us now apply the deferred
tax principles discussed in that chapter to an impairment (or impairment reversal).
Generally, tax authorities only allow deductions relating to the usage of an asset and would
not permit a deduction relating to the impairment of an asset. Certainly, this is the case in
South Africa, where the SA Income Tax Act (ITA) only grants deductions relating to the
usage of an asset (i.e. see deductions allowed in terms of sections 11(e), 12 and 13). This
difference in treatment (between tax and accounting) will result in a temporary difference,
which will give rise to deferred tax.
Example 21: Deferred tax consequences relating to impairment
Imp Limited purchased an item of plant on 1 January 20X4. Details relating to the plant are:
x The plant cost C50 000, has a useful life of 10 years and a nil residual value.
x In November 20X4, a competitor introduced a product that is similar to the product
produced by the plant, for a much cheaper price. As a direct result, management
reliably estimated the plant’s recoverable amount at 31 December 20X4 to be C27 000.
x In 20X5, a consumer protection agency found that t similar product failed to meet certain
regulations, and the product was removed from the market. As a result, management reliably
estimated the plant’s recoverable amount at 31 December 20X5 to be C38 000.
Chapter 11 587
x The depreciation variables remained the same throughout the period.

x The tax authorities grant a wear and tear allowance of 20% p.a. not apportioned for
part of the year.
x The corporate tax rate is 28%.
x There are no other temporary differences, apart from those evident from the above.
Required: Prepare the journal entries relating to deferred tax for the 20X4 and 20X5 year
Solution 21: Deferred tax consequences relating to impairment

Deferred tax: income tax (A) W1: 1 400 (cr) – 5 040 (dr) 3 640
Deferred tax consequences of depreciation and impairment loss
31 December 20X5
Income tax expense (P/L: E) W1: 1 960 (cr) + 3 920 (cr) 5 880
Deferred tax: income tax (A/L) 5 880
Deferred tax consequences of depreciation and impairment loss reversal
W1. Deferred tax CA TB TD DT

Purchase of plant 50 000 50 000 0 0
Depreciation (1)/Wear & Tear (2) (5 000) (10 000) (5 000) (1 400) Cr DT; Dr TE
45 000 40 000
Impairment loss (3) (18 000) 0 18 000 5 040 Dr DT; Cr TE
Closing balance: 20X4 27 000 40 000 13 000 3 640 Asset
Depreciation (4)/Wear & Tear (2) (3 000) (10 000) (7 000) (1 960) Cr DT; Dr TE
24 000 30 000
Impairment loss reversal (5) 14 000 0 (14 000) (3 920) Cr DT; Dr TE
Closing balance 20X5 38 000 30 000 (8 000) (2 240) Liability
(1) (Cost: 50 000 – RV: 0) ÷ 10 yrs UL = C5 000
(2) Cost: 50 000 x 20% = C10 000
(3) CA: 45 000 – RA: 27 000 = C18 000
(4) (CA: 27 000 – RV: 0) ÷ 9 yrs UL = C3 000
(5) RA: 38 000 – CA: 24 000 = C14 000 (note: the RA did not exceed the depreciated cost (HCA) of C40 000)
8. Disclosure (IAS 36.126 – .137)
8.1 In general
The following information must be disclosed for each class of asset:
x For any impairment losses:
The amount debited to expenses and the line-item that includes the impairment loss,
(e.g. profit before tax);
The amount debited against other comprehensive income (i.e. the revaluation surplus account).
x For any reversals of impairment losses:
The amount credited to income and the line-item that includes this impairment
reversal, (e.g. profit before tax);
The amount credited to other comprehensive income (i.e. revaluation surplus). See IAS 36.126
These disclosures may be included in a note supporting the calculation of profit or loss (e.g.
‘profit before tax’ note) or in the note supporting the asset (e.g. the ‘property, plant and
equipment’ note in the reconciliation of carrying amount).
8.2 Impairment losses and reversals of previous impairment losses (IAS 36.130 - .131)
For every material impairment loss or impairment loss reversal, the entity must disclose:
x the events and circumstances that led to the impairment loss or reversal thereof;
x the nature of the asset (or the description of a cash-generating unit);
588 Chapter 11
x the amount of the impairment loss or impairment loss reversed;

x if applicable, the reportable segment in which the individual asset or cash-generating unit
belongs (i.e. if the entity reports segment information in terms of IFRS 8);
x if the recoverable amount is fair value less costs of disposal or value in use;
x if recoverable amount is fair value less costs of disposal, the basis used to measure fair
value (in terms of IFRS 13) less costs of disposal;
x if recoverable amount is value in use, the discount rate used in the current and previous
estimate (if any) of value in use. See IAS 36.130
For impairment losses and impairment loss reversals that are not disclosed as above, indicate
x the main class of assets affected; and
x the main events and circumstances that led to the recognition or reversal of the
impairment losses. IAS 36.131 (reworded)
8.3 Impairment testing: cash-generating units (IAS 36.130 & .134)
Additional disclosure is required when impairment testing is performed on ‘cash-generating
units’ instead of ‘individual assets’. This additional disclosure is listed below:
x a description of the cash-generating unit (e.g. a product line or geographical area);
x the amount of the impairment loss recognised or reversed by class for assets and, if the
entity reports segment information, by reportable segment (IFRS 8);
x if the aggregation of assets for identifying the cash-generating unit has changed since the
previous estimate of the cash-generating unit’s recoverable amount, a description of the
current and former way of aggregating assets and the reasons for changing the way the
cash-generating unit is identified. See IAS 36.130
If a cash-generating unit includes goodwill or an intangible asset with an indefinite useful life,
and the portion of the carrying amount of that goodwill or intangible assets that is allocated to
the unit is significant in relation to the total carrying amount of goodwill or intangible assets
with indefinite useful lives of the entity (as a whole), then we also need to disclose:
x the carrying amount of the allocated goodwill;
x the carrying amount of intangible assets with indefinite useful lives;
x the recoverable amount of the unit and the basis for calculating the recoverable amount of
the cash-generating unit (either its fair value less costs of disposal or value in use);
x where the recoverable amount is based on value in use:
- each key measurement assumption on which management-based cash flow projections;
- a description of how management measured the values assigned to each key
assumption, whether those values reflect past experience or external sources of
information or both, and if not, why and how they differ from past experience or
external sources of information;
- the period over which management has projected cash flows based on financial
budgets approved by management and, when a period of more than five years is used
for a cash-generating unit, an explanation of why that longer period is justified;
- the growth rate used to extrapolate cash flow projections beyond the period covered
by the financial budgets and the justification for using a growth rate that exceeds the
long-term average growth rate; and
- the discount rate applied to cash flow projections;
x where the recoverable amount is based on fair value less costs of disposal, state that this
value has been measured using a quoted price for an identical unit (or group of units),
unless this is not the basis, in which case disclose:
- each key measurement assumption on which management has estimated the fair value
less costs of disposal;
- a description of how management measured the values assigned to each key assumption,
whether those values reflect past experience and external sources of information, and if not,
why and how they differ from past experience or external sources of information;
Chapter 11 589
- the level of fair value hierarchy (see IFRS 13), ignoring observability of disposal costs;
- if there have been changes to the valuation techniques the reason(s) for these changes;
- if the fair value less costs of disposal has been measured using cash flow projections,
the following must also be disclosed:
- The period over which the projected cash flows have been estimated;
- The growth rate used to extrapolate the cash flows over this period; and
- The discount rate used. See IAS 36.134
If a cash-generating unit has goodwill or an intangible asset with an indefinite useful life and
the portion of the carrying amount of goodwill or intangible asset allocated to the unit is
insignificant compared to the total carrying amount of goodwill or intangible assets with
indefinite useful lives of the entity, this shall be disclosed, with the aggregate carrying amount
of goodwill or intangible assets with indefinite useful life allocated to those units. See IAS 35.135
If the recoverable amount of any of those units is based on the same key assumptions, and the aggregate
carrying amount of goodwill and intangible assets with an indefinite useful life allocated to those units
based on same key assumptions is significant compared with the entity’s total carrying amount of
goodwill or intangible assets with an indefinite useful life, this fact shall be disclosed, together with:
x the aggregated carrying amount of goodwill or intangible assets with indefinite useful
lives or allocated to those units;
x the key assumptions
x a description of how management measured the values assigned to each key assumption,
whether those values reflect past experience or external sources of information or both,
and if not, why and how they differ. See IAS 36.135
Whether allocated goodwill or intangible assets with indefinite lives is significant/insignificant, if a key
assumption that was used in determining the recoverable amount might reasonably be expected to
change such that the recoverable amount could decrease below the carrying amount, then disclose:
x the amount by which the recoverable amount currently exceeds the carrying amount;
x the value assigned to the key assumption;
x the amount by which this value would have to change in order for the recoverable amount
to equal the carrying amount. See IAS 36.134(f) & .135(e)
590 Chapter 11
9. Summary
Indicator Review
Should occur annually, with the purpose of identifying

impairments
External information Internal information

x Significant decrease in value x Obsolescence
x Significant adverse current/ future changes in x Physical damage
the market in which the asset is used x Adverse current/ future changes in usage of the
x Increase in market interest rates (decreases asset
value in use) x Actual profits/ cash flows worse than budgeted
x Carrying amount of business net assets > market x Net cash outflows or losses become apparent when
capitalisation etc looking at figures in aggregate (e.g. past + current;
current + future; past + current + future)
Impairment of Assets
If the 'indicator review' identifies a potential impairment,

OR the asset is an IA not yet available for use/IA with
indef. UL/goodwill, calculate the:
carrying amount (CA) and recoverable amount (RA);
If the CA>RA = impairment
Carrying amount Recoverable amount Impairment loss

Per statement of financial Greater of: ACA – RA:
position: x value in use or x first debit RS: ACA>HCA
x cost or fair value x fair value less costs of disposal x then debit IL: HCA>RA
x less ‘accumulated
Calculated if:
depreciation and
x indicator review suggests
impairment losses’
material impairment
x intangible asset that:
- has indefinite useful life
- is not available for use
- is goodwill
Fair value less costs of disposal Value in use

x The price that would be received to sell an The present value of estimated future cash
asset (or paid to transfer a liability) flows(pre-tax) from:
x in an orderly transaction x Use and
x Disposal at end of useful life
x between market participants
x at the measurement date Exclude the following cash flows:
x Less Disposal costs (excluding termination x financing
benefits (IAS 19), finance costs and income x tax
tax expense and restructuring costs) x outflows in respect of obligations already
recognised as liabilities
x that relate to enhancements/restructurings the
entity is not yet committed to
Chapter 11 591
Value in use
Estimated future cash flows Appropriate discount rate

Use cash flows based on managements’ best x Pre-tax
estimated projections: x Market-related risk-free rate
x Short-term projections (less than 5 yrs): x Adjusted for risks specific to the asset
approved budgets only
x Long-term projections (beyond 5 years):
extrapolate the approved budget using a Foreign cash flows
justifiable growth rate (generally stable/ x Discount using rate appropriate to that
declining growth rate below long-term average) currency; then translate at spot rate
Recognition of adjustments
Impairment loss Reversal of impairment loss

If cost model used: If cost model used:
Debit: Debit:
Impairment loss (expense: P/L) Asset: accumulated impairment losses
Credit: Credit:
Asset: accumulated impairment losses Reversal of impairment loss (income: P/L)
Limit to 'Depreciated Cost' (Cost – AD) (i.e. HCA)
or or
If revaluation model used: If revaluation model used:

Decreasing CA to HCA (i.e. there was a reval surplus) Increasing CA up to HCA:
Debit: Debit:
Revaluation surplus (to the extent of the balance Asset: accumulated impairment losses
therein) (OCI) Credit:
Credit: Reversal of impairment loss (income: P/L)
Asset: accumulated impairment losses
Increasing CA above HCA:
Decreasing CA below HCA: Debit:
(e.g. if there was no RS bal or the RS bal has now Asset: accumulated impairment losses
been reduced to nil because of the jnl above) Credit:
Debit: Revaluation surplus (OCI)
Impairment loss (expense: P/L) * Limit to 'Depreciated FV' (FV – AD)*
Credit:
Asset: accumulated impairment losses
*When reducing the CA to RA under the RM, be *An increase above 'Depreciated FV' is possible
careful: Because, when using the RM, the CA should but it would not be an impairment reversal. This
already reflect the FV, we should only ever debit an would be a revaluation increase, so although the jnl
impairment loss expense if the costs of disposal are would still involve a credit to 'Revaluation surplus',
'not negligible'. If CA has not yet been adjusted to the debit would be to 'Asset: cost' (not 'Asset:
reflect FV, we must first reduce the CA to FV by accumulated impairment losses').
debiting a revaluation surplus / revaluation expense
before recognising any further decrease as an
impairment loss expense. See IAS 36.5
Depreciation thereafter: Depreciation thereafter:

A new depreciable amount is calculated (after A new depreciable amount is calculated (after
deducting the accumulated impairment loss). deducting the accumulated impairment loss, if any).
This must be depreciated over the remaining useful This must be depreciated over the remaining useful
life of the asset. life of the asset
592 Chapter 11
Impairment testing of CGUs

A CGU is defined as
x The smallest identifiable group of assets
x That generates cash inflows that are
x Largely independent of the cash inflows from other assets/
groups of assets IAS 36.6
x Decision to scrap asset: remove from CGU: VIU = FV-CoD
Impairments Impairment reversals

x Calc the RA of the CGU (only the As in the CGU x Calc the RA of the CGU (only the As in the
should be taken into account unless the RA of CGU should be taken into account unless the
the CGU cannot be measured without taking RA of the CGU cannot be measured without
the liabilities into account) taking the liabilities into account)
x Calc the CA of the CGU x Calc the CA of the CGU
x If the CA > RA = Imp loss x If the CA < RA = Imp loss Reversal
x The imp loss is allocated as follows: x The imp loss reversal is allocated as follows
First to GW Never to GW
Then to each A in the CGU based on their Then to each A in the CGU based on their
relative CAs within the CGU (ie pro-rata) relative CAs within the CGU (ie pro-rata)
But make sure the CA of each A in the CGU But make sure the CA of each CA in the CGU
does not drop below the greater of: does not increase above:
FV-CoD If CM used: its depreciated cost
VIU If RM used: its depreciated fair value
Zero x Excess IL reversal is allocated in a 2nd/3rd …
x Excess IL is allocated in a 2nd/3rd … round round
x Journals processed for each A in the CGU: x Journals processed for each A in the CGU:
Follow the normal approach (see prior page) Follow the normal approach (see prior page)
e normal approach (see prior page)
Corporate Assets
See IAS 36.6
A corporate asset is defined as:
x assets other than goodwill
x that contribute to the future cash flows of more than 1 CGU
Allocated to CGU(s) on reasonable basis Not allocated

x Impairment test: compare ACA of CGU (incl. x Step 1: test individual CGUs for impairment
portion of allocated corporate asset) to RA x Step 2: test group of CGUs to which corporate
assets can be allocated for impairment
x Step 3: test bigger group of CGUs, until
corporate assets have been fully included.
ACA = actual carrying amount HCA = historical carrying amount RA = recoverable amount
RS = revaluation surplus IL = impairment loss
Chapter 11 593
Gripping GAAP Non-current assets held for sale and discontinued operations
Chapter 12
Non-current Assets Held for Sale and Discontinued Operations
Main reference: IFRS 5 (including any amendments to 10 December 2018)
CHAPTER SPLIT:
This chapter covers IFRS 5, which is the standard that explains the topics of:
x Non-current assets held for sale - a term that refers to both:
- individual assets held for sale, which we will refer to as NCAHFS, and
- disposal groups held for sale, which we will refer to as DGHFS; and also
x Discontinued operations (DO).
Although the concepts in the first topic do have a bearing on the second topic, these topics can be studied separately.
Thus, the chapter is separated into these two separate topics as follows:
PARTS: Page
PART A: Non-current assets held for sale 596
PART B: Discontinued operations 648
PART A:
Non-Current Assets Held for Sale
Contents: Page
A: 1 Overview 596
A: 2 Scope 597
A: 2.1 Non-current assets held for sale: scoped-out non-current assets 597
A: 2.2 Disposal groups held for sale: scoped-out items 598
A: 3 Classification: as ‘held for sale’ or ‘held for distribution’ 598
A: 3.1 What happens if something is classified as HFS or HFD? 598
A: 3.2 The classification criteria in general 598
A: 3.2.1 Overview 598
A: 3.2.2 Classification as held for sale 599
A: 3.2.2.1 The core criterion 599
A: 3.2.2.2 The further supporting criteria 599
A: 3.2.2.3 Meeting the criteria 600
A: 3.2.2.4 An intention to sell may be an indication of a possible impairment 600
A: 3.2.3 Classification as held for distribution 600
A: 3.2.4 Comparison of the classification as held for sale and held for distribution 601
A: 3.3 Criteria when a completed sale is expected within one year 601
A: 3.4 Criteria when a completed sale is not expected within one year 602
A: 3.5 Criteria when an NCA or DG is acquired with the intention to sell 603
A: 4 Measurement: individual non-current assets held for sale 603
A: 4.1 Overview 603
A: 4.2 Measurement if the sale is expected within one year 604
A: 4.3 Measurement when the NCA is not expected to be sold within one year 605
A: 4.4 Measurement when the NCA is acquired with the intention to sell 605
A: 4.5 Initial and subsequent measurement of a NCAHFS or NCAHFD 605
A: 4.5.1 Initial measurement (on the date of classification) 605
A: 4.5.2 Subsequent measurement (after the date of classification as held for sale) 606
A: 4.6 Measurement principles specific to the cost model 607
A: 4.6.1 The basic principles when the cost model was used 607
Example 1: Measurement on date classified as HFS (previously: 607
cost model)
Example 2: Re-measurement after classified as HFS: impairment loss 609
reversal limited
Example 3: Measurement on date classified as a NCAHFS and re- 611
measurement of NCAHFS: reversal of impairment loss
limitation (previously: cost model)
A: 4.6.2 The tax effect when the cost model was used 614
Example 4: Tax effects of classification as NCAHFS and the cost model 615
594 Chapter 12
A: 4.7 Measurement principles specific to the revaluation model 616

A: 4.7.1 The basic principles when the revaluation model was used 616
Example 5: Measurement on date classified as HFS (was revaluation model) 616
Example 6: Re-measurement of a NCAHFS (was revaluation model): 618
further impairments and reversals of impairments
Example 7: Re-measurement of a NCAHFS (was revaluation model): 621
prior revaluation expenses may not be reversed
A: 4.7.2 The tax effect when the revaluation model was used 623
Example 8: Tax effect of reclassification and the revaluation model 623
A: 4.8 Measurement implications of a change to a plan to sell / distribute 627
A: 4.8.2 If a NCAHFS subsequently fails to meet the HFS or HFD classification criteria 627
A: 4.8.3 If a NCAHFS subsequently becomes a NCAHFD, or vice versa 627
Example 9: Re-measurement of assets no longer classified as ‘held for sale’ 628
A: 4.9 Measurement involving ‘scoped-out non-current assets’ 628
Example 10: Asset falling outside the measurement scope of IFRS 5 629
A: 5 Disposal groups held for sale 629
A: 5.1 Overview of disposal groups 629
A: 5.2 Identification of disposal groups 630
A: 5.3 Classification, presentation and disclosure of disposal groups held for sale or distribution 630
A: 5.4 Measurement of disposal groups in general 630
A: 5.4.1 Initial measurement of disposal groups 631
Example 11: Disposal group held for sale – impairment allocation 632
Example 12: Disposal group held for sale – initial impairment 633
A: 5.4.2 Subsequent measurement of a disposal group 635
Example 13: Disposal group held for sale – subsequent impairment 636
Example 14: Disposal group held for sale – subsequent impairment reversal 637
A: 5.5 Measurement of disposal groups that are not expected to be sold within one year 639
A: 5.6 Measurement of disposal groups acquired with the intention to sell 639
A: 5.7 Measurement of disposal groups when there is a change to the plan to sell or distribute 640
A: 5.7.2 If a DG subsequently fails to meet the HFS or HFD classification criteria 640
A: 5.7.3 If a DGHFS subsequently becomes a DGHFD, or vice versa 641
A: 6 Presentation and disclosure: non-current assets (or disposal groups) held for sale or distribution 641
A: 6.1 Overview 641
A: 6.2 In the statement of financial position 642
A: 6.3 In the statement of financial position or notes thereto 642
A: 6.4 In the statement of other comprehensive income and statement of changes in equity 642
A: 6.5 Comparative figures 642
A: 6.6 Other note disclosure 642
A: 6.6.1 General note 642
A: 6.6.2 Change to a plan of sale 642
A: 6.6.3 Events after the reporting period 643
Example 15: Disclosure of non-current assets held for sale 643
A: 7 Summary 645
PART B:
Discontinued Operations
B: 1 Introduction to discontinued operations 648
B: 2 Identification of a discontinued operation 648
B: 3 Measurement of a discontinued operation 649
B: 4 Disclosure of a discontinued operation 649
B: 4.1 Profit or loss from discontinued operation 649
B: 4.2 Cash flows relating to a discontinued operation 651
B: 4.3 Comparative figures 651
B: 4.4 Changes in estimates 651
B: 4.5 Other note disclosure 651
B: 4.5.1 Components no longer held for sale 651
B: 4.5.2 If the discontinued operation also meets the definition of ‘held for sale’ 652
B: 5 Summary 652
Chapter 12 595
INTRODUCTION
This standard (IFRS 5 Non-current assets held for sale and discontinued operations) covers both
non-current assets held for sale (NCAHFS) and discontinued operations (DO):
x Non-current assets held for sale will be explained in this part: Part A.
x Discontinued operations are explained in Part B.
PART A:
Non-current Assets Held for Sale
A: 1 Overview
Although half of the title of IFRS 5 refers to non-current Part A explains how to
assets held for sale, this term actually refers to: classify, measure, present
x individual ‘non-current assets held for sale’ and disclose:
(NCAHFS); and x Individual assets held for sale
(NCAHFS); and
x a group of items held for sale, where this group
x Disposal groups (groups of assets)
sometimes includes not only non-current assets but held for sale (DGHFS).
also current assets and directly related liabilities,
referred to as a ‘disposal group held for sale’ (DGHFS); and
x individual ‘non-current assets held for distribution to owners’ or ‘disposal groups held for
distribution to owners’ (as opposed to being held for sale) (NCAHFD and DGHFD).
This can possibly be better understood by looking at the following diagrammatic summary:
The term ‘non-current assets held for sale’ actually refers to:
Individual non-current assets: Disposal groups:

x held for sale (NCAHFS) x held for sale (DGHFS)
x held for distribution (NCAHFD) x held for distribution (DGHFD)
We will first look at how to account for an individual non-current asset that is held for sale
(NCAHFS) and then how to account for a disposal group that is held for sale (DGHFS).
The method of accounting for an individual non-current asset held for sale applies almost 100%
to an individual non-current asset that is held for
distribution instead. Similarly, the method of accounting Important definitions:
for a disposal group held for sale applies almost 100% to
a disposal group that is held for distribution instead. A non-current asset (NCA) is
defined as:
IFRS 5 App A
x an asset that is not a CA.
For this reason, we will not discuss individual non-current
assets or disposal groups held for sale and held for A current asset (CA) is defined:
distribution separately. Instead, you may assume that x in IAS 1 (please see IAS 1/ chp 3)
See IFRS 5 Appendix A
wherever this chapter refers to something as being held for
sale, that the principles will apply equally if it were held A disposal group (DG) is defined as:
for distribution – unless stated otherwise. x a group of assets
x to be disposed of, by sale or
When we talk about how to account for items that are held otherwise,
for sale (or held for distribution), we are talking about x together as a group in a single
transaction,
their:
x and liabilities directly associated with
x Classification; those assets that will be transferred
x Measurement; in the transaction. See IFRS 5 Appendix A
x Presentation; and
x Disclosure.
596 Chapter 12
Classification refers to the process involved in deciding whether or not an item should be
classified as held for sale (and also whether or not an item should be held for distribution). The
process of classification as held for sale (or for distribution) is the same whether we are looking
at an individual non-current asset or a disposal group. The process of classifying as held for
sale differs very slightly from the process of classifying as held for distribution.
The measurement of items held for sale (or for distribution) follow the basic principle that the
item must be measured at the lower of carrying amount and fair value less costs to sell. The
measurement of items held for distribution follow a similar basic principle that the item must be
measured at the lower of carrying amount and fair value less costs to distribute.
Certain non-current assets that are held for sale (or held for distribution) are not affected by the
measurement requirements stipulated in IFRS 5. I refer to these non-current assets as ‘scoped-
out non-current assets’. These are listed in section A: 2.
Although the basic measurement principles mentioned above are always the same, there are
further complexities when the item being measured is a disposal group rather than an individual
non-current asset. This is because a disposal group could include:
x a variety of assets (current and non-current, some of which may be scoped out) as well as
x directly related liabilities.
Measurement of disposal groups held for sale (or held for distribution) is thus made more
complex because the measurement requirements of IFRS 5 only apply to certain non-current
assets – they do not apply to current assets, scoped-out non-current assets or liabilities. Due to
this extra complexity, the measurement of individual non-current assets held for sale (or held
for distribution) will be explained separately from the measurement of disposal groups held for
sale (or held for distribution):
x measurement of individual non-current assets held for sale/ distribution: section A: 4;
x measurement of disposal groups held for sale/ distribution: section A: 5.
The presentation and disclosure requirements for items that are classified as held for sale are the
same as those for items that are classified as held for distribution – and these requirements are
the same whether we are dealing with an individual non-current asset or a disposal group.
The rest of Part A of this chapter is laid out as follows:
x Section A: 2 explains what assets are scoped out of IFRS 5 and what this means;
x Section A: 3 explains how to classify NCAs & DGs as held for sale or held for distribution;
x Section A: 4 explains how we measure individual NCAs held for sale/ held for distribution;
x Section A: 5 explains how we measure DGs held for sale/ held for distribution;
x Section A: 6 explains how to present and disclose NCAs & DGs held for sale/ distribution.
A: 2 Scope (IFRS 5.2 - .5)
A: 2.1 Non-current assets held for sale: scoped-out non-current assets (IFRS 5.5)
The IFRS 5 measurement requirements do not apply to the The IFRS 5 measurement
following non-current assets: requirements do not
apply to the following
x Financial assets within the scope of IFRS 9 NCAs (scoped-out NCAs):
(IFRS 9 Financial instruments)
x Financial assets covered by IFRS 9
x Investment property measured under the fair value x Investment property measured under
model (IAS 40 Investment property) the fair value model (IAS 40)
x Agricultural non-current assets
x Agricultural non-current assets measured at fair value measured at fair value less costs to
less costs to sell (IAS 41 Agriculture) sell (IAS 41)
x Assets for which FV may be difficult
x Assets for which fair values may be difficult to to determine (e.g. DT assets) See IFRS
5.5
determine:
- Deferred tax assets (IAS 12 Income taxes)
- Assets relating to employee benefits (IAS 19 Employee benefits)
- Contractual rights under insurance contracts (IFRS 4 Insurance contracts). See IFRS 5.5
Chapter 12 597
Please note that these non-current assets are scoped-out only from the measurement requirements
of IFRS 5. Thus, if these assets are considered to be non-current assets held for sale, they would
still be subject to the classification, presentation and disclosure requirements of IFRS 5. See IFRS 5.2
A: 2.2 Disposal groups held for sale: scoped-out items
Disposal groups are simply groups of assets, or sometimes The IFRS 5 measurement
groups of assets and related liabilities, that are to be requirements do not apply
disposed of in a single transaction. Thus, it is important to to (scoped-out items):
realise that a disposal group may actually not contain any x Scoped-out non-current assets
non-current assets. However, as its name suggests, IFRS x Current assets
5 will not apply to a disposal group that does not contain x Liabilities.
any non-current assets.
Conversely, if a disposal group contains a mixture of items (e.g. it contains non-current assets
and/ or current assets and possibly even related liabilities), then IFRS 5 will apply to this disposal
group if it contains just one non-current asset. However, although IFRS 5 would then apply to
this disposal group, we must remember that IFRS 5’s measurement requirements do not apply
to all non-current assets – some non-current assets are scoped out from the IFRS 5 measurement
requirements.
Apart from the specific non-current assets that are scoped out from IFRS 5’s measurement
requirements (see section A: 2.1), all current assets and all liabilities are also scoped-out from
IFRS 5’s measurement requirements.
Please notice that these items (scoped-out non-current assets, all current assets and all liabilities)
are scoped-out only from the measurement requirements of IFRS 5. This means that if a disposal
group held for sale (or distribution) includes any of these items, the measurement requirements
would not apply to these specific items ... but all items in the disposal group would still be subject
to the classification, presentation and disclosure requirements of IFRS 5.
A: 3 Classification as ‘Held for Sale’ or ‘Held for Distribution’ (IFRS 5.6 - .14)
A: 3.1 What happens if something is classified as HFS or HFD? (IFRS 5.6 - .14)
If a non-current asset (NCA) or disposal group (DG) meets the criteria to be classified as ‘held
for sale’ (HFS) or ‘held for distribution’ (HFD), this individual NCA or DG must be:
x measured in terms of IFRS 5 (unless it is a ‘scoped-out asset’ – see section 2);
x separately presented in the statement of financial position as ‘held for sale’ and presented
under ‘current assets’ (i.e. a machine that is held for sale will no longer be presented as part
of property, plant and equipment); and
x disclosed in the notes to the financial statements.
A: 3.2 The classification criteria in general (IFRS 5.6 - .14)
A: 3.2.1 Overview
When to classify a non-current asset (NCA) or disposal group (DG) as held for sale depends on
whether certain criteria are met. Similarly, when to classify a non-current asset (NCA) or
disposal group (DG) as held for distribution depends on whether certain criteria are met.
The criteria relating to classification as held for sale and classification as held for distribution
differ (though they are very similar) and thus we will discuss each separately. At the end of this
discussion, you will find a summary that compares these two set of criteria.
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A: 3.2.2 Classification as held for sale
A: 3.2.2.1 The core criterion A NCA/ DG is classified as

HFS when we expect that:
The core criteria driving the classification of a non- x its carrying amount
current asset (NCA) or disposal group (DG) as ‘held for x will be recovered principally through
sale’ is that it may only be classified as held for sale when x a sale transaction rather than
most of its carrying amount is expected to be recovered through continuing use. IFRS 5.6
through the inflows from the sale of the NCA or DG rather P.S. There are more criteria to be met
than from the use thereof. See IFRS 5.6 before we can say we expect the CA to
be recovered mainly through sale.
If we look at this classification requirement carefully, we can see a non-current asset (NCA) or
disposal group (DG) may continue to be used by the entity and yet still be classified as ‘held for
sale’. The important issue is whether the inflows from the sale of the asset are greater than from
the use of the asset: if the inflows from the sale of the asset are greater, then the asset is classified
as held for sale.
If we look at this classification requirement again, we can also see that a non-current asset
(NCA) or disposal group (DG) that is to be abandoned could not possibly be classified as ‘held
for sale’ because an abandonment means no sale and thus none of its carrying amount would be
recovered through a sale.
Abandoned assets can never
Abandonment means just that – the non-current asset be classified as HFS because:
(NCA) or disposal group (DG) will be discarded,
dumped, ditched, discontinued – there is no future sale x Its carrying amount is recovered
involved. Its carrying amount will therefore be recovered principally through continuing use.
See IFRS 5.13
through future use (until date of abandonment) after
which it will not be sold but will be thrown away instead. See IFRS 5.13
Non-current assets (NCAs) or disposal groups (DGs) to be abandoned include:

x non-current assets (or DGs) that are to be used to the end of their economic life; and
x non-current assets (or DGs) that are to be closed rather than sold.
Please note that assets that have been permanently taken out of use and for which there is no
plan to sell (e.g. the entity plans to drop the asset off at the local dump) would be considered to
be abandoned. Assets that have simply been temporarily taken out of use are not accounted for
as abandoned assets. See IFRS 5.14
A: 3.2.2.2 The further supporting criteria The CA of the NCA/DG will

be said to be recovered
Now, look at the core criterion again (see above). Before mainly through a sale
we may conclude that the carrying amount of the NCA or transaction if:
DG is expected to be recovered mainly through the sale x it is available for immediate sale
rather than through the use thereof, the following two - in its present condition
criteria must also be met: - subject only to terms that are usual
and customary for sales of such
x the asset must be available for sale immediately, in its NCAs (or DGs) and
present condition and based on terms that are x its sale must be highly probable.
considered to be normal, and IFRS 5.7
x the sale must highly probable of occurring. See IFRS 5.7
To prove that the sale is highly probable, a further set of criteria must be met:
x the appropriate level of management must be committed to the plan to sell;
x an active programme to try and sell the asset has begun;
x it must be actively marketed at a selling price that is reasonable relative to its fair value;
x the sale is expected to be complete within one year from date of classification as held for
sale (unless the situation facing the entity allows an exception to this rule: see
section A: 3.4); and
x the remaining actions needed to complete the sale must suggest that the plan to sell will
not need to be withdrawn or significantly changed. See IFRS 5.8
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A: 3.2.2.3 Meeting the criteria
It is quite difficult to meet all these criteria and thus a non-current asset (NCA) or disposal group
(DG) that is intended to be sold will often fail to be classified as ‘held for sale’.
However, if all these criteria are met before reporting date, the non-current asset (NCA) or
disposal group (DG) must be classified as ‘held for sale’ in those financial statements.
If these criteria are met, but only after the reporting period (i.e. after the financial year has ended)
but before the financial statements are issued, the non-current asset (NCA) or disposal group
(DG) is not classified as ‘held for sale’ in that set of financial statements, but certain disclosures
are still required. This is covered in the section on disclosure. See IFRS 5.12
A more thorough discussion of all these criteria outlined above appears in section A: 3.3.
One of the criteria when proving that a sale is highly probable of occurring is that the sale must
be expected to be completed within one year from date of classification. However, an asset
whose sale is not expected to be completed within a year could still be classified as held for sale
if further specified criteria are met. This is discussed in section A: 3.4.
Yet a further variation to the criteria that need to be met arises when a non-current asset is
acquired with the sole intention of being sold. This is discussed in section A: 3.5.
A: 3.2.2.4 An intention to sell may be an indication of a possible impairment
If there is an intention to sell an asset – even if it is not

The mere intention to sell
classified as such – we must bear in mind that the mere a NCA or DG may be
intention to sell the non-current asset may be an indication considered to be:
of a possible impairment. x an indication of a possible impairment
If the intention to sell is considered to be an indication of a possible impairment, we would be

required to calculate the recoverable amount. See IAS 36.9
If the recoverable amount is calculated and found to be less than the carrying amount, an
impairment loss would need to be recognised.
A: 3.2.3 Classification as held for distribution (IFRS 5.12A)
A non-current asset (NCA) or disposal group (DG) may

A NCA/ DG is classified as
only be classified as ‘held for distribution’ if we can
HFD when:
confirm that the entity is committed to the distribution
thereof to the owners of the entity. x the entity is committed
x to distribute the NCA/DG
x to the owners. IFRS 5.12A (slightly reworded)
We can only confirm that the entity is committed to the
P.S. There are more criteria to be met
distribution of the NCA or DG if: before we can say the entity is
x it is ‘already available for immediate distribution’ in committed to the distribution.
its present condition and that
x it is highly probable that the distribution will occur.
A distribution is highly probable if: The entity is committed to

x Actions taken to complete the distribution have begun; the distribution if the:
and x NCA/DG is available for immediate
x Remaining actions to complete the distribution: distribution in its present condition;
are expected to be completed within a year of the x and the distribution is highly probable.
classification as held for distribution; and IFRS 5.12A (slightly reworded)
should suggest that it is unlikely that:

- the distribution will be withdrawn, or that
- there will be any significant changes to the distribution.
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A: 3.2.4 Comparison of the classification as held for sale and held for distribution
The following diagrammatic summary may be helpful in seeing how the process of classifying a non-
current asset or disposal group as held for sale differs from classifying it as held for distribution.
Classification
See IFRS 5.6-.7 See IFRS 5.12A

Held for sale: Held for distribution:
A NCA/DG is classified as HFS if its CA will be A NCA/DG is classified as HFD if the entity is
recovered mainly through a sale of the asset committed to distributing it to the owners.
rather than through continuing use of the asset.
We prove the above if these criteria are met: We prove the above if these criteria are met:
x the asset is available for immediate sale (in x the asset is available for immediate
its present condition and at normal terms); & distribution (in its present condition); &
x the sale thereof is highly probable. x the distribution thereof is highly probable.
See IFRS 5.8 See IFRS 5.12A

Highly probable sale: Highly probable distribution:
A sale is highly probable if: A distribution is highly probable if:
x appropriate level of management is committed x actions to complete the distribution have begun
to a plan to sell; x the distribution is expected to be concluded
x an active programme to sell has begun; within 1 yr of the date of classification as HFD
x it must be actively marketed at a reasonable x actions required to complete the distribution
price relative to its FV; should suggest that it is unlikely that:
x the sale is expected to be concluded within 1 yr - significant changes to the distribution will be
of date of classification as HFS (unless longer made; or that
period is permitted in terms of IFRS 5.9) - the distribution will be withdrawn
x actions required to complete the sale should
suggest that it is unlikely that:
- significant changes to the plan to sell will be
made; or that
- the plan to sell will be withdrawn.
A: 3.3 Criteria when a completed sale is expected within one year (IFRS 5.6- .8)
For a non-current asset (NCA) or disposal group (DG) to To prove that a CA will be
be classified as ‘held for sale’ the carrying amount of the recovered mainly via a
asset is to be recovered mainly through a sale transaction sale, ALL the following
than through continuing use. See IFRS 5.6 criteria must be met:
x the NCA is immediately available for
sale in its present condition and on
In order to prove this, we must meet all of the following normal terms:
criteria listed in IFRS 5: See IFRS 5.7 - .8 - Mgmt must have intention & ability
to complete this sale
x The non-current asset (NCA) or disposal group (DG) x The sale must be highly probable:
must be available for immediate sale: - Must be commitment to the sale
from appropriate level of mgmt,
- in its present condition - Active programme to find a buyer &
- subject only to terms that are usual and complete the sale must’ve begun,
- Sale expected within 1 year of
customary for sales of such asset. IFRS 5.7 classification,
- Selling price reasonable compared
For an asset to be available for immediate sale, the to its FV, and
entity must currently have both the intention and -
Unlikely to be significant changes
ability to transfer the NCA (or DG) to a buyer in its made to the plan of sale See IFRS 5.7 & .8
present condition.
For example, an entity intending to sell its factory where any outstanding customer orders
would be transferred to and completed by the buyer would meet this criterion, but an entity
intending to sell its factory only after completing any outstanding customer orders first
would not meet this criteria (since the delay in timing of the sale of the factory, which is
imposed by the seller, means that the factory is not available for immediate sale in its present
condition). See IFRS 5: Implementation Guidance: Example 2
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x The sale must be highly probable: IFRS 5.7 Highly probable is

For the sale to be considered highly probable, there are five defined as:
sub-criteria to be met: x significantly more likely than
x probable. IFRS 5 App A
- The appropriate level of management must have
committed itself to a sales plan: Probable is defined as:
Management, with the necessary authority to approve more likely than not IFRS 5 App A
the action, must have committed itself to a plan to sell:
this often requires the board of directors to have committed themselves to the plan, but
on occasion, further approval must also be sought, for example shareholder approval
may also be required before it can be said that there is an appropriate level of
commitment to the plan;
- An active programme must have begun to find a buyer and complete the sale:
This simply means that the asset (or DG) must be actively marketed;
- The sale must be expected to happen within one year:
The sale must be expected to qualify for recognition as a completed sale within one year
from the date of classification as ‘held for sale’, (periods longer than one year are
allowed under certain circumstances: these are discussed below);
- The selling price must be reasonable in relation to its current fair value; and
- It must be unlikely that significant changes to the plan will be made:
The actions required to complete the plan must indicate that it is unlikely that significant
changes to the plan will be made or that the plan will be withdrawn.
If all the criteria above are met before reporting date, the non-current asset (or DG) must be
separately classified as a ‘non-current asset held for sale’.
If the entity is committed to a plan that involves the loss of control of a subsidiary and if the
above criteria are met, all the subsidiary’s assets and liabilities must be classified as held for sale,
regardless of whether we retain a non-controlling interest in it. IFRS 5.8A (reworded)
A: 3.4 Criteria when a completed sale is not expected within one year (IFRS 5.9 & App B)
On occasion, an asset may be classified as ‘held for sale’ A NCA/ DG may still be
even though the sale may not be completed and recognised classified as HFS even if
as a sale within one year. This happens when: the sale is not expected
x the delay is caused by events or circumstances beyond within 1 year on condition that:
the entity’s control; and x the delay is beyond the entity’s
control; and
x there is sufficient evidence that the entity remains
x there is sufficient evidence that the
committed to its plan to sell the asset. entity is still committed to the sale.
Certain extra criteria must be met
There are three different scenarios that IFRS 5 identifies depending on the scenario.
as possibly leading to a sale taking longer than one year. See IFRS 5.9 & IFRS 5 App B
For each of these scenarios, certain additional criteria need

to be met for the one-year requirement to fall away. See IFRS 5 App B
Scenario 1: The entity initially commits to selling a non- A firm purchase

current asset (or disposal group), but it has a reasonable commitment is defined as:
expectation that someone other than the buyer will impose x an agreement with an unrelated
conditions that will delay the completion of the sale. party,
x binding on both parties and usually
In this scenario, the NCA (or DG) must be classified as legally enforceable, that:
held for sale if: - specifies all significant terms,
(incl. the price and timing); and
x the entity is unable to respond to these expected - includes a disincentive for non-
conditions until a firm purchase commitment is performance that is large enough
actually obtained, and that performance is highly
probable. IFRS 5 Appendix A (reworded)
x a firm purchase commitment is highly probable within
one year.
602 Chapter 12
Scenario 2: On the date that an entity obtains a firm purchase commitment, someone
unexpectedly imposes conditions that will delay the completion of the sale of the non-current
asset (or disposal group) that was previously classified as held for sale. In this scenario, the
NCA (or DG) must continue to be classified as held for sale if:
x the entity has timeously taken the necessary actions to respond to the conditions, and
x the entity expects that the delaying conditions will be favourably resolved.
Scenario 3: A non-current asset (or disposal group) that was initially expected to be sold within
one year remains unsold at the end of this one-year period due to unexpected circumstances that
arose during the one-year period. In this scenario, the NCA (or DG) must continue to be
classified as held for sale if:
x the entity took the necessary actions during that year to respond to the change in
circumstances,
x the entity is actively marketing the non-current asset (or disposal group) at a reasonable price
bearing in mind the change in circumstances, and
x the criteria in paragraph 7 (i.e. the asset must be available for immediate sale and the sale
must be highly probable) and paragraph 8 (i.e. the criteria for the sale to be highly probable)
are met.
A: 3.5 Criteria when an NCA or DG is acquired with the intention to sell (IFRS 5.11)
It may happen that an entity acquires a non-current asset

A NCA/ DG acquired with
(or disposal group) exclusively with the view to its the intention to sell must
subsequent disposal. In this case, the non-current asset be classified as HFS if:
must be classified as ‘held for sale’ immediately on x the sale is expected within 1 yr; and
acquisition date if: x any criteria in para 7 & para 8 that
x the one-year requirement is met (unless a longer aren’t met on date of acquisition will
be met within a short period (+-3m).
period is allowed by paragraph 9 and the related See IFRS 5.11
appendix B – see section A: 3.4 above); and

x it is highly probable that any criteria in paragraphs 7 and 8 that are not met on date of
acquisition, are expected to be met within a short period (usually three months) after
acquisition.
A: 4 Measurement: Individual Non-Current Assets Held for Sale (IFRS 5.15 - .25)
A: 4.1 Overview
Assets classified as HFS or
HFD will be measured as
There are two phases to the life of an individual non- follows:
current asset (NCA) that is classified as held for sale x before classification:
(HFS) or held for distribution (HFD): - measured in terms of its previous
standard;
x before the date of classification (clearly irrelevant to
x from date of classification:
newly acquired assets) when it is measured in terms of measured in terms of IFRS 5:
its previous relevant standard (e.g. IAS 16); and - initial measurement
x from the date of classification when it is measured in - subsequent measurement.
terms of IFRS 5.
Before the asset is classified as held for sale (or held for distribution), the NCA is simply
measured in terms of its previous relevant IFRS. For example, if the NCA was an item of
property, plant and equipment, the NCA would have been measured in terms of IAS 16 Property,
plant and equipment, which will mean that:
x on initial acquisition, the asset would have been recorded at cost; and
x subsequently, the asset would have been measured either under the:
- Cost model: depreciated and reviewed annually for impairments, or
- Revaluation model: depreciated, reviewed annually for impairments and revalued to fair
value on a regular basis.
Chapter 12 603
From the date that the NCA is classified as held for sale (or held for distribution) the measurement
principles in IFRS 5 must be followed. These measurement principles can be separated into:
x initial measurement; and
x subsequent measurement (depreciation and amortisation ceases).
Essentially, initial measurement of a NCA that is Fair value is defined as:

classified as held for sale (i.e. on the date that it is x the price that would be received to
classified as such) is at the lower of its: sell an asset (or paid to transfer a
x carrying amount (CA) and its liability)
x fair value less costs to sell (FV-CtS). See IFRS 5.15 x in an orderly transaction
x between market participants
x at the measurement date. IFRS 5 App A
Similarly, initial measurement of a NCA that is classified
as held for distribution (i.e. on the date that it is classified as such) is at the lower of its:
x carrying amount (CA) and its
x fair value less costs to distribute (FV-CtD). See IFRS 5.15A
The subsequent measurement of a NCA from the date that it is classified as held for sale or held
for distribution involves ceasing all depreciation and amortisation. See IFRS 5.25
Apart from the cessation of depreciation and amortisation, subsequent measurement of a NCA
held for sale (NCAHFS) involves remeasuring it on each subsequent reporting date to the lower
of its carrying amount (CA) and its latest fair value less costs to sell (FV-CtS). Similarly,
subsequent measurement of a NCA held for distribution (NCAHFD) involves remeasuring it on
each subsequent reporting date, to the lower of its carrying amount (CA) and its latest fair value
less costs to distribute (FV-CtD).
We will first explain the measurement principles in terms Costs to sell are defined
of the normal situation where the asset is expected to be as:
sold within one year.
x the incremental costs
After this we will look at how these principles may need x directly attributable to the
disposal of an asset (or disposal
to be modified if the asset held for sale is expected to be group),
sold after one year from date of classification or if the x excluding finance costs and
asset is acquired with the intention to sell. income tax expense. IFRS 5 Appendix A
Thereafter, we will look at the detailed steps involved in the initial measurement and subsequent
measurement of a non-current asset held for sale.
A: 4.2 Measurement if the sale is expected within one year (IFRS 5.15; .20 - .21 & .25)
Non-current assets (or disposal groups) that are classified as held for sale are measured on date
of classification and then on subsequent reporting dates at the lower of its:
x carrying amount (CA), and
x fair value less costs to sell (FV-CtS). See IFRS 5.15 Measurement of a NCAHFS:
x the lower of:

Assets that are held for sale are not depreciated (nor - carrying amount; and
amortised). This is because their carrying amount is - FV less costs to sell.
principally made up of the future income from the sale of x depreciation/ amortisation ceases.
See IFRS 5.15 & .25
the asset rather than the use thereof (note: depreciation is
a reflection of this usage). Since it is expected that usage will be relatively minimal, we cease
to recognise depreciation on the asset. See IFRS 5.25
When re-measuring a non-current asset held for sale after the date on which it has been classified
as held for sale, (i.e. if the asset had not yet been sold at year-end):
x further impairment losses may be recognised, but
x any impairment loss reversal would be limited to the cumulative impairment losses
recognised, both in terms of IFRS 5 and IAS 36 Impairment of assets. See IFRS 5.20 -21
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A: 4.3 Measurement when the NCA is not expected to be sold within one year (IFRS 5.17)
If, in the unusual instance a sale is expected beyond one year, If the sale is not
expected within 1 year:
it may be necessary (depending on materiality) to measure the
x the costs to sell may need to be
‘costs to sell’ at their present value. The gradual increase in the
present valued. See IFRS 5.17
present value due to the passage of time shall be recognised as
a financing cost in profit or loss. See IFRS 5.17
A: 4.4 Measurement when the NCA is acquired with the intention to sell (IFRS 5.16)
The measurement of NCAs that are acquired with the intention NCAs acquired with the
to sell follows the same measurement principles as described intention of being sold are
above, but with a slight modification. The modification is that, measured:
x using the same principles = lower of:
instead of recognising and measuring the asset as, for example, - carrying amount; and
an item of property, plant and equipment, and then - FV less costs to sell.
reclassifying and remeasuring it as a NCA held for sale, the x where the CA is what it would have
acquisition of the asset is immediately recognised and been if it wasn’t classified as HFS.
measured as a held for sale asset. Thus, generally, it will effectively be
measured at:
See IFRS 5.15 & .16
As a result, the NCA must be immediately measured on its x FV-CtS.
initial recognition at the lower of its:
x carrying amount had it not been classified as held for sale (e.g. its cost), and
x fair value less costs to sell. IFRS 5.16 (slightly reworded)
In other words, in the case of a NCA that is acquired with the sole purpose of selling it, it will not
be initially recognised and measured at cost and then reclassified to held for sale and remeasured
at fair value less costs to sell. Instead, it will immediately be recognised as a held for sale asset
and will thus be immediately measured at the lower of what its carrying amount would have been
on this date if it had not been classified as held for sale and its fair value less costs to sell.
Since the asset’s purchase cost is typically equal to its fair value on date of purchase, it means that,
if the asset is acquired with the intention of selling it, this asset will effectively be measured at fair
value less costs to sell – it would not be initially measured at cost as is normal practice on the initial
recognition of an asset. This is because selling costs are normally expected in order to sell an asset
and thus fair value less costs to sell would normally be lower than its carrying amount (cost) (i.e.
carrying amount on date of purchase had the item not been classified as HFS = cost = fair value
and thus fair value less costs to sell will be the lower amount).
A: 4.5 Initial and subsequent measurement of a NCAHFS or NCAHFD (IFRS 5.18 - 5.21 & 5.25)
A: 4.5.1 Initial measurement (on the date of classification)

There are 3 steps to measuring the non-current asset on Steps to initial
measurement:
the date of the classification:
x Before reclassifying: measure the
x Before reclassifying the asset to ‘held for sale/ asset one last time in terms of its
distribution’ (i.e. before transferring it to a HFS/ HFD previous IFRS
account): Measure the asset one last time in terms of x Reclassify (i.e. transfer this asset
to a new HFS (or HFD) account)
its previous IFRS. x After reclassifying: measure the
For example: if the asset was previously an item of asset to the lower of
- CA and
property, plant and equipment (PPE) that was - FV-CtS (or FV – CtD)
measured using IAS 16’s:
- Cost model: we would depreciate to date of classification and then check for any
indication of an impairment; or
- Revaluation model: we would depreciate to date of reclassification, revalue to its fair
value if materially different and check for any indication of an impairment. See IFRS 5.18
x Transfer the asset from its previous classification to ‘held for sale’.
For example: transfer the asset from property, plant and equipment to ‘held for sale’.
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x After transferring (i.e. classifying) to ‘held for sale’:

Measure the asset in terms of IFRS 5, which requires measuring it at the lower of:
- Carrying amount (CA), and
- Fair value less costs to sell (FV-CtS). See IFRS 5.15
Remember, that there are certain non-current assets that, although are subjected to IFRS 5
classification and presentation requirements, will not be subjected to IFRS 5’s measurement
requirements. These are referred to as the scoped-out non-current assets (See section A: 2.1).
Worked example 1:
If the non-current asset held for sale was previously investment property that was measured
under the fair value model:
x it will be reclassified to ‘held for sale’, and
x it will be presented and disclosed as ‘held for sale’, but
x IFRS 5’s measurement principles will not apply to this property and it will continue to
be measured under IAS 40’s fair value model. See IFRS 5.5
A: 4.5.2 Subsequent measurement (after the date of classification as held for sale)
The measurement principles after classification as ‘held

for sale’ are quite simple: Steps to subsequent
measurement:
x The asset is no longer depreciated or amortised.
x Stop depreciating/ amortising
x The asset continues to be periodically re-measured to x Re-measure to lower of
the lower of carrying amount and its latest fair value - CA and
less costs to sell. See IFRS 5.1; .15 & .25 - FV-CtS
Subsequent re-measurement may result
The re-measurements may result in either: in an:
x impairment loss; or
x an impairment loss, or x impairment loss reversal.
x an impairment loss reversal. See IFRS 5.20-21
The impairment loss reversed may need to be limited

Impairment losses
since impairment losses reversed must not exceed the reversed are limited to:
cumulative impairment losses that have previously been
x the cumulative impairment losses
recognised, both: recognised in terms of:
x in terms of IAS 36 Impairment of assets; and - IAS 36 (i.e. prior to
classification as HFS); plus
x in terms of IFRS 5 Non-current assets held for sale - IFRS 5. See IFRS 5.21
and Discontinued operations. See IFRS 5.21
See IAS Plus Guide on IFRS 5: 2008, example 4.1F

What is meant by ‘carrying amount’?
IFRS 5 does not define ‘carrying amount’ and thus there are a number of interpretations as to how
to apply the measurement rule of ‘lower of carrying amount and fair value less costs to sell’.
This text has adopted the following Deloitte interpretation:
x the measurement rule ‘lower of CA and FV-CtS’ means that the NCAHFS may not be re-measured to ‘FV-
CtS’ if this is greater than the carrying amount, which for IFRS 5 purposes, means the:
x carrying amount that the plant would have had:
- on the date it was classified as held for sale,
- assuming no prior impairment loss had ever been recognised under IAS 36’,
- i.e the depreciated historic cost of the asset (Cost – Accum depreciation to date of classification).
By way of explanation, let us now consider examples involving an item of ‘property, plant and
equipment’ that is now to be reclassified as a ‘held for sale’. Under IAS 16 Property, plant and
equipment, this plant could have been measured using either the:
x Cost model; or
x Revaluation model.
606 Chapter 12
A: 4.6 Measurement principles specific to the cost model
A: 4.6.1 The basic principles when the cost model was used
If an asset measured under the cost model is classified as ‘held for sale’:
x immediately before classifying the asset as ‘held for sale’, the asset must be measured using
its previous cost model in terms of IAS 16:
x depreciate it to the date of classification as NCAHFS, and
x test for impairments; See IFRS 5.18
x then transfer it to NCAHFS;
x immediately after reclassifying the asset as ‘held for sale’, the asset must be measured in
terms of IFRS 5:
x Measure it to the lower of:
- Fair value less costs to sell (FV-CtS); See IFRS 5.15
x Stop depreciating it; See IFRS 5.25 and
x Periodically re-measure to ‘fair value less costs to sell’ whenever appropriate. This may
require the recognition of an impairment loss or an impairment loss reversal.
Impairment losses are always recognised as expenses in profit or loss whereas impairment losses
reversed are recognised as income in profit or loss.
When recognising an impairment loss reversal, we must remember that the NCAHFS must
always be measured at the lower of its CA (i.e. interpreted to mean the depreciated cost, see
interpretation in section A: 4.5.2) and its FV-CtS.
Furthermore, impairment loss reversals are limited to the asset’s cumulative impairment losses,
in other words the impairment losses previously recognised in terms of IAS 36 plus the
impairment losses recognised in terms of IFRS 5. See IFRS 5.20-21 & IFRS 5.37
Costs to sell (IFRS 5) versus disposal costs (IAS 36)?

Have you noticed that:
x IFRS 5 measures assets held for sale at the lower of:
- carrying amount and fair value less costs to sell, whereas
x IAS 36 measures recoverable amount at the higher of:
- value in use and fair value less costs of disposal.
The term cost of disposal (IAS 36) is a wider term than costs to sell (IFRS 5) because IAS 36 refers to not
only disposal by way of sale, but to any form of disposal (e.g. abandoning or scrapping).
It is submitted that, when referring to an asset that is expected to be sold:
the costs to sell (IFRS 5) will be the same as the cost of disposal (IAS 36)
Thus, we will use the terms costs to sell and costs of disposal interchangeably in the following examples (i.e. you
may assume that they are the same amounts).
Example 1: Measurement on date classified as HFS (previously: cost model)

All criteria for classification of a plant as a ‘held for sale’ asset were met on 1 January 20X3,
when the asset had the following account balances:
x Cost: 100 000 and
x Accumulated depreciation: 20 000 (the asset has never been impaired).
This plant had been measured using the cost model in IAS 16.
Required: Journalise the re-classification of plant (PPE) to HFS assuming that on 1 January 20X3:
A. the fair value is C70 000, the expected costs to sell are C5 000 and the value in use is C90 000;
B. the fair value is C70 000, the expected costs to sell are C5 000 and the value in use is C72 000;
C. the fair value is C70 000, the expected costs to sell are C5 000 and the value in use is C60 000.
You may assume that the expected costs to sell (used for measuring the NCAHFS) were a fair indication
of expected costs of disposal (used for impairments).
Chapter 12 607
Solution 1: Measurement on date classified as HFS (previously: cost model)

Comment: Remember the following:
x The asset’s carrying amount (CA) must be checked for impairments by comparing to its recoverable amount
(RA) before transferring to NCAHFS.
x The recoverable amount (RA) is the greater of:
- value in use (VIU); and
- fair value less costs of disposal (FV-CoD).
x If the CA before transfer is greater than the RA, then the asset is impaired in terms of IAS 36 Impairment of
assets. If this RA is represented by VIU (i.e. VIU > FV-CoD), then this asset could be further impaired after
classification (i.e. if the CA transferred is greater than FV-CtS).
x Compare A, B and C: These examples show how an impairment can be recognised under IAS 36 (while still
PPE), under IFRS 5 (when classified as HFS) or under both IAS 36 and IFRS 5.
A. the CA of the PPE is less than its RA and therefore the PPE is not impaired under IAS 16, but the CA
transferred to NCAHFS is greater than its FV-CtS and thus the NCAHFS is impaired under IFRS 5.
B. the CA of the PPE is greater than its RA and thus the PPE is impaired under IAS16, and the CA transferred
to NCAHFS is greater than its FV-CtS and thus the NCAHFS is also impaired under IFRS 5.
C. the CA of the PPE is greater than its RA and thus the PPE is impaired under IAS16, but the CA transferred
to NCAHFS was equal to its FV-CtS and thus the NCAHFS is not impaired under IFRS 5.
Workings: A B C
W1: Impairment of plant before classification: (i.e. measured as PPE: IAS 16 & IAS 36)
PPE: carrying amount Cost: 100 000 – Acc depr: 20 000 80 000 80 000 80 000
PPE: Recoverable amount Higher of: (90 000) (72 000) (65 000)
FV-CoD: 70 000 – 5 000 = 65 000 and:
x A: VIU: 90 000; thus RA=90 000
x B: VIU: 72 000; thus RA=72 000
x C: VIU: 60 000; thus RA=65 000
PPE: Impairment IAS 36 Impairment of PPE on 1 January 20X3 0 8 000 15 000
Plant transferred at Lower of CA and RA 80 000 72 000 65 000
W2: Impairment of plant after classification: (i.e. measured as NCAHFS: IFRS 5)
NCAHFS: CA Transfer at the PPE CA calculated in W1 80 000 72 000 65 000

NCAHFS: FV-CtS A, B & C: FV-CtS: 70 000 – 5 000 (65 000) (65 000) (65 000)
NCAHFS: Impairment IFRS 5 Impairment of NCAHFS on 1 Jan 20X3 15 000 7 000 0
Journals: A B C
Debit/ Debit/ Debit/
1 January 20X3 (Credit) (Credit) (Credit)
Impairment loss – PPE (E) W1 N/A 8 000 15 000

PPE: Plant: acc impairment loss (-A) N/A (8 000) (15 000)
Impairment loss before classification as ‘HFS’
PPE: Plant: acc depreciation (-A) Given 20 000 20 000 20 000

PPE: Plant: cost (A) Given (100 000) (100 000) (100 000)
NCAHFS: Plant: Cost-AD (A) W1 80 000 80 000 80 000
PPE: Plant: acc imp loss (-A) O/bal : 0 + Impairment loss (W1) N/A 8 000 15 000
NCAHFS: Plant: acc imp loss (-A) N/A (8 000) (15 000)
Transfer of plant to non-current asset held for sale
Impairment loss – NCAHFS (E) W2 15 000 7 000 N/A

NCAHFS: accumulated impairment loss (-A) (15 000) (7 000) N/A
Impairment loss after classification as ‘held for sale’
Explanatory notes on the next page…
608 Chapter 12
Explanatory notes:
x Depreciation on the asset stops from the date it is classified as HFS (i.e. it is now measured in terms of IFRS 5).
x IFRS 5 does not require you to separate the NCAHFS ledger accounts into the following:
x its old carrying amount, being calculated as ‘cost – accumulated depreciation’, and
x any accumulated impairment losses relating to the asset
However. This is considered a good idea because any future reversals of impairment losses on a NCAHFS are limited
to these accumulated impairment losses (total of accumulated impairment losses in terms of IAS 36 + IFRS 5).
x In all three scenarios, the NCAHFS is measured at C65 000 and the total impairment is C15 000 but the
difference is that this impairment is recognised:
x A: under IFRS 5 only,
x B: under both IAS 36 and IFRS 5, and
x C: under IAS 36 only.
Example 2: Re-measurement after classification as HFS (previously: cost model)

reversal of impairment loss is limited
A plant met all criteria for classification as ‘held for sale’ on 1 January 20X3, when:
x Cost: C100 000 and
x Accumulated depreciation: C20 000 (the asset has never been impaired).
The following values were established on this date:
x Fair value C70 000
x Costs to sell C5 000 (these were a fair indication of the estimated costs of disposal)
x Value in use C72 000.
Required:
Journalise the re-measurement of the non-current asset held for sale at year-end 30 June 20X3
(i.e. 6 months after re-classification from PPE to NCAHFS) assuming that:
A. on 30 June 20X3: fair value is C70 000 and expected costs to sell are C2 000;
B. on 30 June 20X3: fair value is C90 000 and expected costs to sell are C5 000.
Solution 2: Re-measurement after classified as HFS: impairment loss reversal is limited

Comment:
x This example continues from example 1B where on date of classification as held for sale (HFS):
x the PPE was impaired for the very first time immediately before reclassification, and
x the NCAHFS was impaired immediately after reclassification.
x This example explains the limit to the reversal of an impairment loss. The essence is simply that if the fair
value less costs to sell (FV-CtS) subsequently increases:
x recognise a ‘reversal of impairment loss’ (income) – but remember that this reversal could be limited in
two ways:
- the reversal is limited to the previous accumulated impairment losses on the asset, whether they
arose in terms of IAS 36 or IFRS 5! (let’s call this the ‘first limit’),
- the new carrying amount of the NCAHFS must continue to be measured at the lower of the CA and
FV-CtS (let’s call this the ‘second limit’).
Workings:
See IFRS 5.15 and 5.20-.21
W1: Subsequent measurement after classification as NCAHFS (see above 1B):
W1.1: Subsequent increase in FV – CtS

A B
FV-CtS: 30/06/X3 A: 70 000 – 2 000 = 68 000 68 000 85 000
B: 90 000 – 5 000 = 85 000
Less:
Lower of CA & FV-CtS: 01/01/X3 See example 1B: (65 000) (65 000)
Increase in value: 3 000 20 000
Chapter 12 609
W1.2: First limit:
Subsequent increase in value is limited to prior accumulated impairment losses: See IFRS 5.21
A B
Increase in value: W1.1 3 000 20 000
Limited to prior cumulative PPE imp: 8 000 + NCAHFS imp: (15 000) (15 000)
impairment losses 7 000 (See ex 1B)
Excess disallowed N/A 5 000
Increase in value after first A: not limited (3 000 – excess: N/A) * 3 000 15 000
B: limited (20 000 – excess: 5 000)
limitation*: (20 000 Increase > 15 000 AIL) *
* Comments:
The prior cumulative impairment loss recognised on this asset was 15 000 before the reversal, and thus:
A. The reversal of 3 000 is not limited (because the cumulative impairment loss before the reversal is 15 000,
which is bigger than 3 000). A further 12 000 may be reversed in future if necessary.
B. The reversal of 20 000 is limited (because the cumulative impairment loss before the reversal is 15 000,
which is bigger than 20 000), and thus limits the potential reversal of 20 000 to 15 000). No further
reversals are possible in the future.
W1.3: Second limit:

New carrying amount is limited to carrying amount of PPE on date of classification: See IFRS 5.15
A B
NCAHFS: CA on 01/01/X3 was: See example 1B: 65 000 65 000
Plus planned impairment loss reversal: 30/06/X3 W1.2 above 3 000 15 000
NCAHFS: CA on 30/06/X3 would be: 68 000 80 000
Limited to: CA of the PPE on date it was classified Cost: 100 000 – (80 000) (80 000)
ignoring imp losses: 01/01/X3 (dep historic cost) AD: 20 000
Excess disallowed There is no excess N/A N/A
Therefore, impairment loss reversal : Not limited * 3 000 15 000
* Comments:
x W1.1 calculates whether the FV-CtS has increased/ decreased since the prior measurement date.
x W1.2 ensures that any increase does not exceed the prior accumulated impairment losses (whether
recognised in terms of IAS 36 and/ or IFRS 5).
x W1.3 checks that the new CA of the NCAHFS (i.e. after reversing the proposed impairment loss) will not
exceed the CA of the PPE on date of classification ignoring IAS 36 impairment losses (i.e. cost –
accumulated depreciation).
The following is an alternative layout combining W1, W2 and W3:
W1 (Alternative): Subsequent re-measurement of plant after classification as NCAHFS: See IFRS 5.15 &.20-.21
A B
Lower of CA: 01/01/X3 & FV-CtS: 30/06/X3 68 000 80 000
x CA on date classified but A&B: Cost: 100 000 – AD: 20 000 80 000 80 000
ignoring imp losses: 01/01/X3
x FV - CtS: 30/06/X3 A: 70 000 – 2 000 = 68 000 68 000 85 000
B: 90 000 – 5 000 = 85 000
Less:
Lower of CA & FV-CtS: 01/01/X3 See example 1B: (65 000) (65 000)
Impairment loss reversal: 3 000 15 000
Proof: The impairment loss reversal may not exceed the prior cumulative impairment losses See IFRS 5.21
Impairment loss reversal Above 3 000 15 000
Limited to prior cumulative PPE impairment: 8 000 + NCAHFS (15 000) (15 000)
impairment losses impairment: 7 000 (See example 1B)
Excessive reversal disallowed See comment overleaf N/A N/A
610 Chapter 12
Comment:
This alternative layout of W1 will automatically limit any impairment loss reversal to prior cumulative impairment
losses and thus the comparison of the planned impairment loss reversal to prior cumulative impairment losses in
the above table is only a ‘proof’ on your workings.
Journal: A B
30 June 20X3 Dr/(Cr) Dr/(Cr)
NCAHFS: accumulated impairment losses (-A) 3 000 15 000
Impairment loss reversed – NCAHFS (I) (3 000) (15 000)
Reversal of impairment loss: on re-measurement of ‘NCA held for sale’
Example 3: Measurement on date classified as a NCAHFS and

Re-measurement of NCAHFS (previously: cost model):
reversal of impairment loss limitation
Light Limited owns a plant, measured using the cost model, and which had a carrying amount of
C64 000 on 31 December 20X2:
x Cost: 100 000 (purchased on 1 January 20X1)
x Accumulated impairment loss: 18 000 (processed on 31 December 20X1)
x Accumulated depreciation: 18 000 (depreciation at 10% pa straight line to nil residual values).
On 5 January 20X3, the company that originally supplied the plant to Light Limited announced the
release of an upgraded version of the plant that could decrease processing costs by nearly 20%. On this
date, management placed an order for the new plant and decided that the plant on hand would be sold.
All criteria for classification as a ‘non-current asset held for sale’ are met on 8 January 20X3 on which
date the following values were established:
x Value in use: 75 000
x Fair value less costs to sell (IFRS 5) & Fair value less costs of disposal (IAS 36): 60 000
Required:
A. Journalise the re-classification from PPE to NCAHFS on 8 January 20X3 (depreciation for the
period 01/01/X3 – 08/01/X3 is considered insignificant and must be ignored);
B. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 75 000;
C. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 82 000;
D. Journalise the re-measurement on 30 June 20X3 if the fair value less costs to sell are 85 000.
Solution 3: NCAHFS impairment losses reversed are limited

Comment on parts A, B, C and D:
x This example also explains the limit to the reversal of an impairment loss when subsequently re-measuring
the non-current asset held for sale (NCAHFS), but it differs slightly.
x It differs in that it shows how to apply the limit to the reversal of the impairment loss when an item of PPE
already had a balance on its accumulated impairment loss from impairments processed in the years before the
date on which it is classified as held for sale.
x Part A shows the initial measurement on date of classification as a NCAHFS.
x Part B, C and D show three different scenarios regarding the re-measurement of the NCAHFS after the date
of classification as a NCAHFS.
x Part B, C and D show that an impairment loss reversal on a NCAHFS is limited to the prior cumulative
impairment losses and the carrying amount of a NCAHFS may not exceed the carrying amount calculated as
if it had never been impaired/ classified as HFS, in other words, measure at the lower of:
x carrying amount on reclassification date ignoring impairment losses, calculated as: cost – accumulated
depreciation on reclassification date; and
x fair value less costs to sell.
Comment on Part A:
This example reflects a situation where, on date of classification, the PPE is not further impaired, but the NCAHFS
is impaired (a similar example can be found in Example 1A).
Chapter 12 611
Solution 3A: Measurement on date classified as HFS (previously: cost model)

Comment on Part A continued …
x Immediately before the transfer to NCAHFS (8 Jan 20X3), the plant is measured one last time as PPE.
In terms of IAS 16 and IAS 36, the CA of C64 000 is less than its RA of C75 000 (VIU: C75 000 is
higher than FV-CoD: C60 000) and thus there is no impairment of the plant whilst it is classified as PPE.
However, since the RA exceeds its CA, an impairment loss reversal must be processed because previous
impairment losses (of C18 000) had been recognised in terms of IAS 36. When using the cost model,
please always check if the reversal needs to be limited (the CA may not exceed depreciated cost).
x The plant is then transferred to NCAHFS at C75 000. See working 1.
x Once classified as NCAHFS, it must be measured to the lower of CA and FV-CtS. The FV-CtS
was C60 000 and thus the NCAHFS is impaired by C15 000 (in terms of IFRS 5). See working 2.
W1: Measurement of plant before classification as NCAHFS: (IAS 16 & IAS 36) C
PPE: Carrying amount: 08/01/X3 Cost: 100 000 – AD: 18 000 – AIL: 18 000 Note 1 64 000
PPE: Recoverable amount: 08/01/X3 Higher of VIU: 75 000 and FV-CoD: 60 000 (75 000)
PPE: Impairment reversal: 08/01/X3 RA > CA: No further impairment under IAS 36 11 000
but there is an impairment loss reversal
Note 1: depreciation between 01/01/X3 to 08/01/X3 was ignored because immaterial
Asset transferred from PPE to NCAHFS Lower of CA and RA 75 000
W2: Measurement of plant after classification as NCAHFS: (IFRS 5) C
NCAHFS: Carrying amount: 8/01/X3 W1 75 000
NCAHFS: FV – CtS: 8/01/X3 Given (60 000)
NCAHFS: Impairment of plant: 8/01/X3 Impairment under IFRS 5 15 000
Journals: 8 January 20X3 Debit Credit

PPE: Plant: acc impairment loss (-A) W1 11 000
Impairment loss reversed – PPE (I) 11 000
Impairment on plant is reversed
PPE: Plant: acc impairment loss (-A) O/bal (given): 18 000 – reversal: 7 000
11 000 (W1)
PPE: Plant: acc depreciation (-A) Given 18 000
PPE: Plant: cost (A) Given 100 000
NCAHFS: Plant: Cost – AD (A) Cost: 100 000 – AD: 18 000 82 000
NCAHFS: Plant: acc imp loss (-A) Bal in the PPE: AIL account 7 000
Transfer of plant to non-current asset held for sale: CA was 75 000
Impairment loss – NCAHFS (E) IFRS 5 impairment (W2) 15 000
NCAHFS: Plant: acc impairment loss (-A) 15 000
IFRS 5 Impairment loss on date of classification as held for sale
Note:
x This asset will no longer be depreciated.
x The cumulative impairment loss to date is now C22 000:
(IAS 36: 7 000 + IFRS 5: 15 000)
Solution 3B, 3C & 3D: Re-measurement of NCAHFS: reversal of impairment loss, with
a limitation (previously: cost model)
Comment:
x This example shows that any impairment reversal is limited by the following two rules:
- First limit: The impairment loss reversal may not exceed the prior accumulated impairment losses
(whether in terms of IAS 36 and / or IFRS 5) – this limit is shown in W1.2. See IFRS 5.21
- Second limit: The new carrying amount after the impairment loss reversal may not exceed the carrying
amount of the PPE on date of classification, where this carrying amount is interpreted to mean: ‘cost –
accumulated depreciation’ (i.e. ignoring prior IAS 36 impairment losses – shown at the depreciated
historic cost) – this limit is shown in W1.3. See IFRS 5.15
612 Chapter 12
Solution 3B, 3C & 3D: Continued …

Comments continued…
Example B shows an impairment reversal that is not limited at all. (First limit)
Example C shows an impairment reversal that was not limited by the first limit (i.e. prior accumulated
impairment losses) but was limited by the second limit (i.e. the CA of the NCAHFS may not exceed the CA
of the PPE on the date of classification, ignoring prior impairment losses).
Example D shows an impairment reversal that is limited by both the first and second limit.
Workings:
W1: Subsequent re-measurement of plant after classification as NCAHFS: See IFRS 5.15 and 5.20 -.21
W1.1: Re-measurement to FV-CtS: See IFRS 5.20-.21
B C D
FV-CtS: 30/06/X3 Given 75 000 82 000 85 000
Less Lower of CA & FV-CtS: 08/01/X3 Given (See 3A: W2) (60 000) (60 000) (60 000)
Increase in value: 15 000 22 000 25 000
W1.2: First limit:

B C D
Increase in value: W1.1 15 000 22 000 25 000
Limited to prior cumulative PPE impairment: 7 000 + NCAHFS (22 000) (22 000) (22 000)
impairment losses impairment: 15 000 (see ex 3A: W1 & W2)
Excess disallowed N/A N/A 3 000
Increase in value after first See comments below: * 15 000 22 000 22 000
limitation: *See notes A: not limited (15 000 – excess: 0)
B: not limited (22 000 – excess: 0)
C: is limited (25 000 – excess: 3 000)
* Notes regarding the first limitation:

The cumulative impairment loss recognised on this asset is 22 000 before the reversal, thus:
x B: The intended increase of 15 000 (W1.1) is not limited by this first limit (previous cumulative impairment
losses: 22 000 > increase: 15 000). A cumulative impairment loss of 7 000 remains.
x C: The intended reversal of 22 000 (W1.1) is not limited by this first limit (the prior cumulative impairment
losses 22 000 = the increase 22 000). The remaining cumulative impairment loss is nil.
x D: The intended reversal of 25 000 (W1.1) is limited by the first limit (the previous cumulative imp loss:
22 000 < the increase: 25 000). The increase of 25 000 may not be processed in full: the reversal to be
processed is limited to 22 000. No cumulative impairment loss remains.
W1.3: Second limit:

New carrying amount is limited to carrying amount on date of classification See IFRS 5.15
B C D
NCAHFS: CA on 08/01/X3 was: Given (See 3A: W2) 60 000 60 000 60 000
Plus planned impairment loss reversal: 30/06/X3 W1.2 15 000 22 000 22 000
NCAHFS: CA on 30/06/X3 would be: 75 000 82 000 82 000
Limited to: CA of the PPE on date it Depreciated historic cost: (80 000) (80 000) (80 000)
was classified, ignoring imp losses : Cost: 100 000 – AD: (100 000
01/01/X3 – RV: 0) x 10% x 2yrs
Excess disallowed B: not limited N/A 2 000 2 000
C & D: limited
See note below
Thus, impairment loss reversal: B: not limited 15 000 20 000 20 000
* See notes overleaf C & D: increase of 22 000 –
excess disallowed 2 000
Chapter 12 613
Solution 3B, 3C & 3D: Continued …

* Notes regarding the first and second limitations:
x B was not limited by either the first limit (W1.2) or the second limit (W1.3).
x C was not limited by the first limit (W1.2) but yet was limited by the second limit (W1.3).
x D was limited by both the first limit (W1.2) and the second limit (W1.3).
The following is an alternative layout of working 1:
W1 (Alternative): Subsequent re-measurement of plant after classification as NCAHFS:
B C D
Lower of CA 08/1/20X3 and FV-CtS: 30/06/X3 75 000 80 000 80 000
x CA on date classified, ignoring Cost: 100 000 – AD Note 1: 80 000 80 000 80 000
imp losses: 08/01/X3 (100 000 - 0) x 10% x 2 yrs
x FV - CtS: 30/06/X3 Given 75 000 82 000 85 000
Less:
Lower of CA and FV-CtS: 08/01/X3 Given (See 3A: W2) (60 000) (60 000) (60 000)
Impairment loss reversal 15 000 20 000 20 000
Note 1: depreciation between 01/01/X3 to 08/01/X3 was ignored because immaterial
Proof: The impairment loss reversal may not exceed prior cumulative impairment losses See IFRS 5.21
B C D
Impairment loss reversal Above 15 000 20 000 20 000
Limited to prior cumulative imp losses IAS 36: 7 000 + IFRS 5: 15 000 (22 000) (22 000) (22 000)
Excessive reversal disallowed See note below * N/A N/A N/A
* Notes regarding the use of W1 to calculate the limitation of the reversal:
The above alternative layout of W1 will automatically limit any impairment loss reversal to prior
cumulative impairment losses and thus the comparison of the planned impairment loss reversal to
prior cumulative impairment losses in the above table is only a proof or a ‘check’ on your workings.
Journals: B C D
30 June 20X3 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
NCAHFS: acc. imp losses (-A) W1.3 or W1 (alternative) 15 000 20 000 20 000
Impairment loss reversed – NCAHFS (I) (15 000) (20 000) (20 000)
Reversal of impairment loss when re-measuring the NCAHFS
Comments:
x There is no depreciation on this asset as it is classified as a NCAHFS.
x The cumulative impairment loss to date is now:
B: 7 000 (AIL 22 000 – Reversal 15 000), but of which a reversal of only C5 000 is possible in future (a
reversal in excess of C5 000 would increase the latest CA of the NCAHFS from 75 000 to above the CA
of the PPE on date of classification calculated ignoring any impairment losses of 80 000 (Cost: 100 000 –
Accumulated depreciation on date of classification: 20 000).
C&D: 2 000 (AIL 22 000 – Reversal 20 000), but of which no further reversal is possible (any further
reversal would increase the CA of the NCAHFS from 80 000 above the CA of the PPE on date of
classification calculated ignoring any impairment losses of 80 000 (Cost: 100 000 – Accumulated
depreciation on date of classification: 20 000).
A: 4.6.2 The tax effect when the cost model was used
As soon as an asset is classified as held for sale, depreciation thereon ceases. The tax authorities,
however, generally do not stop allowing tax deductions (assuming that the cost of the asset was
tax deductible) simply because you have decided to sell the asset.
The difference between an accountant’s nil depreciation (and any impairment losses or reversals)
and the tax authority’s tax deductions (assuming the cost of the asset is tax deductible) causes a
temporary difference on which deferred tax must be recognised.
The principles affecting the current tax payable and deferred tax balances are therefore exactly
the same as for any other non-current asset.
614 Chapter 12
Example 4: Tax effect of classification as NCAHFS and the cost model

Plant, measured using the cost model, has the following balances on 31 December 20X2:
x Cost of C100 000 (1 January 20X2)
x Accumulated depreciation of C30 000
x Accumulated impairment losses of C0
x A tax base of C90 000.
All criteria for classification as ‘held for sale’ are met on 8 January 20X3, following a
decision on this date to purchase an upgraded model of the plant. On this date:
x Fair value less costs of disposal & Fair value less costs to sell is C65 000, and
x Value in use is C80 000.
Other information for the year ended 31 December 20X3:
x The tax authorities allow the deduction of the cost of this asset at 10% per annum.
x The profit before tax is correctly calculated to be C200 000.
Required:
A. Calculate the current tax payable and the deferred tax balance at 31 December 20X3.
B. Journalise the current tax and the deferred tax for the year ended 31 December 20X3.
Solution 4A: Calculations

W1. Current income tax Calculations C
Profit before tax Given 200 000

Add back depreciation on plant Plant is now a NCAHFS & thus not depreciated 0
Add back impairment on plant Impairment of NCAHFS in terms of IFRS 5: 5 000
CA of PPE: 70 000 (Cost 100 000 – AD: 30 000) –
FV-CtS of NCAHFS: 65 000 (given)
Less tax deduction on plant Cost: 100 000 x 10% pa (10 000)
Current tax 195 000 x 30% 58 500
Note:
The impairment and depreciation expenses are added back to profit before tax as they are accounting
entries that are not allowed as a deduction for tax purposes.
W2. Deferred tax: PPE – NCAHFS Carrying Tax Temporary Deferred

amount base difference tax
Balance – 1 January 20X3 70 000 90 000 20 000 6 000 Asset
Less impairment of CA to FV-CtS (5 000) 0 Cr DT,
(1 500)
(CA: 70 000 – FV-CtS: 65 000) (5 000) Dr TE
Depreciation/ tax allowance 0 (10 000)
Balance – 31 December 20X3 65 000 80 000 15 000 4 500 Asset
Solution 4B: Journals

Current tax payable (estimated)

Deferred tax: income tax (Asset is reduced) 1 500
Deferred tax adjustment
Chapter 12 615
A: 4.7 Measurement principles specific to the revaluation model
A: 4.7.1 The basic principles when the revaluation model was used
If an asset measured under the revaluation model is classified as ‘held for sale’, we need to
follow these steps:
x Step 1: immediately before reclassifying the asset as ‘held for sale’, the asset must be
measured using its previous revaluation model in terms of IAS 16:
- depreciate it to date of classification as ‘held for sale’;
- re-measure to fair value (if materially different to the carrying amount); and
- check for impairments;
x Step 2: transfer it to NCAHFS;
x Step 3: immediately after reclassifying the asset as ‘held for sale’, the asset must be
measured in terms of IFRS 5:
- Measure it to the lower of:
- Fair value less costs to sell (FV-CtS); See IFRS 5.15
- Stop depreciating it; See IFRS 5.25 and
x Step 4: Periodically re-measure to ‘fair value less costs to sell’ whenever appropriate: this
may necessitate the recognition of an impairment loss or an impairment loss reversal.
An impairment loss recognised in terms of IFRS 5 is always recognised as an expense in profit
or loss, even if there is a related revaluation surplus An impairment loss is
balance (i.e. from a prior revaluation in terms of IAS 16). always expensed in P/L
A revaluation surplus balance existing on the date of even if there is a
revaluation surplus!
reclassification to ‘held for sale’ remains there until the
asset is sold, at which point this balance will be transferred
to retained earnings. See IFRS 5.37 & .20
An impairment loss
Similarly, impairment losses reversed are always reversed is always an
income in P/L.
recognised as income in profit or loss. See IFRS 5.37
It is limited in 2 ways:
The IL reversed must never exceed
The amount of the reversal is limited to the asset’s the cumulative IL recognised in terms
cumulative impairment losses recognised. See IFRS 5.21 of IAS 36 & IFRS 5
The CA after the IL reversed must
A further limitation is possible in that, when reversing an never exceed the lower of CA (if the
reval model was used, the CA is the
impairment loss, the NCAHFS must always be measured at ‘depreciated FV’) and FV-CtS (see
the lower of its carrying amount and fair value less costs to interpretation in section A: 4.5.2)
sell, (where the carrying amount is measured on date of
classification, calculated as if it had never been impaired: see interpretation in section A: 4.5.2 above).
Example 5: Measurement on date classified as HFS
x previously: revaluation model
An item of plant, measured under IAS 16’s revaluation model, met all criteria for
classification as ‘held for sale’ on 1 January 20X4. The following information is relevant:
x Cost: 100 000 (purchased 1 January 20X1)
x Depreciation: 10% per annum straight-line to nil residual values
x Fair value: 120 000 (revalued 1 January 20X3)
x Revaluations are performed using the net replacement value method
x The revaluation surplus is transferred to retained earnings over the life of the asset.
x The value in use has always been greater than the plant’s carrying amount and therefore
the asset has not previously been impaired. (Costs to sell equal costs of disposal)
Required: Journalise the reclassification of plant (PPE) to HFS assuming that on 1 January 20X4:
A. Fair value is C100 000, the expected selling costs are C9 000 and the value in use is C105 000;
B. Fair value is C150 000, the expected selling costs are C20 000 and the value in use is C155 000.
C. Fair value is C60 000, the expected selling costs are C20 000 and the value in use is C65 000.
616 Chapter 12
Solution 5: Measurement on date classified as HFS (previously: revaluation model)

Comment: This example explains the following:
x How to measure an asset on the date it is classified (transferred) from PPE to NCAHFS and where it was
previously measured under the revaluation model:
x Measure in terms of IAS 16 before reclassifying: revalue to FV and check for impairments
- A and C reflect a decrease in the FV of the PPE;
- B reflects an increase in the FV of PPE.
x Measure in terms of IFRS 5 immediately after reclassifying: at lower of CA & FV – CtS
- A, B and C all reflect an impairment loss.
x If the asset is impaired in terms of IFRS 5 (i.e. once the asset has been classified as a NCAHFS), this impairment
loss is expensed, even if there is a revaluation surplus balance (see A and B).
Workings:
W1: Measurement of plant before classification as NCAHFS (IAS 16 & IAS 36)
W1.1 Revaluation in terms of IAS 16 A B C
PPE: CA: 1/01/X3 100 000 – (100 000-0) x 10% x 2 yrs 80 000 80 000 80 000
PPE: Rev surplus:1/01/X3 Balancing: FV 120 000 – CA 80 000 40 000 40 000 40 000
PPE: FV: 1/01/X3 Given 120 000 120 000 120 000
PPE: Acc. depr: 31/12/X3 120 000/ 8 remaining years (15 000) (15 000) (15 000)
PPE:CA: 1/01/X4 Balancing: 120 000 – 15 000 105 000 105 000 105 000
PPE: Incr/(decr): 1/01/X4 Balancing – also see note 1 (5 000) 45 000 (45 000)
- Adjust reval surplus A&C: decrease, limit to RS bal: (W3) (5 000) 45 000 (35 000)
- Adjust reval expense A: nil since deval does not exceed RS bal (0) N/A (10 000)
B: N/A since it was an increase in FV
C: deval: 45 000 exceeds RS bal: 35 000 W3
PPE: FV: 1/01/X4 Given 100 000 150 000 60 000
W1.2 Check for impairments in terms of IAS 16 & IAS 36:

A B C
PPE: FV: 01/01/X4 before impairment See W1.1/ Given 100 000 150 000 60 000
PPE: Recov Amt: 01/01/X4 Greater of VIU and FV-CoD 105 000 155 000 65 000
- Value in use Given 105 000 155 000 65 000
- FV less costs of disposal A: 100 000 – 9 000 = 91 000 91 000 130 000 40 000
B: 150 000 – 20 000 = 130 000
C: 60 000 – 20 000 = 40 000
PPE: Imp loss expense RA is greater than CA N/A N/A N/A
Therefore:
PPE: FV: 01/01/X4 before impairment See W1.1/ Given 100 000 150 000 60 000
Less IAS 36 impairment loss expense See W1.2 (0) (0) (0)
PPE: Carrying amt: 01/01/X4 None were impaired 100 000 150 000 60 000
W2: Measurement of plant after classification as NCAHFS (IFRS 5)

(Lower of the PPE’s CA (W1) and FV-CtS See IFRS 5.15)
A B C
NCAHFS: CA: 1/1/X4 Tfr from PPE: W1.2 100 000 150 000 60 000
NCAHFS: Imp of plant: 1/1/X4 Balancing and see Note 3 9 000 20 000 20 000
NCAHFS: FV-CtS: 1/1/X4 A: 100 000 – 9 000 = 91 000 (91 000) (130 000) (40 000)
B: 150 000 – 20 000 = 130 000
C: 60 000 – 20 000 = 40 000
Chapter 12 617
W3: Balance on revaluation surplus A B C

Revaluation surplus: 01/01/X3 Opening balance 0 0 0
Increase to fair value: 01/01/X3 FV 120 000 – CA 80 000 (W1) 40 000 40 000 40 000
Transfer to ret. earnings:31/12/X3 40 000 / 8 yrs remaining (5 000) (5 000) (5 000)
Revaluation surplus: 01/01/X4 Before transfer (see Note 1) 35 000 35 000 35 000
Incr/ (decr) in FV: 01/01/X4 W1 (5 000) 45 000 (35 000)
Revaluation surplus: 01/01/X4 After transfer (see Note 4) 30 000 80 000 0
Journals:
A B C
1 January 20X4 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
PPE: Plant: acc. depreciation (-A) W1.1: Acc depr to 15 000 15 000 15 000
PPE: Plant: cost (A) 31/12/X3 and see Note 2 (15 000) (15 000) (15 000)
NRVM: Acc. depreciation set-off against cost
PPE: Plant: cost (A) W1.1 (5 000) 45 000 (45 000)
Revaluation surplus – plant (OCI) W1.1 5 000 (45 000) 35 000
Revaluation expense – plant (E) W1.1 0 0 10 000
Revaluation of plant (PPE) to FV immediately before
reclassification to NCAHFS
NCAHFS: Plant: Cost – AD W1.2 100 000 150 000 60 000
PPE: Plant: cost (A) (100 000) (150 000) (60 000)
Transfer from PPE to NCAHFS on date classified as HFS
(transfer at the CA after any depreciation, revaluation and
impairments to date of classification)
Impairment loss – NCAHFS (E) W2 and see Note 3 9 000 20 000 20 000
NCAHFS: acc imp loss (-A) (9 000) (20 000) (20 000)
Measurement of plant as a NCAHFS on date of classification to
lower of CA as PPE on date of classification and FV-CtS
Comment: There is no further depreciation on this asset.
Notes:
Note 1. We calculate the revaluation surplus balance (W3) immediately prior to the PPE’s final revaluation
to fair value on 1/1/X4, since any drop in its value must first be set-off against this balance and any
further decrease in the value of the PPE is then expensed as a revaluation expense.
Note 2. As the net replacement value method was used, the accumulated depreciation immediately before
the revaluation must be set-off against the cost of the asset before revaluing the asset on 1/1/X4.
Note 3. Despite the fact that a balance remains in the revaluation surplus after the revaluation on 1/1/X4
(see W3: A & B), the impairment loss relating to the NCAHFS is expensed (i.e. impairments in
terms of IFRS 5 are always expensed). The balance in the revaluation surplus on the date of
classification as a NCAHFS remains there until the asset is disposed of, at which point it will be
transferred to retained earnings.
Note 4. While the plant is PPE, the entity would transfer the revaluation surplus to retained earnings over
the useful life of the asset (i.e. at the same rate as the asset is depreciated) but since the asset is
now a NCAHFS (from 1/1/X4), both depreciation and this transfer must cease.
Example 6: Re-measurement of a NCAHFS: (previously revaluation model):

x further impairments and reversals of impairments
This example is based on ex 5A’s plant, which was measured using the revaluation model:
x Cost: C100 000 (purchased 1 January 20X1).
x Depreciation: 10% per annum straight-line to nil residual values.
x Fair value: C120 000 (as at date of revaluation: 1 January 20X3).
x Revaluations are performed using the net replacement value method.
x The revaluation surplus is transferred to retained earnings over the asset’s useful life.
618 Chapter 12
The recoverable amount had always exceeded the carrying amount.

This plant met all criteria for classification as ‘held for sale’ on 1 January 20X4, on which date the
following values applied (these figures are the same as those used in example 5A):
x Fair value of C100 000 and expected selling costs of C9 000 (equated to expected disposal costs;
x Value in use of C105 000.
Required:
Journalise the re-measurement of the NCAHFS at year-ended 30 June 20X4 (i.e. 6 months after
reclassification) assuming that:
A. on 30 June 20X4, the fair value is C110 000 and the expected selling costs are C15 000;
B. on 30 June 20X4, the fair value is C110 000 and the expected selling costs are C3 000;
C. on 30 June 20X4, the fair value is C90 000 and the expected selling costs are C3 000.
Solution 6: Re-measurement of a NCAHFS: the revaluation model

Comment:
x This example follows on from example 5A where the journals relating to the measurement on the date it was
classified as a NCAHFS (1 January 20X4) were processed.
x This example shows how to re-measure a NCAHFS after the date it was classified as a NCAHFS. It shows
the journals that occur on 30 June 20X4.
x This example shows that when re-measuring a NCAHFS, its CA can increase or decrease.
x If the CA increases, any impairment loss reversal is limited to prior cumulative impairment losses
(impairments when the asset was PPE: (in terms of IAS 36) plus impairments when the asset was NCAHFS
(in terms of IFRS 5)) and the new CA is further limited to the CA that the asset would have had on date of
reclassification, assuming that it had never been impaired:
- Ex 6A shows an impairment loss reversal that was not limited; and
- Ex 6B shows an impairment loss reversal that is limited.
x If the CA decreases, an impairment loss is recognised (this is recognised in profit or loss, even if there is a
balance on the RS account):
- Ex 6C shows a further impairment loss when there was a balance in RS (of 30 000).
Workings:
W1: Subsequent re-measurement of plant after classification as NCAHFS: See IFRS 5.15 & 5.20-.21
W1.1: Re-measurement to FV-CtS: See IFRS 5.20-.21 A B C

FV less costs to sell: 30/06/X4 A: FV: 110 000 – CtS: 15 000 95 000 107 000 87 000
B: FV: 110 000 – CtS: 3 000
C: FV: 90 000 – CtS: 3 000
Less:
Lower of CA & FV-CtS: 01/01/X4 Lower of CA: 100 000 and (91 000) (91 000) (91 000)
FV-CtS: 91 000 (FV: 100 000
– CtS: 9 000)
(see Ex 5A: W2)
Increase / (decrease) in value 4 000 16 000 (4 000)
W1.2: First limit: A B C

See IFRS 5.21
Subsequent increase in value is limited to prior accumulated impairment losses:
Increase in value before limit W1.1 4 000 16 000 N/A

Limited to prior cumulative PPE impairment: 0 (Ex 5A W1.2) + 9 000 9 000 N/A
impairment losses NCAHFS impairment: 9 000 (Ex 5A: W2)
Increase after the 1st limit NOTE 1 A: 4 000 is not limited by the 9 000 4 000 9 000 N/A
B: 16 000 is limited by the 9 000
C: N/A: there was no increase at all
Chapter 12 619
Solution 6: continued …
Note 1: In the case of this first limit:

x A: The total cumulative impairment loss recognised on this asset is 9 000 before the reversal, thus the increase
of 4 000 is not limited by the first limitation (the previous cumulative IL of 9 000 is bigger than 4 000).
There is a remaining cumulative impairment loss of 5 000.
x B: The total cumulative impairment loss recognised on this asset is 9 000 before the reversal, thus the increase
of 16 000 is limited by the first limitation (the previous cumulative IL of 9 000 is less than 16 000). There
is no remaining cumulative impairment loss.
x C: The asset decreased in value and thus there is obviously no planned reversal of an impairment loss. The
latest accumulated impairment loss has now increased to 13 000:
- the NCAHFS impairment on classification date (Ex 5A: W2): 9 000, plus
- the NCAHFS impairment after classification date (Ex 6C: W1.1): 4 000.
Impairment losses of 13 000 may thus be reversed in future if necessary.
W1.3: Second limit:

New carrying amount is limited to carrying amount of PPE on date of classification:See IFRS 5.15
A B C
NCAHFS: CA on 01/01/X4 was: Given (See 5A: W2) 91 000 91 000 N/A
Plus planned impairment loss reversal 30/06/X4 W1.2 4 000 9 000 N/A
NCAHFS: CA on 30/06/X4 would be: 95 000 100 000 N/A
Limited to: CA of the PPE on date it was FV: 100 000 – AD: 0 100 000 100 000 N/A
classified (ignoring imp losses): 01/01/X4 (immediately reclassified)
Excess disallowed A, B & C: not limited N/A N/A N/A
Therefore, impairment loss reversal See calculations below 4 000 9 000 N/A
Calculations:
x A: planned reversal of 4 000 (W1.2) – excess disallowed 0 (W1.3) = 4 000 reversal of imp loss
x B: planned reversal of 9 000 (W1.2) – excess disallowed 0 (W1.3) = 9 000 reversal of imp loss
x C: N/A: there was no planned reversal (W1.2); the asset was further impaired instead.
W1 (Alternative): Subsequent re-measurement of plant after classification as NCAHFS:
A B C
Lower of CA: 01/01/X4 and FV-CtS: 30/06/X4 Given 95 000 100 000 87 000
x CA on date classified (ignoring FV: 100 000 – Acc depr: 0 100 000 100 000 100 000
imp losses): 01/01/X4
x FV - CtS: 30/06/X4 A: FV: 110 000 – CtS: 15 000 95 000 107 000 87 000
B: FV: 110 000 – CtS: 3 000
C: FV: 90 000 – CtS: 3 000
Less:
Lower of CA and FV-CtS: 1/1/X4 FV: 100 000-CtS: 9 000 (91 000) (91 000) (91 000)
(Ex5A)
Imp loss reversal / (impairment loss) 4 000 9 000 (4 000)
Check: The impairment loss reversal may not exceed the prior cumulative impairment losses See IFRS 5.21
Impairment loss reversal W1 4 000 9 000 N/A

Limited to prior cumulative imp losses See calculation (1) below 9 000 9 000 N/A
Excessive reversal disallowed See note below * N/A N/A N/A
Calculation (1):
IAS 36 impairment: 0 (Ex 5A: W1.2) + IFRS 5 impairment: 9 000 (Ex 5A: W2)
*Note:
This alternative layout of W1 will automatically limit any impairment loss reversal to prior cumulative
impairment losses and thus the comparison of the planned impairment loss reversal to prior cumulative
impairment losses in the above table is only a ‘check’ on your workings.
620 Chapter 12
Journals: A B C
30 June 20X4 Dr/(Cr) Dr/(Cr) Dr/(Cr)
NCAHFS: acc impairment loss (-A) W1 4 000 9 000 N/A
Reversal of impairment loss – NCAHFS (I) (4 000) (9 000) N/A
Re-measurement of NCAHFS: increase in FV-CtS (W1.3 or W1)
Impairment loss – NCAHFS (E) W1 or W1.1 * Note 1 N/A N/A 4 000
NCAHFS: acc impairment loss (-A) N/A N/A (4 000)
Re-measurement of NCAHFS: decrease in FV-CtS (W1.1 or W1)
*Note 1:
Notice that the impairment is recognised in P/L even though there is a balance of C30 000 in the
revaluation surplus (see Ex5A: W3).
Example 7: Re-measurement of a NCAHFS (previously: revaluation model):

x prior revaluation expenses may not be reversed
The following relates to a plant that was measured using the revaluation model:
x Cost: 100 000 (purchased 1 January 20X1)
x Depreciation: 10% per annum straight-line to nil residual values.
x Fair value: 120 000 (as at date of revaluation: 1 January 20X3).
x Revaluations are performed using the net replacement value method.
x The revaluation surplus is transferred to retained earnings over the life of the
underlying asset.
x The recoverable amount has always been greater than its carrying amount and thus the
asset has not previously been impaired in terms of IAS 36.
This plant met all criteria for classification as ‘held for sale’ on 1 January 20X4, on which
date the following values applied (following on from example 5C):
x Fair value of C60 000 and expected selling costs of C20 000 and
x Value in use of C65 000.
Required:
Journalise the re-measurement of the NCAHFS at year-end 30 June 20X4 when its fair value is C80 000
and the expected selling costs are C10 000.
Solution 7: Re-measurement of a NCAHFS: the revaluation model

Comment:
x This example follows on from example 5C where the journals relating to the measurement on the date it was
classified as a NCAHFS (1 January 20X4) were shown.
x This example shows that, whilst prior impairment losses may be reversed, prior revaluation expenses may not
be reversed.
Workings:
W1: Subsequent re-measurement of plant after classification as NCAHFS: See IFRS 5.15 & 5.20-.21
W1.1: Re-measurement to FV-CtS: See IFRS 5..20-.21 C
FV less costs to sell: 30/06/X4 FV: 80 000 – CtS: 10 000 70 000

Less:
Lower of CA & FV-CtS: 01/01/X4 FV: 60 000 – CtS: 20 000 (see Ex5C) (40 000)
- CA: 01/01/X4 FV: Given 60 000
- FV-CtS: 01/01/X4 FV: 60 000 – CtS: 20 000 (see Ex5C) 40 000
Increase in value 30 000
Chapter 12 621
W1.2: First limit: C
Increase in value W1.1 30 000

Limited to prior cumulative impairment losses Calculation (1) 20 000
Impairment loss reversal *Note 1 30 000 is limited by the 20 000 20 000
Calculation 1:
IAS 36 impairment before reclassification: 0 (Given)
plus: IAS 36 impairment on reclassification: 0 (Ex 5C: W1.2)
plus: IFRS 5 impairment on reclassification: 20 000 (Ex 5C:W2)
= 20 000
*Note 1: In the case of this first limit:

x The total cumulative impairment loss recognised on this asset is 20 000 as at 1/1/X4, thus the planned reversal
of 30 000 on 30/6/X4 is limited by the first limitation (the previous cumulative IL of 20 000 is less than
30 000). The remaining cumulative impairment loss is nil.
x Please notice that when the asset:
- was previously classified as PPE, it was devalued from its CA of 105 000 to a FV of 60 000 (in terms of
IAS 16); and then
- was classified as a NCAHFS, its FV of 60 000 was decreased to its FV-CtS of 40 000 (in terms of IFRS
5).
The CA was thus decreased by a total of 65 000.
- However, the decrease of 45 000 to its FV of 60 000 is a devaluation to fair value and not an impairment
to FV-CtS.
This devaluation to FV is debited to revaluation surplus (35 000) and revaluation expense (10 000) (See
Ex 5C: W1.1 and the journals).
- The remaining decrease of 20 000 was recognised as an impairment loss expense.
Only impairment losses expensed may be reversed and thus only the decrease of 20 000 that was
recognised as an impairment loss expense may be reversed.
W1.3: Second limit:

New carrying amount is limited to carrying amount of PPE on date of classification:See IFRS 5.15
C
NCAHFS: CA on 01/01/X4 was: Given (See 5C: W2) 40 000
Plus planned impairment loss reversal: 30/06/X4 W1.2 20 000
NCAHFS: CA on 30/06/X4 would be: 60 000
Limited to: CA of the PPE on date it was FV: 60 000 – AD: 0 (immediately (60 000)
classified (ignoring imp losses): 01/01/X4 reclassified, thus no depreciation)
Excess disallowed Not limited N/A
Therefore, impairment loss reversal Planned reversal of 20 000 (W1.2) – 20 000
excess disallowed: 0 = 20 000
The following is an alternative layout of working 1:
W1 (Alternative): Subsequent re-measurement of plant after classification as NCAHFS

C
Lower of CA and FV-CtS: 30/06/X4 60 000
x CA on date classified (ignoring imp losses): 01/01/X4 FV: 60 000 – Acc depr: 0 60 000
x FV - CtS: 30/06/X4 FV: 80 000 – CtS: 10 000 70 000
Less:
Lower of CA and FV-CtS: 01/01/X4 (40 000)
- CA: 01/01/X4 FV : Given 60 000
- FV-CtS: 01/01/X4 FV: 60 000 – CtS: 20 000 (Ex5C) 40 000
Impairment loss reversal / (impairment loss) 20 000
622 Chapter 12
Check: The impairment loss reversal may not exceed the prior cumulative impairment losses See IFRS 5.21
Impairment loss reversal Above 20 000
Limited to prior cumulative imp losses IAS 36: 0 + IFRS 5: 20 000 (20 000)
Excessive reversal disallowed N/A
Journals:
Dr/(Cr)
30 June 20X4
NCAHFS: acc impairment loss (-A) W1 or W1.3 20 000
Reversal of impairment loss – NCAHFS (I) (20 000)
Re-measurement of NCAHFS: increase in FV-CtS (W1.3 or W1)
A: 4.7.2 The tax effect when the revaluation model was used
Depreciation ceases as soon as an asset is classified as held for sale. However, the tax authorities
generally do not stop allowing the deduction of capital allowances (assuming the cost of the asset
is tax deductible) simply because you have decided to sell the asset.
The difference between the accountant’s nil depreciation (and any impairment losses or reversals
thereof) and the tax authority’s tax deductions (assuming the cost of the asset was tax deductible)
causes a temporary difference on which deferred tax must be recognised.
The principles affecting the current tax payable and deferred tax balances are therefore exactly
the same as for any other non-current asset. But one must be careful when measuring the
deferred tax balance if an asset has been revalued above its original cost.
The reason for this is that this deferred tax balance may have previously been calculated based
on the assumption that the carrying amount of the asset represents the future inflow of benefits
resulting from the usage of the asset. Profits from the usage of the assets would be referred to as
non-capital profits and the deferred tax balance would have been calculated at the tax rate that
would apply to profits arising from trading (i.e. the 'normal' tax rate).
When this asset is reclassified as ‘held for sale’, however, the future benefits are obviously now
expected to come from the sale of the asset rather than the use thereof. Profits from the sale of
the asset may involve capital profits. These capital profits will generally result in measuring the
deferred tax based on capital gains tax legislation rather than normal tax legislation. If this is the
case, the deferred tax balance will simply need to be adjusted to take into account the effects of
the different tax calculations.
As a result, reclassifying an asset into the ‘held for sale’ classification will generally result in an
adjustment to deferred tax in order to re-measured the deferred tax balance using the capital
gains tax legislation rather than the 'normal' tax legislation.
Example 8: Tax effect of reclassification and the revaluation model

An item of plant met all criteria for classification as ‘held for sale’ on 1 January 20X4.
x Cost: C100 000 (purchased 1 January 20X1);
x Depreciation: 10% per annum straight-line to nil residual values;
x The plant was measured under the revaluation model:
- Fair values were measured in accordance with market prices;
- Revaluations were accounted for using the net replacement value method;
- The revaluation surplus is transferred to retained earnings over the life of the asset.
31/12/20X2: 31/12/20X3:
date of 1st revaluation date of 2nd revaluation
Fair value 120 000 150 000
Costs to sell 10 000 20 000
Value in use 130 000 155 000
Chapter 12 623
x On 31 December 20X4, the fair value was now C140 000 and the cost to sell C20 000.
x Tax related information:
- The tax authorities allow a deduction of 20% on the cost of this asset;
- The tax rate is 30%;
- Only 80% of the capital gain (proceeds - base cost) is taxable;
- Base cost: 120 000.
x Profit before tax is correctly calculated to be C200 000 for the year ended 31 December 20X4.
x There are no temporary or permanent differences other than evident from the above.
Required:
Show all related journal entries for the year ended 31 December 20X2, 20X3 and 20X4 (including the
current tax and deferred tax entries) to the extent possible from the information provided.
Solution 8: Tax effect of reclassification and the revaluation model

Comment: This example shows the effect on the deferred tax adjustments when the intention changes from using
the asset to selling it and when there has been a previous upward revaluation.
Journals
Depreciation: plant (E) (100 000 – 0) / 10 yrs x 1 year 10 000
PPE: Plant: acc depreciation (-A) 10 000
Depreciation on plant: cost 100 000, RV = 0 and useful life 10yrs
PPE: Plant: acc depreciation (-A) (100 000 – 0) / 10 yrs x 2 years 20 000
PPE: Plant: cost (A) 20 000
NRVM: Accumulated depreciation to 31/12/20X2 set-off against cost
PPE: Plant: cost (A) FV: 120 000 – CA: (100 000 - 20 000) 40 000
Revaluation surplus: PPE: Plant (OCI) 40 000
Revaluation of PPE according to IAS 16’s revaluation model
Revaluation surplus: PPE: Plant (OCI) 40 000 x 30% or W2 12 000
Tax on revaluation: tax rates based on usage (i.e. non-capital profits)
Deferred tax balance is adjusted: CA and tax base changed (deferred
tax measured based on intention to use)
31 December 20X3
Depreciation: plant (E) (120 000 – 0) / 8 yrs x 1 year 15 000
PPE: Plant: acc depreciation (-A) 15 000
Depreciation on plant: FV: 120 000, RV: 0, Remaining useful life: 8yrs
PPE: Plant: acc depreciation (-A) 10 000 + 10 000 – 20 000 + 15 000 15 000
PPE: Plant: cost (A) 15 000
NRVM: Accumulated depreciation to 31/12/20X3 set-off against cost
PPE: Plant: cost (A) FV: 150 000 – CA: (120 000 - 15 000) 45 000
Revaluation surplus: PPE: Plant (OCI) 45 000
Revaluation of PPE according to IAS 16’s revaluation model
Revaluation surplus: PPE: Plant (OCI) 45 000 x 30% 13 500
Tax on revaluation: tax rates based on usage (i.e. non-capital profits)
Revaluation surplus: PPE: Plant (OCI) (40 000 revaluation gain – 12 000 3 500
Retained earnings deferred tax)/ 8 remaining yrs 3 500
624 Chapter 12

Journals continued ...
NCAHFS: Plant: Cost (A) At fair value 150 000

PPE: Plant: Cost (A) 150 000
Transfer of PPE to NCAHFS: not re-measured in terms of IAS16
immediately prior to the transfer – see note 2 (below)
Deferred tax (A/L) W2 and W3 7 800

Revaluation surplus – plant (OCI) 7 800
Deferred tax balance is adjusted: change in intention (from held for use
to held for sale thus deferred tax measured based on intention to sell)
Impairment loss – NCAHFS (E) CA: 150 000 – FV -CtS: (150 000–20 000) 20 000
NCAHFS: Plant: acc impairment losses (-A) 20 000
Re-measurement to lower of CA or FV -CtS on reclassification:
Deferred tax (A/L) W2 and W3 4 800

Income tax expense (E) 4 800
tax measured based on intention to sell)
31 December 20X4
Impairment loss – NCAHFS (E) CA: 130 000 – FV -CtS: (140 000 –20 000) 10 000
NCAHFS: Plant: acc impairment losses (-A) 10 000
Re-measurement to lower of CA and FV -CtS after reclassification:
Income tax expense (E) W2 and W3 3 600

tax measured based on intention to sell)

Current tax payable: income tax(L) 63 000
Current tax payable
Note 1. There is no further depreciation on this asset from 1 January 20X4.

Note 2. Since a revaluation in terms of the plant’s previously applicable standard (IAS 16) had been
done a day before the asset was reclassified as ‘held for sale’, the plant is not revalued in terms
of IAS 16 on 1/1/X4 in terms of IAS 16. In other words, the plant’s carrying amount on date
of reclassification (1/1/X4) was already up-to-date in terms of IAS 16.
Note 3. The plant was not impaired at the end of either 20X2 or 20X3 since its recoverable amount
(greater of FV-CtS and VIU) was greater than its FV on both year-ends.
Workings
W1: Current income tax Calculations 20X4

C
Profit before tax Given 200 000
Add back depreciation Assets held for sale are not depreciated 0
Add back impairment Impairment on the NCAHFS: 20 000 + 10 000 30 000
Less tax allowance 100 000 x 20% (20 000)
Current tax 210 000 x 30% 63 000
Chapter 12 625
W2: Deferred tax: PPE – NCAHFS Carrying Tax Temporary Deferred

amount base difference tax
Purchase: 01/01/X1 100 000 100 000 0 0
Depreciation: (100 000 – 0)/ 10 x 1yr Cr DT
Tax allowance: 100 000 x 20% x 1yr (10 000) (20 000) (10 000) (3 000) Dr TE
PPE: Balance: 31/12/X1 90 000 80 000 (10 000) (3 000) Liability

(10 000) (20 000) (10 000) (3 000) Dr TE
Tax allowance: 100 000 x 20% x 1yr
80 000 60 000 (20 000) (6 000) Liability
Cr DT
Revaluation (IAS 16): 31/12/X2 40 000 0 (40 000) (12 000)
Dr RS

(15 000) (20 000) (5 000) (1 500)
Tax allowance: 100 000 x 20% x 1yr Dr TE
105 000 40 000 (65 000) (19 500)
Cr DT
Revaluation (IAS 16): 31/12/X3 45 000 0 (45 000) (13 500) Dr RS
Tfr out of PPE (150 000)

Dr DT
Trf into NCAHFS W3 150 000 7 800 Cr RS
DT adj: change in intention
NCAHFS: Balance: 01/01/X4 W3 150 000 40 000 (110 000) (25 200)
Dr DT
Impairment (IFRS 5): 01/01/X4 W3 (20 000) 0 20 000 4 800 Cr TE
FV – CtS: 150 000 – 20 000 W3 130 000 40 000 (90 000) (20 400)
Impairment (IFRS 5): 31/12/X4 (10 000)
FV – CtS: 140 000 – 20 000 W3 120 000 Cr DT
Depreciation: no depreciation 0 (10 000) (3 600) Dr TE
Tax allowance:100 000 x20%x1yr (20 000)
Balance: 31/12/X4 120 000 20 000 (100 000) (24 000) Liability
Values:
W3: Deferred tax adjustment in above table 01/01/X4 01/01/X4 31/12/X4
150 000 130 000 120 000
DT on the capital gain
Expected selling price Carrying amount ( FV) 150 000 130 000 120 000
Base cost Given (120 000) (120 000) (120 000)
Capital gain 30 000 10 000 0
Inclusion rate Given 80% 80% 80%
Taxable capital gain Capital gain x Inclusion rate 24 000 8 000 0
Taxed at 30% A: Taxable capital gain x 30% 7 200 2 400 0
01/01/X4 01/01/X4 31/12/X4

DT on the recoupment
Selling price limited to costCA (150 000), limited to cost (100 000) 100 000 100 000 100 000
CA (130 000), limited to cost (100 000)
CA (120 000), limited to cost (100 000)
Tax base 1/1/X4: 100 000 – 100 000 x20% x3yrs (40 000) (40 000) (20 000)
31/12/X4: 100 000 – 100 000 x20%x4yrs
Recoupment 60 000 60 000 80 000
Taxed at 30% B: Recoupment x 30% 18 000 18 000 24 000
Therefore:
DT Balance should be Liability: A + B (25 200) (20 400) (24 000)
DT Balance was Liability: See W2 (33 000) (25 200) (20 400)
Adjustment needed 7 800 4 800 (3 600)
Dr DT; Cr RS Dr DT; Cr TE Cr DT; Dr TE
626 Chapter 12
A: 4.8 Measurement implications of a change to a plan to sell/ distribute (IFRS 5.26 - .29)
A: 4.8.1 Overview
A non-current asset that was previously classified as held for sale (or held for distribution) could
subsequently fail to meet the criteria to remain classified as held for sale (or held for
distribution). If this occurs, then the non-current asset must be reversed out of the held for sale
(or distribution) classification and back to its previous classification (e.g. property, plant and
equipment). See section A: 4.8.2.
It can also happen that a non-current asset that was previously held for sale is now held for
distribution (or vice versa). In this case, there is still a plan to dispose of the asset and thus the
change in classification is considered to be a continuation of the original plan of disposal.
However, this does not mean that there are no adjustments required. See section A: 4.8.3.
A: 4.8.2 If a NCAHFS subsequently fails to meet the HFS or HFD classification criteria
If a non-current asset that was previously classified as ‘held for sale’ (or held for distribution)
no longer meets the criteria necessary for such a classification, the asset must be removed from
this classification. See IFRS 5.26
This means, it will have to be transferred out of the held for sale (or held for distribution)
classification and back into its previous classification (e.g. PPE). See IFRS 5.26
Before the transfer out of ‘held for sale’ (or ‘held for distribution’) it must be re-measured to the
lower of the following, measured on the date it ceased to be classified as held for sale:
x its carrying amount assuming the non-current asset had never been classified as such
(adjusted for any depreciation, amortisation and/ or revaluations that would have been
recognised had the asset not been classified as held for sale/ distribution); and
x its recoverable amount. See IFRS 5.27
An adjustment to the asset’s carrying amount is recognised in profit or loss unless the asset is an
item of property, plant and equipment or an intangible asset that was previously measured under
the revaluation model. In the case of the asset having previously been measured under the
revaluation model, the adjustment would be recognised in the same way that you would
recognise increases or decreases under the revaluation model. See IFRS 5.28 & footnote 6
A: 4.8.3 If a NCAHFS subsequently becomes a NCAHFD, or vice versa (IFRS 5.26A)
A non-current asset that was previously held for sale may cease to be held for sale and become
held for distribution instead (or vice versa). In this case, the asset would simply be transferred
from the held for sale classification to the held for distribution classification (or vice versa).
This non-current asset, which was previously held for sale (or held for distribution) would then
effectively be classified, measured and presented as held for distribution (or held for sale).
A measurement adjustment may be necessary since there is a tiny difference in how each
classification is measured: the held for sale classification is measured at the lower of carrying
amount and fair value less costs to sell, whereas the held for distribution classification is
measured at the lower of carrying amount and fair value less costs to distribute.
Any measurement adjustment would simply be accounted for as an impairment loss or

impairment loss reversal in terms of IFRS 5.20-25.
Since a reclassification from HFS to HFD (or vice versa) does not change the fact that the DG
is to be disposed of, and is thus considered to be a continuation of the original plan of disposal,
the date on which it was originally classified as HFS (or HFD) is not changed.
Chapter 12 627
Example 9: Re-measurement of assets no longer classified as ‘held for sale’

Plant measured under the cost model was classified as held for sale on 31 December 20X2
when its:
x Carrying amount was C80 000:
x Cost: C100 000 on 1 January 20X1 and
x Accumulated depreciation: C20 000 on 31 December 20X2
- 10% straight-line
- to nil residual values;
x Recoverable amount was C65 000:
x Fair value less costs of disposal: of C65 000
x Value in use: C40 000.
x Fair value less costs to sell: C65 000
On 30 June 20X3 (six months later), it ceased to meet all criteria necessary for classification
as ‘held for sale’. On this date its recoverable amount was C85 000. Its fair value less costs
to sell remained unchanged at C65 000.
Required: Show the journals as at 30 June 20X3 and 31 December 20X3.
Solution 9: Re-measurement of assets no longer classified as ‘held for sale’

30 June 20X3
NCAHFS: Plant: Acc imp losses (-A) W1 10 000
Impairment loss reversed – NCAHFS (I) 10 000
Re-measurement of NCAHFS before reclassifying as ‘PPE’: criteria for
‘held for sale’ no longer met
PPE: Plant: cost (A) Original cost (given) 100 000
PPE: Plant: acc. depreciation (-A) 100 000 x 10% x 2.5 25 000
NCAHFS: Plant: CA (A) Given: 100 000 – 20 000 80 000
NCAHFS: Plant: Acc imp losses (-A) CA: 80 000 – RA: 65 000 – ILR: 10 000 (W1) 5 000
Transfer from NCAHFS to PPE when no longer classified as HFS
31 December 20X3
Depreciation – plant (E) 100 000 x 10% x 0.5 5 000
Depreciation of plant for 6 months from 1 July 20X3
Workings: C
New carrying amount (30 June 20X3) to be lower of: 75 000
x Carrying amount had the asset never 100 000 – [(100 000-0) x 10% x 2.5 yrs] 75 000
been classified as ‘held for sale’
x Recoverable amount Given 85 000
Current carrying amount (30 June 20X3) Fair value – costs to sell (65 000)
Impairment loss to be reversed 10 000
Comment: Depreciation on this asset is backdated as if it never ceased.
A: 4.9 Measurement involving ‘scoped-out non-current assets’
As mentioned in section A: 2, the measurement provisions of IFRS 5 do not apply to the

following assets (see IFRS 5.5):
x Deferred tax assets (IAS 12)
x Assets relating to employee benefits (IAS 19)
x Financial assets (IFRS 9)
x Investment properties measured under the fair value model (IAS 40)
x Non-current assets measured at fair value less point-of-sale costs (IAS 41: Agriculture)
x Contractual rights under insurance contracts (IFRS 4). IFRS 5.5
628 Chapter 12
The scope exclusion simply means that these assets are not re-measured in terms of IFRS 5 (i.e.
to the lower of the carrying amount and fair value less cost to sell). However, IFRS 5 still requires
them to be classified as non-current assets held for sale and still requires the same presentation
and disclosure.
Example 10: Asset falling outside the measurement scope of IFRS 5
Land that is classified as investment property and measured using the fair value model, is
measured at its fair value of C80 000 (cost: 50 000) on 1 January 20X3. On 30 June 20X3
all criteria for separate classification as ‘held for sale’ are met, on which date the:
x fair value is C70 000, expected costs to sell are C5 000 and value in use is C60 000.
Required: Journalise the reclassification of the investment property on 30 June 20X3. Ignore tax.
Solution 10: Asset falling outside the measurement scope of IFRS 5

Comment:
x Investment properties measured under the fair value model in IAS 40 are excluded from the IFRS 5
measurement requirements and thus continue to be measured at ‘fair value’. They are thus not re-measured
to ‘fair value less costs to sell’ and thus the selling costs are ignored.
x Investment properties measured under the fair value model are not tested for impairment in terms of IAS 36
and thus the value in use was also ignored.
x Remember that the scope exclusion only applies to measurement of the asset and thus, the investment
property, although not measured in terms of IFRS 5, must be reclassified to the HFS classification and will be
presented and disclosed as such.
x Remember that the exclusion only applies to investment properties measured under the fair value model:
investment property under the cost model must be re-measured in terms of IFRS 5.
Journals: 30 June 20X3 Debit Credit

Fair value loss on investment property (E) W1 10 000
Investment property: Land (A) 10 000
NCAHFS: Land: CA (A) W1 70 000
Investment property: Land (A) 70 000
W1: Impairment of investment property on reclassification: C
Investment property at fair value on 1 January 20X3 Given 80 000
Fair value on 30 June 20X3 Given (70 000)
Fair value loss on investment property 10 000
A: 5 Disposal Groups Held for Sale
A: 5.1 Overview of disposal groups (IFRS 5 Appendix A and IFRS 5.4-5.6; 5.15 and .25)
As was explained in the introduction to this chapter (see section A: 1), IFRS 5 refers not only to
individual non-current assets that are held for sale (or distribution), but also to disposal groups
that are held for sale (or distribution).
The classification of a disposal group as held for sale is exactly the same as the classification of
an individual non-current asset as held for sale. Similarly, the presentation and disclosure
requirements that apply to individual non-current asset as held for sale apply equally to disposal
groups held for sale. Even the essential measurement principles that apply to individual non-
current asset as held for sale apply equally to disposal groups. However, because a disposal
group includes a variety of items (non-current assets and current assets and possibly even
liabilities), the measurement of a disposal group is slightly more complex than the measurement
of an individual non-current asset held for sale.
This section will explain how to identify whether you have a disposal group. You will then need
to apply the criteria previously discussed in section A: 3 to determine whether you must classify
this disposal group as held for sale.
Chapter 12 629
If you find that you have a disposal group that should be classified as held for sale, this section
will then explain how to measure it using the measurement principles previously discussed in
section A: 4. The presentation and disclosure of disposal groups is explained in section A: 6
together with the presentation and disclosure of individual non-current assets held for sale.
A: 5.2 Identification of disposal groups
A disposal group is simply a grouping of assets that are to be disposed of by sale or by some
other means. What is of supreme importance is that all of these assets (together with any directly
related liabilities) are to be disposed of together in a single
transaction. A disposal group is defined
as:
It is important to notice that there is a difference between x a group of assets (and liabilities
a disposal group and a disposal group held for sale. If directly associated with those assets
you look carefully at the definition of a disposal group, that will be transferred in the
transaction)
the group can be disposed of through a sale or by any other
x to be disposed of:
means. However, for the disposal group to meet the - by sale or
criteria for classification as held for sale, its carrying - otherwise,
amount must be expected to be recovered mainly through x as a group in a single transaction.
a sale transaction. Thus, for example, although a group of IFRS 5 Appendix A (slightly reworded)
assets that is to be abandoned may meet the definition of

a disposal group, it would not be classified as a disposal group held for sale.
A: 5.3 Classification, presentation and disclosure of disposal groups held for sale or
distribution
IFRS 5 also explains how to classify, measure, present and disclose disposal groups held for sale.
The principles of classification, presentation and disclosure that apply to non-current assets held
for sale (i.e. individual assets) apply equally to disposal groups held for sale (i.e. groups of assets
– or groups of assets with liabilities). Thus, these topics are not discussed again.
For classification of a disposal group as either held for sale or held for distribution, please revise
the principles that were explained in section A: 3. For presentation and disclosure of a disposal
group held for sale, please see the principles explained in section A: 6.
It is just the measurement principles that do not necessarily apply to all items in the disposal
group and may possibly not even apply to any of the items within the disposal group. These new
measurement principles will be explained in section A: 5.4.
A: 5.4 Measurement of disposal groups in general
Measurement of DGs
that are HFS or HFD:
The measurement of a disposal group that is held for sale
Disposal groups are measured
(or held for distribution) is interesting because it could at the lower of:
include all sorts of assets and even liabilities. However, x Its CA, and
we must remember that, as explained in Section A: 2, the x Its FV – CtS.
IFRS 5 measurement requirements do not apply to: Scoped-in NCAs in the DG are:
x Liabilities; x Not depreciated or amortised.
x Current assets; and Only those items in the DG that are
x Scoped-out non-current assets: scoped-in NCAs are affected by the
x Financial assets within the scope of IFRS 9 measurement requirements in IFRS 5.
Financial instruments;
x Investment property measured under the fair value model in terms of IAS 40 Investment
property;
x Non-current assets measured at ‘fair value less costs to sell’ in terms of IAS 41 Agriculture;
and
x Assets for which there might be difficulties in determining their fair value:
- Deferred tax assets, measured in terms of IAS 12 Income taxes;
- Assets relating to employee benefits, measured under IAS 19 Employee benefits;
- Contractual rights under insurance contracts, measured under IFRS 4 Insurance
contracts. See IFRS 5.5
630 Chapter 12
We will refer to those assets that the IFRS 5 measurement requirements do apply to as ‘scoped-
in non-current assets’.
If the disposal group includes at least one ‘scoped-in non-current asset’, the disposal group as a
whole will be subjected to the IFRS 5 measurement requirements (as well as the classification,
presentation and disclosure requirements).
If the disposal group does not contain any ‘scoped-in non-current assets’, then the disposal group
will not be subjected to the IFRS 5 measurement requirements at all (although it will still be
subjected to IFRS 5’s classification, presentation and disclosure requirements).
If the disposal group includes at least one ‘scoped-in non- A disposal group may
current asset’, the disposal group as a whole is thus include goodwill acquired in
measured in terms of IFRS 5 at: a business combination if it:
x is an operation within a cash-
x the lower of its carrying amount and its fair value less generating unit (CGU); or
costs to sell (if held for sale); or
x is a CGU to which goodwill has been
x the lower of its carrying amount and its fair value less allocated in accordance with the
costs to distribute (if held for distribution). requirements of IAS 36 Impairment
of Assets (IAS 36.80-.87).
IFRS 5 Appendix A
An entity must not depreciate (or amortise) a disposal
group once it has been classified as held for sale (or held for distribution).
If the disposal group contains liabilities, any interest or other expenses related to these liabilities
must continue to be recognised. See IFRS 5.25
A: 5.4.1 Initial measurement of disposal groups (IFRS 5.4 & 5.15 - 5.18 & 5.20 & 5.23 &
IAS 36.104)
The process to be followed on initial measurement is:

Initial measurement of
x Immediately before re-classification, all individual a DGHFS (or DGHFD):
assets and liabilities within the disposal group (DG)
must be measured in terms of their own standard (e.g. a x Before reclassification:
plant measured under the cost model must be Measure each item in the DGHFS
using its own IFRSs;
depreciated to date of classification and checked for
x After reclassification:
impairments, whereas inventory must be measured to
Measure DGHFS at lower of CA and
the lower of cost and net realisable value on FV-CtS (could lead to an imp loss).
classification date).
x The individual assets and liabilities must then be
transferred to the disposal group held for sale An impairment loss on the
initial measurement of a
(DGHFS) or the disposal group held for distribution DGHFS is allocated:
(DGHFD). x First to: goodwill, if applicable;
x The entire disposal group is then re-measured as x Then to: Scoped-in NCAs.
follows:
x for a DG held for sale, to the lower of its:
- carrying amount; or
- fair value less costs to sell.
x for a DG held for distribution, to the lower of its:
- carrying amount; or
- fair value less costs to distribute.
x Any impairment loss is apportioned to those assets in the disposal group which fall within
the measurement scope of IFRS 5:
x If goodwill is present, any impairment loss is first allocated to goodwill; and
x Any remaining impairment loss is then allocated proportionately to those assets in the
disposal group that fall within the IFRS 5 measurement requirements (i.e. to the scoped-
in non-current assets) based on their relative carrying amounts. See IAS 36.104
Chapter 12 631
None of the impairment loss is ever to be allocated to the other assets (i.e. to current assets or
scoped-out non-current assets) or to the liabilities within a disposal group.
An unintended consequence of the method of allocating impairment losses
The requirement that the impairment loss on a DGHFS (or DGHFD) be allocated only to those items in the
group that are ‘scoped-in non-current assets’ means that it is possible that the carrying amount of these
individual assets may be decreased to the point that they no longer reflect their value.
In fact, these individual values may drop not only below their true recoverable amounts but may even end up
being negative (i.e. an asset with a credit balance!)
It seems this was not intentional and that either an interpretation on this issue or an amendment to IFRS 5 is
clearly necessary.
Example 11: Disposal group held for sale – impairment allocation

Air Limited disposes of a group of 5 assets and a liability in a single transaction.
On 20 June 20X3, all criteria for separate classification as a ‘disposal group held for sale’
are met.
Immediately before the assets are classified as ‘held for sale’, they were re-measured in terms of their
own relevant standards to the following carrying amounts:
x Inventory: C70 000 (net realisable value: C70 000);
x Property, plant and equipment: C150 000 (recoverable amount: C150 000);
x Investment property measured using the fair value model: C80 000;
x Investment property measured using the cost model: C50 000 (recoverable amount: C60 000);
x Goodwill: C30 000;
x Trade payables: C10 000.
The fair value less costs to sell of the disposal group on 20 June 20X3 is C270 000.
Required: Calculate the impairment loss and show the allocation within the disposal group.
Solution 11: Disposal group held for sale – impairment allocation

Comment:
This example shows the following:
x Since the disposal group includes some scoped-in non-current assets, the entire disposal group is measured in
terms of IFRS 5.
x An impairment loss is first allocated to goodwill; any remaining impairment loss is allocated to other scoped-in
non-current assets based on their relative carrying amounts.
CA immediately Impairment loss CA immediately

before classification allocation after classification
as HFS as HFS
Note 2
Inventory 70 000 N/A 70 000
Note 4 & 5
Property, plant and equipment 150 000 (52 500) 97 500
Note 2
Investment property (FV model) 80 000 N/A 80 000
Note 4 & 5
Investment property (cost model) 50 000 (17 500) 32 500
Note 3
Goodwill 30 000 (30 000) 0
Note 2
Trade payables (10 000) N/A (10 000)
Note 1
Net assets 370 000 (100 000) 270 000
Note 1. The total impairment loss of 100 000 is calculated as:

CA: 370 000 (per table above) – FV-CtS (given): 270 000 = 100 000
Note 2. The measurement requirements of IFRS 5 only apply to ‘scoped-in non-current assets’ and
thus no part of the impairment loss on the measurement of the disposal group is allocated to
inventory (a current asset), trade payables (a liability) or the investment property under the fair
value model (a scoped-out non-current asset).
632 Chapter 12

Note 3. The impairment loss is first set-off against any goodwill, and any impairment loss remaining
is then allocated to the remaining ‘scoped-in non-current assets’ on the basis of the relative
carrying amounts:
Total IL: 100 000 – Goodwill: 30 000 = IL still to be allocated: 70 000
Note 4. The remaining impairment loss of 70 000 is allocated based on the carrying amounts of the
scoped-in non-current assets:
Property, plant and equipment: 70 000 x 150 000 / (150 000 + 50 000) = 52 500
Investment property (cost model): 70 000 x 50 000 / (150 000 + 50 000) = 17 500
Note 5. Notice how the carrying amount of the scoped-in non-current assets were dropped below the
carrying amounts that they would have had under IAS 36 Impairment of assets (i.e. property,
plant and equipment would not have dropped below C150 000 had this asset not been part of
a disposal group).
Note 6. If the impairment loss was greater than the carrying amounts of the scoped-in non-current
assets, the allocation of the impairment loss would have resulted in the property, plant and
equipment and investment property under the cost model being measured at negative amounts!
Example 12: Disposal group held for sale – initial impairment

Production Limited decides to dispose of a group of assets in a single sale transaction on
30 June 20X3, upon which date all criteria for separate classification as ‘held for sale’ are
met. Production viewed the intention to sell as an indication of a possible impairment and
thus calculated all amounts necessary in order to estimate recoverable amount.
Measurement details relating to the three assets in this group are as follows:
x Plant: measured using the cost model:
- 1 January 20X3: its carrying amount is C80 000 (bought on 1 January 20X1 at a cost of
C100 000 and depreciated at 10% pa to a nil residual value; never impaired);
- 30 June 20X3: its fair value is C70 000, expected selling cost is C5 000 and value in use is
C90 000.
x Factory building: measured using the cost model:
- 1 January 20X3: its carrying amount is C180 000 (bought on 1 January 20X1 at a cost of
C200 000 and depreciated at 5% pa to a nil residual value; never impaired);
- 30 June 20X3: its fair value is C170 000, expected cost to sell C15 000 and value in use is
C210 000.
x Investment property: measured using the fair value model:
- 1 January 20X3, its fair value is C80 000 (bought on 1 January 20X1 at a cost of C50 000);
- 30 June 20X3: its fair value is C70 000, expected selling cost is C5 000 and value in use is
C60 000.
On 30 June 20X3, the fair value less costs to sell of the disposal group as a whole was C285 000.
Required:
Calculate if there is an impairment or impairment reversal when measuring the disposal group on date
of classification as held for sale, 30 June 20X3. Show how it will be allocated. Ignore tax.
Solution 12: Disposal group held for sale – initial impairment

Comment:
x Since the intention to sell was considered to be an indication of a possible impairment, the value in use (VIU)
and fair value less costs of disposal (FV-CoD) were calculated. The higher of these two amounts is the
recoverable amount (RA) - see IAS 36. If the RA is less than the CA (prior to the classification), then the asset
must first be impaired in terms of IAS 36.
x Since the disposal group includes some scoped-in non-current assets, the entire disposal group is remeasured in
terms of IFRS 5.
x Any scoped-out non-current assets, current assets or liabilities in the disposal group must first be remeasured in
terms of their own standards. In this example, there was one such item, being an investment property measured
under the fair value model.
x Any impairment loss is first allocated to goodwill; any remaining impairment loss is allocated to other scoped-
in non-current assets based on their relative carrying amounts. There was no goodwill in this example and thus
the entire impairment loss is allocated to the two scoped-in non-current assets: plant and building.
Chapter 12 633

W1: Impairment of plant before reclassification: 30/06/20X3 C
(i.e. still PPE, measured in terms of IAS 16):
Plant: carrying amount 80 000 – (100 000 -0) x 10% x 6/12: Depreciation for 6 months 75 000
Recoverable amount Higher of VIU: 90 000 and FV-CoD: 70 000 – 5 000 = 65 000 (90 000)
Impairment of plant Plant is not impaired 0
W2: Impairment of factory building before reclassification: 30/06/20X3 C
(i.e. still PPE, measured in terms of IAS 16):
Building: carrying amount 180 000 –( (200 000 – 0) x 5% x 6/12) : Depreciation for 6 months 175 000
Recoverable amount Higher of VIU: 210 000 and FV-CoD 170 000–15 000 =155 000 (210 000)
Impairment of building Factory building is not impaired 0
W3: Fair value adjustment of investment property before reclassifying: 30/06/X3 C
(i.e. still investment property, measured in terms of IAS 40):
Investment property at fair value on 1 January 20X3 Given 80 000
Fair value on 30 June 20X3 Given (70 000)
Fair value loss 10 000
W4: Impairment of disposal group after reclassification C
(i.e. now NCAHFS, measured in terms of IFRS 5):
Plant: carrying amount W1 75 000
Building: carrying amount W2 175 000
Investment property: carrying amount W3 70 000
Carrying amount of disposal group 320 000
Fair value less costs to sell Given (285 000)
Impairment of disposal group 35 000
W5: Allocation of impairment to assets in disposal group C
Plant (cost model) 35 000 x 75 000 / (75 000 + 175 000) 10 500
Building (cost model) 35 000 x 175 000 / (75 000 + 175 000) 24 500
Investment property (FV model) None allocated: as outside IFRS 5 measurement scope N/A
Total impairment expense W4 35 000
An alternative layout of workings (instead of W4 and W5):
CA immediately Impairment loss CA immediately
before classification allocation after classification
as HFS as HFS
Note 3
Plant (cost model) 75 000 (10 500) 64 500
Note 3
Building (cost model) 175 000 (24 500) 150 500
Note 2
Note 1
Net assets 320 000 (35 000) 285 000

Note 2. The measurement requirements of IFRS 5 only apply to ‘scoped-in non-current assets’.
Investment property at fair value is a scoped-out non-current asset and thus none of the disposal
group’s impairment loss is allocated to investment property.
Note 3. The impairment loss is first set-off against any goodwill, and any impairment loss remaining
is then allocated to the remaining ‘scoped-in non-current assets’ on the basis of the relative
carrying amounts:
Total impairment loss: 35 000 – Goodwill: 0 = IL still to be allocated: 35 000
The remaining impairment loss of 35 000 is allocated based on the carrying amounts of the
Plant (scoped-in): 35 000 x 75 000 / (75 000 + 175 000) = 10 500
Building (scoped-in): 35 000 x 175 000 / (75 000 + 175 000) = 24 500
634 Chapter 12
A: 5.4.2 Subsequent measurement of a disposal group (IFRS 5.4; 5.19/.20; 5.23; IAS 36.122)
As with an individual asset, a disposal group must be remeasured to the lower of carrying amount
on classification date and its latest ‘fair value less costs to sell’ at the subsequent reporting date if
it remains unsold at this date. However, if a disposal group includes items that are excluded from
the measurement provisions of IFRS 5, please remember that the carrying amounts of these items
must be measured in accordance with their own relevant IFRS before the disposal group is
remeasured to its latest ‘fair value less costs to sell’. In other words:
x Within a disposal group, there may be two categories
of items: Subsequent measurement
of a DGHFS or DGHFD:
- Scoped-in non-current assets (measured in terms
of IFRS 5): these are not depreciated or amortised x Before remeasurement:
(per IFRS 5); and Scoped-in NCAs in the DG: do not
depreciate or amortise
- Other items (not measured in terms of IFRS 5): All other items in the DG: measure
current assets and/ or scoped-out non-current using their own IFRSs;
assets and liabilities: these continue to be x Remeasurement:
measured in terms of their relevant standards. Measure the DG at its latest FV-CtS
(or FV-CtD): this could lead to an:
x The carrying amount of the disposal group is adjusted - impairment loss
to reflect any changes to the carrying amounts of the - impairment loss reversal.
items not measured by IFRS 5 (i.e. current assets, scoped-out non-current assets and
liabilities), as measured in terms of their own standards.
x The latest fair value less costs to sell (or costs to distribute) for the disposal group as a whole
is then re-estimated and appropriate adjustments may be necessary, involving either:
- a further impairment loss; or
An impairment loss on
- an impairment loss reversal. subsequent measurement
of a DG is allocated:
An impairment loss will need to be recognised if the x First to: goodwill, if applicable;
carrying amount of the disposal group as a whole is x Then to: scoped-in NCAs.
greater than its latest most recent fair value less costs to (i.e. same as for initial measurement).
sell (or fair value less costs to distribute). An impairment
loss arising on subsequent measurement of the disposal group is allocated to individual assets in
the disposal group in the same way that an impairment loss on initial measurement was allocated.
In other words, the impairment loss is:

x first allocated against any goodwill that may be included, and then
x any remaining impairment loss is allocated to the other scoped-in non-current assets based on
their relative carrying amounts. See IAS 36.104
An impairment loss reversal will need to be recognised if the carrying amount of the disposal
group as a whole is less than its latest most recent fair value less costs to sell (or fair value less
costs to distribute). However, an impairment loss reversal is limited in that it may only be
recognised to the extent that:
x It has not been recognised in the re-measurement of An impairment loss
any current assets, scoped-out non-current assets or reversal on subsequent
liabilities; and measurement of a DG is:
x allocated to scoped-in NCAs (there is
x It does not exceed the cumulative impairment losses no limit to the amount allocated to
recognised in terms of IAS 36 Impairment of assets these items);
and/ or IFRS 5. IFRS 5.22 & See IAS 36.117 x never allocated to goodwill or any of
the other items in the DG. See IAS 36.122
An impairment loss reversed would then be allocated to scoped-in non-current assets based on
their relative carrying amounts but may never be allocated to goodwill. See IAS 36.122-123
There are no limits to which an impairment / reversal may be allocated to a scoped-in non-current
asset in the disposal group.
Chapter 12 635
Example 13: Disposal group held for sale – subsequent impairment

This example is a continuation of the example 12, relating to Production Limited.
A disposal group containing one scoped-out non-current asset, (investment property at fair
value), was impaired to its fair value less costs to sell of C285 000 on date of classification
(30 June 20X3) as follows:
Plant 75 000 (Example 12: W4) – 10 500 (Impairment: Ex 12: W5) 64 500
Building 175 000 (Example 12: W4) – 24 500 (Impairment: Ex 12: W5) 150 500
Investment property 70 000 (Example 12: W3) – N/A (Impairment: Ex 12: W5) 70 000
285 000
At 31 December 20X3, the disposal group has not yet been sold but still meets the criteria for
classification as ‘held for sale’. On this date, the investment property has a fair value of C69 000 and
the disposal group as a whole has a fair value less costs to sell of C270 000.
Required: Calculate whether there is an impairment or impairment reversal when re-measuring the
disposal group as at the year ended 31 December 20X3. Show how it would be allocated. Ignore tax.
Solution 13: Disposal group held for sale – subsequent impairment

Comment: This example shows how a subsequent impairment loss on a disposal group is recognised and allocated
in the same way as an initial impairment loss.
W1: Fair value adjustment of investment property at year end: C
Carrying amount is currently Example 13 (W4 and W5): 70 000 70 000

Fair value Given (69 000)
Fair value loss 1 000
W2: Impairment of disposal group at year end: C
Plant 75 000 (Example 12: W4) – 10 500 (Example 12: W5) 64 500
Building 175 000 (Example 12: W4) – 24 500 (Example 12: W5) 150 500
Investment property Given; or 70 000 – 1 000 (W1) 69 000
Carrying amount: 31/12/X3 284 000
FV - costs to sell: 31/12/X3 Given (270 000)
Impairment of disposal group 14 000
W3: Allocation of impairment to assets in disposal group C
Plant 14 000 x 64 500 / (64 500 + 150 500) 4 200

Building 14 000 x 150 500 / (64 500 + 150 500) 9 800
Investment property None allocated as the asset is ‘scoped-out’ from IFRS 0
measurement requirements See IFRS 5.5
Total impairment expense W7 14 000
An alternative layout of workings (instead of W2 and W3)

CA immediately before Impairment loss CA immediately
re-measurement allocation after re-
measurement
Note 3
Plant (cost model) 64 500 (4 200) 60 300
Note 3
Building (cost model) 150 500 (9 800) 140 700
Note 2
Note 1
Net assets 284 000 (14 000) 270 000

Note 2. The measurement requirements of IFRS 5 only apply to ‘scoped-in non-current assets’.
Investment property at fair value is a scoped-out non-current asset and thus none of the disposal
group’s impairment loss is allocated to investment property.
636 Chapter 12

Note 3. The impairment loss is first set-off against any goodwill, after which any impairment loss
remaining is allocated to the remaining ‘scoped-in non-current assets’ on the basis of the
relative carrying amounts:
Total impairment loss: 14 000 – Goodwill: 0 = IL still to be allocated: 14 000
The remaining impairment loss of 14 000 is allocated based on the carrying amounts of the
Plant (scoped-in): 14 000 x 64 500 / (64 500 + 150 500) = 4 200
Building (scoped-in): 14 000 x 150 500/ (64 500 + 150 500) = 9 800
Example 14: Disposal group held for sale – subsequent impairment reversal
Rescue Limited has a disposal group that met the criteria for classification as held for sale
on 5 May 20X2. The inexperienced accountant has calculated the values of the individual
items in the disposal group using their relevant individual standards as follows but has not journalised
anything:
x Immediately prior to the reclassification on 5 May 20X2:
- Inventory: lower of cost and net realisable value: C30 000 (IAS 2 Inventory);
- Plant: depreciated cost: C50 000 (IAS 16 Property, plant & equipment).
x At year-end, 31 December 20X2:
- Inventory: lower of cost and net realisable value: C75 000 (IAS 2 Inventory);
- Plant: depreciated cost: C25 000 (IAS 16 Property, plant & equipment).
x It has never been necessary to impair the plant.
The fair value less costs to sell of the disposal group as a whole was estimated as follows:
x 5 May 20X2: C70 000;
x 31 December 20X2: C150 000.
Required:
Show the measurement of the disposal group on 5 May and 31 December 20X2 and explain to the
accountant how the disposal group should be measured.
Solution 14: Disposal group held for sale – subsequent impairment reversal
Comment:
x This example shows a disposal group involving:
- An initial impairment; and
- A subsequent impairment loss reversal.
x The example shows that such a subsequent impairment loss reversal on a disposal group is recognised only to
the extent that:
- it has not been recognised in the re-measurement of any current assets, scoped-out non-current assets or
liabilities; and
- it does not exceed the cumulative impairment losses recognised in terms of IAS 36 Impairment of assets
and/ or IFRS 5.
W1: On 5 May 20X2 CA immediately Impairment loss CA immediately

before classification allocation after classification as
as HFS HFS
Inventory (scoped-out) 30 000 Note 1 N/A Note 3 30 000
Plant (scoped-in) 50 000 Note 1 (10 000) Note 3 40 000
Net assets 80 000 (10 000) Note 2 70 000 Note 2
Note 1. All individual items in the disposal group are first measured in terms of their own relevant
standards before classifying the items into the disposal group held for sale.
Note 2. The disposal group is then initially measured to the lower of its carrying amount (80 000) and
fair value less costs to sell (70 000). An impairment loss of 10 000 must be processed.
Note 3. The impairment loss must first be allocated to goodwill (not applicable in this example) and
then allocated to the scoped-in non-current assets (there was only one such item: plant).
Chapter 12 637
W2: On 31 December 20X2 CA immediately Impairment loss CA immediately

before re- reversal after re-
measurement allocation measurement
Inventory (scoped-out) 75 000 Note 1 N/A Note 4 75 000
Plant (scoped-in) 40 000 Note 2 10 000 Note 4 50 000
Net assets 115 000 10 000 Note 3 125 000 Note 2
Note 1. All items other than the scoped-in non-current assets must be remeasured in terms of their own
relevant standards first. Inventory is a current asset and must thus first be measured to the
lower of cost or net realisable value of C75 000 (given) in terms of IAS 2 Inventory.
Note 2. The depreciated cost that the accountant had calculated of C25 000 must be ignored because,
from 5 May, he should no longer be depreciating the plant. Thus, the plant’s carrying amount
before the IFRS 5 remeasurement should be its carrying amount after the last IFRS 5
remeasurement (i.e. C40 000).
Note 3. The fair value less costs to sell have increased by C80 000 (from C70 000 to C150 000). An
impairment loss reversal, however, may only be recognised to the extent that:
x the increase has not already been recognised in terms of standards relating to items other
than the scoped-in non-current assets;
x the increase does not exceed the previous cumulative impairment losses recognised in
terms of IAS 36 Impairment of assets and IFRS 5.
Part of the C80 000 increase has already been recognised by re-measuring the inventory
upwards by C45 000 (from C30 000 to C75 000). See note 1.
This leaves an increase of C35 000 (total increase: 80 000 – increase recognised in terms of
other standards: 45 000) but the portion thereof that will be recognised is limited to the
cumulative impairment losses in terms of IAS 36 Impairment of assets and IFRS 5.
The plant has never been impaired in terms of IAS 36 Impairment of assets (given) but was
impaired by C10 000 in terms of IFRS 5 (see W1). The remaining gain of C35 000 is thus
limited to the cumulative impairment loss of C10 000 (IAS 36: 0 + IFRS 5: C10 000).
Note 4. The impairment reversal would be allocated to the scoped-in non-current assets based on their
relative carrying amounts and would never be allocated to goodwill (not applicable in this
example). The entire impairment reversal is allocated to plant as it is the only scoped-in asset.
Explanation to accountant: re-measurement of disposal group:

On 5 May 20X2:
x Immediately before the classification as ‘held for sale’, all individual items within the disposal
group should be measured based on their relevant standards. The accountant was therefore correct
in measuring inventory using IAS 2 Inventory and measuring plant in terms of IAS 16 Property,
plant and equipment.
x The items are then transferred to the ‘held for sale’ category. The carrying amount of this disposal
group held for sale is C80 000 (Inventory: C30 000 + Plant: C50 000).
x Immediately after the classification as ‘held for sale’, the disposal group as a whole should then
have been measured to the lower of carrying amount and fair value less costs to sell. Since the fair
value less costs to sell were C70 000 and the carrying amount of the disposal group as a whole was
C80 000 the disposal group should have been impaired to the lower amount of C70 000 by
processing an impairment loss in terms of IFRS 5 of C10 000.
x The impairment loss must first be allocated to goodwill (not applicable in this example) and then
allocated to scoped-in non-current assets (there was only one such asset: plant). The plant should
thus have been impaired by C10 000 to C40 000 (C50 000 – C10 000).
x The revised carrying amount of the disposal group would thus have been C70 000 (Inventory:
C30 000 + Plant: C40 000).
638 Chapter 12

On 31 December 20X2:
x The fair value less costs to sell of the disposal group as a whole was re-estimated to be C150 000.
Before any adjustment is made, however, any current assets, scoped-out non-current assets and
liabilities should first be re-measured using their relevant standards.
- There was only one such item, being inventory (a current asset). Inventory was correctly re-
measured to the lower of cost and net realisable value in terms of IAS 2 Inventory: C75 000.
This required a write-back of C45 000 (C75 000 – C30 000).
- Since plant is a scoped-in non-current asset, it should not have been measured using IAS 16
Property, plant and equipment. The plant should have remained measured at C40 000.
x The carrying amount of the disposal group would then have been adjusted to C115 000:
- Inventory of C75 000 + Plant of C40 000 = C115 000, or
- Previous CA of disposal group: C70 000 + IAS 2 Inventory write-back: C45 000 = C115 000.
x The fair value less costs to sell of the disposal group as a whole has increased from C70 000 to
C150 000, however, being an increase of C80 000. This impairment loss reversal may only be
recognised to the extent that it has not already been recognised in terms of other standards and to
the extent that it does not exceed prior impairment losses in terms of IAS 36 and IFRS 5:
- Since inventory has already been increased by C45 000 (write-back in terms of IAS 2
Inventory), the impairment loss reversal is limited to C80 000 – C45 000 = C35 000;
- The remaining impairment loss reversal of C35 000 is then limited to the prior impairment
losses in terms of IAS 36 Impairment of assets (nil) and IFRS 5 (C10 000).
x Thus, an impairment loss reversal of C10 000 is recognised in terms of IFRS 5, raising the carrying
amount of the disposal group to C125 000. This gain would be allocated to scoped-in non-current
assets (only the plant in this example). (Please note: any impairment on goodwill may never be
reversed). Thus, the carrying amount of the disposal group would be adjusted to:
- Inventory of C75 000 + Plant of C50 000 (40 000 + 10 000) = C125 000, or
- Previous CA of disposal group: C115 000 + IFRS 5 Impairment reversal: C10 000 =
C125 000.
A: 5.5 Measurement of disposal groups that are not expected to be sold within one year
When measuring the fair value less costs to sell of a DGHFS that is not expected to be sold
within a year, we must measure the costs to sell at their present value. This present value will
obviously ‘unwind’ over time (i.e. the present value will increase over time) and this increase in
the present value must be recognised in profit or loss. See IFRS 5.17
A: 5.6 Measurement of disposal groups acquired with the intention to sell
A disposal group that is acquired with the intention to sell, and meets the necessary criteria for
classification as held for sale, will be immediately recognised and measured as a disposal group
held for sale and measured in terms of IFRS 5 (i.e. at the lower of carrying amount and fair value
less costs to sell). In other words, the assets and liabilities contained within the newly acquired
disposal group will not first be recognised and measured in terms of their own relevant standards
before then being transferred to the held for sale classification and measured in terms of IFRS 5.
Thus, the measurement of a disposal group held for sale that was acquired with the purpose of
selling, will be initially measured at the lower of:
x its carrying amount had it not been so classified (for example, cost); and
x its fair value less costs to sell. IFRS 5.16 (slightly reworded)
When measuring the DGHFS on initial recognition, the carrying amount is the cost that would
have been recognised had the assets and liabilities contained in the disposal group not been
immediately classified as held for sale.
Chapter 12 639
A: 5.7 Measurement of disposal groups when there is a change to a plan to sell or

distribute (IFRS 5.26 - .29)
A: 5.7.1 Overview
A disposal group that was previously classified as held for sale (or held for distribution) could
subsequently fail to meet the criteria to remain classified as held for sale (or held for
distribution). If this occurs, then the disposal group must be reversed out of the held for sale (or
distribution) classification and back to its previous classification (e.g. property, plant and
equipment). See section A: 5.7.2.
It can also happen that a disposal group that was previously held for sale is now held for
distribution (or vice versa). In this case, there is still a plan to dispose of the disposal group and
thus the change in classification is considered to be a continuation of the original plan of disposal.
However, this does not mean that there will be no adjustments needed. See section A: 5.7.3.
A: 5.7.2 If a DG subsequently fails to meet the HFS or HFD classification criteria
If a disposal group that was previously classified as ‘held for sale’ (HFS) or 'held for distribution'
(HFD) no longer meets the criteria necessary for such a classification, the disposal group must
be removed from this classification. See IFRS 5.26
This means, that the disposal group, (i.e. the individual assets and liabilities that were contained
in the disposal group) will have to be transferred out of the classification as ‘held for sale’ (or
‘held for distribution’) and back into its previous classification (e.g. property, plant and
equipment: PPE). See IFRS 5.26
Before transferring the disposal group out of the classification as ‘held for sale’ (or ‘held for
distribution’), the disposal group must be re-measured to the lower of:
x its carrying amount had the disposal group never been classified as such (adjusted for any
depreciation, amortisation and/ or revaluations that would have been recognised had the
disposal group not been classified as held for sale/ distribution); and
x its recoverable amount. See IFRS 5.27
Any re-measurement adjustments necessary (i.e. any adjustments to the carrying amounts of the
individual assets and liabilities) are generally recognised in profit or loss. However, if the item
that is being adjusted is either an item of property, plant and equipment or an intangible asset
that was previously measured under the revaluation model, then the adjustment would be
recognised in the same way that you would recognise increases or decreases under the
revaluation model. See IFRS 5.28 & footnote 6
If it is only an individual asset or liability from within the disposal group that subsequently fails
to meet the criteria to be classified as held for sale (HFS) or held for distribution (HFD), then we
remove that asset or liability from the disposal group held for sale (or held for distribution) but
we must then also reassess whether the remaining disposal group will continue to meet the
relevant classification criteria. See IFRS 5.29
If the remaining disposal group continues to meet the relevant classification criteria, then it
remains measured as a disposal group in terms of IFRS 5.
However, if the remaining disposal group no longer meets the relevant classification criteria,
then it may no longer be measured as a group in terms of IFRS 5. However, each of the individual
non-current assets that were contained in the disposal group will need to be individually assessed
in terms of these criteria.
640 Chapter 12
If the individual non-current assets:

x meet the criteria to be classified as held for sale (or held to distribute) then each such asset
would be individually measured in terms of IFRS 5 (i.e. at the lower of its carrying amount
and fair value less costs to sell/ distribute);
x do not meet the criteria to be classified as held for sale (or held to distribute) then each such
asset would cease to be classified as held for sale (or held for distribution). See IFRS 5.29
A: 5.7.3 If a DGHFS subsequently becomes a DGHFD, or vice versa (IFRS 5.26A)
A disposal group that was previously held for sale may cease to be held for sale and become held
for distribution instead (or vice versa). In this case, the disposal group must simply be transferred
from the held for sale classification to the held for distribution classification (or vice versa).
This disposal group, which was previously held for sale (or distribution) is now effectively
classified, measured and presented as held for distribution (or sale).
A measurement adjustment may be necessary since there is a tiny difference in how each
classification is measured: the held for sale classification is measured at the lower of carrying
amount and fair value less costs to sell, whereas the held for distribution classification is
measured at the lower of carrying amount and fair value less costs to distribute. Any
measurement adjustment would simply be accounted for as an impairment loss or impairment
loss reversal in terms of IFRS 5.20-25.
Since a reclassification from HFS to HFD (or vice versa) does not change the fact that the DG
is to be disposed of, and is thus considered to be a continuation of the original plan of disposal,
the date on which it was originally classified as HFS (or HFD) is not changed.
A: 6 Presentation and disclosure:

Non-Current Assets (or Disposal Groups) Held for Sale or Distribution (IFRS 5.30 & 38 - 42)
A: 6.1 Overview
Presentation and disclosure refer to different things:

x presentation refers simply to how and where the item/s should appear in the financial
statements and whether, for example, certain line items may be offset; whereas
x disclosure refers to the more detailed information that must be included in the financial
statements (generally in the notes).
In other words, presentation is more ‘surface level’ whereas disclosure refers to the ‘detail’ or
‘deeper level’ information.
When talking about presentation of a non-current asset (or disposal group) held for sale, the key
word to remember is ‘separate’.
Extra disclosure will be required where the financial statements include either:
x a ‘non-current asset (or disposal group) held for sale’; or
x a ‘sale of a non-current asset’.
Please note that the classification of a non-current asset (or disposal group) as ‘held for sale’ will
only affect the period during which it was classified as ‘held for sale’. This means that no
adjustment should be made to the measurement or presentation of the affected assets in the
comparative periods presented. See IFRS 5.40
The presentation and disclosure requirements will now be discussed with reference to each
component that is affected.
Chapter 12 641
A: 6.2 In the statement of financial position
A non-current asset (and any asset held within a disposal group) that is classified as ‘held for
sale’ must be presented separately from the other assets in the statement of financial position.
If a disposal group includes liabilities, these liabilities must also be presented separately from
other liabilities in the statement of financial position.
Liabilities and assets within a ‘disposal group held for sale’ may not be set-off against each other
– the assets held for sale must be shown under assets (but separately from the other assets) and
the liabilities held for sale must be shown under liabilities (but separately from the other
liabilities). See IFRS 5.38
A non-current asset (or disposal group) held for sale is presented as a current asset. See IFRS 5.3
A: 6.3 In the statement of financial position or notes thereto
The major classes of assets and major classes of liabilities that are classified as held for sale must
be separately presented from one another. In other words, if an item of property, plant and
equipment is classified as held for sale and an investment property is classified as held for sale,
each of these classifications must be presented as held for sale, but separately from one another.
This presentation may be made on the face of the statement of financial position or in the notes.
If the major class of asset and major class of liability that is classified as held for sale is presented
separately in the notes, these may then be added together and presented as a single line-item on
the face of the statement of financial position. See IFRS 5.38
A: 6.4 In the statement of other comprehensive income and statement of changes in equity
Any other comprehensive income recognised on a non-current asset (or disposal group) held for
sale must be separately presented and separately accumulated in equity. See IFRS 5.38
A: 6.5 Comparative figures
Comparative figures are not restated to reflect a reclassification to ‘held for sale’. For example,
if an item of property, plant and equipment is reclassified to held for sale during the current period,
the asset remains presented as property, plant and equipment in the comparative period.
A: 6.6 Other note disclosure (IFRS 5.12 and 5.41-.42)
A: 6.6.1 General note (IFRS 5.41)

An entity shall disclose the following information in the notes in the period in which a non-
current asset (or disposal group) has been classified as held for sale or sold:
a) a description of the non-current asset (or disposal group);
b) a description of the facts and circumstances of the sale, or leading to the expected disposal,
and the expected manner and timing of that disposal;
c) the gain or loss recognised in accordance with IFRS 5 (paragraph 20-22) and, if not
separately presented in the statement of comprehensive income, the caption in the statement
of comprehensive income that includes that gain or loss;
d) if applicable, the reportable segment in which the non-current asset (or disposal group) is
presented in accordance with IFRS 8 Operating Segments. See IFRS 5.41
A: 6.6.2 Change to a plan of sale (IFRS 5.42)
If, during the current period, there was a decision to reverse the plan to sell the non-current asset
(or disposal group), the following extra disclosure would be required:
a) the description of the facts and circumstances leading to the decision not to sell; and
b) the effect of the decision on the results of operations for all periods presented. See IFRS 5.42
642 Chapter 12
A: 6.6.3 Events after the reporting date (IFRS 5.12 and 5.41)
If the criteria for classification as ‘held for sale’ are met after the year-end, the non-current asset
must not be classified as held for sale in that reporting period (no re-measurements should be
performed and no reclassification of the asset to ‘held for sale’ should take place). Instead, it is
treated as a non-adjusting event, with the following disclosure:
a) a description of the non-current asset (or disposal group);
b) the facts and circumstances of the sale, or leading to the expected disposal;
c) the expected manner and timing of that disposal; and
d) the segment (if applicable) in which the non-current asset (or disposal group) is presented.
IFRS 5.12 and 5.41 (a) (b) & (d)
The note disclosure of an event after the reporting period might look like this:
Example Ltd
4. Events after the reporting period

On 15 February 20X4, the board of directors decided to dispose of the shoe division following
severe losses incurred by it during the past 2 years.
The division is expected to continue operations until 30 April 20X4, after which its assets will be
sold on a piecemeal basis. The entire disposal of the division is expected to be completed by
31 August 20X4.
This shoe division is reported in the Clothing Segment.
Example 15: Disclosure of non-current assets held for sale

An entity owns only the following non-current assets:
x Factory buildings; and
x Plant.
Details of the factory buildings are as follows:
x The factory buildings were purchased on 01/01/20X1 at a cost of C600 000.
x Depreciation is provided over 10 years to nil residual values on the straight-line basis.
Details of the factory building continued…:

x The company is transferring part of its business to a new location and thus the existing factory
building is to be sold. The sale is expected to take place within 7 months of the end of the reporting
period. The factory building is expected to be sold for cash.
x Factory buildings were reclassified as ‘held for sale’ on 30/06/20X3, on which date its fair value
less costs of disposal was C445 000 and its value in use was C440 000. Costs to sell and costs of
disposal are the same. Fair value less costs to sell remained unchanged at 31/12/20X3.
Details of the plant are as follows:
x Plant was purchased on 01/01/20X1 at a cost of C100 000;
x Depreciation is provided over 10 years to a nil residual value on the straight-line basis;
x Plant was reclassified as ‘held for sale’ on 31/12/20X2 on which date:
- its fair value less costs of disposal was C65 000 (costs to sell = costs of disposal); and
- its value in use was C60 000;
On 30/06/20X3 (six months later), plant ceased to meet all criteria necessary for classification as ‘held
for sale’, on which date its recoverable amount is C85 000 (fair value less costs to sell were still
C65 000). The plant is no longer classified as ‘held for sale’ since the intention is now to redeploy it to
other factories rather than it being sold together with the factory buildings.
Required:
Disclose all information necessary in relation to the plant and factory buildings in the financial
statements for the year ended 31 December 20X3.
Chapter 12 643
Solution 15: Disclosure of non-current assets held for sale

Comment:
This example explains how to disclose:
x non-current assets held for sale,
x a non-current asset that is no longer held for sale.
Company name
At 31 December 20X3
20X3 20X2
Non-current assets C C
Property, plant and equipment 26 70 000 480 000
Current assets
Non-current assets (and disposal groups) held for sale 27 445 000 65 000
Current liabilities
Liabilities of a disposal group held for sale 27 xxx xxx
Company name
20X3 20X2
5. Profit before tax C C
Profit before tax is stated after taking into consideration the following (income)/ expenses:
Depreciation: factory building 30 000 60 000
Depreciation: plant 5 000 10 000
Impairment loss: factory building 5 000 0
Impairment loss: plant 0 15 000
Impairment loss reversed: non-current asset held for sale COMMENT 1 (10 000) 0

Factory building 0 480 000
Plant 70 000 0
70 000 480 000
Factory building:
Net carrying amount – 1 January 480 000 540 000
Gross carrying amount – 1 January 600 000 600 000
Accumulated depreciation and impairment losses – 1 January (120 000) (60 000)
Depreciation (to 30 June 20X3) (30 000) (60 000)
Impair loss in terms of IAS 36 (CA: 450 000 – FV-CoD: 445 000) (5 000) 0
Non-current asset now classified as ‘held for sale’ (445 000) 0
Net carrying amount – 31 December 0 480 000
Gross carrying amount – 31 December 0 600 000
Accumulated depreciation and impairment losses – 31 December 0 (120 000)
Plant:
Net carrying amount – 1 January 0 90 000
Gross carrying amount – 1 January 0 100 000
Accumulated depreciation and impairment losses – 1 January 0 (10 000)
Non-current asset no longer classified as ‘held for sale’ COMMENT 1 75 000 0
Depreciation (20X3: (75 000 – RV: 0) / 7,5 remaining years x 6/12) (5 000) (10 000)
Impairment loss in terms of IAS 36 (CA: 80 000 – FV-CoD: 65 000) 0 (15 000)
Non-current asset now classified as ‘held for sale’ 0 (65 000)
Net carrying amount – 31 December 70 000 0
Gross carrying amount – 31 December 100 000 0
Accumulated depreciation and impairment losses – 31 December (30 000) 0
644 Chapter 12
Company name
20X3 20X2
27. Non-current assets held for sale C C
Factory buildings 445 000 0
Plant 0 65 000
Less non-current interest-bearing liabilities COMMENT 2 0 0
445 000 65 000
The company is transferring its business to a new location and thus the existing factory building is
to be sold (circumstances leading to the decision).
The sale is expected to take place within 7 months of year-end (expected timing). The factory
building is expected to be sold for cash (expected manner of sale).
No gain or loss on the re-measurement of the buildings was recognised in terms of IFRS 5.
Plant is no longer classified as ‘held for sale’ since it is now intended to be moved to other existing
factories instead of being sold as part of the factory buildings (reasons for the decision not to sell).
The effect on current year profit from operations is as follows: C
- Gross (impairment loss reversed: 10 000 – depr:5 000) 5 000
- Tax (1 500)
- Net 3 500
Comment 1: The NCAHFS is transferred back to PPE on 30 June 20X3: the NCAHFS is first re-measured to the
lower of its RA: 85 000 and its historical CA: 75 000 (100 000 – 100 000 x 10% x 2,5 years); thus,
an increase from 65 000 to 75 000 (the lower). It is thus measured as if it had always been measured
in terms of IAS 16.
Comment 2: The presentation of the non-current interest-bearing liabilities is shown here purely for interest
purposes since there are no liabilities in this example.
A: 7 Summary: Non-current assets held for sale

Non-current assets held for sale/ distribution
Classification
See IFRS 5.6-.7 See IFRS 5.12A

Held for sale: Held for distribution:
A NCA/DG is classified as HFS if its CA is A NCA/DG is classified as HFD if the entity is
expected to be recovered mainly through a sale committed to distributing it to the owners.
of the asset than through use of the asset.
We prove the above if these criteria are met: We prove the above if these criteria are met:
x the asset is available for immediate sale (in x the asset is available for immediate
its present condition and at normal terms); & distribution (in its present condition); &
x the sale thereof is highly probable. x the distribution thereof is highly probable.
See IFRS 5.8

Highly probable sale: Highly probable distribution:
A sale is highly probable if: A distribution is highly probable if:
x the appropriate level of mgmt is committed to it; x actions to complete the distribution have begun
x an active programme to sell has begun; x the distribution is expected to be concluded
x it must be actively marketed at a reasonable price within 1 yr of the date of classification as HFD
relative to its FV; x actions required to complete the distribution
x the sale is expected to be concluded within 1 yr should suggest that it is unlikely that:
of the date of classification as HFS (unless a - significant changes to the distribution will be
longer period is permitted in terms of IFRS 5.9) made; or that
x actions required to complete the sale should - the distribution will be withdrawn
suggest that it is unlikely that:
- significant changes to the plan to sell will be
made; or that
- the plan to sell will be withdrawn.
Chapter 12 645
Non-current assets (or disposal groups) held for sale
Classification: as held for sale
General If asset not expected to Assets acquired with

be sold within 1 yr intention to sell
Normal 6 criteria x 3 scenarios and related Normal 6 criteria, except, apart
criteria from the 1-yr requirement that
x Costs to sell to be must be met on acquisition date,
discounted (IFRS 5.17) the other criteria need not be
met on acquisition date if it is
highly probable they will be met
within a short period (normally
3m) from acquisition date
Measurement: Non-current asset held for sale
Cost model Revaluation model Assets acquired with

intention to sell
Initially: at cost Initially: at cost Initially: Lower of CA (cost)
Subsequently: Subsequently: and FV – CtS
Before reclassification: Before reclassification:

Depreciate and impair (if Depreciate; revalue (if FV
necessary and material) materially different to CA) and
impair (if necessary and material)
Reclassify: Reclassify:
Transfer to NCAHFS Transfer to NCAHFS

After reclassification: After reclassification:
x Adjust to lower of CA or FV x Adjust to lower of CA & FV – CtS

– CtS x Stop depreciating
x Stop depreciating x Remeasure to latest FV – CtS
x Remeasure to latest FV – at subsequent reporting dates
CtS (reversals of IL limited to
(reversals of IL limited to accumulated IL’s & never
accumulated IL’s & never exceed FV - AD)
exceed Cost - AD) x ILs are always expensed –
never debited to a RS bal.
If no longer held for sale
Transfer back to PPE Remeasure to lower of:

x CA (had asset never been classified as
NCAHFS); and
x RA
Resume depreciation
646 Chapter 12
Measurement: Disposal groups held for sale (DGHFS)

Can include:
x Non-current assets (NCAs)
- Scoped-in
- Scoped-out
x Current assets
x Liabilities
Only scoped-in NCAs are measured in terms of IFRS 5.

All other items remain measured in terms of their own IFRSs.
If the DG includes at least one scoped- If the DG does not include any scoped-
in non-current asset in non-current assets
The disposal group as a whole will be measured in The disposal group as a whole will not be
terms of IFRS 5 measured in terms of IFRS 5
The disposal group will be classified and disclosed The disposal group will be classified and disclosed
in terms of IFRS 5 in terms of IFRS 5
Measurement of the DG if the DG includes at least one scoped-in NCA
Immediately before Immediately after Subsequent re-measurement

classification as HFS classification as HFS of a DGHFS
Re-measure each item in the Measure the DG to the lower x Measure each of the items
DG based on their own of: excluding the scoped-in NCAs
standards x Cost or using their own standards.
x FV-CtS. x Calculate the DG’s new CA.

x Measure the DG to its latest
FV-CtS.
An impairment loss is first x Calculate the difference: New
allocated to goodwill (if any) CA less latest FV-CtS
and any further IL is allocated x An impairment loss is first
to the scoped-in NCAs, pro- allocated to goodwill (if any) and
rata based on their relative any further IL is allocated to
carrying amts. the scoped-in NCAs, pro-rata
based on their relative carrying
amts
x An IL Reversal is recognised (a)
to the extent that it has not
been recognised through an
increase in the CA of scoped-
out assets when measured in
terms of their own standards,
and (b) to the extent that it
does not exceed cumulative ILs
in terms of IAS 36 and IFRS 5,
and (c) pro-rata to the scoped-
in NCAs based on their relative
carrying amounts (but prior ILs
recognised against GW may
never be reversed).
Chapter 12 647
PART B:
Discontinued Operations
B: 1 Introduction to Discontinued Operations (IFRS 5.31 - .36)
IFRS 5 Non-current assets held for sale and discontinued

operations explains how to account for both non-current A component of an entity
is defined as comprising:
assets held for sale and discontinued operations. Part A
explained how we account for non-current assets (and x operations and cash flows
disposal groups) held for sale. In this part, Part B, we will x that can be clearly distinguished,
look at how to account for a discontinued operation. operationally and for financial
reporting purposes,
x from the rest of the entity.
IFRS 5 states that, if an entity has a component that is See IFRS 5 Appendix A
identified as a discontinued operation, certain additional

presentation and disclosure requirements will need to be Ax component of an entity is either:
a cash-generating unit (CGU), or
applied to this discontinued operation so that users can x a group of CGUs. See IFRS 5.31
assess the impact of the discontinuance. The discontinued
operation is measured in the same way that a disposal group held for sale is measured.
B: 2 Identification of a Discontinued Operation (IFRS 5.31 - .36)
The definition of a discontinued operation explains that, before an operation may be classified
as a discontinued operation, it must meet the definition of a component (i.e. being a CGU or
group of CGU’s), meet one of three specified criteria (see grey pop-up below) and must either
be classified as held for sale or be disposed of already.
A component comprises operations and cash flows that are clearly distinguishable from the rest
of the entity, from both an operational and financial reporting perspective (see definition in grey
pop-up in the section above). This means that a component is either a cash-generating unit or a
group of cash-generating units (while it was in use). If, for example, a disposal group meets the
criteria to be classified as held for sale but is only part of a cash generating unit, it would not
meet the definition of a component and thus would not meet the definition of a discontinued
operation. See IFRS 5.31 and App A
A discontinued operation
A component that represents a separate major line of is defined as:
business or geographical area of operations and which is x a component of an entity that has
either classified as held for sale or is disposed of would either been
meet the definition of a discontinued operation. For - disposed of, or
example, an entity may wish to dispose of all it operations - is classified as held for sale;
(component) within KwaZulu-Natal (a geographical area) x and meets one of the following
and thus these operations would be classified as held for criteria:
sale. In this case, these operations would qualify as a - is a separate major line of
business or geographical area of
discontinued operation. operations; or
- is part of a single co-ordinated
However, if only some of the outlets in KwaZulu-Natal plan to dispose of a separate
are to be disposed of, this would not represent a separate major line of business or
geographical area of operations;
geographical area. If one then concluded that it was also or
not a separate major line of business, then the disposal of - is a subsidiary acquired
these outlets would not meet the definition of a exclusively with a view to resale.
See IFRS 5 Appendix A (Reworded)
discontinued operation, unless the disposal of these outlets
formed part of a single co-ordinated plan to dispose of a separate major line of business or
geographic area of operations. In other words, if the disposal of some of the outlets in KwaZulu-
Natal was just a stepping stone to selling all the outlets in that geographic area or a stepping
stone to selling a larger major line of business of which these outlets were just a part, then the
disposal of these outlets would qualify as a discontinued operation.
648 Chapter 12
Now let us consider an operation that is a component that has not yet been disposed of but is
intended to be disposed of by abandonment instead of by sale. Such a component would not meet
the criteria to be classified as held for sale because its carrying amount will not be recovered
principally through a sale transaction than through use (see section A:3.2.2.1). Since a component
that is to be abandoned does not qualify to be classified as held for sale, it will not be able to be
classified as a discontinued operation until the operation has actually been abandoned (i.e. in which
case it will have been disposed of). Abandonment includes the following two situations:
x the non-current assets (or DGs) will be used until the end of their economic life; and
x the non-current assets (or DGs) will not be sold but will be simply closed down instead. See IFRS 5.13
When an entity decides to discontinue an operation, it generally (unless it involves a planned
abandonment) involves non-current assets and/ or disposal groups being classified as held for sale.
Thus, when dealing with discontinued operations, we will generally need to apply the disclosure
requirements for both disposal groups held for sale and discontinued operations.
B: 3 Measurement of a Discontinued Operation
A discontinued operation is, in effect, a disposal group (or multiple disposal groups) that is held for
sale (or one that has already been disposed of) and that also meets the definition of a component of
the entity and also meets the definition of a discontinued operation. See IFRS 5.31
Thus, the principles that we applied when measuring non-current assets (or disposal groups) as held
for sale are also applied when measuring the individual items within a discontinued operation. In
other words, just as with ‘disposal groups held for sale’ (DG), ‘discontinued operations’ (DO) could
also involve all sorts of assets as well as directly related liabilities.
Whereas the classification and presentation requirements of IFRS 5 applies to all ‘discontinued
operations’, the measurement requirements apply only to those non-current assets that are included
in the discontinued operation and which are ‘not scoped-out’ from the measurement requirements.
For more information on measurement, please revise section A: 4 and section A: 5.
B: 4 Disclosure of a Discontinued Operation
B: 4.1 Profit or loss from discontinued operation (IAS 1.82 (ea) & IFRS 5.33)
A separate line-item showing the total profit for the period from the discontinued operation must be
presented on the face of the profit or loss section in the statement of comprehensive income where
this total amount comprises:
x the post-tax profit or loss of the discontinued operations;
x the post-tax gain or loss recognised on measurement to fair value less costs to sell; and
x the post-tax gain or loss recognised on the disposal of assets/ disposal groups making up the
discontinued operations. IFRS 5.33 (a)
An analysis of this single amount that is presented in the statement of comprehensive income must
be presented ‘for all periods presented’. This single amount must be analysed into the following:
x revenue of discontinued operations; IFRS 5.33 (b) (i)
x expenses of discontinued operations; IFRS 5.33 (b) (i)
x profit (or loss) before tax of discontinued operations; IFRS 5.33 (b) (i)
x tax expense of the profit (or loss) on the discontinued operations; IFRS 5.33 (b) (ii)
x gain or loss on re-measurement to fair value less costs to sell; IFRS 5.33 (b) (iii)
x gain or loss on disposal of discontinued operation’s assets/disposal groups; IFRS 5.33 (b) (iii)
x tax effects of gain/ loss on re-measurement or disposal. IFRS 5.33 (b) (iv)
IFRS 5.34
The analysis of this single amount must be provided ‘for all periods presented’.
The analysis of this single amount may be provided in the notes (see option A) or on the face of the
statement of comprehensive income (see option B). IFRS 5.33 (b)
Chapter 12 649
Option A: If the analysis of the profit is presented on the face of the statement of comprehensive
income, the presentation would be as follows (the figures are assumed):
Example Ltd
20X3 20X3 20X3 20X2 20X2 20X2
C’000 C’000 C’000 C’000 C’000 C’000
Continuing Discontinued Total Continuing Discontinued Total
Revenue 800 150 800 790
Expenses (300) (100) (400) (500)
Profit before tax 500 50 400 290
Taxation expense (150) (32) (180) (97)
Gains/ (losses) after tax 40 7
Gain/ (loss): re-measurement 30 10
to fair value less costs to sell
Gain/ (loss): disposal of assets 20 0
in the discontinued operations
Tax on gains/ (losses) (10) (3)

Other comprehensive income: 0 0 0 0 0 0
Option B: If the total profit or loss is presented on the face of the statement with the analysis in
the notes, the presentation would be as follows (the figures are assumed):
Example Ltd
20X3 20X2
Note C’000 C’000
Revenue 800 800
Expenses (300) (400)
Taxation expense (150) (180)
Profit for the period from continuing operations 350 220
Profit for the period from discontinued operations 4 58 200
Profit (or loss) for the period 408 420
Example Ltd
20X3 20X2
C’000 C’000
4. Discontinued operation: analysis of profit
The profit from discontinued operations is analysed as follows:
x Revenue 150 790
x Expenses (100) (500)
x Profit before tax 50 290
x Tax on profit before tax (32) (97)
x Gains/ (losses) after tax (this line item is not required) 40 7
Gain/ (loss) on re-measurement to fair value less selling costs 30 10
Gain/ (loss) on disposal of assets 20 0
Tax on gains/ (losses) (10) (3)
650 Chapter 12
B: 4.2 Cash flows relating to a discontinued operation (IFRS 5.33(c))

An entity must disclose the following in respect of discontinued operations, either on the face of
the statement of cash flows or in the notes thereto, and ‘for all periods presented’:
x net cash flows from operating activities;
x net cash flows from investing activities; and
x net cash flows from financing activities.
Example Ltd
Notes to the statement of cash flows
20X3 20X2
4. Discontinued operation: analysis of cash flows C’000 C’000
The statement of cash flows includes the following net cash flows from a discontinued operation:
Net cash flows from operating activities (assumed figures) 5 6
Net cash flows from investing activities (assumed figures) 0 1
Net cash flows from financing activities (assumed figures) (9) (4)
Net cash inflows/outflows (assumed figures) (4) 3
B: 4.3 Comparative figures (IFRS 5.34)

Comparative figures are re-presented when a component becomes classified as a discontinued
operation. For example, if a component is classified as a discontinued operation during the
current period, the profit or loss from this component in the prior period must be re-presented as
being from a discontinued operation, even though the component did not become a discontinued
operation in that prior period. The fact that the prior period profit or loss has been re-presented
must obviously be disclosed to the users.
B: 4.4 Changes in estimates (IFRS 5.35)
A change in estimate may arise in respect of the profit or loss from the period relating to a
discontinued operation disposed of in a prior period. Examples of situations in which a change
in estimate may arise include the resolution of previous uncertainties relating to:
x the disposal transaction (e.g. adjustments to the selling price); and
x the operations of the component before its disposal (e.g. adjustments to warranty/ legal
obligations retained by the entity).
The nature and amount of the change in estimate must be disclosed (prior periods are obviously
not adjusted since changes in estimates are processed prospectively).
B: 4.5 Other note disclosure
B: 4.5.1 Components no longer held for sale (IFRS 5.36)
Where the component is no longer ‘held for sale’, the amounts previously disclosed as
‘discontinued operations’ in the prior periods must be reclassified and included in ‘continuing
operations’. The prior period amounts must be described as having been re-presented. This will
facilitate better comparability.
See the examples of disclosure provided in B: 4.1 and assume that the discontinued operation
was first classified as such in 20X2, but that during 20X3 the criteria for classification as
‘discontinued’ were no longer met. Now look at the example disclosure below (using option B
as the preferred layout) which shows the statement of comprehensive income for 20X3. Notice
that the prior year 20X2 figures shown below, whereas previously split into ‘continuing’,
‘discontinued’ and ‘total’ (in B: 4.1’s Option B) are now re-presented by reabsorbing the
discontinued amounts into the line items relating to the continuing operation. There is now no
reference to a discontinued operation.
Although IFRS 5 does not require it, it is suggested that a note be included explaining to the user that a
previously classified ‘discontinued operation’ has been reabsorbed into the figures representing the
‘continuing operations’ of the entity, thus explaining the re-presentation of the 20X2 figures (see the
heading at the top of the 20X2 column, where the fact that it is re-presented is made clear).
Chapter 12 651
Example Ltd
20X3 20X2
C’000 C’000
Re-presented
Revenue X2: 800 + DO revenue: 790 + DO gain: 10 1 000 1 600
X3: 800 + DO revenue: 150 + DO gains: 50
Expenses X2: 400 + DO expense:500 (400) (900)
X3: 300 + DO expense:100
Tax expense X2: 180 + DO taxes(97 + 3) (192) (280)
X3: 150 + DO taxes(32 + 10)
Comment: The above amounts tie up with the previous Option A and Option B (see Section B: 4.1).
B: 4.5.2 If the discontinued operation also meets the definition of ‘held for sale’
Bearing in mind that a discontinued operation is a component that either has already been disposed of
or is still held for sale, it means that if the component has not yet been disposed of, then all the
disclosure relating to non-current assets (or disposal groups) held for sale would also be required:
x The assets in the discontinued operation would be presented as held for sale and separated
from the entity’s other assets. The same would apply to its liabilities. IFRS 5.38
x A note would be required showing:
x a description of the non-current asset (or disposal group); IFRS 5.41 (a)
x a description of the facts and circumstances leading to the expected disposal; IFRS 5.41 (b)
x the expected manner and timing of the disposal; IFRS 5.41 (b)
x the gain or loss on re-measurements in accordance with IFRS 5 and, if not presented on the face of
the statement of comprehensive income, the line item that includes this gain or loss; and IFRS 5.41 (c)
x the segment (if applicable) in which the NCA (or DG) is presented. IFRS 5.41 (d)
B: 5 Summary: Discontinued Operations
Discontinued operations
Identification A component that has been disposed of or is classified as held for sale and is:
x Separate major line or geographical area; or
x Part of a single disposal plan to dispose of a separate major line or geographical area; or
x Is a subsidiary acquired to sell
Measurement Same as for non-current assets held for sale
Disclosure Statement of comprehensive income:
Face:
Total profit or loss from discontinued operations (show in profit or loss section)
Notes or on the face:
Analysis of total profit or loss for the period:
x Profit or loss
x Tax effects of P/L
x Gain or loss on re-measurement
x Gain or loss on disposals
x Tax effects of gains/ losses
x Changes in estimates
Statement of cash flows: (face or notes)
x Operating activities
x Investing activities
x Financing activities
Other notes:
x Components no longer held for sale
x Criteria met after the end of the reporting period
652 Chapter 12
Gripping GAAP Inventories
Chapter 13
Inventories
Main references: IAS 2; IFRS 13; IFRS 15, IAS 16 (incl. amendments to 10 December 2018)
Contents: Page
1. Introduction 655
2. Scope 656
3. The recognition and classification of inventory 656
4. Recording inventory movement: periodic versus perpetual systems 657
4.1 Overview 657
4.2 Perpetual system 657
4.3 Periodic system 658
Example 1: Perpetual versus periodic system 660
4.4 Stock counts, inventory balances and missing inventory 660
4.4.1 The perpetual system and the use of stock counts 661
4.4.2 The periodic system and the use of stock counts 661
Example 2: Perpetual versus periodic system and missing inventory 662
Example 3: Perpetual and periodic system: stock loss due to theft and profits 663
4.4.3 Presenting inventory losses 665
5. Initial measurement: cost 666
5.1 Overview 666
5.2 Purchase costs 666
5.2.1 Overview 666
5.2.2 Transaction taxes and import duties 666
Example 4: Transaction taxes and import duties 667
5.2.3 Transport costs 667
5.2.3.2 Transport/ carriage inwards 667
5.2.3.3 Transport/ carriage outwards 668
Example 5: Transport costs 668
5.2.4 Rebates 668
Example 6: Rebates 668
5.2.5 Discount received 669
Example 7: Discounts 670
5.2.6 Finance costs 671
Example 8: Deferred settlement terms 672
5.2.7 Imported inventory 673
5.2.7.1 Spot rates 673
Example 9: How to convert a foreign currency into a local currency 673
5.2.7.2 Transaction Dates 673
Example 10: Imported inventory – transaction dates 673
5.3 Conversion costs (manufactured inventory) 674
5.3.1 Overview 674
5.3.2 Conversion costs are split into direct costs and indirect costs 674
Example 11: Conversion costs 676
5.3.3 The ledger accounts used by a manufacturer 677
5.3.3.2 Accounting for the movements: two systems 678
5.3.3.3 Calculating the amount to transfer: three cost formulae 678
Example 12: Manufacturing journal entries 679
5.3.4 Manufacturing cost per unit 681
Chapter 13 653
Contents continued: Page

5.3.5 Variable manufacturing costs (costs that vary directly with production) 682
Example 13: Variable manufacturing costs 682
5.3.6 Fixed manufacturing costs (costs that do not vary directly with production) 683
Example 14: Fixed manufacturing costs and the use of a suspense account 684
Example 15: Fixed manufacturing cost suspense account – 3 scenarios 685
5.3.6.1 Under-production leads to under-absorption of FMCs 687
Example 16: FMC application rate – under-absorption 687
5.3.6.2 Over-production leads to over-absorption of FMCs 688
Example 17: FMC application rate – over-absorption 689
5.3.6.3 Budgeted versus actual fixed manufacturing rates summarised 690
Example 18: Fixed manufacturing costs – over-absorption 690
Example 19: Fixed manufacturing costs – under-absorption 691
5.3.7 Joint and by-products 693
Example 20: Joint and by-products 693
5.4 Other costs 694
5.4.1 General rule for capitalisation of other costs 694
5.4.2 Capitalisation of borrowing costs 694
5.4.3 Other costs that may never be capitalised 695
Example 21: All manufacturing costs including other costs 695
6. Subsequent measurement: inventory movements (cost formulae) 696
6.1 Overview 696
6.2 Specific identification formula (SI) 696
Example 22: SI purchases and sales 697
6.3 First-in, first-out formula (FIFO) 697
Example 23: FIFO purchases 697
Example 24: FIFO sales 697
6.4 Weighted average formula (WA) 698
Example 25: WA purchases 698
Example 26: WA sales 699
6.5 The cost formula in a manufacturing environment 699
Example 27: Manufacturing ledger accounts – FIFO vs WA formulae 700
7. Subsequent measurement: year-end 702
7.1 Overview 702
7.2 Net realisable value 703
Example 28: Net realisable value and events after reporting period 704
Example 29: Net realisable value based on purpose of the inventory 705
7.3 Inventory write-downs 705
Example 30: Lower of cost or net realisable value: write-downs 705
7.4 Reversals of inventory write-downs 706
Example 31: Lower of cost or net realisable value: reversal of write-downs 706
7.5 Presenting inventory write-downs and reversals of write-downs 708
Example 32: Lower of cost or net realisable value – involving raw materials 709
8. Disclosure 710
8.1 Accounting policies 710
8.2 Statement of financial position and supporting notes 710
8.3 Statement of comprehensive income and supporting notes 710
Example 33: Disclosure – comparison between the nature and function method 710
Example 34: Disclosure of cost of sales and inventory related depreciation 712
Example 35: Disclosure of inventory asset and related accounting policies 713
9. Summary 714
654 Chapter 13
1. Introduction
The standard that explains how we account for inventories is IAS 2 Inventories. Its main focus
is on the determination of the cost of the inventories, and when to recognise this cost as an
inventory expense (e.g. when the revenue is recognised or when it needs to be written-down).
Interestingly, unlike other standards that show us how to account for assets, such as
IAS 16 Property, plant and equipment and IAS 38 Intangible assets, this standard does not deal
with when to recognise costs as an inventory asset.
Inventory is an asset that the entity either ultimately intends to sell or is an asset that is in the
form of ‘materials and supplies’ that the entity intends to use in the production process or in
providing a service (often called ‘consumable stores’). Inventories can be tangible or intangible.
Notice that the classification of inventories, as with all other asset classifications, depends on
intentions. For example, if we owned the following 3 properties, but have a different intention
for each, we would have to classify and account for them separately as follows:
x Property that we purchased with the intention of using as our factory: this would be
classified as property in terms of IAS 16 Property, plant and equipment;
x Property that we purchased with the intention of holding for capital appreciation: this
would be classified as investment property in terms of IAS 40 Investment property; and
x Property that we purchased with the intention of selling in the ordinary course of business:
this would be classified as inventories in terms of IAS 2 Inventories.
The type of inventory that a business has depends on the nature of the business, for instance,
whether the business is a retailer, manufacturer, or perhaps a combination thereof.
Classes of inventory according to business-type:

Retailer: Manufacturer:
x Merchandise x Finished goods
(or ‘merchandise for sale’)
x Work-in-progress
x Raw materials
Note: A further category of inventories is consumable stores, being ‘materials and supplies’ that the
entity intends using in the production process or in providing a service..
In the case of retailers and manufacturers, inventories often represent a significant portion of
the entity’s total assets (inventory is presented as a current asset in the SOFP).
As an item of inventory is sold, a relevant portion of the cost of inventory must be removed
from the inventory asset and expensed. Inventory that is sold is generally called cost of sales,
and is expensed in profit or loss. This expense is often the biggest expense that a retailer or
manufacturer has, thus it also significantly affects an entity’s profit or loss.
The principles regarding inventories that we need to consider include:

x when to recognise and classify the purchase of an asset as inventory (section 3);
x how to record inventory movements using the periodic or perpetual system (section 4);
x how to measure inventory on initial recognition (section 5);
x how to measure inventory subsequently:
- how to measure the 'cost of inventory sold expense' (i.e. how to measure the cost of
individual items of inventory as they are sold) – this is often referred to as the
measurement of the inventory movements and involves the use of one of the cost
formulae (SI, FIFO and WA formulae) (section 6),
- how to measure the cost of inventory that remains unsold at year-end (section 7);
x when to derecognise inventory (this occurs when it is either sold or scrapped);
x how to disclose inventories in the financial statements (section 8).
Chapter 13 655
2. Scope
IAS 2 applies to all assets that meet the definition of inventories except for the following:
x Financial instruments (these are accounted for in terms of IFRS 9 Financial instruments
and IAS 32 Financial instruments: Presentation)
x Biological assets related to agricultural activity and agricultural produce at the point of
harvest (these are accounted for in terms of IAS 41 Agriculture). IAS 2.2 (reworded)
Although IAS 2 does apply to the following assets, its measurement requirements do not:
x producers of agricultural and forest products, agricultural produce after harvest, and
minerals and mineral products, to the extent that they are measured at net realisable value
in accordance with well-established practices in those industries. When such inventories
are measured at net realisable value, changes in that value are recognised in profit or loss
in the period of the change.
x commodity broker-traders* who measure their inventories at fair value less costs to sell.
When such inventories are measured at fair value less costs to sell, changes in fair value
less costs to sell are recognised in profit or loss in the period of the change. IAS 2.3
*
Commodity brokers are similar to investment bankers, except that, instead of trading in equities,
commodity brokers buy and sell commodities (i.e. products or services), such as wheat, cattle, etc.
Changes to IAS 2 since the new IFRS 15 Revenue from contracts with customers was issued
Please note that:
x Before the publication of IFRS 15 Revenue from contracts with customer, IAS 2 clarified that costs
incurred by a service provider would be recognised as inventory to the extent that the related revenue
could not be recognised. This has now been removed from IAS 2 (previously para 8 of IAS 2).
x After the publication of IFRS 15, IAS 2 was also amended to clarify that any costs that are not able to be
accounted for in terms of IAS 2 Inventories or in terms of any other standard (e.g. IAS 16 Property, plant
and equipment) must be accounted for in terms of IFRS 15 instead. See IAS 2.8
3. The Recognition and Classification of Inventory
The focus of IAS 2 is on how to measure the inventory An asset is:

asset, and how and when this inventory asset should
subsequently be recognised as an expense. x Recognised: when it meets the asset
definition and recognition criteria
IAS 2 does not explain when inventory should be
x Classified as inventory: when it meets
recognised. However, IAS 2’s definition of inventory the definition of inventory
(see pop-up below) states, amongst other things, that
inventory is an asset. Thus, we look to the Conceptual Framework (CF) because it provides
guidance on when to recognise an asset. The CF states that we must initially recognise an item
as an asset when the CF’s definition of an asset and related recognition criteria are met (see
chapter 2).
Inventory is defined as:
So, if an item meets the asset definition and recognition
criteria, per the CF, we recognise it as an asset. When x an asset
x that is:
recognising it as an asset, we then decide what type of asset - held for sale in the ordinary course
to classify it as (inventory, investment property, plant etc): it of business; or
would be classified as an inventory asset if it meets the - in the process of production for
such sale; or
inventory definition given in IAS 2 (see pop-up alongside). - in the form of materials or supplies
to be consumed in the production
If we look carefully at this definition of inventory, we process or in the rendering of
IAS 2.6
services.
see that it essentially includes what:
x retailers commonly refer to as merchandise;
x manufacturers commonly refer to as raw materials, work in progress and finished goods; &
x various entities commonly refer to as consumable stores.
656 Chapter 13
Looking at the inventory definition again, we also see that it clarifies that, other than consumables, an
asset may only be classified as inventory if it is held for sale (or held in the process of manufacture for
the eventual sale) in the ordinary course of business. Thus, if our ordinary business involves buying
and selling properties, we would classify these properties as inventories. However, if our ordinary
business does not involve the buying and selling of properties and yet we happen to buy a property
that we intend to sell as soon as we can make a profit, although our intention is to sell it, we would not
classify this property as inventory because it will not be sold as part of our ordinary business activities.
Inventory assets are subsequently recognised either as expenses or as other assets as follows:
x inventory is subsequently recognised as an expense in the periods in which:
- the inventory is sold and the related revenue is recognised, or
- the inventory is written down to net realisable value; or
x inventory is subsequently recognised as part of another asset if the inventory was used in
the manufacture of the other asset (e.g. a self-constructed plant), in which case the cost of
this inventory will eventually be expensed (e.g. when depreciating the plant). See IAS 2.34 -.35
4. Recording Inventory Movement: Periodic Versus Perpetual Systems
4.1 Overview
The movement of inventory refers to the purchase, and subsequent sale of inventory. However,
the focus of this section is the sale of inventory. Entities often experience high volumes of
inventory sale transactions. The perpetual system, which requires processing a separate journal
entry for each one of these transactions, can be difficult for certain entities, especially smaller
entities. Thus, s simpler system, called the periodic system, was devised. This system processes
a single journal entry to record the sales transaction at the end of a period.
These systems are not laid down in IAS 2, and thus the exact mechanisms of how to record
inventory movements under these two systems differ slightly from entity to entity.
Essentially, however, the difference between these two systems is simply that:
x Under the perpetual system, we perpetually (i.e. continually) update our ledger to account
for the cost of each ‘inventory purchase transaction’ and for the cost of each ‘inventory
sale transaction’; whereas
x Under the periodic system, although we update our ledger to account for the cost of each
‘inventory purchase transaction’, we do not update it to account for the cost of each ‘inventory
sale transaction’ but, instead, we record the total cost of all ‘inventory sale transactions’ for
a period (e.g. the period could be a month or a year) as a single transaction.
Although the periodic system is simpler, the ability to detect any theft of inventory is generally
not possible. This means that the gross profit calculated under the perpetual system may differ
from that calculated under the periodic system. The final profit or loss, calculated in the profit
or loss account will, however, be the same. This is explained under section 4.4.
The periodic system is generally used by smaller businesses that do not have the necessary
computerised accounting systems to run a perpetual system. However, with the proliferation
of computerised accounting packages, most businesses nowadays, and certainly most of the
larger manufacturing businesses, would normally apply the perpetual system.
4.2 Perpetual system

The perpetual system is used by businesses that have more sophisticated needs (i.e. large
businesses and manufacturing concerns), or have access to computerised accounting systems
that can accommodate this ‘real-time’ processing.
The perpetual system uses two accounts:
x an inventory account (an asset); and
x a cost of sales account (an expense).
Chapter 13 657
The perpetual system:

Both these accounts are perpetually (constantly) updated for
each purchase and each sale of inventory, as and when these x is used by bigger entities
occur. Thus, the balance in the inventory account on any one x uses the following ledger accounts,
day reflects what we should physically have on hand on that which are continously updated:
- inventory account &
day and similarly the cost of sales account reflects the latest - cost of sales account
cumulative cost of sales. x can detect missing stock e.g. from theft.
The fact that our inventory account reflects what the closing balance should be means that a physical
stock count can then be used to check our closing balance. This stock count is performed at the end of
the period (normally at year-end). This comparison between the balance in the inventory account and
the results of the physical count will thus be able to identify any missing inventory, which is then
recorded as a separate expense (e.g. inventory loss due to theft).
4.3 Periodic system

The periodic system:
Computerised accounting packages have made the x is used by smaller entities
perpetual system far more popular among businesses. x uses the following ledger accounts,
However, small businesses, which may not have access which are not all continously updated:
to these packages, will use the periodic system. Thus, the - purchases account
periodic system is still important to understand. - inventory account &
- cost of sales account
Under the periodic system, we do continually update our x uses a physical stock count to
ledger accounts for the cost of each inventory purchase, but determine the inventory c/ balance
we do not continually update our ledger accounts for the cost x cannot identify lost stock (e.g. theft)
of each sale of inventory. Instead, the entity processes one single journal entry to account for the total
cost of all the inventory sales during the period, where this amount is calculated as a balancing figure
after performing a stock count.
This stock count is done periodically, generally at year-end. It involves physically counting all
the items of inventory on hand. We then calculate the total cost of all items of inventory on
hand by multiplying the number of units counted by the cost per unit. This total cost of the
inventory on hand (per the stock count) is then used as our inventory closing balance.
Once we have determined our inventory closing balance, we can balance back to our cost of sales. We
do this by comparing this inventory closing balance with the total of our inventory opening balance
plus the cost of our inventory purchased during the year (i.e. opening balance + purchases – closing
balance). All inventory that is ‘missing’ is assumed to have been sold and thus the cost of the ‘missing
inventory’ is recognised, by way of one single entry, as the total cost of all the ‘inventory sale
transactions’ during the period (i.e. the total cost of sales). Thus, we are overlooking the possibility that
some of this inventory may not have been sold but could, for example, have been stolen instead. This
means that this periodic system is not designed to automatically detect and separately record stock theft
and thus this system is not as accurate as the perpetual system.
For example, an entity with no inventory on hand at the beginning of a year, records each of the
inventory purchases during the year, totalling C5 000. The entity then counts the inventory on hand at
year-end and calculates the cost thereof to be C2 000. In this case, the entity will record the difference
of C3 000 as the cost of sales for the year.
In summary, when using the periodic system, we need a physical stock count to determine the
value of our closing inventory, which we then use to balance backwards to the cost of sales.
The periodic system uses three accounts:
x a purchases account in which we continually record the cost of all purchases in the period;
x an inventory account in which we periodically record the cost of inventory on hand on a specific
date (generally year-end). This cost is calculated after doing a physical stock count (please note
that this account is not continuously updated for cost of purchases and cost of sales);
x a cost of sales account which we use to calculate the cost of sales during the period (by
comparing the information in the purchases account and the balances in the inventory
account) (this account is not continuously updated for the cost of sales during the period).
658 Chapter 13
The journals that are processed under the periodic system will now be explained. During the
period, we would process the following journal for each and every purchase of inventory (let’s
call this journal 1). Notice that we are not debiting the purchases to the ‘inventory asset’ account
but are using a ‘purchases’ account – this account is simply a temporary account (T) the total
of which will eventually be transferred to the ‘cost of sales’ account:
Journal 1 Debit Credit
Purchases (T) xxx
Bank/ accounts payable xxx
Purchase of inventories
We would record the following three journals after both physically counting the stock on hand
(at reporting date) and then calculating the cost of this stock.
Journal 2: Remove the opening balance in inventory (credit) and transfer it to cost of sales (debit)
Rationalise this journal as follows: We start by assuming that all of our opening inventory
must have been sold during the year – thus we simply expense it to cost of sales.
Journal 3: Remove the amount in the purchases account (credit) and transfer it to cost of sales (debit).
Rationalise this journal as follows: we then assume that all the inventory we purchasedd
during the year was also sold during the year – thus we simply expense this to cost of sales
Journal 4: Recognise the inventory on hand (the cost of the items counted in the stock count) as the
new closing inventory balance (debit) and simultaneously reduce the cost of sales (credit).
Rationalise this journal as follows: The first 2 journals assumed that we had sold the entire
opening inventory plus the entire purchases of inventory during the year. But when we look at
our closing inventory it is obvious that these assumptions were not entirely correct! We clearly
did not sell everything, which means that expensing all of the opening inventory and all of the
purchases was a little too optimistic. This journal is thus reversing an amount back out of cost of
sales and into inventory to the extent that this inventory is still on hand.
Journal 2 Debit Credit

Cost of sales (E) xxx
Inventory (A) xxx
Transfer of the inventory opening balance to cost of sales
Journal 3
Purchases (T) xxx
Transfer of the inventory purchases to cost of sales
Journal 4
Inventory (A) xxx
Recognition of the results of the stock count as the new inventory closing
balance, with the contra entry being to cost of sales
At this point, we simply balance our cost of sales account to calculate what the cost of sales
expense is for the period:
Cost of sales (expense)
Inventory (opening balance) Jnl 2 Xxx Inventory (closing balance) Jnl 4 Xxx
Purchases Jnl 3 Xxx Balance c/f
Xxx Xxx
Balance b/f Xxx
An obvious problem with the periodic system is that it requires us to assume that the inventory
on hand according to the stock count is indeed what the inventory closing balance should be.
This means that this system cannot detect inventory that may have gone missing, in which case
it would result in an overstatement of cost of sales.
The periodic system and the detection of stock theft is explained in more detail in section 4.4.2.
Chapter 13 659
Example 1: Perpetual versus periodic system

Opening inventory balance C55 000
Purchases during the year (cash) C100 000
A stock count at year-end reflected 18 000 units on hand (each unit had been purchased for C5).
Required: Show the ledger accounts using:
A. the periodic system
B. the perpetual system, assuming that 13 000 units were sold during the year.
Solution 1A: Using the periodic system
Purchases (Temporary) Cost of sales (Expense)
Bank (2) 100 000 Invent. (o/b) (3) 55 000 Inventory (c/b)(4) 90 000
Cost of sales (5) 100 000 Purchases (5) 100 000 Total c/f (6) 65 000
100 000 100 000 155 000 155 000
Total c/f 0 Total b/f (6) 65 000
Inventory (Asset)
O/ bal (1) 55 000 Cost of sales (3) 55 000
Cost of sales (4) 90 000
Notes to the ledger accounts:
(1) This balance remains C55 000 for the entire period until such time as the stock count is performed.
(2) The purchases are recorded in the purchases account during the period (dr purchases and cr bank/ payable).
(3) In order to record the closing balance, the opening balance (C55 000) must first be removed from this
account. This is done by transferring it out and into the cost of sales account (dr cost of sales & cr inventory).
(4) The closing balance of the inventory account is determined at the end of the period by physically counting
the inventory on hand and valuing it at cost (C90 000). This cost (given as C90 000) is recorded in the
inventory account, while simultaneously reducing the cost of sales account (dr inventory and cr cost of sales).
(5) The total of the purchases during the period is transferred to the cost of sales account.
(6) Notice how the balance on the cost of sales account now reflects the cost of sales expense.
Solution 1B: Using the perpetual system

Inventory (Asset) Cost of sales (Expense)
O/ balance 55 000 Cost of sales (2) 65 000 Inventory (2) 65 000
Bank (1) 100 000 C/ balance 90 000
155 000 155 000
C/ bal (3) 90 000

(1) The cost of the purchases is debited directly to the inventory (asset) account.
(2) The cost of each sale is calculated: 13 000 x C5 = C65 000 (the cost per unit was constant at C5 throughout
the year). In reality, this amount would have been processed as individual cost of sales journals as and when
each sale occurred (i.e. rather than as a total cost of sales journal).
(3) The final inventory on hand at year-end is calculated as the balancing figure by taking the opening balance
plus the increase in inventory (i.e. purchases) less the decrease in inventory (i.e. the cost of the sales):
C55 000 + C100 000 – C65 000 = C90 000. This is then compared to the physical stock count, which
reflected that the balance should be C90 000. If the stock count reflected an actual inventory balance lower
than C90 000, this would have suggested that there had been theft and an adjustment would have had to be
processed to account for the theft. In this example, the stock count also reflected C90 000 and thus no
adjustment was necessary.
In example 1, the cost of sales and inventory balances are not affected by whether the periodic
or perpetual system is used (i.e. cost of sales was C65 000 and inventory was C90 000 in both
part A and part B), since there was clearly no missing inventory. Let us now look at the
difference between the perpetual and periodic system where there is missing stock.
4.4 Stock counts, inventory balances and missing inventory
As already mentioned, when we use the perpetual system, we are able to compare our inventory
closing balance with a physical stock count and thus identify any missing inventory (e.g. theft).
660 Chapter 13
Unfortunately, this is not possible when using the periodic system, because this system uses the
stock count to determine (not check) the inventory closing balance. Thus, a disadvantage of the
periodic system is that any stock losses will generally remain undetected.
4.4.1 The perpetual system and the use of stock counts

An advantage of the perpetual system is that it is able to The perpetual system:
detect whether there is any missing inventory (e.g. due to
theft). When using the perpetual system, the accountant x uses stock counts as a check; & thus
calculates the balance of the inventory account without the x can detect stock losses
use of a stock count. This balance thus reflects what the
balance should be (i.e. theoretical balance). A stock count is then performed to determine what
the actual balance is.
If the physical count reveals a lower stock level than is reflected by the theoretical balance on
the inventory account (i.e. there is missing stock), the difference will be accounted for by
reducing the carrying amount of the inventory asset and recognising this reduction as an
inventory loss expense, as follows:
Debit Credit
Inventory loss (E) xxx
Inventory (A) xxx
Inventory loss recognised due to missing stock (e.g. theft of inventories)
If the physical count reflects more stock than appears in the inventory account, then this
suggests that either an error has occurred in recording the purchases or sales during the period,
or in the physical counting of the stock. Further investigation would be required to determine
what adjustments are required.
4.4.2 The periodic system and the use of stock counts

When using the periodic system, the accountant does not The periodic system
have any idea what either his inventory balance is or
x requires a stock count in order to
what his cost of sales are, until the inventory on hand is calculate the closing inventory
physically counted and the cost thereof is calculated. balance & to balance back to the cost
This cost of the inventory physically on hand is used as of sales; & thus it
the inventory closing balance. Once we have determined x cannot detect stock losses.
the inventory closing balance in this way, we then
balance back to the cost of sales.
This system, where we do not balance to the closing balance, means that there is no way of
knowing what the actual inventory balance should be. Thus, it means that when using the
periodic system, any missing inventory (e.g. due to theft) will generally be ‘hidden’ in the cost
of sales. For example, if there were thefts during the period and we thus counted a low number
of units during the stock count, this would translate into a lower inventory closing balance and
this lower inventory closing balance would then mean we would balance back to a higher cost
of sales. This cost of sales would thus be overstated by the cost of the missing inventory.
Worked example 1: Periodic system and no stock loss

Imagine we had no opening inventory, but had purchased C100 during the period. Then, if the stock
count revealed that we had inventory of C20 on hand at year-end, we would we process a journal
recording the closing inventory at C20 and then balance back to our cost of sales:
Opening inventory: C0 + Purchases: C100 – Closing inventory: C20 = Cost of sales: C80.
Worked example 2: Periodic system and unidentified stock loss

Now use the same information as provided in worked example 1, but assume that, unbeknownst to us,
C15 of our inventory had been stolen during the year with the result that the stock count revealed that
the closing inventory was only C5 (not C20). In this case our cost of sales would reflect C95:
Opening inventory: C0 + Purchases: C100 – Closing inventory: C5 = Cost of sales: C95
Chapter 13 661
Notice:
x The cost of sales is higher than it should have been because it includes the theft of C15.
x It is not incorrect to expense C95 because this is truly the cost of inventory that is no longer on hand.
x The problem with this system is simply that it is not accurate to reflect C95 as the cost of sales when
the cost of sales is truly C80 and the remaining C15 is truly a cost of theft (or inventory loss expense).
If we were able to identify the loss at the time they occurred (e.g. imagine that we were
unfortunate enough to experience a significant robbery where it was possibly clear to us what
had been stolen), then we would process the following adjustment:
Debit Credit
Inventory loss (E) xxx
Purchases (Temporary account) xxx
Inventory loss recognised due to stolen stock
Worked example 3: Periodic system and identified stock loss

Looking again at the previous worked example:
If we experienced a specific robbery and were thus able to identify the loss of C15 at the time of the
robbery, we could then process a journal which would reduce our purchases by the theft and recognise
it as a separate loss of C15. Our purchases account at year-end would then reflect only C85 (Purchases:
C100 – Stock theft: C15). In this scenario, the cost of sales for the year would be C80 :
Opening inventory: C0 + Purchases: C85 – Closing inventory: C5 = Cost of sales: C80
Notice:
x The expenses would be correctly reflected at: cost of sales of C80 and an inventory loss of C15.
x The total expense would still be C95 (same as in worked example 2), but it would be a more accurate
reflection of the state of affairs.
Example 2: Perpetual versus periodic system and missing inventory

C Units
Opening inventory balance 24 000 3 000
Purchases during the year (cash) 96 000 12 000
Stock count at year-end (cost per unit C8) 32 000 4 000
Required: Show the ledger accounts using:
A. the periodic system;
B. the perpetual system, assuming that the company sold 10 000 units during the year.
Solution 2: Perpetual versus periodic system and missing inventory

Comments:
x The periodic system in Part A indicates that cost of sales is C88 000, whereas the perpetual system in Part
B more accurately reflects that cost of sales was C80 000 and that there was a cost of lost stock of C8 000.
x In other words, the periodic system assumes that all the missing stock was sold.
x The periodic system is thus less precise in describing its expense but it should be noted that:
- The total expense is the same under both systems:
o periodic: C88 000 and
o perpetual: C80 000 + C8 000 = C88 000
- The inventory balance is the same under both methods: C32 000
Solution 2A: The periodic system does not identify missing inventory

Bank (2) 96 000 Cost of sales (5) 96 000 Inventory o/b(3) Inventory c/b 32 000
(4)
24 000
(5)
Purchases 96 000 Total c/f (6) 88 000
96 000 96 000 120 000 120 000
Total b/f 0 Total b/f (6) 88 000
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Inventory (Asset) Bank

(1)
O/ balance 24 000 Cost of sales (3) 24 000 Purchases (2) 96 000
(4
(1) This balance remains C24 000 for the entire period until such time as the stock count is performed.
(2) The purchases are recorded in the purchases account during the year.
(3) In order for the inventory closing balance to be recorded, the opening balance (C24 000) first needs to be
removed from this account. This is done by transferring it out and into the cost of sales account.
(4) The closing balance of the inventory account is determined at the end of the period by physically counting the
inventory on hand and valuing it (4 000u x C8 = C32 000). This figure is debited to the inventory account with
the credit-entry posted to the cost of sales account.
(5) The total of the purchases during the period is transferred to the cost of sales account.
(6) After processing all the entries, the balance on the cost of sales account reflects an expense of C88 000.
Solution 2B: The perpetual system does identify missing inventory

O/ balance 24 000 Cost of sales (2) 80 000 Inventory (2) 80 000
Bank (1) 96 000
Subtotal c/f 40 000
120 000 120 000
Subtotal (3) 40 000 Cost of theft (4) 8 000
C/ bal c/f 40 000 Inventory losses: theft (Expense)
40 000 90 000 Inventory (4) 8 000
C/ bal (5) 32 000
(1) The purchases are debited directly to the inventory (asset) account.
(2) The cost of sales is C80 000 (10 000u x C8). The inventory and cost of sales accounts are generally updated
immediately for the cost of each sale that takes place. For simplicity, however, this example processes the
cumulative cost of sales for the year.
(3) The final amount of inventory that should be on hand at year-end is calculated as the balancing figure by taking
the opening balance plus the purchases less the cost of the sales:
C24 000 + C96 000 – C80 000 = C40 000 (being 5 000u x C8)
(4) A stock count is performed and whereas there should have been 5 000 units on hand at year-end (3 000u +
12 000u – 10 000u), we are told there are only 4 000 units on hand. It is therefore clear that 1 000 units have
gone missing. The cost of this lost stock is therefore C8 000 (1 000u x C8).
(5) The closing balance of inventory must reflect this reality and therefore the balance has been reduced from what
it should have been (5 000u x C8 = C40 000) to what it is (4 000u x C8 = C32 000).
Example 3: Perpetual and periodic system: stock loss due to theft and profits
C Units
Inventory balance: 1 January 20X1 (cost per unit: C5) 55 000 11 000
Purchases during 20X1 (cash) (cost per unit: C5) 100 000 20 000
Stock count results at 31 December 20X1 (cost per unit: C5) 16 000
Revenue from sales for 20X1 (cash) 95 000
Required: Assuming that the entity prefers to present its inventory losses separately to its cost of sales:
A. Show the ledger accounts using the perpetual system (including closing accounts): the company
sold 13 000 units during 20X1.
B. Show the ledger accounts using the periodic system (including closing accounts).
C. Prepare the extracts of the statement of comprehensive income for each of the two methods,
assuming that there were no other income and expenses during the year.
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Solution 3A: Perpetual system: stock loss due to theft and profits
O/ balance (1) 55 000 Cost of sales(2) 65 000 Inventory (2) 65 000 Trading a/c (4) 65 000
Bank (1) 100 000 Subtotal c/f 90 000
155 000 155 000
Subtotal b/f 90 000 Inv loss: theft(3) 10 000 Inventory loss: theft (Expense)
C/ bal c/f 80 000 Inventory (3) 10 000 P or L a/c (6) 10 000
90 000 90 000
C/ balance 80 000
Sales (Income)
Trade Acc (4) 95 000 Bank (1) 95 000
Trading account (Closing account) Profit or loss (Closing account)

CoS (4) 65 000 Sales (4) 95 000 Inv loss: theft (6) 10 000 TA (GP) (5) 30 000
P&L (GP) (5) 30 000 Total c/f 20 000
95 000 95 000 30 000 30 000
Total b/f (7) 20 000
(1) Amounts given
(2) Cost of sales = 13 000u (given) x C5 (given) = C65 000
(3) Cost of theft = (o/bal: 11 000 + purchases: 20 000 – sold: 13 000 – c/bal: 16 000) x C5 = C10 000
(4) Sales and cost of sales are transferred to the trading account.
(5) The total on the trading account (GP = gross profit) is transferred to the profit or loss account.
(6) All other income and expenses are closed off at the end of the year to the profit or loss account, including the
inventory loss caused by theft (cost of theft, as opposed to cost of sales).
(7) If there were no other income and expense items, then this total represents the final profit for the year. It would
then be transferred to the equity account: retained earnings.
Solution 3B: Periodic system: stock theft and profits

Inventory (Asset) Sales (Income)
O/balance (1) 55 000 Cost of sales (2) 55 000 TA (6) 95 000 Bank (1) 95 000
Cost of sales (4) 80 000

Bank (1) 100 000 Cost of sales (3) 100 000 Invent. o/b (2) 55 000 Inventory c/b (4) 80 000
Purchases (3) 100 000 TA (5) 75 000
155 000 155 000
Trading account (Closing account) Profit or loss (Closing account)

Cost of sales (5)
75 000 Sales (6) 95 000 TA (GP) (7) 20 000
(7)
P&L 20 000
95 000 95 000

(1) Amounts given
(2) Transfer the inventory opening balance to cost of sales (assumption: all opening inventory is sold during the period).
(3) Transfer all purchases to cost of sales (assumption: all purchases are sold during the period).
(4) We record the physical closing balance in the inventory asset account and credit the cost of sales account (this
is the portion of the inventory opening balance and purchases that were clearly not sold):
Inventory closing balance (per stock count) = 16 000u (given) x C5 (given) = C80 000
(5) We balance to the amount of C75 000, which is the cost of sales expense. This is closed off to the trading account.
(6) Sales are closed off to the trading account.
(7) The balance on the trading account represents the gross profit and this is transferred to the profit or loss account.
All other income and expense accounts are then also transferred to (closed off to) the profit or loss account.
The profit or loss account therefore converts gross profit into the final profit for the period.
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Solution 3C: Disclosure – perpetual versus periodic

Company name
For the period ended 31 December 20X1 (extracts)
Perpetual Periodic
C C
Revenue from sales 95 000 95 000
Cost of sales (65 000) (75 000)
Gross profit (1) 30 000 20 000
Inventory loss (10 000) (0)
Profit for the period (1) 20 000 20 000
Comment:
(1) Notice how the gross profit is C20 000 under the periodic system but is C30 000 under the perpetual system. The
perpetual system is a more accurate reflection of what happened. The final profit in both cases is, however, C20 000.
4.4.3 Presenting inventory losses (IAS 2.34 and .38)
Inventory losses refer to the loss of inventory (which could be due, for example, to theft of stock). If
inventory has gone missing, the cost of the missing inventory must be recognised as an expense.
As explained above, it is easier to detect lost stock when using the perpetual system than when
using the periodic system since the perpetual system provides us with a theoretical inventory
closing balance against which we can check the actual results of our physical count.
Depending on the circumstances, however, we could still detect certain losses when using the
periodic system. For example, although constant petty theft may be difficult or impossible to
detect using the periodic system, we may be able to identify the exact inventory stolen if, for
example, we identified a specific theft and were able to quantify the loss (see section 4.4.2).
Irrespective of whether the periodic system or perpetual Cost of inventory

system is used, if a loss of inventory has been identified, expense (also called cost
of sales) includes:
we must decide how to present this loss. However, the
standard does not state whether an inventory loss (an x the cost of inventory sold;
expense) should be presented separately from or x unallocated manufacturing overheads;
included with the ‘cost of inventory expense’ (often x any abnormal production costs (e.g.
wastage);
called ‘cost of sales expense’).
x other costs depending on the
See IAS 2.38
circumstances.
The standard states that the ‘cost of inventory expense’
includes the cost of inventory sold, the cost of unallocated manufacturing overheads and the
cost of abnormal manufacturing costs. It also explains that an ‘entity’s circumstances’ could
also justify including other amounts in this ‘cost of inventory expense’ (e.g. distribution costs).
Thus, an inventory loss (e.g. cost of lost or stolen inventory – or even an impairment due to damage)
could, under certain circumstances, be included in the ‘cost of inventory expense’ as an ‘other
amount’. Professional judgement is thus required. It is suggested that a general rule of thumb would
be to apply the following logic:
x if the loss is considered to be a normal part of trading, this inventory loss expense could be
included in the cost of inventory expense (cost of sales expense);
x if the loss is abnormal (e.g. a theft took place during a significant armed robbery), this
inventory loss expense should not be included in the cost of inventory expense (cost of
sales); but rather as an ‘inventory loss’.
The reason why one would want to exclude the cost of an ‘abnormal loss’ of inventory from
the cost of inventory expense is that if one included this loss, it would distort the gross profit
percentage and damage comparability of the current year profits with prior year profits and
would also damage comparability of the entity's results with the results of its competitors.
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5. Initial Measurement: Cost (IAS 2.10 - .18)
5.1 Overview (IAS 2.10 and IAS 2.20)

Cost of inventory includes:
The initial measurement of inventory (whether we x Purchase costs
simply purchase the inventory or manufacture it x Conversion costs
ourselves) is always at cost. The costs that one should x Other costs to bring it to its current
See IAS 2.10
capitalise to the inventory account include the: location and condition.
x costs to purchase the inventory (section 5.2), In the case of agricultural produce
x costs to convert the inventory (section 5.3), and harvested from biological assets, cost is
See IAS 2.20
x other costs required in order to bring the inventory x FV less costs to sell
to its present location and condition (section 5.4). See IAS 2.10
Conversion costs arise if an entity buys goods that still need to be put into a saleable or usable
condition (i.e. an entity that manufactures its own inventory). In other words, entities that
simply purchase goods for immediate resale (merchandise), would not incur conversion costs.
Cost is relatively easy to determine but, when dealing with inventory that constitutes
agricultural produce harvested from biological assets, the cost is measured on the date it is
harvested at fair value less costs to sell. See IAS 2.20
5.2 Purchase costs (IAS 2.11 & IAS 2.11’s Educational Footnotes: E1, E2 & E3)
5.2.1 Overview
All purchase costs should be capitalised as part of the cost of the inventory asset. Purchase
costs are the costs directly associated with the acquisition, being the:
x purchase price,
x transaction taxes and import duties that the entity is unable to reclaim from tax authorities
(section 5.2.2), and
x transport costs (inwards) (section 5.2.3.2) and other directly attributable costs. See IAS 2.11
Purchase costs exclude the following (i.e. these would not be capitalised to inventory):
x transport costs (outwards) (section 5.2.3.3),
x transaction taxes and import duties that are reclaimable by the business (section 5.2.2),
x financing costs due to extended payment terms (section 5.2.6).
The following would be set-off against (i.e. deducted from) the cost of the inventory:
x rebates received (section 5.2.4);
x discounts received, including:
- trade, bulk and cash discounts received, and
- settlement discounts received or expected to be received (section 5.2.5).
A further issue to consider (although not complicated at all) is how to calculate the inventory's
cost when it was imported rather than purchased from a local supplier (section 5.2.7).
5.2.2 Transaction taxes and import duties (IAS 2.11)

Transaction taxes &
The purchase of inventory often involves the payment of Import duties:
transaction taxes and import duties. However, the only x Not claimable: capitalise to inventory
time that transaction taxes (e.g. VAT) and import duties x Claimable: capitalise to receivable a/c.
will form part of the cost of inventory is if they may not be claimed back from the tax
authorities. This happens, for example, where the entity fails to meet certain criteria laid down
by a tax authority (e.g. if the entity is not registered as a vendor for VAT purposes).
In summary:
x If the transaction taxes and import duties are not reclaimable, then obviously the business
has incurred a cost and this cost may then be capitalised to the inventory account.
x If the transaction taxes and import duties are reclaimable at a later date from the tax
authorities, then no cost has been incurred.
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Example 4: Transaction taxes and import duties

An entity purchased inventory. The costs thereof were as follows:
x Total invoice price (including 15% VAT) paid in cash to the supplier: C9 200
x Import duties paid in cash directly to the country’s Customs Department: C5 000
Required: Show the ledger accounts assuming:
A. The VAT and the import duties were refunded by the tax authorities one month later.
B. The VAT and the import duties will not be refunded.
Solution 4A: Refundable taxes and import duties

Inventory (Asset) VAT (Asset)
Bank (1) (5) 8 000 Bank (1) 1 200 Bank (3) 1 200
Bank Import duties receivable (Asset)
VAT (3) 1 200 Inv & VAT (1) 9 200 Bank (2) 5 000 Bank (4) 5 000
I/D receivable(4) 5 000 I/D receivable(2) 5 000
Comments:
(1) The VAT portion of the invoice price must be recognised separately as a receivable because the entity claims
this VAT back: C9 200 / 115 x 15 = C1 200. The rest of the invoice price is recognised as inventory since
this represents a real cost to the entity: C9 200 / 115 x 100 = C8 000
(2) The import duties payable directly to the Customs Department were refundable and therefore the entire
import duty paid is recognised as a receivable – and not as part of the cost of the inventory.
(3) VAT refund received.
(4) Import duty refund received.
(5) Notice that the inventory account reflects C8 000 and that equals net amount paid per the bank account is
also C8 000: Payments: (C9 200 + C5 000) – Receipts: (C1 200 + C5 000).
Solution 4B: Non-refundable taxes and import duties

Bank (1) 9 200 Inventory (1) 9 200
Bank (2) 5 000 Inventory (2) 5 000
14 200 (3) 14 200
Comments:
(1) The VAT portion of the invoice price is not separated since none of it is refundable.
(2) The import duties payable directly to the Customs Department were not refundable and are therefore part of
the costs of acquiring the inventory.
(3) Notice that the inventory account reflects a balance of C14 200 and that this equals the amount paid per the
bank account: C9 200 + C5 000.
5.2.3 Transport costs (IAS 12.11)
5.2.3.1 Overview Transport costs:

x Inwards: capitalise to inventory
There are two types of transport (carriage) costs, each x Outwards: expense.
of which is accounted for differently:
x transport inwards; and
x transport outwards.
5.2.3.2 Transport/ carriage inwards
The cost of transport inwards refers to the cost of transporting the purchased inventory from the
supplier to the purchaser’s business premises.
It is a cost that was incurred in ‘bringing the inventory to its present location’ and should
therefore be capitalised to (i.e. included in) the cost of inventory asset.
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5.2.3.3 Transport/ carriage outwards

Frequently, when a business sells its inventory, it offers to deliver the goods to the customer’s
premises. The cost of this delivery is referred to as ‘transport outwards’.
It is a cost that is incurred in order to sell the inventory rather than to purchase it and may
therefore not be capitalised (since it is not a cost that was incurred in ‘bringing the inventory to
its present location’). Transport outwards should, thus, be recorded as a selling expense in the
statement of comprehensive income instead of capitalising it to the cost of the inventory.
Example 5: Transport costs
Bee Limited purchased inventory for C100 000 on credit. No VAT was charged.
This inventory was then sold for C150 000 on credit.
A professional trucking company charged C25 000 to:
x transport this inventory inwards (from the supplier to Bee) C10 000
x transport this inventory outwards (from Bee to the customer) C15 000
Required: Calculate the cost of the inventory and show all related journals.
Solution 5: Transport costs

Debit Credit
Trade payable (L) 100 000
Cost of inventory purchased on credit
Transport (E) 15 000
Cost of delivery: delivery to our premises (transport inwards) is capitalised
and delivery to our customer (transport outwards) is expensed.
Trade receivable (A) 150 000
Sale (I) 150 000
Sale of inventory
Cost of sales (E) 100 000 + 10 000 110 000
Cost of the inventory sold
5.2.4 Rebates (IAS 2.11 & IAS 2.11: E2)

The entity purchasing inventory may receive a rebate.
There are many different types of rebates possible, but Rebates received are set-
off:
essentially the rebate received could be designed:
x to reduce the purchase price; or x against purchase cost: cr inventory.
x to refund certain of the entity’s selling expenses. x against selling costs: cr income
The purpose of the rebate affects how we account for it:

x if the rebate was essentially a reduction in the purchase price, then the rebate is credited to
the inventory asset (i.e. the rebate will reduce the cost of inventory); or
x if the rebate was essentially a refund of certain of our selling expenses, the rebate is credited
to income (i.e. the rebate will not reduce the cost of inventory).
Example 6: Rebates
An entity purchased inventory for cash. The details thereof were as follows: C
x Invoice price (no VAT is charged on these goods) 9 000
x Rebate offered to the entity by the supplier 1 000
Required: Show the ledger accounts assuming that the terms of the agreement indicated the rebate:
A. was a reduction to the invoice price of the inventory;
B. was a refund of the entity’s expected selling costs.
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Solution 6A: Rebate reducing cost of inventory

(1)
Bank 8 000 Inv (1) 8 000
Comments:
(1) The rebate reduces the cost of inventory: 9 000 – 1 000 = 8 000
Solution 6B: Rebate not reducing cost of inventory

Bank/RR (1) 9 000 Inv (1) 8 000
Rebate received (RR) (Income)

Inv (1) 1 000
Comments:
(1) The cost of inventory is C9 000 even though only C8 000 is paid. This is because the rebate of C1 000 is not
related to the inventory purchase cost but the entity’s future expected selling costs. Thus, the rebate is recognised
as income, (this rebate income can then be matched with the related selling expenses).
5.2.5 Discount received (IAS 2.11 & IAS 2.11E1&E2)

All discounts received:
There are a variety of discounts that you could receive x are credited to the inventory account.
on the purchase of goods:
x trade discount or bulk discount: this is usually received after successfully negotiating the
invoice price down, because you are a regular customer, or you are buying in bulk;
x cash discount: this is sometimes received as a ‘reward’ for paying in cash;
x settlement discount: this is sometimes received as a ‘reward’ for paying promptly.
Trade, bulk and cash discounts are generally agreed to on the transaction date. Settlement
discounts, however, are estimated on transaction date based on when the entity expects to settle
its account with the creditor.
The cost of our inventory is reduced by any discounts offered to us; it is even reduced by
settlement discounts... even though we may be unsure of being able to pay in time, and thus
unsure of being able to secure the settlement discount.
While trade discounts, bulk discounts, and cash discounts are straight-forward, settlement
discounts require more explanation. As mentioned above, when purchasing inventory where
there is the possibility of a settlement discount, the cost of the ‘inventory’ is measured net of
the settlement discount (we apply the same principle to all discounts received). If we do not pay
on time and thus forfeit this settlement discount, the cost of the ‘inventory’ will need to be
increased by the amount of this forfeited discount. When recording a purchase that involves
settlement discount (and the subsequent payment to the supplier), there are a number of ways
in which we can account for the related contra account, the ‘trade payable’. We will discuss
two options. These are best explained by way of a worked example: we buy inventory for C1 000
and are offered a C200 settlement discount that we have the ability to take advantage of:
Option 1:
When processing the purchase, we could recognise the ‘trade payable’ measured at the net amount
after deducting the expected discount (debit inventory and credit payable: 800):
When processing the payment, we will either have paid on time or not:
x If we pay on time, we process the payment of 800 (debit payable and credit bank: 800).
x If we do not pay on time, there will be two steps:
- the inventory and payable accounts will first need to be increased by the amount of the
forfeited discount of 200 (debit inventory and credit payable: 200); and then
- the payment of 1 000 is recorded (debit payable and credit bank: 1 000).
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Option 2:
We could be more detailed and keep track of both the full amount we owe the supplier, in case we do
not pay on time (1 000), and the settlement discount we have been offered (200). This alternative
involves using the following two accounts instead of just one, recognising both
x a ‘payable’ measured at the gross amount (we credit this): 1 000, and
x a ‘deferred discount’ measured at the amount of the possible discount (we debit this): 200.
The payable would be reflected in the statement of financial position at the net of these account
balances, at C800 and the inventory is measured at the net amount of 800 (same as option 1).
Thus, when processing the purchase, although the journal is a little more detailed, the net effect is still
that the inventory and payable are measured at the amount net of discount, 800 (debit ‘inventory’ 800;
credit ‘payable’ 1 000 and debit ‘deferred discount’ 200)
When processing the payment, we will either have paid on time or not:
x If we pay on time, there will be two steps:
- Since the discount of 200 is realised, it is no longer deferred, so we reverse the ‘deferred
discount’ and set it off against the payable (debit ‘payable’ and credit ‘deferred discount’:
200) – the payable balance is now 800, which is the same amount that the inventory was
initially measured at.
- the payment of 800 is recorded (debit payable and credit bank: 800).
x If we do not pay on time, there will be two steps:
- Since the discount of 200 is forfeited, it is no longer deferred, so we reverse the ‘deferred
discount’ and add it to the cost of inventory (debit ‘inventory’ and credit ‘deferred discount’:
200) – the payable balance is still 1 000, and although inventory was initially measured at
800, the inventory cost has now been increased to 1 000.
- the payment of 1 000 is recorded (debit payable and credit bank: 1 000).
Example 7: Discounts
An entity purchased inventory. The costs thereof were as follows: C
x Marked price (no VAT is charged on these goods) 9 000
x Trade discount 1 000
Required: Show the ledger accounts assuming:
A. The entity pays in cash on transaction date and receives a cash discount of C500.
B. The supplier offers an early settlement discount of C400 if the account is paid within 20 days: the entity pays
within the required period of 20 days. Record the initial payable at the net amount (option 1).
C. The supplier offers an early settlement discount of C400 if the account is paid within 20 days: the entity pays
after a period of 20 days. Record the initial payable at the net amount (option 1).
D. Repeat Part B, but record the initial payable by using a deferred discount account (option 2).
E. Repeat Part C, but record the initial payable by using a deferred discount account (option 2).
Solution 7A: Trade discounts and cash discounts

Bank (1) 7 500 Inventory (1) 7 500
(1) The marked price is reduced by the trade discount and the cash discount: 9 000 – 1 000 – 500 = 7 500
Solution 7B: Trade discounts and settlement discounts – payment on time (using option 1)
Inventory (Asset) Trade payables (Liability)
T/payable (1) 7 600 Inventory (1) 7 600
Bank (2) 7 600
Bank
TP (2) 7 600
Comments:
1. We recognise the inventory and the trade payable at the amount net of the discount: 7 600 (9 000 – 1 000 - 400)
2. Since we ‘receive’ the discount, we make a payment of only 7 600 (9 000 – 1 000 – 400)
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Solution 7C: Trade discounts and settlement discounts – payment late (using option 1)
T/payable (1) 7 600 Inventory (1) 7 600
T/payable (2) 400 Bank (3) 8 000 Inventory (2) 400
Bank
TP (3) 8 000
Comments:
1. We recognise the inventory and the trade payable at the amount net of the discount: 7 600 (8 000 – 400)
2. We ‘forfeit’ the discount and thus will need to pay 8 000, which means the inventory actually costs C8 000.
Thus, we must increase both the inventory cost and the payable with the forfeited discount of 400.
3. Since we ‘forfeit’ the discount, we make a payment based on the gross amount: 8 000.
Solution 7D: Trade discounts and settlement discounts – payment on time (using option 2)
TP & DD (1) 7 600 Inventory (1) 8 000
DD (2) 400
Bank (3) 7 600
Bank Deferred discount (DD)
TP (3) 7 600 Inventory (1) 400
TP (2) 400
Comments:
1. We recognise both the inventory and payable at the net amount of 7 600, but we recognise the payable using
two accounts: credit a ‘trade payable’ with 8 000 and debit a ‘deferred discount’ with 400
2. We pay on time and thus ‘receive’ our discount. We record this by transferring the deferred discount to the
payable account, thus reducing the payable balance. The discount is no longer deferred.
3. Since we ‘receive’ the discount, we make a payment of only 7 600 (8 000 – 400)
Solution 7E: Trade discounts and settlement discounts – payment late (using option 2)
TP & DD (1) 7 600 Inventory (1) 8 000
DD (2) 400 Bank (3) 8 000
8 000
Bank Deferred discount (DD)
TP (3) 8 000 Inventory (1) 400
Inventory (2) 400
Comments:
1. We recognise both the inventory and payable at the net amount of 7 600, but when recognising the inventory, the contra
entry involves two accounts: credit a ‘trade payable’ with 8 000 and debit a ‘deferred discount’ with 400
2. We pay late and thus ‘forfeit’ our discount. We record this by transferring the deferred discount to the inventory
account. There is no longer any deferred discount and the inventory is now measured at the cost of C8 000.
3. Since we ‘forfeited’ the discount, we make a payment based on the gross amount: 8 000.
5.2.6 Finance costs (IAS 2.18)

Deferred settlement terms:
Instead of paying in cash on transaction date, or paying x measure inventory at PV (cash price)
within normal credit terms, an entity could arrange to pay x if difference between PV and agreed
after a longer than normal time-period (i.e. over an extended price is material (the difference is
recognised as interest expense).
settlement period). These special terms are often called
deferred settlement terms/extended credit terms/ extended settlement terms etc.
If inventory is purchased on deferred settlement terms, the total amount we end up paying is generally
more than the price we would pay on normal terms. In this case, we measure inventory at the price that
would be paid on normal terms (e.g. cash price). The difference between the higher amount we will
actually pay and the price on normal terms is the cost of financing, which is recognised as interest
expense, assuming the difference is material. If the price on normal terms price is not obvious, we can
estimate it by calculating the present value of the future payments, discounted using a market interest
rate (i.e. estimating a cash price). See IAS 2.18
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Example 8: Deferred settlement terms

An entity purchased inventory on 1 January 20X1. The costs were as follows:
x Invoice price payable on 31 December 20X2 C6 050
x Market interest rate 10% p.a.
Required: Show the journal entries assuming:
A. The effect of the time value of money is not considered to be material; and
B. The effect of the time value of money is considered to be material.
Solution 8A: Deferred settlement terms: immaterial effect

Inventory (A) 6 050
Cost of inventory purchased on credit (cost of financing is immaterial)
31 December 20X2
Bank (A) 6 050
Payment for inventory purchased from X on 1 Jan 20X1 (2 years ago)
Solution 8B: Deferred settlement terms: material effect

The cost of the inventory must be measured at the present value of the future payment. Thus, we
remove the cost of financing from the total cost of the purchase, and recognise it as an interest expense.
The present value can be calculated using a financial calculator by inputting the repayment period
(2 years), the future amount (6 050) and the market related interest rate (10%) and requesting it to
calculate the present value: (n = 2; FV = 6 050, i = 10, COMP PV)
This can also be done without a financial calculator, by following these steps:
Step 1: calculate the present value factors (PV factor)
PV factor on due date 1.00000
PV factor 1 year before payment is due 1 ÷ (1+10%) 0.90909
PV factor 2 years before payment is due 0.90909 ÷ (1 + 10%) or 0.82645
1 ÷ (1 + 10%) ÷ (1 + 10%) or 1 ÷ (1 + 10%) 2
Step 2: calculate the present values
Present value on transaction date 6 050 x 0.82645 (2 years before payment is due) 5 000
Present value one year later 6 050 x 0.90909 (1 year before payment is due) 5 500
Present value on due date Given: future value (or 6 050 x 1) 6 050
The interest and trade payable balance each year is calculated using an effective interest rate table:
Year Opening balance Interest expense Payments Closing balance
20X1 5 000 Opening PV 500 5 000 x 10% (0) 5 500 5 000 + 500
20X2 5 500 550 5 500 x 10% (6 050) 0 5 500 + 550 – 6 050
1 050 (6 050)
Notice that the present value on purchase date is C5 000 and yet the amount paid is C6 050. The
difference between these two amounts is C1 050 and is recognised as interest expense over 2 years.
Inventory (A) 5 000
Cost of inventory purchased on credit (invoice price is 6 050, but
recognised at present value of future amount) – see step 2 above
31 December 20X1
Interest expense (E) Payable o/b: 5 000 x 10% 500
Trade payable (L) 500
Effective interest incurred on present value of creditor
31 December 20X2
Interest expense (E) Payable o/b: (5 000 + 500) x 10% 550
Trade payable (L) 550
Effective interest incurred on present value of creditor
Trade payable (L) Payable c/b: 5 000 + 500 + 550 6 050
Bank (A) 6 050
Payment of creditor
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5.2.7 Imported inventory Cost of imported inventory

is calculated as:
When inventory is purchased from a foreign supplier the x the cost,
goods are referred to as ‘imported’. denominated in foreign currency,
x converted into local currency
5.2.7.1 Spot rates (see chapter 20 for more detail) x using the spot exchange rate on
transaction date
A complication of an imported item is that the cost of the goods purchased is generally
denominated (stated) in a foreign currency on the invoice.
Before we can record this purchase, the foreign currency amount must be:
x converted into the reporting entity’s functional currency (generally his local currency)
x using the spot exchange rate (the exchange rate on a specific date) on transaction date.
Example 9: How to convert a foreign currency into a local currency
We have $1 000 and want to convert it into our local currency: South African Rands (R).
Required: Calculate the Rand amount received when converting $1 000, if on the date of the exchange :
A. the spot exchange rate is R5: $1 (direct method); and
B. the spot exchange rate is $0.20: R1 (indirect method).
Solution 9: How to convert a foreign currency into a local currency

Tip: divide by the currency you’ve got and multiply by the currency you want. Thus, since we have a
dollar amount and want to know the Rand amount, we divide by the dollar and multiply by the Rand.
A: Dollar is the base (i.e. the exchange rate is reflected based on $1): $1 000 / $1 x R5 = R5 000
B: Rand is the base (i.e. the exchange rate is reflected based on R1): $1 000 / $0.20 x R1 = R5 000
The transaction date is
5.2.7.2 Transaction dates generally the date on which
control passes to the purchaser.
When importing inventory, there is often a significant delay
between the date on which goods are ordered, loaded and finally received. Somewhere in all these dates is
the transaction date.
The ‘transaction date’ is not a defined term but it is the date on which we recognise the inventory purchase
and measure its cost. When importing inventory, identifying the correct transaction date is very important
because we measure its cost using the currency exchange rate ruling on transaction date (i.e. the spot
exchange rate on transaction date). This means that the cost of inventory could vary wildly depending on
which date it is measured. See IAS 21.21
To identify the transaction date, we consider the terms of the transaction to assess when the entity obtains
control over the inventory and thus when the inventory should be recognised. One of the indicators of control
is when the entity obtains the risks and rewards of ownership. When dealing with imports (or exports), we
refer to these terms as InCoTerms (International Commercial Terms). These are the trade terms used under
international commercial law and published by the International Chamber of Commerce. There are many
such terms, each of which differs in terms of when risks are transferred,.
For example, two common INCO terms are ‘free on board’ (FOB) and ‘delivered at terminal’ (DAT):
x if goods are purchased on a FOB basis, risks are transferred to the purchaser as soon as the
goods are delivered over the ship’s rail at the foreign port (i.e. loaded onto the ship);
x if goods are purchased on a DAT basis, the risks of ownership are transferred when the
goods are unloaded at the named destination terminal/ port/ other named destination.
Example 10: Imported inventory – transaction dates
A South African company (currency: Rands: R) purchases $100 000 of raw materials from an
American supplier (currency: Dollars: $).
x The goods were loaded onto the ship in New York on 1 January 20X2 and were unloaded at the
prescribed Durban harbour (South Africa) on 15 February 20X2.
x The South African company pays the American supplier on 15 March 20X2
Chapter 13 673
x The following are the spot rates (rates of exchange on a particular date):
Date: R: $1
1 January 20X2 R7,20: $1
15 February 20X2 R7,30: $1
15 March 20X2 R7,50: $1
Required: Show the related journal entries, assuming the following:
A. The goods are purchased FOB.
B. The goods are purchased DAT: Durban harbour (South Africa).
Solution 10: Imported inventory – transaction dates
A: FOB B: DAT
1 January 20X2 (Part A: FOB) OR 15 February 20X2 (Part B: DAT) Dr/ (Cr) Dr/ (Cr)
Inventory (A) A: $100 000 x 7,20 = R720 000 720 000 730 000
Account payable (foreign) (L) B: $100 000 x 7,30 = R730 000 (720 000) (730 000)
Purchase of inventory from a supplier in New York, on credit
15 March 20X2
Foreign exchange loss (E) A: ($100 000 x 7,50) – 720 000 30 000 20 000
Account payable (foreign) B: ($100 000 x 7,50) – 730 000 (30 000) (20 000)
Translation of foreign creditor on payment date
Account payable (foreign) (L) A & B: $100 000 x 7.50 750 000 750 000
Bank (A) (750 000) (750 000)
Payment of foreign creditor
Comment:
x The amount paid under both situations is R750 000 (using the spot rate on payment date).
x The transaction dates differed between part A (FOB) and part B (DAT) and thus the cost of inventory differs
in each case since inventory is measured at the rate ruling on the transaction date.
x The movement in the spot rate between transaction date and payment date is recognised in the profit or loss
account (i.e. not as an adjustment to the inventory asset account). See chapter 20 for more detail.
5.3 Conversion costs (manufactured inventory) (IAS 2.12 - .14)
5.3.1 Overview
Some entities purchase goods in an ‘already complete’ state (also called merchandise), which they
then sell to customers. These are called retailers. Other entities manufacture goods (also called finished
goods), which they then sell to their customers. These entities are called manufacturers.
The cost of goods that are purchased in a ‘ready-to-sell’ state (merchandise) is often referred to simply
as the ‘purchase cost’. The cost of goods that are manufactured include both ‘purchase costs’ (i.e. the
cost of purchasing raw materials), and ‘conversion costs’. ‘Conversion costs’ are those costs that are
incurred during the manufacturing process, when converting the raw materials into finished goods .
Retail business Manufacturing business
Purchase cost: merchandise Purchase cost: raw materials (direct materials)
Other costs: to bring to present location & condition Conversion costs (other direct costs & indirect costs)
Other costs: to bring to present location & condition
5.3.2 Conversion costs are split into direct costs and indirect costs
The conversion process refers to the process of turning raw Conversion costs include:
materials into a finished product. It is also called the x Direct manuf. costs (e.g. wages)
production or manufacturing process. Conversion costs are x Indirect manuf. costs (overheads)
thus part of the production costs (i.e. part of the - Variable manuf. overheads
manufacturing costs). Please note the difference: raw (e.g. cleaning)
- Fixed manuf. overheads (e.g. rent)
material is being converted, and thus raw material is not a
conversion cost. However, the cost of raw materials is a production cost.
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These conversion costs could either be:

x directly involved in the manufacturing process, and thus referred to as direct conversion costs
(e.g. direct labour); or
x indirectly involved in the manufacturing process, and thus referred to as indirect conversion costs
(also known as manufacturing overheads).
Variable manuf. overheads
The indirect conversion costs (i.e. manufacturing are defined as:
overheads) can be further categorised into costs that are: x indirect costs of production that
x Variable: Indirect conversion costs that are variable are xx vary directly or nearly directly
with the volume of production. IAS 2.12
also called variable manufacturing overheads, and are
the indirect costs that increase or decrease as production increases or decreases (e.g. cleaning
materials); and
x Fixed: Indirect conversion costs that are fixed are Fixed manuf. overheads
also called fixed manufacturing overheads and are are defined as:
the indirect costs that remain relatively unchanged x indirect costs of production that
despite the number of items produced (e.g. factory x remain relatively constant
rent; administration costs relating to the factory; x regardless of the volume of IAS 2.12
production.
depreciation and maintenance of factory buildings
and equipment; and the depreciation and maintenance costs of leased assets, called ‘right-
of-use assets’, that are used in production ). See IAS 2.12
When calculating the cost of manufactured inventory, we must ensure that we exclude:
x costs that do not relate to the manufacturing process (e.g. administration costs relating to
sales or to head office activities); and
x costs incurred during periods of idleness. See IAS 2.12-.13
The following diagram provides an overview of what makes up ‘conversion costs’ and how
conversion costs ‘fit into’ the total manufacturing cost.
Diagram 1: Conversion costs (manufacturing overheads) as part of total manufacturing costs
Purchase cost: Raw materials (direct cost)

PLUS
Conversion costs (manufacturing overhead)
Direct costs Note Indirect costs

(e.g. direct labour) (i.e. manufacturing costs)
Variable manuf. costs Fixed manuf. costs

(e.g. electricity) (e.g. factory rent)
Vary Do not vary

with production levels with production levels
PLUS
Other costs (if any)
Note: Direct costs generally vary with production, but some don’t (e.g. the cost of wages for factory workers
where the terms of the wage contracts result in a constant wage irrespective of the level of production)
As far as ledger accounts go, we first debit the raw material purchase costs to the ‘raw materials’
inventory account. As we start converting raw materials into finished goods, the cost of these raw
materials is transferred out of the raw materials account and into the ‘work-in-progress’ inventory
account. We then allocate conversion costs to this work-in-progress account. When the item is
complete, we then transfer its total manufacturing cost (raw material cost + conversion costs) out
of the work-in-progress account and into the ‘finished goods’ inventory account, (section 5.3.3).
Chapter 13 675
Example 11: Conversion costs

Local Limited manufactures flags. The following information relates to January 20X1:
x Raw materials of C100 000 were used in the manufacturing process during January.
x Factory wages for January paid in cash: C200 000.
x Electricity for January paid in cash: C80 000 (only 80% relates to the factory).
x Depreciation on factory machines: C40 000 - 70% of the time this machinery was used
in producing inventory whereas 30% of the time it was standing idle.
x Depreciation on office equipment: C10 000 - 25% of the office equipment is used by
factory administration staff and 75% is used by head office administration staff.
Required:
Journalise the above information.
Solution 11: Conversion costs

Debit Credit
Inventory: work-in-progress (A) Given 100 000
Inventory: raw materials (A) 100 000
Raw materials used in the manufacturing process transferred to WIP
Inventory: work-in-progress (A) Given 200 000
Bank 200 000
Cost of labour used in the manufacturing process (a conversion cost)
Inventory: work-in-progress (A) C80 000 x 80% 64 000
Electricity (E) C80 000 x (100% - 80%) 16 000
Bank 80 000
Electricity costs: the portion used in the manufacturing process is
capitalised to inventory (a conversion cost) and the rest is expensed
Depreciation – machinery (E) Given 40 000
Machines: acc. depreciation (-A) 40 000
Depreciation – office equip. (E) Given 10 000
Equipment: acc. depreciation (-A) 10 000
Depreciation on factory machinery and office equipment
Inventory: work-in-progress (A) 30 500
Depreciation – machinery (E) 40 000 x 100% factory-related x 70% not idle 28 000
Depreciation – office equip (E) 10 000 x 25% factory-related 2 500
Depreciation relating to the manufacturing process is capitalised to inventory
(conversion cost)
Comments:
x All costs capitalised to the inventory work-in-progress account are ‘manufacturing costs’. However, not all
of these costs are called ‘conversion costs’. The cost of the raw materials is a manufacturing cost but it is not
a conversion cost (all the other manufacturing costs debited to work-in-progress are conversion costs).
x The depreciation on machinery:
- that is incurred while inventory was being manufactured is capitalised to the inventory account as part
of the ‘costs directly related to the units of production’ [IAS 2.12];
- while the machinery is idle is expensed [IAS 2.13 states that costs of idle plant should not be capitalised].
Thus, since the machinery was idle 30% of the time, the depreciation on machinery to be capitalised to the
cost of inventory (indirect cost: fixed manufacturing overhead) is only C28 000 (C40 000 x 70%).
x The depreciation on the office equipment that relates to the management/ administration of the factory
qualifies to be capitalised to the cost of inventory, but the depreciation on the equipment that is used for
administration purposes outside of the factory process remains expensed [IAS 2.12 & .16(c)]
x A neat way to account for depreciation is to first expense it and then, at the end of the period, reallocate the
relevant portion to inventory (i.e. first expensed in full and then a portion capitalised), as done above.
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5.3.3 The ledger accounts used by a manufacturer
5.3.3.1 Overview
The physical sequence of events in a manufacturing business is reflected in the inventory ledger
accounts that we use. Start by imagining three hypothetical buildings:
x A store-room: we use this to store our raw materials;
x A factory building: we use this to convert our raw materials into finished goods;
x A shop: we use our shop to sell our finished goods.
Now, what happens in each of these 3 imaginary buildings is actually depicted in our ledger:
x What happens in our store-room is reflected in the raw materials account;
x What happens in our factory building is reflected in the work-in-progress account; and
x What happens in our shop is reflected in the finished goods account.
Diagram 2: Flow of inventory in a manufacturing environment
Store-room Factory Shop Customer

Raw materials account Work-in-progress account Finished goods account Cost of sales account
Manufacturing process
Imagine the following scene:
x Raw materials account (RM)
x Raw materials are purchased. They are delivered to - In: purchases
our premises and put in a storeroom. The accountant - Out: transfers to WIP:
shows raw materials stored in the storeroom in the x Work-in-progress account (WIP)
raw materials account (an inventory asset). - In: transfers from RM plus
conversion costs
x Some of the raw materials are now loaded onto a - Out: transfers to FG: completed item
truck and driven out of the storeroom to the factory x Finished goods account (FG)
- In: transfers from WIP
building, 100 metres away. The accountant shows - Out: transfers to CoS: items sold
this scene by moving an amount out of the raw x Cost of sales account (CoS)
materials account and into the work-in-progress - In: transfers from FG
account (an inventory asset).
All events occurring in the factory are reflected in the work-in-progress account. Thus, as
the raw materials arrive in the factory building (from the store-room), the work-in-progress
account is increased. But, it is not just the raw materials that enter the factory building – it’s
the conversion costs too: the factory workers come inside (costing us factory wages), as do
many other supplies such as cleaning materials, electricity, water and our machinery gets
used up too. So each of these conversion costs is also added to the work-in-progress account
(notice: costs that are incurred in the production process, such as wages and depreciation,
are capitalised to this inventory account and are thus not expensed!)
x When some of the raw materials have been successfully converted into finished products
(i.e. completed), the finished products are loaded onto a vehicle and driven out of the factory
and delivered to our shop. The accountant reflects this movement of inventory out of the
factory and into the shop by taking an appropriate amount out of the work-in-progress
account and putting it into the finished goods account instead (an inventory asset account).
x The finished goods account shows the story about what happens in our hypothetical shop.
When these goods are sold to customers, the relevant cost per unit sold is removed from
this account and allocated to the cost of goods sold account (an expense account).
As you can see, in this manufacturing scenario, there would actually be three inventory asset
accounts. The total of these three balances will be the inventory carrying amount presented on
the face of the statement of financial position.
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Diagram 3: Flow of inventory ledger accounts in a manufacturing environment

Raw materials account Conversion costs
Direct costs Indirect costs

(e.g. direct labour) (i.e. manufacturing overheads)
Variable costs Fixed costs

(e.g. electricity) (e.g. factory rent)
Work-in-progress account
Finished goods account
Cost of sales account
5.3.3.2 Accounting for the movements: two systems There are two systems:
x Perpetual system
The movement of inventory between these inventory accounts x Periodic system
can be accounted for in two different ways, commonly referred to as the perpetual system and the
periodic system.
These two systems are not referred to in IAS 2 Inventories, but are simply two systems that have been
designed by accountants to help in how and when to account for inventory movements.
x The perpetual system involves accounting for each inventory movement as and when it
occurs. For example, we would record a transfer from raw materials to work-in-progress
each time units of raw material are taken out of storage to use in the factory.
x The periodic system involves counting the items of inventory on hand periodically (e.g. at
year-end) and assuming that all items that are no longer on hand were either sold or used.
In other words, the periodic system does not continually record the movement, rather it
balances back to the movement. For example: if we had 50 units of raw materials on hand
at the beginning of a period and bought another 100 units during the period, and counted
30 units on hand at the end of the period, we assume that 120 units of raw material (50 +
100 – 30) must have been transferred from the store-room to use in the factory. Thus, at the
end of the period, we transfer the cost of 120 units from raw materials to work-in-progress.
The perpetual and periodic systems are explained in more detail in section 4.
5.3.3.3 Calculating the amount to transfer: three cost formulae (IAS 2.23-27)
In the above explanation, where we spoke about the physical There are three cost
movement in and out of the three imaginary buildings being formulae:
reflected in the relevant inventory accounts (raw materials, x Specific identification
work-in-progress, finished goods and eventually cost of x First-in-first-out
inventory expense – often called cost of sales), we spoke of x Weighted average
an amount being transferred out from one account to another.
For example, we mentioned that an amount would be taken out of the raw materials account and put
into our work-in-progress account when raw materials were taken out of our store-room and put into
the factory (where they would then be worked on in order to convert into finished goods). In this
example, this amount would be the cost of the raw materials being transferred.
There are three formulae which may be used to calculate the cost of the inventory being transferred:
the specific identification formula, the weighted average formula and the first-in-first-out formula.
These cost formulae are explained in more depth in section 6, but a quick discussion in the context of
a manufacturing environment may be helpful to you.
x The specific identification formula must be used in certain situations. However, if your
situation does not warrant the use of the specific identification formula, then you could
choose between the weighted average formula and the first-in-first-out formula.
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x The first-in-first-out formula assumes that the items that are bought or manufactured first
are the items that will be sold first. This approach is ideal for items of inventory that may
perish (e.g. food) or may quickly become obsolete (e.g. technology items).
x The weighted average formula calculates the average cost per item based on the cost of the items
on hand at the beginning of the period plus the cost of the items purchased during the period.
Entities manufacturing mass-produced goods (i.e. interchangeable items) would use either the
weighted average or first-in-first-out formula. Entities manufacturing unique and individualised
items of inventory would have to use the specific identification formula.
The same formula should be used for all inventory with similar natures and similar uses. This
means we may use different formulae for inventory with different natures or uses. For example,
if we manufacture sweets and cups, we could argue that the first-in-first-out formula is the most
appropriate formula to use for sweets since these have a sell-by date and we may prefer to use
a formula that reflects the physical reality (i.e. the first sweets made are the first sweets sold)
and yet use the weighted average formula to measure the cost of the cup movements.
The next example shows the flow of costs from raw materials through to cost of inventory
expense (also called cost of sales). It only involves variable costs (fixed conversion costs are
explained in examples 14 – 19), uses the perpetual system and has been designed in such a way
that the complications of which cost formula to use (specific identification, first-in-first-out or
weighted average) was not necessary. These cost formulae are explained in more depth in
section 6 together with a more complex version of example 12 (example 27: involving
manufacturing ledger accounts using the first-in-first-out and weighted average formulae).
Example 12: Manufacturing journal entries
Saudi Limited manufactures sunglasses. The following applies to January 20X1:
x C20 000 of raw materials were available on 1 January 20X1, (20 000 kilograms).
x C40 000 of raw materials (40 000 kilograms) were purchased and paid for in cash.
x 40% of the raw materials available during January 20X1 were used in January 20X1.
x Wages of C100 000 were incurred and paid during January 20X1:
- 80% related to factory workers,
- 6% related to cleaning staff operating in the factory,
- 4% related to cleaning staff operating in the head office and
- 10% related to office workers in the administrative offices.
x Electricity incurred and paid during January 20X1: C62 000 (100% related to the
factory operations).
x Depreciation on machinery was C28 000 for the month based on the units of production
method (thus a variable cost). All machinery was used in the production of inventory.
x Depreciation on office equipment was C10 000, all of which was used by head office.
x There was no opening balance of work-in-progress on 1 January 20X1.
x All work-in-progress was complete by 31 January 20X1 (20 000 complete units).
x Finished goods had an opening balance of C30 000 on 1 January 20X1 (3 000 units).
x All units of finished goods were sold during January 20X1.
Required: Show all the above information in the ledger accounts using the perpetual system.
Solution 12: Manufacturing journals
Comments: This example involves purchase costs (raw materials) and conversion costs (electricity, wages, depreciation).
Debit Credit
Inventory: raw materials (A) Given: 40 000kg for C40 000 (thus C1/kg) 40 000
Bank (A) 40 000
Raw materials purchased Note: the cost/ kg of these purchases is
unchanged from the cost/ kg of the opening inventory (C1/ kg)
Chapter 13 679
Journals continued … Debit Credit

Inventory: work-in-progress (A) (o/b 20 000 + purchase: 40 000) x 40% 24 000
Raw materials used in production transferred to WIP. See note 1
Inventory: work-in-progress (A) 100 000 x (80% + 6%) 86 000
Wages (E) 100 000 x (10% + 4%) 14 000
Bank 100 000
Wages: the portion used in the manufacturing process is capitalised to
inventory (a conversion cost) and the rest is expensed. See note 2
Inventory: work-in-progress (A) 62 000 x 100% 62 000
Bank (A) 62 000
Electricity paid is capitalised to inventory because 100% used in factory
Depreciation – machinery (E) Given 28 000
Machinery: acc. depreciation (-A) 28 000
Depreciation on machinery is first expensed
Note: the next journal capitalises the depreciation expense to WIP
Depreciation – machinery (E) 28 000
Depreciation on machinery capitalised to inventory (WIP) to the extent it
was used to make inventory (it was used exclusively to make inventory in
this case) See note 3
Depreciation – equipment (E) Given 10 000
Equipment: acc. depreciation (-A) 10 000
Depreciation on office equipment (none of this will be capitalised to
inventory because this equipment was not used in production) See note 3
Inventory: finished goods (A) (o/ bal: 0 + 24 000 + 86 000 + 62 000 200 000
Inventory: work-in-progress (A) + 28 000) x 100% 200 000
Work-in-progress that is complete is transferred to finished goods.
Notice: all WIP was started and completed in the same month. See note 4
Cost of sales (E) (o/ bal: 30 000 + 200 000) x 100% 230 000
Inventory: finished goods (A) 230 000
Finished goods that are sold (100% of the FG are sold)
Notice: since all the FG were sold, we simply transferred the entire FG
balance to cost of sales. See note 5
Notes:
(1) Transfer from RM to WIP: Raw materials used: (opening balance 20 000 + purchases 40 000) x 40% = 24 000. Please
note that since the cost per kilogram of the opening balance was C1/ kg (C20 000/ 20 000 kg) and the cost per kilogram
of the purchases was also C1/ kg (C40 000 / 40 000 kg), there is no complication when allocating the raw materials
used from the RM account to the WIP account.
However, if the costs per kg had differed, we would have had to decide whether we should be using the specific
identification formula, first-in first-out formula or weighted average formula to measure the cost of the raw materials
used (i.e. how much to transfer out of RM to WIP). These three formulae are explained in section 6.
(2) Wages incurred in the factory environment are capitalised whereas wages incurred outside of this environment are
expensed: 100 000 x (80% + 6%) = 86 000.
Notice: the wages for the factory workers (80 000) is direct labour whereas the wages for the factory cleaners (6 000)
is indirect labour: both are necessary part of the manufacturing process and thus both are capitalised.
(3) Depreciation on machines was initially expensed but then, to the extent the machines were used to produce inventory,
it is then transferred out of the depreciation expense and capitalised to the inventory WIP account as part of the costs
of conversion [IAS 2.12]. This machinery was used exclusively to make inventory and thus 100% of the depreciation
is capitalised to inventory.
Please note that assets continue to be depreciated during periods in which they stand idle (unless depreciation is based
on the units of production method, in which case idle time is automatically excluded from the depreciation expense).
This is important because the costs of idle property, plant and machinery should not be capitalised to inventory
[IAS 2.13]. Thus, if depreciation for a period was C40 000, calculated on the straight-line method, but the asset had
stood idle for 30% of that period, then we would only capitalise C28 000 (C40 000 x 70%) to inventory.
Depreciation on office equipment is expensed (nothing is subsequently capitalised to inventory) since it was not used
in the manufacturing process.
680 Chapter 13
(4) Transfer from WIP to FG: Items of work-in-progress (WIP) that are no longer ‘in progress’ but are now
finished (completed) must be transferred from WIP to finished goods (FG).
Since all of the WIP was completed, we simply transferred the entire balance on the WIP account to the FG account.
This example was made simple in the sense that all WIP was started and completed in the same month.
Had there been some WIP incomplete at either the beginning or the end of the year, we would have had to
decide whether to use the specific identification, first-in, first-out or weighted average formula to measure
the cost of the amount to be transferred from WIP to FG (i.e. the cost of the finished items).
These three formulae are explained in section 6.
(5) Transfer from FG to Cost of sales: 100% of the FG are sold and since we no longer have these FG assets, the cost
thereof must be expensed as cost of sales.
Since all the FG were sold, we simply transferred the entire balance on the FG account to the cost of sales account.
However, had there been some FG that remained unsold at either the beginning or end of the year, we would have had
to decide whether to use the specific identification, first-in first-out or weighted average formula to measure what
portion of the FG balance had been sold and thus was needed to be transferred out of FG and expensed to cost of sales.
These three methods are explained in section 6.
As explained previously, when goods are completed, they are moved, hypothetically, from the
factory to the shop (or warehouse) and thus a journal is processed to transfer the cost of these
goods from the work-in-progress account to the finished goods account. This previous example
was simple in that the entire work-in-progress balance was completed and thus we simply
transferred the entire balance of the work-in-progress costs to the finished goods account.
However, if only a portion of the work-in-progress was completed, we would have to identify
how many units had been completed and how many were incomplete. We would then need to
calculate how much it had cost the entity to manufacture each of these completed units. This
cost per unit is called the manufacturing cost per unit. When journalising the transfer of
completed goods from the work-in-progress account to the finished goods account, we would
multiply the manufacturing cost per unit by the number of items that had been completed.
5.3.4 Manufacturing cost per unit The manufacturing cost per

unit includes:
The cost to manufacture a unit of inventory is called the x Variable costs / unit (direct/ indirect)
manufacturing cost per unit (also called production cost x Fixed costs / unit (indirect)
per unit). This manufacturing cost per unit is estimated
for purposes of quoting customers, and is used in calculating the cost of completed units that
must be transferred from the work-in-progress account to the finished goods account.
The manufacturing cost per unit of inventory includes variable and fixed costs, comprising:
x the purchase cost of the raw materials (section 5.2) plus
x the conversion costs (section 5.3.1 and 5.3.2) and possibly
x other costs related to bringing it ‘to its present location and condition’ (section 5.4). See IAS 2.10
It is important, when calculating the total manufacturing cost per unit, to assess whether each
manufacturing cost is:
x A variable manufacturing cost:
Variable costs are the costs that vary directly with the level of production.
Direct costs (e.g. raw materials, direct labour) are generally variable and many indirect costs
are also variable (e.g. electricity) (i.e. indirect costs can vary directly – see note 1, below).
OR
x A fixed manufacturing cost:
Fixed costs are the costs that do not vary directly with the level of production.
Some indirect costs are fixed (e.g. factory rent) (see note 1, below).
Note 1: Sadly, the terminology can be confusing, but it is important to notice that:
x an indirect cost can vary directly with production and yet
x a direct cost may not necessarily vary directly (e.g. factory wages are a core production cost and
are thus direct costs, but depending on the terms of the wage contracts, the wage may not
necessarily fluctuate directly (or even at all) with production levels). See IAS 2.12
Chapter 13 681
Diagram 4: Manufacturing costs

Manufacturing costs
Variable manufacturing costs Fixed manufacturing costs

Includes, for example: Includes, for example:
x Purchase cost of raw materials x Direct conversion costs that do not vary
x Direct conversion costs that vary with with production (e.g. wages that do not
production (e.g. direct labour) increase/decrease with production levels)
x Indirect conversion costs that vary with x Indirect conversion costs that don’t
production (e.g. electricity) vary with production (e.g. factory rent)
(variable manufacturing overhead) (fixed manufacturing overhead)
5.3.5 Variable manufacturing costs (costs that vary directly with production)
The variable manuf. cost
Variable manufacturing costs are simply costs that vary per unit could include:
with the level of production. Thus, by their very nature,
x Purchase cost of raw materials
it is easy to calculate the variable manufacturing cost per
unit. This cost per unit would be the total of all the x Direct conversion costs that vary
x Indirect conversion costs
manufacturing costs per unit that vary with production.
(manufacturing overheads) that vary
Variable manufacturing costs per unit would typically
x Other costs that vary
include costs such as:
x the purchase cost of the raw materials;
x the direct conversion costs that vary with production (e.g. factory labour)
x the indirect conversion costs (i.e. manufacturing overheads) that vary with production, in
which case they would be called variable manufacturing overheads, (e.g. electricity).
Example 13: Variable manufacturing costs

Choc Limited manufactured 10 units, each of which used:
x 3 manufacturing labour hours (at C20 per hour), paid in cash
x 2 cleaning labour hours (at C10 per hour), paid in cash
x 1 kilogram of raw material X (at C50 per kg excluding VAT)
x 1 litre of cleaning material (at C5 per litre).
Required:
A. Calculate the variable manufacturing cost per unit of inventory.
B. Journalise the above assuming all materials were already in stock, there were no opening balances
of raw materials or work-in-progress and that all 10 units were finished.
Solution 13A: Calculation: variable manufacturing cost per unit

C
Direct labour: 3 hours x C20 60
Indirect labour: 2 hours x C10 20
Direct materials: 1 kg x C50 50
Indirect materials: 1 litre x C5 5
Variable manufacturing cost per unit 135

Debit Credit
Inventory: work-in-progress (A) 10 units x 1 kg x C50 500
Inventory: raw materials (A) 500
Cost of raw materials used (manufacture of 10 units: 10 units x C50)
Inventory: work-in-progress (A) 10 units x 1 litre x C5 50
Inventory: consumables (A) 50
Cost of cleaning materials used (manufacture of 10 units: 10 units x C5)
Inventory: work-in-progress (A) 10 units x 3 hours x C20 600
Bank (A) 600
Cost of factory labour used (manufacture of 10 units: 10 units x C60)
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Debit Credit
Inventory: work-in-progress (A) 10 units x 2 hours x C10 200
Bank (A) 200
Cost of cleaning labour used (manufacture of 10 units: 10 units x C20)
Inventory: finished goods (A) 500 + 50 + 600 + 200 1 350
Completed units transferred to finished goods (10 units x C135: See 13A)
5.3.6 Fixed manufacturing costs (costs that do not vary directly with production)
Manufacturing costs that do not vary with the level of Fixed manufacturing costs
production are referred to as fixed manufacturing costs. are:
x First debited to a suspense account
These manufacturing costs generally include only those x Then the suspense account is
indirect conversion costs that are fixed (fixed manufacturing allocated to:
overheads). However, as was explained, even direct costs - Inventory: no. of units x fixed
manufacturing cost per unit
may actually turn out to be fixed in nature. For example,
- Expense: Any remaining unallocated
factory wages that are considered to be core production costs, balance is expensed
and thus termed direct costs, may be considered to be fixed
costs if the wage bill remains the same irrespective of the number of units produced.
Fixed manufacturing costs are thus costs that do not vary in relation to the number of units
produced. What makes accounting for these fixed costs slightly different to how we account
for variable costs is that these fixed costs cannot simply be debited to the work-in-progress
account when they are incurred (as is the case with variable manufacturing costs).
Why? Because imagine the extreme situation where we pay, on the first day of the year,
C100 000 rent for our factory building (a fixed cost): if we debit this amount directly to the
inventory account and were then immediately required to draft a statement of financial position
(e.g. to raise a loan from the bank), we would be declaring that we had C100 000 of inventory
on hand – and yet manufacturing had not yet even begun! To get around this problem, our fixed
manufacturing costs are initially debited to a suspense account instead.
A suspense account is simply an account that one uses

when one is not yet sure what element to debit or credit. Notice that example 12
involved a manufacturing
In this instance, we are not yet sure how much of the entity but it avoided fixed costs:
fixed cost will ultimately be debited to the asset account x all costs were variable
(inventory) and how much will be debited to the expense account (fixed overhead expense).
As units are produced during the period, the amount in the suspense account gets gradually
allocated to the inventory work-in-progress account. To do this, we need to calculate a fixed
manufacturing cost per unit. Each time a unit is worked on, we transfer this ‘per unit cost’ out
of the suspense account to the work-in-progress account. This fixed manufacturing cost per unit
is often referred to as the fixed manufacturing cost application rate (FMCAR).
There are two such rates – one that we estimate at the There are two fixed
beginning of the period (budgeted) and one that we manufacturing application
rates:
calculate at the end of the period (actual):
x Budgeted rate (BFMCAR)
x Budgeted fixed manufacturing cost application rate x Actual rate (AFMCAR)
(BFMCAR) The budgeted rate is used to allocate
our fixed costs to inventory during the
x Actual fixed manufacturing cost application rate year – we only know what our actual rate
(AFMCAR). is after our year has ended.
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As mentioned above, a rate is needed from the beginning of Normal production level
the year to be used in allocating fixed manufacturing costs (normal capacity) is the:
from the suspense account to the inventory account (as well x expected average production levels
as for the purposes of quoting, budgeting and interim x under normal conditions
reporting). This means that a budgeted rate (BFMCAR), x after taking into account expected
loss of capacity during planned
using budgeted normal production level (also known as maintenance See IAS 2.13
normal capacity IAS 2.13) as the denominator, is needed as an

interim measure. This budgeted rate is calculated as:
Fixed manufacturing costs (currency)
Normal budgeted production level (units)
The actual rate (AFMCAR) obviously depends on the actual level of inventory produced in any
one year and is thus only determinable at year-end. This actual rate is calculated as:
Fixed manufacturing costs (currency)
Greater of: actual and normal production level (units)
Example 14: Fixed manufacturing costs and the use of a suspense account
Fixed annual head-office rent (paid for at the beginning of the year) C50 000
Fixed annual factory rent (paid for at the beginning of the year) C100 000
Budgeted annual production (normal expected production in units) 50 000
Actual production for 3 months (units) 15 000
Required: Show the journals and the ledger accounts after the 3-month period.
Solution 14: Fixed manufacturing costs and the use of a suspense account
Calculation: Budgeted fixed manufacturing cost per unit (BFMCAR):
= Fixed manufacturing costs
Normal production level
= C100 000
50 000 units
= C2 per unit
Comment on the rate:
x We do not have an actual fixed rate per unit yet since our year has not yet ended, with the result that we do
not know what our actual production for the year will be. Thus, we calculate a budgeted rate in the interim.
x We use the budgeted rate (C2/unit) when quoting customers and when processing journals during the year.

Rent – head-office (E) Given 50 000
Bank (A) 50 000
Fixed costs relating to administration are expensed
Fixed manufacturing costs (Suspense a/c) Given 100 000
Bank (A) 100 000
Fixed costs relating to manufacturing are first allocated to the suspense account
Inventory: work-in-progress (A) 15 000u x C2 (BFMCAR) 30 000
Fixed manufacturing costs (Suspense a/c) 30 000
Allocation of fixed manufacturing costs to inventory over the 3 months
Ledger accounts:
Bank Fixed manufacturing costs (Suspense)
Rent exp (1) 50 000 Bank (2) 100 000 Inv WIP (3) 30 000
FMCS (2) 100 000 Balance (4) 70 000
100 000 100 000
Balance (4) 70 000
Inventory: work-in-progress (Asset) Rent of head-office (Expense)
FMC (3) 30 000 Bank (1) 50 000
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(1) Payment of head-office rent is a non-manufacturing fixed cost: C50 000 – this is always expensed.
(2) Payment of factory rent is a manufacturing fixed cost: C100 000 – this is first accumulated in a suspense
account (after this, they will be either capitalised to inventory or expensed).
(3) Fixed manufacturing costs are allocated to the inventory asset (i.e. absorbed/ capitalised into inventory) using
the budgeted rate:
BFMCAR x actual production: C2 x 15 000 = C30 000
(4) Notice that the suspense account still has a balance. This is because the remaining 35 000 units that we expect
to make have not yet been made.
The fact that we are processing journals using a budgeted rate during the period will result in
three possible outcomes. These possible outcomes (illustrated in example 15) are that, at year-
end the suspense account could have:
x a zero balance because our actual production equalled our normal production,
x a debit balance because our actual production was less than the normal production,
x a credit balance because our actual production exceeded the normal production.
Example 15: Fixed manufacturing cost suspense account – 3 scenarios

Fixed manufacturing costs for the year (paid for at the start of the year) C100 000
Budgeted annual production level (normal expected production in units) 50 000
Required: Show the journals and the ledger accounts at the end of the year, before any possible
adjustments that may be necessary due to under- or over-production, assuming:
A. 50 000 units were produced during the year;
B. 40 000 units were produced during the year;
C. 60 000 units were produced during the year.
Solution 15: Fixed manufacturing cost suspense account – the budgeted rate used
Calculation: Budgeted fixed manufacturing cost per unit (BFMCAR):
= C100 000
50 000 units
= C2 per unit
Solution 15A: Fixed manufacturing cost suspense account – no balance (AP = BP)
Bank (A) 100 000
Fixed manufacturing costs are first allocated to the suspense account
Allocation of fixed manufacturing costs to the number of units of
inventory actually produced during the year
Ledger accounts:
FMCS (1) 100 000 Bank (1) 100 000 Inv WIP (2) 100 000
Balance (3) 0
100 000 100 000
Balance (3) 0
Inventory: work-in-progress (Asset)
FMCS (2) 100 000
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(1) Payment of fixed manufacturing overheads: C100 000 (first recorded in the suspense account).
(2) Fixed manufacturing overheads are allocated to the inventory asset (i.e. absorbed into inventory) as units are
produced using the budgeted fixed manufacturing cost application rate: C2 x 50 000 = C100 000
(3) The suspense account now has a nil balance because the actual production (in units) equalled the normal
production level.
Comment on Part A in general:
Part A shows that, when actual production equals normal production, the fixed manufacturing costs are perfectly
absorbed into the inventory account (i.e. there is no balance left in the suspense account).
Solution 15B: Fixed manufacturing cost suspense account – a debit balance (AP < BP)
Journals:
Debit Credit
Bank (A) 100 000
Ledger accounts:
FMCS (1) 100 000 Bank (1) 100 000 Inv WIP(2) 80 000
Balance (3) 20 000
100 000 100 000
Balance (3) 20 000
FMCS (2) 80 000

(1) Payment of fixed manufacturing overheads: C100 000 (first recorded in the suspense account).
(2) Fixed manufacturing overheads are allocated to the inventory asset (i.e. absorbed into inventory) as units are
produced using the budgeted fixed cost application rate: C2 x 40 000 = C80 000
(3) The suspense account still has a balance because the actual production was less than the normal production.
This must be transferred to an expense account (see section 5.3.6.1). This is an example of under-absorption.
Comment on Part B in general:
Part B shows how, when actual production is less than the normal production, that the fixed manufacturing costs
are under-absorbed into the inventory account (i.e. there is a debit balance remaining in the suspense account).
Solution 15C: Fixed manufacturing cost suspense account – a credit balance (AP >BP)
Journals:
Debit Credit
Bank (A) 100 000
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Ledger accounts:
Bank (Asset) Fixed manufacturing costs (Suspense)
FMCS (1) 100 000 Bank (1) 100 000 Inv WIP (2) 120 000
(3)
Balance 20 000
120 000 120 000
Balance (3) 20 000
FMCS (2) 120 000

(1) Payment of manufacturing fixed overheads: C100 000 (first recorded in the suspense account).
(2) Manufacturing fixed overheads are allocated to the inventory asset (i.e. absorbed into inventory) as units are
produced using the budgeted fixed cost application rate: C2 x 60 000 = C120 000
(3) Notice that the suspense account now has a credit balance. This is because the actual production exceeded
the normal production level. The problem is now that the inventory account is not shown at cost since it
reflects an amount of C120 000, when in fact the actual cost was only C100 000. This will need to be
reversed – see section 4.3.6.2. This is an example of over-absorption.
Comment on Part C in general:
Part C shows how, when actual production is greater than the normal production level, that the fixed manufacturing
costs are over-absorbed into the inventory account (i.e. there is now a credit balance in the suspense account).
5.3.6.1 Under-production leads to under-absorption of fixed manufacturing costs

If an entity actually produces at a level below the budgeted normal production level, the use of
the budgeted rate means that a portion of the fixed manufacturing costs in the suspense account
will not get allocated to the inventory asset account (see part B of the previous example). This
unallocated amount is termed an under-absorption (or under-allocation) of fixed manufacturing
costs.
Since an under-absorption results from under-productivity, it effectively reflects the cost of the
inefficiency, which quite obviously cannot be an asset! It thus makes sense that the amount of
the under-absorption must be expensed instead.
Example 16: Fixed manufacturing cost application rate – under-absorption

Fixed annual manufacturing overheads (paid for at the beginning of the year) C100 000
Normal expected production per year (units) 100 000
Actual production for the year (units) 50 000
Required:
A. Calculate the budgeted fixed manufacturing cost application rate.
B. Journalise the fixed manufacturing costs.
C. Calculate the actual fixed manufacturing cost application rate.
D. Explain what is meant by the actual fixed manufacturing cost application rate, how it is calculated
and why, when allocating fixed manufacturing costs to the inventory account, we used a rate that
was calculated by dividing the cost by the normal production level rather than the actual production.
Solution 16A: Budgeted fixed manufacturing cost application rate

Calculation of the budgeted fixed manufacturing cost per unit (BFMCAR):
= C100 000
100 000 units
= C1 per unit
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Solution 16B: Fixed manufacturing costs – journals

During the year Debit Credit
Fixed manufacturing costs (Suspense account) 100 000
Bank (A) 100 000
Fixed manufacturing overheads paid: given
Inventory: work-in-progress (A) 50 000 x C1 (BFMCAR) 50 000
Fixed manufacturing costs (Suspense account) 50 000
Allocation of fixed manufacturing costs to inventory over the year
At year-end
Fixed manufacturing cost (Expense) C100 000 (total paid) – 50 000
Fixed manufacturing costs (Suspense) C50 000 (capitalised) 50 000
Under-absorption: balance on the fixed manufacturing cost suspense
account at year-end is expensed
Solution 16C: Actual fixed manufacturing cost application rate

Calculation of the actual fixed manufacturing cost per unit (AFMCAR):
Greater of: normal (100 000u) and actual (50 000u) production
= C100 000
100 000 units
= C1 per unit *
*: This is the actual fixed manufacturing costs per unit that will have been allocated to the inventory account. It
is based on the total fixed manufacturing costs divided, in this case, by the budgeted production in units.
Check: Actual rate: C1/u x Actual production: 50 000 = C50 000 (which is the amount allocated to inventory).
Solution 16D: Explanation of the actual fixed manufacturing cost application rate
The actual fixed manufacturing costs application rate (AFMCAR) is the rate at which the fixed manufacturing
costs actually ends up being applied to the units of inventory that were actually produced – it is commonly
referred to as the ‘actual rate’ (C1 per unit – see solution 13C).
To calculate this actual rate (i.e. the actual fixed cost that we ended up allocating to each unit), we divide the
fixed manufacturing costs by the greater of the normal production (100 000u) and actual production (50 000u).
If, in this case, where actual production was less than normal production, we had incorrectly used an
application rate that was calculated by dividing the fixed cost by the actual production levels rather than the
normal production levels, we would have calculated a rate of C2 per unit (C100 000 / 50 000u). If we had
then used this rate of C2 to allocate the fixed costs to the inventory account (i.e. instead of the C1 per unit), we
would have allocated the full C100 000 to inventories (C2 x 50 000u actually produced).
This would not have made sense, since we would have effectively capitalised inefficiency: capitalising fixed
costs of C2 per unit instead of the normal C1 per unit doesn’t make sense given that the only reason for the
higher cost of C2 is that we produced less than we should have. In other words, a C2 fixed cost per unit is
inflated (i.e. higher than the C1 per unit) purely due to the company’s inefficiency!
5.3.6.2 Over-production leads to over-absorption of fixed manufacturing costs

If the actual production exceeds the normal budgeted production for a period (i.e. we experience
over-production), then, when we apply our budgeted rate to these actual units, it will mean the
fixed manufacturing costs allocated from the suspense account to the inventory account will
initially be greater than the actual costs incurred. We call this an over-allocation of costs.
This over-allocation (over-absorption) of costs into the inventory account results in too much being
taken out of the suspense account (leaving the suspense account with a credit balance) and results in
the inventory asset being overstated (i.e. the inventory asset will be shown at a value that exceeds the
costs that were actually incurred). Since inventory may not be measured at an amount higher than cost
(inventory is measured at the lower of cost and net realisable value), the over-absorption is thus simply
reversed out of the inventory account (credit) and back into the suspense account (debit).
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Example 17: Fixed manufacturing cost application rate – over-absorption

Fixed annual manufacturing overheads (paid at the beginning of the year) C100 000
Normal expected production per year (units) 50 000
Actual production for the year (units) 100 000
Required:
A. Calculate the budgeted fixed manufacturing cost application rate;
B. Journalise the fixed manufacturing costs; and
C. Calculate the actual fixed manufacturing cost application rate.
D. Using your own words, explain the use of the budgeted application rate and how this compares to
use of the actual application rate and what happens in the case of an over-absorption.
Solution 17A: Budgeted fixed manufacturing cost application rate (BFMCAR)

= C100 000
50 000 units
= C2 per unit
Solution 17B: Fixed manufacturing cost – journal
During the year Debit Credit

Fixed manufacturing costs (suspense account) 100 000
Bank (A) 100 000
Fixed manufacturing overheads paid at the beginning of the year: given
Inventory: work-in-progress (A) 100 000 x C2 (BFMCAR) 200 000
Fixed manufacturing costs (suspense account) 200 000
Allocation of fixed manuf. overheads to actual inventory over the year
At year-end
Fixed manufacturing costs (suspense account) C100 000 (pd) – C200 000 100 000
Inventory: work-in-progress (A) (capitalised) 100 000
Over-absorption: reversing out the excessive fixed manuf. costs that
were debited to inventory and reversing these back into the suspense
account (after which the suspense account now has a nil balance)
Solution 17C: Actual fixed manufacturing cost application rate

Greater of: normal (50 000u) and actual (100 000u) production
= C100 000
100 000 units
= C1 per unit
Solution 17D: Explanation of budgeted and actual rates in context of over-absorption
The actual fixed manufacturing costs application rate (AFMCAR) refers to the actual rate at which
the fixed manufacturing costs effectively ends up being applied to the units of inventory that were
actually produced. In other words, it is the amount of fixed manufacturing costs that each unit actually
cost. This actual application rate was C1 per unit in this example (see solution 17C).
To calculate the actual rate (the actual fixed cost to be allocated to each unit), we divide the fixed manufacturing
costs incurred by the greater of budgeted normal production (50 000u) and actual production (100 000u).
The budgeted fixed manufacturing costs application rate (BFMCAR) is the rate used throughout the
year to quote customers and to allocate fixed manufacturing costs to the inventory account during the
period. This budgeted application rate was C2 per unit in this example (see solution 17A).
Chapter 13 689
At the end of the period, we compare our actual production with our budgeted normal production. In
this example, our actual production exceeded our normal production, and thus our actual rate per unit
(C1) was lower than the budgeted rate per unit (C2). This drop in the cost per unit reflects efficiency.
However, since we used the budgeted rate (C2) to allocate fixed costs to the units of inventory actually
produced (100 000u), by the end of the year we will have allocated too much to the inventory account:
we will have allocated C200 000 (100 000u x C2), when the fixed costs were only C100 000. This
excess allocation of C100 000 (C200 000 capitalised – C100 000 incurred) means that, instead of
clearing the debit balance in the suspense account to nil, the suspense account will now have a credit
balance of C100 000 and we will have effectively debited inventory with costs that were not incurred.
This cannot be allowed since the inventory standard prohibits the measurement of inventory at above
cost – since it did not cost C200 000, we cannot capitalise C200 000. See IAS 2.13 Thus, the over-allocation
of C100 000 must be reversed out of inventory (credit) and back to the suspense account (debit) and
in so doing, reversing the nonsensical credit balance in this suspense account.
5.3.6.3 Budgeted versus actual fixed manufacturing rates summarised
The fixed manufacturing cost application rate is calculated at the:

x start of the year to estimate the budgeted fixed cost per unit during the year; and the
x end of the year to measure the actual fixed cost per unit.
The budgeted fixed manufacturing cost application rate is calculated at the start of the year:
Fixed manufacturing costs
BFMCAR =
The actual fixed manufacturing cost application rate is calculated at the end of the year:
Fixed manufacturing costs
AFMCAR = Greater of: normal production and actual
production
This actual rate will be easier to remember if you

understand that, if actual production is: Over & Under production:
x greater than normal production, the actual fixed cost x Over-production = Over absorption
= Adjust: Cr Inventory & Dr Suspense
application rate (AFMCAR) is calculated using actual
x Under-production = Under-absorption
production since this avoids inventory being overvalued = Adjust: Cr Suspense & Dr Expense
as a result of over-efficiency. So, if AP > BP, use AP.
x less than normal production, the actual fixed cost application rate is calculated using normal
production level, since this avoids inventory being overvalued as a result of inefficiencies.
So, if AP < BP, use BP.
Budgeted normal production seldom equals actual production. As a result, the budgeted rate
(BFMCAR) seldom equals the actual rate (AFMCAR). Thus, when the actual units produced are
multiplied by the budgeted rate (BFMCAR), either too much (over-absorption) or too little (under-
absorption) of the fixed overheads actually incurred will be capitalised to inventory. Adjustments will
be required to correct this.
Example 18: Fixed manufacturing costs – over-absorption
Budgeted normal annual production 1 000 units
Actual annual production 1 500 units
Fixed non-manufacturing costs per year C10 000
Fixed manufacturing costs per year C40 000
Variable manufacturing costs per unit C12 per unit
Required:
A. Calculate the budgeted fixed cost application rate at the beginning of the year.
B. Show the journal entries processed in the related ledger accounts.
C. Calculate the actual cost per unit of inventory.
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Solution 18A: Budgeted fixed manufacturing overheads rate (AP > BP)
= C40 000
1 000 units
= C40 per unit
Solution 18B: Ledger accounts (AP > BP)

Bank (A) Fixed manufacturing costs (Suspense)
FOE (1) 10 000 Bank (2) 40 000 Inv (4) 60 000
FMCS (2) 40 000 Inv (5)
20 000
Inv (3) 18 000 (7)
60 000 (7)
60 000
Inventory: work-in-progress (Asset) Fixed non-manufacturing costs (Expense)
Bank (3) 18 000 FMCS (5) 20 000 Bank (1) 10 000
(4)
FMC 60 000 Balance c/d 58 000
78 000 78 000
Balance (6) 58 000
(1) Payment of fixed non-manufacturing costs: C10 000 – these are always expensed
(2) Payment of fixed manufacturing costs: C40 000 – these are first accumulated in a suspense account and then
either capitalised to inventory or expensed
(3) Payment of variable manufacturing costs: C12 x 1 500 = C18 000, debited directly to inventory
(4) Fixed manufacturing costs are allocated to the inventory asset (i.e. absorbed into inventory) using the
budgeted rate: C40 x 1 500 = C60 000
(5) Since the fixed manufacturing costs incurred only amounted to C40 000, C20 000 too much (Allocated:
C60 000 – Incurred: C40 000) has been debited to inventory: this over-absorption is simply reversed.
(6) Note that the balance is C58 000, which equals the variable cost per unit plus the final fixed man. costs per
unit: (C12 + C26,67) x 1 500 = C58 000 (C26.67 is calculated in part C)
(7) Notice that the suspense account has been cleared out (has a zero balance)!
Solution 18C: Actual manufacturing cost per unit (AP > BP)
C
Variable manufacturing cost per unit Given 12.00
Fixed manufacturing cost per unit: AFMCAR W1 26.67
38.67
W1: Actual fixed manufacturing cost application rate:
Greater of: normal and actual production
= C40 000
1 500 units
= C26,67 per unit
Example 19: Fixed manufacturing costs – under-absorption

Budgeted normal production 1 000 units
Actual production 500 units
Fixed non-manufacturing costs per year C10 000
Fixed manufacturing costs per year C40 000
Variable manufacturing costs per unit C12 per unit
Required:
A. Calculate the budgeted fixed cost application rate at the beginning of the year.
B. Show the entries in the related ledger accounts.
C. Calculate the actual fixed cost application rate at the end of the year.
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Solution 19A: Budgeted fixed manufacturing overheads rate (BP > AP)
= C40 000
1 000 units
= C40 per unit
Solution 19B: Ledger accounts (BP > AP)

Bank (Asset) Fixed manufacturing cost (Suspense)
FOE (1) 10 000 Bank (2) 40 000 Inv WIP(4) 20 000
FMCS (2) 40 000 FMCE (5) 20 000
Inv WIP(3) 6 000 Balance (7) 0
40 000 40 000
Balance (7) 0
Inventory: work-in-progress (Asset) Fixed non-manufacturing costs (Expense)

Bank (3) 6 000 Bank (1) 10 000
FMCS (4) 20 000 Balance c/d 26 000
26 000 26 000
Balance (6) 26 000
Fixed manufacturing costs (Expense)

FMCS (5) 20 000

(1) Payment of fixed non-manufacturing costs: C10 000 – these are always expensed
(2) Payment of fixed manufacturing costs: C40 000 – these are first accumulated in a suspense account and then
either capitalised to inventory or expensed
(3) Payment of variable manufacturing costs: C12 x 500 = C6 000 – debited directly to inventory
(4) Fixed manufacturing overheads are allocated to (i.e. absorbed into) inventory using the budgeted fixed cost
application rate: BFMCAR x actual production: C40 x 500 = C20 000
(5) The fixed manufacturing costs incurred amounted to C40 000, but since only 500 units have been produced,
only C20 000 has been debited to inventory, with C20 000 remaining unallocated in the fixed manufacturing
cost suspense account. This must be recognised as an expense since this relates to the cost of the inefficiency
(abnormal wastage).
(6) Notice that the inventory balance is C26 000, which is the number of units on hand measured at the total of
the prime cost (the total of the variable manufacturing costs) plus the final fixed manufacturing costs per
unit: 500u x (C12 + C40) = C26 000
(7) Notice that the balance on the fixed manufacturing cost suspense account has been reduced to nil.
Solution 19C: Actual manufacturing cost per unit (BP > AP)
C
Variable manufacturing cost per unit Given 12.00
Fixed manufacturing cost per unit (actual): AFMCAR W1 40.00
52.00
W1: Actual fixed manufacturing cost application rate:
Greater of: normal (1 000u) and actual (500u) production
= C40 000
1 000 units
= C40 per unit
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5.3.7 Joint and by-products (IAS 2.14)
Joint products are two or more products that share a process. In a manufacturing plant, inventory may
go through many processes on its conversion from raw materials to finished goods. Where two products
share the same process, the costs associated with that process must be apportioned to each product.
An example of joint products is brown and white sugar, produced by the same sugar mill. The raw
sugar is extracted from sugar cane and refined until all the molasses is removed (this is the shared
process). Once this is complete, the sugar is ‘split up’ into the quantity that will be sold as white sugar,
and the quantity sold as brown sugar. In a separate process, a certain quantity of molasses is added
back to the brown sugar to give it the brown colour (this is a separate process).
The costs incurred by the initial extracting and refining process (i.e. the shared process… the joint
process) must be apportioned to each of the products on a rational and consistent method IAS 2.14.
Examples of these methods are the ‘physical methods measure’, the ‘selling price at split-off method’
and the ‘relative sales value (net realisable value) method’.
By-products are products that are created incidentally in the production process. For instance, in the
sugar mill example above, the excess molasses would be considered a by-product, as it is created
incidentally in the process of refining sugar. The sales value of a by-product is often negligible, and
thus, the net realisable value of the by-product is simply deducted from the total cost of the main
product. Sugar refineries often sell the excess molasses to bakeries or other companies in the food
manufacturing industry. See IAS 2.14
Example 20: Joint and by-products

Cake Limited manufactures two types of cake: chocolate and vanilla. The cake sponges
for both products are created in the same baking process. However, after the sponges are
baked, the cakes undergo separate icing and decoration processes.
x The total joint cost incurred by the baking process is C60 500 per month
x The sponges could be sold, without further processing, to a bakery for C40 per sponge
x The company produces 1 000 chocolate cakes per month. The selling price of a
chocolate cake is C200, and the cost of icing and decorating it is C20 per cake
x The company produces 2 000 vanilla cakes per month. The selling price of a vanilla
cake is C80, and the cost of icing and decorating it is C20 per cake
x After the baking process, the crumbs left over in the oven are collected, packaged and
sold to a local caterer for a net amount of C500 per month. This amount is considered
to be immaterial to the production of the cakes
Required: Calculate the portion of the total joint cost attributable to the two cakes, and the joint cost
per unit, using:
A. The physical measures method.
B. The sales value at split-off method.
C. The relative sales value on completion (net realisable value) method.
Solution 20A: Allocating Joint Costs using physical measures method

Product Units Joint Cost allocated Cost per unit
Produced (2) C C
Chocolate 1 000 1 000/3 000 x C60 000 (1) 20 000 20
Vanilla 2 000 2 000/3 000 x C60 000 (1) 40 000 20
3 000 60 000
Comments
(1) The joint cost is C60 000 (C60 500 – C500 = C60 000) (The net amount received from the by-product
(crumbs) is considered negligible, and is thus deducted from the joint costs incurred).
(2) The physical measures method can only be used if both products have the same unit of measurement (in this
example, number of cakes). If each product had a different unit of measurement (litres and kilograms, for instance),
this method could not be used, as it is impossible to compare items with different units of measurement.
Chapter 13 693
Solution 20B: Allocating Joint Costs using the selling price at split-off method
Product Units SP at Total Joint Cost Cost per
Produced split-off allocated unit
C C C C
Chocolate 1 000 40 (2) 40 000 40 000/120 000 x 60 000 (1) 20 000 20
Vanilla 2 000 40 (2) 80 000 80 000/120 000 x 60 000 (1) 40 000 20
3 000 120 000 60 000
Comments
(2) Notice that we use the selling price of the sponge since this is the sales value at split-off point.
Solution 20C: Allocating Joint Costs using the relative sales value method
Product Units Relative Total Joint Cost Cost per
Produced Sales Value allocated unit
C C C C
Chocolate 1 000 200-20 (2) 180 180 000 180K/300K x 60 000 (1) 36 000 36
Vanilla 2 000 80-20 (2) 60 120 000 120K/300K x 60 000 (1) 24 000 12
3 000 300 000 60 000
Comments
(2) This method allocates joint costs on the net realisable value method i.e. selling price less further processing
costs. The further processing cost of C20 per cake refers to the cost of icing and decorating the cake.
5.4 Other costs (IAS 2.15 -.16) Other costs are capitalised
if they are:
5.4.1 General rule for capitalisation of other costs x incurred in bringing the inventory to
x its present location and condition.
If other costs (i.e. other than purchase and conversions costs)
are incurred in relation to inventory, these must be included in the inventory’s cost (i.e. capitalised)
but only if they are incurred in the process of bringing the inventory to its ‘present location and
condition’. In all other cases, they must be expensed.
5.4.2 Capitalisation of borrowing costs (IAS 2.17 and IAS 23)
Borrowing costs (e.g. interest expense) may need to be capitalised to the inventory. This happens if the
inventory is a qualifying asset, as defined in IAS 23 Borrowing costs. A qualifying asset is ‘an asset that
necessarily takes a substantial period of time to get ready for its intended use or sale’.
x Inventory that is purchased as a finished product, for example, would not meet this definition and
thus any related interest expense would not be capitalised; whereas
x Inventory that an entity produces, and where the production process takes a substantial period of
time, would meet the definition of a ‘qualifying asset’, in which case, any related financing costs
recognised as an interest expense must now be capitalised to that inventory
Debit Interest expense
Credit Interest payable / bank
Interest expense is incurred
Debit Inventory
Credit Interest expense
Interest expense is capitalised
For example, the process of manufacturing wine and cheese can involve a substantially long
period of time, in which case the inventory of wine and cheese would be examples of inventory
that meet the definition of a qualifying asset.
x There is one exception: if this inventory is produced in large quantities on a repetitive basis, then the
entity may choose whether to capitalise this interest expense or not. See IAS 23.4-6
Determining how much, if any, of a borrowing cost must be capitalised is determined by

IAS 23 Borrowing costs and covered in detail in chapter 14.
694 Chapter 13
5.4.3 Other costs that may never be capitalised

There are many types of ‘other costs’ that you may come across, including some which may
never be capitalised. The 'other costs' that may never be capitalised include:
x abnormal amounts of production costs (e.g. excessive wastage of materials or labour);
x administration costs, unless these help bring the inventory to its location and condition;
x storage costs, unless storage was necessary in the production process before a further production
stage (i.e. the costs of storage during a production process or after the completion of a final
production process must always be expensed…however, the cost of storage necessary between one
production process and another production process must be capitalised); and
x selling costs.
Example 21: All manufacturing costs including other costs
Super Limited manufactures concrete statues. The following information is provided:
x Raw materials of C500 000 were used during the year:

- 10% of the raw materials were wasted during the normal manufacturing process
- 2% of the raw materials were lost in the manufacturing process when a machine operator
collapsed due to illness, leaving the machine unmanned for 5 hours
- 20% of the raw materials were destroyed during a riot for higher wages
x Rent of C800 000 was incurred and paid for (to a single landlord) during the year:
- 10% was for the storeroom (used to store raw materials)
- 75% was for the factory building:
- 60% is for the main factory production processes
- 20% storage of work-in-progress whilst the concrete set (before painting thereof)
- 15% storage of work-in-progress while paint dried (no further process occurs after this)
- 5% was storage of finished goods prior to being taken to the shop
- 15% was for the shop where finished goods are sold to the public
x Advertising costs totalling C100 000 were incurred and paid for during the year.
x Salaries to administration personnel totalling C200 000 was incurred during the year:
- 10% was for paperwork related to the importation of some of the raw materials
- 70% was for general head-office administration costs
- 20% was for paperwork involved in the sale of finished goods
Required: Show the journal entries that would have been necessary during the period.
Solution 21: All manufacturing costs including other costs

Debit Credit
Inventory expense: raw material write-off (E) 500 000 x (20% + 2%) 110 000
Raw materials destroyed during a riot (20%) and raw materials destroyed
during manufacture (abnormal wastage: 2%)
Inventory: work-in-progress (A) 500 000 - 110 000 (abnormal wastage) 390 000
Raw materials used during the year (i.e. as opposed to being destroyed)
Rent expense (E) Storeroom: 800 000 x 10% = 80 000 320 000
Factory: 800 000 x 75% x (15% + 5%) = 120 000
Shop: 800 000 x 15% = 120 000
Thus: 80 000 + 120 000 + 120 000 = 320 000
Fixed manuf. cost suspense Factory: 800 000 x 75% x (60%+20%) 480 000
Bank (A) 800 000
Rent paid: storeroom, factory building and shop Note 1 and Note 2
Advertising (E) 100 000
Bank (A) 100 000
Advertising costs paid for relating to the sale of goods Note 3
Chapter 13 695
Continued… Debit Credit

Administration expense – sales (E) 200 000 x 20% (selling admin) 40 000
Administration expense – other (E) 200 000 x 70% (general admin) 140 000
Inventory: work-in-progress (A) 200 000 x 10% 20 000
Bank/ salaries payable (A/L) 200 000
Administration costs incurred: 10% related to costs incurred to get
inventories to location and condition that enabled them to be sold
Notes:
1. The rent relates to an area using for storage (various kinds of storage), a shop and production.
x The portion of the rent relating to production is capitalised as part of the fixed manufacturing overheads.
x Rent for the shop is expensed as it is part of the cost of selling inventory and not part of producing inventory.
x The rent relating to storage may only be capitalised to inventory if it is:
necessary in the production process
before a further production phase.
The storage of raw materials occurs before the production process begins and must thus be expensed.
The rent relating to the storage while the concrete dries is capitalised because there is still a further production
process after the concrete dries (i.e. the painting) – it is a necessary cost between production processes.
The rent relating to storage while the paint dries is expensed because it does not relate to storage before a
further production process (i.e. there is no further production process after the painting process).
2. The fixed manufacturing costs that will be capitalised to the inventory cost (rental of certain areas of the factory: see
note 1 above) are first debited to the fixed manufacturing cost suspense account. These will then be capitalised to the
cost of inventory (by crediting the suspense account and debiting the inventory work-in-progress account) using the
budgeted fixed manufacturing cost allocation rate. The budgeted fixed manufacturing cost allocation rate was not
given in the question and thus the journal allocating these fixed overheads to inventory is not shown.
3. The advertising costs are expensed since these are selling costs and selling costs may never be capitalised.
6. Subsequent Measurement: Inventory Movements (Cost Formulae) (IAS 2.23 - .27)
6.1 Overview Cost formulae:

Inventory movements include purchases and subsequent sales x SI/ FIFO/ WA
thereof and, if applicable, the conversion into another type of x If SIM doesn’t apply, you can
inventory or asset (i.e. in the case of a manufacturer, the choose between FIFO and WA
conversion from a raw material into work-in-progress and then into finished goods).
There are three different cost formulae allowed when measuring these movements:
x specific identification (SI);
x first-in, first-out (FIFO); and
x weighted average (WA).
We first assess whether the specific identification formula is suitable for our specific type of inventory.
If it is appropriate for our type of our inventories, then it must be used, but if it is not appropriate, then
we may choose between the first-in-first-out formula and the weighted average formula.
The measurement of the cost of the initial recognition of inventory does not differ with the
method chosen but, if the cost of each item of inventory purchased (or manufactured) during
the year is not constant, then the measurement of the cost of goods sold or converted will change
depending on the formula chosen.
The same cost formula must be used for all inventories having a similar nature and use.
6.2 Specific identification formula (SI) (IAS 2.23 - .24)
Specific identification is
The use of the specific identification formula is not a used for:
choice - it must be used if inventories: x Items that are not interchangeable; or
x consist of ‘items that are not ordinarily x Goods/ services produced & segregated
interchangeable’ or for specific projects
x are ‘goods or services produced and segregated for specific projects’. See IAS 2.23
696 Chapter 13
The specific identification formula is perfect, for example, for inventory that is made up of
items that are dissimilar in value (e.g. a retailer of exotic cars). How it works is that each item of
inventory is assigned its actual cost and it is this actual cost that is expensed when this specific item is
sold (using any of the other formulae would be materially inaccurate and misleading).
Example 22: Specific identification formula - purchases and sales
January Purchase 1 Beetle cost: C25 000
March Purchase 1 Porsche cost: C150 000
April Sold 1 Porsche selling price: C175 000
Required: Post the related journal entries in the ledger accounts using the SI formula.
Solution 22: Specific identification formula - purchases and sales

It would be unreasonable to use the first-in, first-out formula, in which case the cost of the Beetle would be
matched with the sale proceeds of the Porsche.
Similarly, the weighted average formula would not be suitable since the values of each of the vehicles are so
dissimilar that it would cause the cost to be distorted to unacceptable proportions.
The only formula suitable in this case is the specific identification formula, which simply means identifying the
actual unit sold and then using the actual cost of that unit when matching the cost of its sale against its sale proceeds.
Inventories (A) Bank
Beetle 25 000 Porsche 150 000 Beetle 25 000
Porsche 150 000 Balance 25 000 Porsche 150 000
175 000 175 000
Balance 25 000 Cost of Sales (E)
Porsche 150 000
Comment: The profit on sale can now be accurately determined as C175 000 – C150 000 = C25 000.
6.3 First-in, first-out formula (FIFO) (IAS 2.25-27) First-in-first-out formula

assumes:
This formula may be used where the goods forming part of oldest moves out first.
inventories are similar in value. The general assumption
under this method is that the oldest inventory is used or sold first (whether or not this is the actual fact).
The formula is best explained by way of example.
Example 23: First-in-first-out formula - purchases

1 January purchases one kilogram of X C100
2 January purchases two kilograms of X C220
Required: Post the related journal entries in the ledger accounts using the FIFO method.
Solution 23: First-in-first-out formula - purchases (ledger accounts)

1 Jan 100 1 Jan 100
2 Jan 220 2 Jan 220
320 320
Comment:
x There are now two balances in the inventory account. This is necessary in order that when the goods are
sold, the cost of the older inventory can be determined.
x The inventory presented in the SOFP would be the total of the 2 balances (i.e. C320).
Example 24: First-in-first-out formula – sales

Use the information from the previous example together with a sale on 3 January 20X1
(see information in the required section, below).
Required: Post the cost of sales journal in the ledger accounts using the FIFO method, if the sale was:
A. a sale of a 0.5 kilogram of X;
B. a sale of 1.5 kilograms of X.
Chapter 13 697
Solution 24A: First-in-first-out formula - sales (ledger accounts)

Inventories (A) Cost of Sales (E)
Balance 1 100 3rd Jan 50 3rd Jan 50(1)
Balance 2 220 Balance c/f 270
320 320
Balance 1 50
Balance 2 220
Comment:
x The inventory bought earlier is assumed to be sold first. In other words, the cost of the inventory sold is
measured based on the cost of the oldest stock first.
x Thus half of the first batch is sold and the cost of the sale is estimated at C100 x 0.5kg = C50(1)
x The inventory account still has two balances, where the oldest balance (balance 1) has been reduced. None
of the second batch has been used yet and therefore balance 2 remains unchanged.
x If the selling price was C150, the gross profit would be C150 – C50 = C100.
Solution 24B: First-in-first-out formula - sales (ledger accounts)

Balance 1 100 3rd Jan 155 3rd Jan 155(1)
Balance 2 220 Balance c/f 165
320 320
Balance 1 0
Balance 2 165
Comment:
x The inventory purchased earlier is assumed to be sold first. In other words, the cost of the inventory sold is
measured based on the cost of the oldest stock first:
- the entire first batch (1 kilogram) is sold plus
- 0.5 kilogram of the second batch (which consisted of 2 kilograms).
x The cost of the sale is thus estimated at 100 x 1 / 1 kilogram + 220 x 0.5 / 2 kilograms) = C155 (1)
x The inventory account now only has one balance, since the first batch (balance 1) has been entirely used up.
A quarter of the second batch has been used and therefore balance 2 is now ¾ of its original value:
¾ x 220 = 165 or 220 x (2 – 0.5) / 2 kilograms.
x If the selling price was C250, the gross profit would be C250 – C155 = C95.
6.4 Weighted average formula (WA) (IAS 2.25-27) Weighted average formula:
we average the costs per unit
As with the first-in-first-out formula, the weighted average The WA cost per unit will change when
formula is suitable only when the goods are similar in value. more goods are purchased at a new
price per unit.
Whenever goods are sold or converted, the cost of the
sale is measured by calculating the average cost of the goods sold, rather than simply assuming
the oldest goods were sold first. The average costs incurred over a time period will therefore be
used to calculate the cost of inventory sold, rather than the actual cost incurred on the item.
This is best explained by way of example.

Example 25: Weighted average formula - purchases
1 January Purchases one kilogram of X C100
2 January Purchases two kilograms of X C220
Required: Post the related journal entries in the ledger accounts using the weighted average method.
Solution 25: Weighted average formula – purchases

1 Jan 100 1 Jan 100
2 Jan 220 2 Jan 220
Balance 320 320
698 Chapter 13
Example 26: Weighted average formula - sales

Use the same information given in the previous example (i.e. that the entity had
purchased 3 kg of a product at a total cost of C320) together with the following sale:
3 January Sales one kilogram of X
Required: Post the cost of sale journal in the ledger accounts using the weighted average method.
Solution 26: Weighted average formula – sales

The weighted average cost per kilogram is calculated as follows:
total cost of inventories C320
= = C106,67 per kg
quantity of inventories on hand 3kg

Balance 320.00 3 Jan 106.67 3 Jan 106.67
Balance c/d 213.33
320.00 320.00
Balance b/d 213.33
Comments:
1. If the selling price was C150, then the gross profit would be C150 – C106,67 = C43,33.
2. When using the weighted average formula, there is only one balance in the inventory account (i.e. we have
2 kg remaining on hand, costing C213.33 in total – or C106.67 per kg).
6.5 The cost formula in a manufacturing environment

Many students panic when faced with applying the cost formulae in the context of a
manufacturing entity with its three core inventory accounts: raw materials, work-in-progress
and finished goods. However, the principles explained above remain absolutely unchanged.
If, for example, the manufacturing entity applied the first-in-first-out formula, it simply means
that before you transfer the cost of raw materials used from the raw materials account to the
work-in-progress account, you need to stop and calculate what the cost per unit should be based
on the first-in-first-out principles explained above.
Complexities arise only when dealing with the work-in-progress account since this requires
application of cost accounting principles (process costing) that are not dealt with in financial
accounting. However, once having applied your process costing principles to your work-in-
progress account, you can easily calculate the amount to be transferred to finished goods.
Due to space constraints, process costing will not be explained in this text. Instead, the
following examples will give you the amounts to be transferred from the work-in-progress
account to finished goods account as if you had applied your process costing principles. The
following examples will thus only require you to calculate the costs per unit when transferring
the cost of raw materials from the raw materials account to the work-in progress account and
when transferring the cost of finished goods that have been sold from the finished goods account
to the cost of sales expense account.
The previous example that dealt with the inventory accounts of a manufacturing entity
(example 12) had been deliberately simplified in the following respects:
x the cost per unit of the raw materials opening balance was the same as the cost per unit of
the raw material purchases during the year;
x the cost per unit of the finished goods opening balance was the same as the cost per unit of
the finished goods completed during the year;
x all the work-in-progress was completed during the year; and
x all the finished goods were sold during the year; and
x none of the manufacturing costs were fixed costs.
Chapter 13 699
Example 12 was kept deliberately simple so as to avoid the issue of the cost formulae and to
avoid the issue of fixed manufacturing cost application rates, both of which had not yet been
explained. The following example is based on example 12 but has been changed so that the
impact of the different cost formulae can be demonstrated. A fixed manufacturing cost has also
been added so this is now a comprehensive example which shows how the application rate
works. The changes from example 12 have been highlighted in bold for your interest.
Example 27: Manufacturing ledger accounts – FIFO vs WA formulae

Arabia Limited manufactures sunhats. The following information applies:
x C20 000 of raw materials were available on 1 January 20X1, (15 000 kilograms).
x C40 000 of raw materials were purchased during January 20X1 (40 000 kilograms).
x 26 000kg of raw materials were used during January 20X1.
x Wages of C100 000 were incurred and paid during January 20X1:
- 80% related to factory workers,
- 6% related to cleaning staff operating in the factory,
- 4% related to cleaning staff operating in the head office and
- 10% related to office workers in the administrative offices.
All factory-related wages were considered to be variable.
x Electricity of C62 000 was incurred and paid during January 20X1. All of this related to the factory
operations. The entire electricity bill was considered to be variable.
x Depreciation of C38 000 is incurred during January 20X1:
- C28 000 relates to machinery used exclusively in the factory; and
- C10 000 relates to equipment used by head office.
Depreciation of C28 000 is calculated using the units of production method and is thus a variable cost.
x The factory building is rented at C40 000 per month (and always paid in cash).
x Budgeted normal production for January 20X1 was 20 000 units.
x 21 000 units were put into production during January 20X1.
x Work-in-progress on 1 January 20X1 was C35 000.
x 18 000 units were completed during January 20X1, at a cost of C162 000.
x The finished goods opening balance (01/01/X1) was C30 000 (representing 3 000 units).
x 80% of all finished goods were sold during January 20X1.
Required: Show the ledger accounts for raw materials, work-in-progress and finished goods using the
perpetual system and assuming that:
A. the first-in-first-out formula is used.
B. the weighted average formula is used.
Solution 27A: Manufacturing ledger accounts – FIFO formula

Inventory: raw materials (A)
O/ balance Given 20 000 Work-in-progress W1 31 000
Bank Given 40 000 C/ balance c/f Balancing 29 000
60 000 60 000
C/ balance b/f Balancing 29 000
Inventory: work-in-progress (A)
O/ balance Given 35 000 FMC suspense W3 2 000
Raw materials W1 31 000
Bank W4 86 000 Finished goods Given 162 000
Bank Given 62 000
Depreciation Given/ Note 1 28 000 C/ balance c/f Balancing 120 000
FMC suspense W2 42 000
284 000 284 000
700 Chapter 13
Inventory: finished goods (A)

O/ balance Given 30 000 Cost of sales W5 154 200
Work-in-progress Given 162 000 C/ balance c/f 37 800
192 000 192 000
C/ balance b/f 37 800
Cost of goods sold (E)
Finished goods W5 154 200
Fixed manufacturing costs suspense (T)

Bank Given 40 000 Inventory: WIP W2 42 000
Inventory: WIP W3 2 000 C/ balance c/f 0
42 000 42 000
C/ balance b/f 0
Workings:
W1: The cost of the 26 000kg raw materials is allocated from RM to WIP using the FIFO formula:
Available Used Used
kg C C/kg kg Calculation C
Open/ balance 15 000 kg 20 000 C1.3/ kg 15 000kg 15 000 kg x C1.3/ kg 20 000
Purchases 40 000 kg 40 000 C1/ kg 11 000kg (26 000kg – 15 000kg) x C1 11 000
55 000 kg 60 000 26 000kg 31 000
W2: Allocation of the fixed manufacturing costs to WIP using the budgeted rate:
W2.1: Budgeted fixed manufacturing cost allocation rate (BFMCAR)
= C40 000
= C2 per unit
20 000 units
W2.2: Budgeted fixed manufacturing cost allocated during January 20X1
= BFMCAR x Actual production (units put into production)
= C2 x 21 000 = C42 000
W3: Check for over or under-allocation of the fixed manufacturing costs at end January 20X1
= Fixed manufacturing costs total – Fixed manufacturing costs allocated
= C40 000 (Given) – C42 000 (W2) = C2 000 (Over-allocation)
W4: Wages related to the manufacturing process
= C100 000 x (80% + 6%) = C86 000
W5: The cost of the units sold from FG to cost of sales using the FIFO formula:
Units C C/ unit Units Calculation C
available sold
Open/ balance 3 000 u 30 000 C10/ u 3 000 u 3 000u x C10/ u 30 000
Purchases 18 000 u 162 000 C9/ u 13 800 u (80% x 21 000u – 3 000u) x C9 124 200
21 000 u 192 000 16 800 u 154 200
Notes:
1. The contra entry is depreciation expense because the total depreciation is first expensed and then the portion
to be capitalised is reallocated from the depreciation expense account to the work-in-progress.
This is done because we are required to disclose the ‘total depreciation’ as well as the ‘depreciation expense’
(if we had not debited the ‘depreciation expense’ account first, this account would not be able to help us
determine what the ‘total depreciation’ was).
Chapter 13 701
Solution 27B: Manufacturing ledger accounts – WA formula

Inventory: raw materials (A)
O/ balance Given 20 000 Work-in-progress W1 28 364
Bank Given 40 000 C/ balance c/f Balancing 31 636
60 000 60 000
Inventory: work-in-progress (A)
O/ balance Given 35 000 FMC suspense W3 2 000
Raw materials W1 28 364
Bank W4 86 000 Finished goods Given 162 000
Bank Given 62 000
Depreciation Given 28 000 C/ balance c/f Balancing 117 364
FMC suspense W2 42 000
281 364 281 364
Inventory: finished goods (A)
O/ balance Given 30 000 Cost of sales W6 153 600
Work-in-progress Given 162 000 C/ balance c/f 38 400
192 000 192 000
C/ balance b/f 38 400
Cost of goods sold (E)
Finished goods W5 153 600
Fixed manufacturing costs suspense (T)

Bank Given 40 000 Inventory: WIP W2 42 000
Inventory: WIP W3 2 000 C/ balance c/f 0
42 000 42 000
C/ balance b/f 0
Workings:
All the workings in the previous solution (solution 26A) with the exception of the following two workings (W1
and W5) are the same and are thus not repeated here.
W1: The cost of the 26 000kg raw materials is allocated from RM to WIP using the WA formula:
Available Used Used
Kg C C/kg Kg Calculation C
Open/ balance 15 000 kg 20 000
Purchases 40 000 kg 40 000
55 000 kg 60 000 C1.09/kg 26 000kg 26 000 kg x C1.0909/ kg C28 364
W5: The cost of the units sold from FG to cost of sales using the WA formula:
Available Sold Calculation C
units C C/ unit units
Open/ balance 3 000 u 30 000
Completed 18 000 u 162 000
21 000 u 192 000 C9.14286 16 800 u (80% x 21 000u) x C9.14286 153 600
7. Subsequent Measurement: Year-End (IAS 2.9 and .28 - .33)
7.1 Overview
In the interests of ensuring that the inventory balance is not overstating the potential inflow of future
economic benefits, we measure the inventory balance at the lower of cost and net realisable value.
702 Chapter 13
If the net realisable value is:

x lower than cost, the inventories must be written down to this lower amount.
x greater than cost, then no adjustment is made: the
practice of valuing inventories to a net realisable Subsequent measurement
value that is higher than cost is not allowed. of inventories:
x Lower of:
Inventory write-downs are recognised as expenses (i.e. - Cost; or
See IAS 2.9
- Net realisable value.
cr inventory asset, dr write-down expense). Write-downs
may subsequently be reversed, in which case they will be recognised as income (e.g. dr
inventory asset, cr reversal of inventory write-down income). See IAS 2.34
7.2 Net realisable value (IAS 2.6 and IAS 2.28-.33)
Net realisable value is an entity-specific value based on the Net realisable value is
defined as:
entity’s estimation of the inventory’s selling price in the
Estimated selling price in the
ordinary course of business less the costs the entity estimates x ordinary course of business
it will still need to incur in order to make such a sale, being: x Less:
x any costs that may still need to be incurred in order - estimated costs of completion &
IAS 2.6
- estimated selling costs.
to make it saleable; (costs of completion) and
x any costs that may need to be incurred in order to secure the sale (selling costs). See IAS 2.6
It is important to make a distinction between the net realisable value (used to subsequently
measure inventory), and the fair value less cost to sell, which is used in other standards, such
as IAS 36 Impairment of assets and IFRS 5 Non-Current Assets Held for Sale and Discontinued
Operations. The net realisable value is the net amount expected to be received when the entity
sells inventory in the ordinary course of business. This measurement is entity-specific, which
means that different entities may have different net realisable values for the same item of
inventory. Fair value less costs to sell is based on a fair value, which is not entity-specific,
because the fair value refers to the price that the item would sell for in the most
advantageous/principal market. See IAS 2.7 Fair value is measured in accordance with IFRS 13.
When estimating the net realisable value, we must use the most reliable evidence available to
us. This may mean using information that comes to light due to events after the reporting date
but before the financial statements are finalised for issue (see chapter 18). Information that
arises during this period (i.e. before reporting date and the date on which the financial
statements are finalised) may be used on condition that it gives more information about events
that existed at reporting date. See example 28.
When estimating the net realisable value, we must also take into account the purpose for which
the inventory is held (see example 29). If, for example, certain inventory has been set aside for
a specific customer at a specified contractual price, then:
x the net realisable value for the part of the inventory that has been set aside for the specific
customer is based on the related contracted price while
x the net realisable value for the remaining inventory is based on general selling prices.
When testing for write-downs, each inventory item should generally be tested separately. Thus,
providing for an estimated percentage write-off across all inventory would not be acceptable.
However, whether to test on an item-by-item basis depends on the actual circumstances. For
example, in certain circumstances a product line (e.g. a cutlery set) must be looked at as a whole
rather than on an individual item-by-item basis if the individual items cannot be sold separately:
e.g. if the knives, forks and spoons manufactured as part of the cutlery set are not sold
separately, then the cutlery set should be tested for impairment as a separate product-line rather
than trying to measure the individual knives, forks and spoons. See IAS 2.29
Chapter 13 703
Inventory should generally not be tested for impairment based on general classifications, such
as raw materials, work-in-progress, finished goods and consumable stores. For example, raw
materials with a net realisable value lower than cost, will still be used in the manufacture of a
final product and will thus not be sold in their raw state. Thus, a write down of raw materials
based on a net realisable value in its raw state makes no sense.
On the other hand, the testing for impairment of a general classification such as raw materials
would be appropriate if, for example, the finished product in which the raw materials were used
is no longer profitable and the expectation is that the raw materials (or work-in-progress) will
be sold in their current unfinished state or even dumped.
If the price of raw materials has dropped to below cost, no write-down is processed unless the
drop in the price of the raw material causes the net realisable value of the finished product
dropping below its cost. If the drop in the price of raw materials has resulted in the net realisable
value of the finished product also dropping below cost, then the affected raw materials on hand
would need to be written down. However, the net realisable value of the raw material will then
generally be the replacement cost of the raw materials. See IAS 2.32
Example 28: Net realisable value and events after reporting period
Cold Limited has a branch in Woop Woop. There is very little infrastructure in Woop Woop
and, as a result, the Woop Woop factory manager only managed to send a fax through to
head office on 10 January 20X2 to advise that the entire warehouse and the entire finished
goods inventory contained therein (with a carrying amount of C900 000) had been destroyed
in a series of storms.
x The first storm hit the warehouse on 29/12/20X1 destroying 70% of the inventory.
x The remaining undamaged inventory was quickly moved to higher ground but flood
waters from a second storm on 5 January 20X2 destroyed this too.
The factory manager estimates that the entire inventory:
x will be saleable as scrap for C100 000 and the related costs to sell will be C1 000;
x would normally have sold for C1 500 000, with related selling costs being 10% thereof.
Required: Calculate the net realisable value at 31 December 20X1
Solution 28: Net realisable value and events after reporting period C
Comment:
x Although the entire inventory at Woop Woop has been destroyed, only 70% of the inventory was destroyed
before reporting date. This means that:
- the net realisable value of 70% of the inventory is based on scrap values; but
- the net realisable value for the remaining 30% of the inventory that existed at reporting date should be
based on normal prices.
- The valuation was conducted after reporting date and is thus an event after reporting date, however the
inventory has to be written down as it was destroyed before year end.
Damaged Inventory Estimated selling price C100 000 x 70% 70 000

(70%) Less estimated selling costs C1 000 x 70% (700)
Net realisable value 69 300
The above NRV would be compared to the CA of the damaged inventory at year-end of C63 000 (900 000 x 70%).
The write down of the damaged inventory at year-end would be C560 700 (CA: C630 000 – NRV: C69 300)
Undamaged Inventory Estimated selling price C1 500 000 x 30% 450 000
(30%) Less estimated selling costs C1 500 000 x 10% x 30% (45 000)
The NRV would be compared to the CA of the undamaged inventory at year-end of C270 000 (C900 000 x 30%).
The write down of the undamaged inventory at year-end would thus be NIL (CA: C270 000- NRV: C405 000 =N/A)
704 Chapter 13
Example 29: Net realisable value based on purpose of the inventory

At 31 December 20X1, Shaks Limited had inventory of finished goods with a carrying
amount C400 000 (being 100 000 widgets at a cost of C4 each).
x Of this, 20 000 widgets had been set-aside for Era Limited in terms of a firm sales
commitment at C6 per widget.
x The current selling price per widget is C4.50.
x Selling costs for the 20 000 widgets is only C1 000 whereas the normal estimated selling
costs are C1 per unit.
Required: Calculate the net realisable value at 31 December 20X1.
Solution 29: Net realisable value based on purpose of the inventory
C
Estimated selling price 20 000 x C6 + 80 000 x C4.50 480 000
Less estimated selling costs C1 000 + 80 000 x C1 (81 000)
Less estimated costs to complete N/A (0)
7.3 Inventory write-downs (IAS 2.28)

If the net realisable value is less than its carrying amount, we write the inventory balance down
to the net realisable value.
The comparison between carrying amount (cost) and net realisable value should be done on an item-
for-item basis. In other words, at the end of each financial year, the inventory balances on an item-for-
item basis should be checked to be sure they do not exceed the lower of cost or net realisable value.
Example 30: Lower of cost or net realisable value: write-downs
A company has inventory on hand at year-end (31 December 20X2) that it expects to be
able to sell in the ordinary course of business for C100.
In order to sell this inventory, the company expects to incur selling costs of C20 and expects to incur
further costs of C30 to put this inventory into a saleable condition.
Required:
A. Assuming that the cost of the inventory is C70:
i.) Calculate the net realisable value;
ii.) Calculate any possible write-down
iii.) Journalise any write-down necessary
iv.) Show where the write-down would be included and disclosed in the financial statements
B. Repeat Part A assuming that the cost of the inventory is C30 (not C70).
Solution 30: Lower of cost or net realisable value: write-downs

Part A Part B
i) Calculation: Net realisable value C C
Estimated selling price 100 100
Less estimated selling costs (20) (20)
Less estimated costs to complete (30) (30)
ii) Calculation: Write-down C C

Cost 70 30
Lower of cost or net realisable value (A: 70 or 50); (B: 30 or 50) (50) (30)
Inventory write-down 20 0
iii) Journal Dr/ (Cr) Dr/ (Cr)

Inventory write-down (E) Part (ii) above: C70 – C50 20 N/A
Inventories (A) (20) N/A
Write-down of inventories to net realisable value
Chapter 13 705
iv) Disclosure
Company name
Note Part A Part B
C C
Revenue X x
Cost of inventory expense (A: cost of sales + write-down: 20) See note below (x + 20) (x + 0)
(B: cost of sales + write-down: 0) See note below
Other costs disclosed using function or nature method (x) (x)
Profit before tax 3 (x) (x)
Company name
Part A Part B
Profit before taxation is stated after taking into account the following separately disclosable items:
- Write-down of inventories expense See note below 20 N/A
Note: The inventory write-down may be included in cost of inventory expense or could be shown as part of the
entity’s other expenses – this choice is based on professional judgement (see section 7.5)
7.4 Reversals of inventory write-downs (IAS 2.33)

If inventory that was written down in a prior year is still on hand at the end of the current year
and the circumstances that led to the write-down have now reversed such that the net realisable
value has now increased, then the previous write-down may be reversed.
Be careful not to increase the inventory to an amount that exceeds its cost! In other words, if
the net realisable value exceeds the carrying amount, the carrying amount may be increased
back up to cost but not above cost. The write-back is limited since the principle of lower of cost
or net realisable value must always be observed.
Example 31: Lower of cost or net realisable value: reversal of write-downs
A company has inventory on hand at its year-end of 31 December 20X2, which had been written
down at 31 December 20X1 to a net realisable value of C50. Its original cost was C70.
Required: Process the journals in 20X1 and 20X2 and show how the write-back (if any) would be
disclosed in 20X2 assuming that the net realisable value of this stock at 31 December 20X2 is:
A. C55;
B. C75.
Solution 31A: Lower of cost or net realisable value: reversal of write-downs (write-back)
Inventory write-down (E) 20
Inventories (A) 20
Write-down of inventories to net realisable value: W1
31 December 20X12
Inventories (A) 5
Reversal of inventory write-down (I) 5
Reversal of previous write-down of inventories: W1
W1: Calculation of write-down or reversal of write-down 20X2 20X1

Lower of cost or net realisable value (20X1: 70 or 50) (20X2: 70 or 55) (55) (50)
Write-down/ (reversal of previous write-down) (5) 20
706 Chapter 13
Disclosure
Company name
Note 20X2 20X1
C C
Revenue x x
Cost of inventory expense (x) (x)
Other costs Note 1 20X2: (x - 5) 20X1: (x + 20) Note 2 (x - 5) (x + 20)
Notes:
Note 1: Other costs would need to be disclosed either by function or by nature.
Note 2: The inventory write-down and reversal could be included in cost of inventory expense or could be shown
as part of the entity’s other expenses – this is a choice based on professional judgement.
Company name
20X2 20X1
Profit before taxation is stated after taking into account the following separately disclosable
(income)/ expense items:
- Write-down/ (Reversal of write-down) of inventories (W1) (5) 20
Solution 31B: Net realisable value calculation and journal

Inventory write-down (E) 20
Inventories (A) 20
Write-down of inventories: W1
31 December 20X12
Inventories (A) 20
Reversal of inventory write-down (I) 20
Reversal of previous write-down of inventories: W1
W1: Calculation of write-down or reversal of write-down 20X2 20X1

Lower of cost or net realisable value (20X1: 70 or 50) (20X2: 70 or 75) (70) (50)
Write-down/ (reversal of previous write-down) (20) 20
Disclosure
Company name
Note 20X2 20X1
C C
Revenue x x
Cost of inventory expense (x) (x)
Other costs Note 1 20X2: (x - 20) 20X1: (x + 20) Note 2 (x - 20) (x + 20)
Notes:
Note 1: Other costs would need to be disclosed either by function or by nature.
Note 2: The inventory write-down and reversal could be included in cost of inventory expense or in the entity’s
other expenses – this is a choice based on professional judgement (see section 7.5).
Chapter 13 707
Company name
20X2 20X1
Profit before taxation is stated after the following separately disclosable (income)/ expense items:
- Write-down/ (Reversal of write-down) of inventories (W1) (20) 20
7.5 Presenting inventory write-downs and reversals of write-downs (IAS 2.34 & .38)
An ‘inventory write-down’ expense and ‘reversal of inventory write-down’ income are both separately
disclosable items, which means that the write-down (or reversal) will have to be disclosed somewhere
in the financial statements. We could disclose this detail on the face of the financial statements or in
the notes to the financial statements. However, disclosure and presentation are not the same thing.
With respect to presentation, IAS 2 does not state where we Cost of inventory
expense (also called cost
must present an inventory write-down expense (or reversal of sales) includes:
of write-down income). Thus, we could present it as part of
x the cost of inventory sold;
the line item 'cost of inventory expense' (often called cost of
x unallocated manufacturing overheads;
sales), or we could include it in the line item 'other costs' or
x any abnormal production costs (e.g.
we could present it as a separate line item altogether, such wastage);
as 'inventory write-down'. There are many possibilities. x other costs depending on the
See IAS 2.38
circumstances.
However, IAS 2 describes the ‘cost of inventory expense’
(cost of sales) as including the cost of the inventory items that have been sold, any unallocated
manufacturing costs and also any abnormal production costs (e.g. wastage). It also goes on to explain
that the circumstances facing the entity may justify including other amounts in this ‘cost of inventory
expense’ (cost of sales). Thus, professional judgement is needed when deciding if an inventory write-
down expense (or reversal of inventory write-down income) should be included in the ‘cost of
inventory expense’ line-item or presented as a separate line item. See IAS 2.38
It is submitted that, unless circumstances suggest otherwise, a general rule of thumb is that:
x if the write-down is considered to be a normal part of trading, this inventory write-down expense
could be presented as part of the ‘cost of inventory expense’ line-item (cost of sales expense); but
x if the write-down is not normal, this inventory write-down expense should not be presented as
part of the ‘cost of inventory expense’ line-item (cost of sales). See IAS 2.34 and IAS 2.38
Sometimes write-downs are simply a normal part of an entity’s business. For example, inventory
represented by fresh vegetables with a short-shelf life may result in regular write-downs. It could be
argued in this case that such an inventory write-down should be presented as part of the cost of
inventory expense line-item (cost of sales).
Presentation of inventory
Conversely, write-downs may be caused by something that write-downs/ reversals:
is not part of an entity's normal business. For example, if a Inventory write-downs/reversals may be
new technology was released resulting in certain inventory included in:
on hand becoming obsolete and thus needing to be written- x the cost of inventory expense line item,
down, this type of write-down may be considered so x other costs line item,
significant and out of the ordinary that we may argue that x any other relevant line item, or even
the write-down should not be presented as part of the cost x an entirely separate line item.
of inventory expense line-item (cost of sales) but should (IAS 2 does not prescribe where it should
rather be presented as an entirely separate line-item. be presented).
One of the reasons behind excluding the cost of an unusual and significant inventory write-down
expense (or reversal income) from the cost of inventory expense is that the cost of this inventory write-
down expense may otherwise distort the gross profit percentage and thus damage comparability of the
current year financial results with those of the prior year and also damage comparability of the entity's
results with its competitors' results.
708 Chapter 13
Deciding where to present an inventory write-down or reversal will need your professional judgement.
This judgement needs to be guided by the fact that we must provide financial information that is useful
(the presentation should provide information that is relevant and a faithful representation).
Example 32: Lower of cost or net realisable value – involving raw materials
A bookkeeper has provided you with the following working papers regarding inventory on
hand at 31 December 20X2. The company is a manufacturer of two product lines: motorbikes
and bicycles:
Cost NRV: Write-down
C C C
Raw materials 100 000 75 000 25 000
x Motorbike parts 40 000 25 000
x Bicycle parts 60 000 50 000
Work-in-progress 80 000 85 000 0
x Incomplete motorbikes 30 000 25 000
x Incomplete bicycles 50 000 60 000
Finished Goods 160 000 165 000 0
x Complete motorbikes 80 000 55 000
x Complete bicycles 80 000 110 000
340 000 325 000
Due to the strengthening of the local currency, the parts used in the manufacture of both the motorbikes
and bicycles became cheaper. As a direct result thereof, the net realisable value of both the finished
motorbikes and bicycles also dropped.
Required: The bookkeeper asked that you explain whether his calculated write-down is correct.
Solution 32: Lower of cost or net realisable value – involving raw materials
Explanation to the bookkeeper:
Inventory write-downs should generally not be done based on inventory classifications (raw materials,
work-in-progress and finished goods) but should be done on an item-by-item basis.
Although both items of raw materials have net realisable values that are lower than cost, raw materials
should not be written-down unless the reason for the drop in the NRV of the raw materials has also resulted
in the NRV of the related finished product also dropping.
x Since the NRV of the finished motorbikes has dropped below cost, motorbike parts (raw materials) should be
written-down to their net realisable value (the NRV in this case is usually the net replacement cost).
x Despite the NRV of the finished bicycles having dropped, the NRV of the bicycles has not dropped
below cost. The bicycle parts (raw materials) should therefore not be written-down.
The write-down is thus calculated as follows: Cost NRV: Write-down Comment

C C C
Motorbikes:
x Motorbike parts (raw materials) 40 000 25 000 15 000 (a)
x Incomplete motorbikes (work-in-progress) 30 000 25 000 5 000 30 000 – 25 000
x Complete motorbikes (finished goods) 80 000 55 000 25 000 80 000 – 55 000
Bicycles:
x Bicycle parts (raw materials) 60 000 50 000 0 (b)
x Incomplete bicycles (work-in-progress) 50 000 60 000 0 NRV greater
x Complete bicycles (finished goods) 80 000 110 000 0 NRV greater
45 000
Comments:
(a) A write-down of the raw material of motorbike parts is necessary because the NRV of complete motorbikes
has dropped below cost.
(b) No write-down of the raw material of bicycle parts is processed since the NRV of the complete bicycles
remained above cost.
Chapter 13 709
8.1 Accounting policies (IAS 2.36 (a))
An accounting policy note is required indicating the accounting policy in respect of:
x the measurement of inventories (i.e. lower of cost and net realisable value) and
x the cost formula used (FIFO, WA or SI formulae).
8.2 Statement of financial position and supporting notes
Inventories must be presented as a separate line item on the face of the statement of financial
position and must be included under the classification of current assets. See IAS 1.54(g) and IAS 1.66(a)
The note supporting this inventories line item should indicate the:
x Carrying amount of inventories broken down into classifications appropriate to the entity:
- Merchandise or Finished goods
- Work-in-progress
- Raw materials
- Other production supplies (e.g. cleaning materials & other consumables); See IAS 2.36 (b)
x Carrying amount of inventories measured at fair value less costs to sell (this applies to
agricultural produce only – agricultural industries are not covered in this text); See IAS 2.36 (c)
x Amount of inventories pledged as security. IAS 2.36 (h)
8.3 Statement of comprehensive income and supporting notes
The following disclosure is required, either on the face of the statement of comprehensive
income or in a note supporting specific line items on the face:
x The cost of inventories expense (often referred to as cost of sales). See IAS 2.36 (d)
Cost of inventory expense constitutes:
- cost of goods sold,
- fixed manufacturing overheads expensed (i.e. due to under-production),
- abnormal production costs (e.g. abnormal wastage of raw materials), and
- other costs, depending on ‘the circumstances of the entity'. IAS 2.38
x Write-down of inventories. See IAS 2.36 (e)
- Write-downs may be included in cost of sales depending on ‘the circumstances of
the entity'. See IAS 2.38
- If write-downs are not included in cost of sales, they may be included as a separate
line item in operating costs.
x Reversal of an inventory write-down (an income item), together with the circumstances that
led to this reversal. See IAS 2.36 (f and g)
The cost of inventories expense is disclosed whether the function or nature method is used.
Remember that the cost of inventories expense, which must be presented separately, includes
costs such as depreciation on factory-related property, plant and equipment (which are
capitalised to inventory), and which are line-items that must also be disclosed separately.
Example 33: Disclosure: comparison between nature and function methods
The following schedule of costs for the year ended 31 December 20X2 is presented to you:
x Raw materials: - Balance: 1 January 20X2: C20 000

- Balance: 31 December 20X2: C10 000
- Purchases: during 20X2: C40 000
710 Chapter 13
x Work-in-progress: - Balance: 1 January 20X2: C40 000

x Finished goods: - Balance: 1 January 20X2: C60 000
x Production costs: - Wages: during 20X2: C60 000
- Factory depreciation: during 20X2: C80 000
x Other income and - Distribution & administration costs: C30 000 each
expenses during X2: - Sales income: C290 000
- Other income: C10 000 (other comprehensive income: C0)
- Interest expense: C10 000
- Tax expense: C20 000
x Actual production exceeded normal production.
Required:
Disclose the statement of comprehensive income in as much detail as possible assuming:
A. the function method is used;
B. the nature method is used.
Solution 33A: Disclosure – function method
Entity name
Note 20X2
C
Revenue 290 000
Other income 10 000
Less cost of inventory expense W3 (180 000)
Less distribution costs (30 000)
Less administrative costs (30 000)
Less finance costs (10 000)
Taxation (20 000)
Workings:
W1. Raw Materials O/bal + Purchases - Used = C/bal

20 000 40 000 (50 000) 10 000
(balancing)
W2. Work-in-progress O/bal + Production costs - Finished goods = C/bal

W4
40 000 190 000 (200 000) 30 000
(balancing)
W3. Finished Goods O/bal + Finished goods - Cost of sales = C/bal

W2
60 000 200 000 (180 000) 80 000
(balancing)
W4. Production costs C
Wages 60 000
Depreciation 80 000
W1
RM used 50 000
190 000
Chapter 13 711
Solution 33B: Disclosure – nature method
Entity name
Statement of comprehensive income 20X2
For the year ended 31 December 20X2 (extracts) C
Revenue 290 000
Add other income 10 000
Add increase in inventory of finished goods W3. 80 000 – 60 000 20 000
Less decrease in inventory of work-in-progress W2. 30 000 – 40 000 (10 000)
Less Raw materials and consumables used W1. (50 000)
Less Staff costs (60 000)
Less Depreciation (80 000)
Less other operating expenses No detail given so 30 000 + 30 000 (60 000)
Less finance costs (10 000)
Taxation (20 000)
Note: please see workings in solution 33A
Example 34: Disclosure of cost of sales and inventory-related depreciation

An entity earned sales income of C620 000 and listed the following expense accounts in
its trial balance at 31 December20X2 (year-end):
x Cost of sales: C100 000;
x Fixed manufacturing overheads: C80 000 (all expensed due to under-productivity);
x Fixed administration overheads: C70 000;
x Write-down of green paint (raw materials): C20 000
x Write-down of green picket fences (finished goods): C30 000
x Reversal of write-down of white paint (raw materials): C10 000 (New technology in 20X1
caused a write-down of white paint (raw materials) and related white fencing (finished
product). This technology was declared illegal in 20X2 due to health risks; as a result, the
net realisable value of the white paint and white fencing on-hand increased at end 20X2.)
x Depreciation – office equipment: C25 000
x Depreciation – distribution vehicles: C35 000
x Depreciation – plant: C5 000 (depreciation on plant of C75 000 was capitalised to inventory
during 20X2; the depreciation of C5 000 was due to plant being idle during a strike)
x Salaries and commissions: sales representatives: C130 000
x Salaries: administrative staff: C60 000
x Interest expense: C15 000
The entity presents inventory write-downs within the cost of inventory expense (cost of sales) line-item.
Required: Prepare the statement of comprehensive income and related notes in as much detail as
possible assuming the function method is used.
Solution 34: Disclosure of cost of sales and inventory-related depreciation

Entity name
20X2
Note C
Revenue 620 000
Cost of inventory expense 100 000 + 80 000 + 20 000 + 30 000 – 10 000 + 5 000 (225 000)
Cost of administration 70 000 + 25 000 + 60 000 (155 000)
Cost of distribution 35 000 + 130 000 (165 000)
Finance costs Given (15 000)
Profit before tax 3. 60 000
712 Chapter 13
Entity name
20X2
C
Profit before tax is stated after the following separately disclosable (income)/ expense items:
Depreciation – office equipment 25 000
Depreciation – distribution vehicles 35 000
Depreciation – plant 5 000
- Total depreciation 5 000 expensed + 75 000 capitalised 80 000
- Less capitalised to work-in-progress Given (75 000)
Write-down of inventories 20 000 + 30 000 50 000
Reversal of write-down of inventories (10 000)
Reason for the reversal of the write-down of inventories: The new technology which caused the
write-down of white paint (raw materials) and white fencing (finished product) in 20X1 was
declared illegal during 20X2 due to health concerns.
Example 35: Disclosure of the inventory asset and related accounting policies
The following were included in the trial balance at 31 December 20X2 (year-end):
x Finished goods (tyres: styles XYZ and XXX): C500 000;
x Work-in-progress: C100 000;
x Raw materials: C300 000.
Finished goods of C500 000 have been pledged as security for a loan..
Required: Disclose the above in the statement of financial position and related notes thereto.
Solution 35: Disclosure of the inventory asset and related accounting policies
Entity name
20X2 20X1
Current assets Note C C
Inventories 500 000 + 100 000 + 300 000 5 900 000 xxx
Accounts receivable xxx xxx
Cash xxx xxx
Entity name
20X2 20X1
Note C C
2.1 Inventories Inventories are valued at the lower of cost and net realisable value, where the cost is
calculated using the actual cost/ standard cost/ retail method (selling price less gross profit
percentage). Inventory movements are recorded using the weighted average formula (or FIFO or SI).
5. Inventories
Finished goods 500 000 xxx
Work-in-progress 100 000 xxx
Raw materials 300 000 xxx
900 000 xxx
The entire finished goods has been pledged as security for a loan (see ‘note xxx’ for further details).
Chapter 13 713
9. Summary
Inventory measurement:
Lower of ‘cost’ and
‘net realisable value’
Cost: Net realisable value:

Calculation techniques: Calculation:
- Actual; Estimated selling price
- Standard; or Less: estimated costs to complete
- Retail method. Less: estimated selling costs
Include Exclude
- The general rule: costs that are incurred in
order to bring the asset to its present - Abnormal wastage;
location and condition: - Storage costs (unless necessary mid-
- purchase cost (e.g. of raw material – a production);
direct cost);
- conversion cost - Administrative costs that do not
- other costs contribute to the ‘general rule’
- Purchase cost include, for example, - Selling costs;
purchase price, transport costs inwards,
non-refundable taxes and import duties, - Transport costs outwards (involved in
other directly attributable costs the sale);
- Conversion costs include for example: - Transaction taxes that are recoverable
- direct costs e.g. direct labour: these are (e.g. VAT).
normally variable but could be fixed);
- indirect costs (variable manuf.
overheads and fixed manuf. overheads)
- Other cost include, for ex., borrowing costs
- All discounts plus rebates that are
designed to reduce the purchase price
should be set-off against the costs
Inventory measurement involving:

*** Fixed manufacturing cost (FMC):
A FMC allocation rate must be used to measure how
much of the FMC’s to include in the cost of the
inventory asset.
The rate is based on:
Normal production level if: Actual production level if:

Actual production = / < Normal Actual production > Normal production
production
- If AP < NP, then some of the FMC will not be - If AP > NP, then all of the FMC will be
capitalised and will be included as part of the capitalised (if normal production was used
cost of inventory expense (considered to be as the base instead of actual production,
abnormal wastage) then more costs would be capitalised than
- If AP = NP, then all FMC’s are capitalised is incurred!)
Inventory measurement:
The cost formulae used for measuring inventory movements
Same cost formulae for all inventory with similar nature and use
If goods are similar: use either If goods are not similar: use
- Weighted average (WA) formula - Specific identification (SI) formula
- First-in, first-out (FIFO) formula
714 Chapter 13
Inventory Systems:
Periodic: Perpetual:
Inventory account updated at the end of the Two accounts are used, both of which are
period (typically this is year-end) with the: updated immediately on purchase and sale of
x new closing balance (physically count) goods:
x old opening balance transferred out. x Inventory account (and any sub-
accounts such as Raw Materials, WIP,
Finished Goods etc); and
Purchases during the period are debited to
purchases account. This is transferred out at x Cost of sales account.
year-end.
All contra accounts: cost of sales
Derecognition:
Inventory is derecognised
once it is sold or written-off
(due to theft/being scrapped)
Disclosure of inventory
Statement of financial position and Statement of comprehensive income

related notes and related notes
x SOFP face: x SOCI face:
- Total carrying amount of inventories - Cost of inventory expense (often
called cost of sales):
x Inventory note: show the carrying amt - cost of sales
- Per class of inventory: - + cost of write-downs Note 1
- finished goods, - - reversals of write-downs Note 1
Note 1
- work in progress, - + inventory losses
- raw materials, - + fixed manuf costs expensed
(under-absorbed)
- consumables
- + abnormal wastage
- Of inventory carried at fair value less
costs to sell (this applies to Note 1: these costs could be included in cost
commodity brokers only) of inventory expense if we believed they
were a normal part of our trading activities –
- Of inventory pledged as security
otherwise, we could present them separately
- Inventory write-down
- Reversal of inventory write-down
(include conditions causing reversal)
- Depreciation capitalised to inventory
Accounting policies (notes)

x Lower of cost and net realisable value
x Cost formula used (FIFO, WA, SI)
Chapter 13 715
Gripping GAAP Borrowing costs
Chapter 14
Borrowing Costs
Reference: IAS 23 (including amendments to 10 December 2018)
Contents: Page
1. Introduction 717
2. Scope 717
3. Understanding the terms: borrowing costs and qualifying assets 717
3.1 Borrowing costs 717
3.2 Qualifying assets 718
4. Expensing borrowing costs 718
4.1 Recognition as an expense 718
4.2 Measurement of the expense 719
Example 1: Expensing borrowing costs 719
5. Capitalising borrowing costs 719
5.1 Recognition as an asset 719
5.1.1 Commencement of capitalisation 720
Example 2: Capitalisation of borrowing costs: all criteria met at same time 720
Example 3: Commencement of capitalisation: criteria met at different times 721
Example 4: Commencement of capitalisation: criteria met at different times 721
5.1.2 Suspension of capitalisation 722
Example 5: Suspension of capitalisation: delays in construction 722
5.1.3 Cessation of capitalisation 723
Example 6: Cessation of capitalisation: end of construction 723
5.2 Measurement of the amount capitalised 724
5.2.1 Measurement: specific loans 724
Example 7: Specific loans 724
Example 8: Specific loans: costs paid on specific days 725
Example 9: Specific loans: costs paid evenly over a period 726
Example 10: Specific loans: loan raised before construction begins 727
5.2.2 Measurement: general loans 727
Example 11: General loan: the effect of when payments are made 728
Example 12: General loan: more than one general loan 731
5.2.3 Measurement: Foreign exchange differences 733
Example 13: Foreign exchange differences 73
6. Deferred tax effects of capitalisation of borrowing costs 735
Example 14: Deferred tax on a qualifying asset (cost model): deductible 735
Example 15: Deferred tax on a qualifying asset (cost model): non-deductible 736
7. Disclosure 738
8. Summary 739
716 Chapter 14
1. Introduction (IAS 23.1)
IAS 23 is the standard that sets out how to account for borrowing costs. If borrowing costs are
directly attributable to the acquisition, construction or production of a qualifying asset’, these
borrowing costs must be capitalised as part of the cost of that asset. All other borrowing costs
are expensed when they are incurred. There are two exceptions where the entity may choose
not to capitalise the borrowing costs (see section 2).
Before we capitalise borrowing costs as part of the cost of that asset, we must be sure:
x that the borrowing costs do indeed meet the definition of borrowing costs (‘interest and
other costs that an entity incurs in connection with the borrowing of funds’); and
x that the asset meets the definition of a qualifying asset (‘an asset that necessarily takes a
substantial period of time to get ready for its intended use or sale’).
Both terms are explained in more detail in section 3.
Capitalisation of the borrowing costs incurred takes place from commencement date and ends
on cessation date, and must be suspended during ‘extended periods’ during which the entity
‘suspends active development’ of the asset. This is explained in section 5.1.
The measurement of the borrowing costs that must be capitalised can become a little technical
and will depend on whether the borrowings are specific borrowings (i.e. specifically raised to
fund the acquisition, construction production of the asset) or general borrowings (i.e. the
entity simply tapped into the entity’s available borrowings). This is explained in section 5.2.
The capitalisation of borrowing costs has deferred tax implications. Tax authorities generally allow
the deduction of borrowing costs when they are incurred and thus, if we capitalise these costs to the
cost of our asset, a temporary difference will arise on which deferred tax must be recognised. This
deferred tax will reverse as the asset is expensed (e.g. depreciation). This is explained in section 6.
And finally, there are a few small disclosure consequences – see section 7.
2. Scope (IAS 23.1 - .4 and IAS 23.BC4)
Costs that meet the definition of borrowing costs and relate to the ‘acquisition, construction or
production of a qualifying asset’ must be accounted for in terms of IAS 23 (i.e. they must be
capitalised). However, you are not forced to apply IAS 23 if the qualifying asset is:
x ‘measured at fair value’; or is
x inventory that is produced ‘in large quantities on a repetitive basis’. See IAS 23.1 and .4
The reason we are not forced to apply IAS 23 to assets measured at fair value is that it makes
no difference to the closing carrying amount at fair value (the borrowing costs would be
capitalised before measuring to fair value). See IAS 23.4 & IAS 23.BC4
The term borrowing costs does not include the costs of equity (e.g. dividends on shares).
3. Understanding the Terms: Borrowing Costs and Qualifying Assets
3.1 Borrowing costs (IAS 23.5 and .6)

Borrowing costs are defined
Borrowing costs include not only interest incurred (also as:
referred to as finance costs), but also include other costs x interest and other costs
incurred in connection with borrowing funds. x that an entity incurs
x in connection with
x the borrowing of funds. IAS 23.5
Borrowings costs may include, for example:
x interest expense recognised on lease liabilities, per IFRS 16 Leases;
x interest expense calculated using the effective interest method described in
IFRS 9 Financial instruments; and
x exchange difference on foreign loan accounts to the extent that they are regarded as an
adjustment to the interest on the loan. See IAS 23.6
Chapter 14 717
Notice that this list excludes certain costs associated with raising funds or otherwise financing
a qualifying asset. This suggests that costs that do not appear on this list may not be
capitalised. Borrowing costs therefore exclude:
x cost of raising share capital that is recognised as equity, for example:
- dividends on ordinary share capital;
- dividends on non-redeemable preference share capital (note: dividends on redeemable
preference share capital would be capitalised because redeemable preference shares
are recognised as liabilities and not equity – thus these dividends are recognised as
interest calculated using the effective interest rate method described in IFRS 9);
x cost of using internal funds (e.g. if one uses existing cash resources instead of borrowing
more funds, there is an indirect cost being the lost income, often measured using the
companies weighted average cost of capital or the market interest rates that could
otherwise have been earned).
Borrowing costs is a broad definition that encompasses interest expense. The implication of
this is that any costs recognised as an interest expense in terms of the effective interest rate
method (in IFRS 9 Financial instruments) may also be capitalised. For example: a premium
payable on the redemption of preference shares is recognised as an interest expense using the
effective interest rate method and thus this premium
may also effectively be capitalised. Borrowing costs must be
capitalised to the cost of the
asset if they:
If borrowing costs are incurred as a direct result of x are directly attributable
acquiring, construction or producing an asset that meets x to the acquisition, construction or
the definition of a qualifying asset, these costs must be production
x of a qualifying asset. IAS 23.8 (reworded)
capitalised-there is no choice.
Sometimes proving that borrowing costs are directly attributable is difficult because:
x the borrowings may not have been specifically raised for that asset, but may be general
borrowings (i.e. the entity may have a range of debt at a range of varying interest rates);
x the borrowings may not even be denominated in your local currency (i.e. the borrowings
may be foreign borrowings). See IAS 23.11
These issues are expanded upon in the section entitled ‘measurement’.
3.2 Qualifying assets (IAS 23.5 and .7)
A qualifying asset is simply an asset that requires a A qualifying asset is defined

long time to get ready for its intended use or sale. as:
Thus, qualifying assets could include a variety of asset x an asset
types, such as plant and machinery, owner-occupied x that necessarily takes
x a substantial period of time
property or investment property, intangible assets and x to get ready for its intended:
even inventories. See IAS 23.7 - use or
- sale. IAS 23.5
Qualifying assets do not include:
x assets (including inventories) that are ‘ready for their intended use or sale’ on acquisition,
x financial assets (e.g. an investment in shares), and
x inventories that take a ‘short period of time’ to manufacture. See IAS 23.7
4. Expensing Borrowing Costs
4.1 Recognition as an expense (IAS 23.8 - .9)
If borrowing costs do not meet the conditions for capitalisation (section 5.1), they are
expensed. Expensing borrowing costs simply means to include the borrowing costs as an
expense in profit or loss in the period in which they were incurred (i.e. as and when interest is
charged in accordance with the terms of the borrowing agreement).
718 Chapter 14
4.2 Measurement of the expense (IAS 23.10)
When the conditions for capitalisation are not met, the borrowing costs are expensed. The
amount of this expense is simply the amount charged by the lender in accordance with the
borrowing agreement, being the interest calculated using the effective interest rate method.
Example 1: Expensing borrowing costs
Yay Limited raised a loan of C1 000 000 on 30 June 20X5:
x Yay has not made any capital repayments during 20X5.
x The loan has an effective interest rate of 10%.
x The loan was used to finance the construction of a factory plant.
x The factory plant was not considered to be a qualifying asset.
Required: Journalise the interest in Yay Limited’s books for the year ended 31 December 20X5
Solution 1: Expensing borrowing costs

Comment: This example shows:
x When to recognise interest on a non-qualifying asset as an expense: when the interest is incurred.
x How much to expense: the amount of interest calculated using the effective interest rate method.
Finance costs (E) 1 000 000 x 10% x 6/12 50 000
Interest incurred during the period is expensed
5. Capitalising Borrowing Costs
5.1 Recognition as an asset (IAS 23.8 - .9) Capitalise borrowing

costs only if they meet
To capitalise borrowing costs simply means to include them the:
in the cost of the related qualifying assets. In other words, x definition of borrowing costs, and
the borrowing costs are recognised as an asset. x recognition criteria per IAS 23
- inflow of future economic
benefits are probable, and
Costs that meet the definition of borrowing costs and that are - cost is reliably measurable.
See IAS 23.8-9
directly attributable to the acquisition, construction or
production of the qualifying asset must be capitalised to the cost of the qualifying asset if the
recognition criteria (per IAS 23) are satisfied:
x an inflow of future economic benefits are probable; and
x the costs must be measured reliably. See IAS 23.9
Recognition criteria: Conflict between IAS 23 and the Conceptual Framework:

The two recognition criteria provided in IAS 23 (above) differ from the two recognition criteria in the new
‘2018 Conceptual Framework’, which are that an item should only be recognised if it provides relevant information and
would be a faithful representation of the phenomena it purports to present. However, the IASB concluded that we
should continue to use the two recognition criteria in IAS 23 because these will still achieve the same outcome.
Directly attributable means: if the assets had not been acquired, constructed or produced then
these costs could have been avoided.
x An example of an acquisition is the purchase of a building.
x An example of the construction of an asset is the building of a manufacturing plant.
x An example of the production of an asset is the manufacture of inventory.
Borrowing costs are recognised as part of the cost of the asset (capitalised) during what can be
called the capitalisation period. This capitalisation period has a start date and an end date and
may be broken for a period of time somewhere between these dates:
x Commencement date: capitalisation starts from the date on which certain criteria are met;
x Suspension period: capitalisation must stop temporarily when certain criteria are met;
x Cessation date: capitalisation must stop permanently when certain criteria are met.
Chapter 14 719
Capitalisation occurs during the construction period
Start Pause Stop

The commencement date The suspension period The cessation date
(an official IAS 23 term): (not a defined term): (not a defined term):
When: When construction is: When the asset
x Activities are in progress; x actively suspended x is ready for its intended
x BC’s are being incurred; & x for a long period of time; use or sale; or
x Expenditure on the production Do not pause if the delay is x is substantially ready.
See IAS 23.22 - .23
of the asset is being incurred. short or if it is long but
See IAS 23.17
necessary to the construction.
See IAS 23.20 - .21
When borrowing costs are capitalised, the carrying amount of the asset will obviously be
increased by the borrowing costs incurred. The cost of these borrowings will eventually
reduce profits, but only when the qualifying asset affects profit or loss (e.g. through the
depreciation expense when the qualifying asset is an item of property, plant and equipment).
5.1.1 Commencement of capitalisation (IAS 23.17 - .19)

If the basic recognition criteria per IAS 23 are met (see Capitalisation of BCs must
section 5.1), an entity must start to capitalise borrowing commence when:
costs from the date that all the following criteria are met:
x Activities necessary to prepare the
x borrowing costs are being incurred; asset for its intended use or sale have
x expenditure is being incurred by the entity in begun;
preparing the asset; and x Borrowing costs are incurred; and
x Expenditures are incurred. See IAS 23.17
x activities are underway to prepare the asset for its
intended use or sale (activity is happening).
It is interesting to note that expenditures on a qualifying asset include only those for which
there have been payments of cash, transfers of other assets or the assumption of interest-
bearing liabilities. Thus, the expenditures incurred for purposes of capitalisation must be
calculated net of any government grants received (IAS 20) and any progress payments
received in relation to the asset. See IAS 23.18
The activity referred to above need not be the physical activity of construction, but could also
be associated technical and administrative work prior to the physical construction.
The date that all three criteria are met is known as the commencement date.
Example 2: Capitalisation of borrowing costs - all criteria met at same time
Yippee Limited incurred C100 000 interest during the year on a loan that was specifically
raised to finance the construction of a building, a qualifying asset:
x The loan was raised on 1 January 20X5.
x Construction began on 1 January 20X5 and related construction costs were incurred
from this date.
Required: Journalise the interest in Yippee Limited’s books for the year ended 31 December 20X5
Solution 2: Capitalisation of borrowing costs - all criteria met at same time

Comment: Interest must be recognised as part of the cost of the qualifying asset. Interest is recognised as part
of the asset (capitalisation) from the time that all criteria for capitalisation are met. All criteria for capitalisation
are met on 1 January 20X5:
x activities start on 1 January 20X5;
x construction costs are being incurred from 1 January 20X5; and
x the loan was raised on 1 January 20X5 and thus interest is being incurred from this date.
Thus, assuming the basic recognition criteria are also met (future economic benefits are probable and the
borrowing cost is reliably measurable), all interest from this date must be capitalised to the qualifying asset.
720 Chapter 14

Finance costs (E) 100 000 x 12 / 12 100 000
Interest on the loan incurred first expensed
Building: cost (A) 100 000 x 12 / 12 100 000
Finance costs (E) 100 000
Interest on the loan capitalised to the cost of the building
Example 3: Commencement of capitalisation - criteria met at different times

Dawdle Limited borrowed C100 000 on the 30 June 20X5 in order to construct a building in
which to store its goods. The building materials were only available on 31 August 20X5,
from which point Dawdle began construction. The building is considered to be a qualifying asset.
Required: Discuss when Dawdle Limited may begin capitalising the interest incurred.
Solution 3: Commencement of capitalisation - criteria met at different times

Comment: This example shows when an entity may commence capitalisation on a qualifying asset
where borrowing costs are incurred before activities start and before expenditure is incurred.
Discussion: All three criteria must be met before the entity may begin capitalisation.
x From 30 June 20X5, Dawdle borrowed funds and began incurring borrowing costs, but had not yet met the
other two criteria (i.e. activities had not begun and construction costs were not yet being incurred).
x On 31 August 20X5, Dawdle incurred the cost of acquiring the construction materials and began
construction, thus fulfilling the remaining two criteria.
Dawdle must thus begin capitalising the borrowing costs from the 31 August 20X5, assuming that the basic
recognition criteria were also met (probable inflow of economic benefits and cost is reliably measurable).
Example 4: Commencement of capitalisation - criteria met at different times

Hoorah Limited incurred C100 000 interest for the year ended 31 December 20X5 on a loan
of C1 000 000, raised on 1 January 20X5.
The loan was raised specifically to finance the construction of a building, a qualifying asset.
Construction began on 1 February 20X5 and was not yet complete at 31 December 20X5.
Required: Show the related journals in Hoorah’s books for the year ended 31 December 20X5.
Solution 4: Commencement of capitalisation - criteria met at different times

Comment: Borrowing costs are incurred from 1 January 20X5, but activities only start and related
expenditure are only incurred from 1 February 20X5. Thus, all 3 criteria for capitalisation are only met
from 1 February 20X5 with the result that capitalisation may only occur from 1 February 20X5.
Journals:
Bank 1 000 000
Loan payable (L) 1 000 000
Receipt of cash from loan raised
31 December 20X5
Finance costs (E) 100 000 x 12 / 12 100 000
Interest on loan incurred first expensed: total interest incurred
Building: cost (A) 100 000 x 11 / 12 91 667
Interest on the loan capitalised to the cost of the building; measured
from commencement date (1 February 20X5)
Chapter 14 721
5.1.2 Suspension of capitalisation (IAS 23.20 - .21)
We must temporarily suspend (i.e. stop for a time) the Capitalisation of BCs must
capitalisation of borrowing costs when active be suspended during:
development of a qualifying asset is suspended (i.e. x extended periods during which
interrupted or delayed) for a long period of time. Let’s x active development is suspended.
IAS 23.20 (reworded)
call this the suspension period.
The capitalisation of borrowing costs will resume (i.e. capitalisation will start again) after the
suspension period has ended, assuming the criteria for capitalisation continue to be met.
In other words, any borrowing costs incurred in a long period during which construction has
been suspended may not be capitalised. But as soon as construction begins again, the
capitalisation of borrowing costs must resume.
When referring to the suspension of borrowing costs, the standard specifically refers to the
words ‘extended periods’ (see grey pop-up above). This means that the capitalisation of
borrowing costs would not be suspended in cases when the delay is only a short delay.
The standard also clarifies that the capitalisation of Suspend capitalisation if

borrowing costs must not be suspended if the delay is a and only if, the delay:
necessary part of getting the asset ready for its intended x is for a long period of time; and
use. A typical example of when borrowing costs should x is not necessary in getting the asset
continue to be capitalised despite a delay is a wine farm ready for its intended use;
that has to wait for its inventory of wine to mature in x is not for substantial technical or
administrative work. See IAS 23.20-.21
order to ensure a saleable condition. In this case,
borrowing costs that are incurred during this period of maturation would continue to be
capitalised to the cost of the inventory of wine.
The standard also clarifies that the capitalisation of borrowing costs must not be suspended if
the delay is due to substantial technical or administrative work. It is submitted that an
example of when borrowing costs should continue to be capitalised during a delay that is due
to substantial technical work would be the development and submission of engineering plans
necessary before the construction of the second stage of a particular project may begin.
Example 5: Suspension of capitalisation - delays in construction
The Halt Inn is constructing a hotel in the Durban area.
x Construction began in 20X4 and was not yet complete at 31 December 20X5.
x Borrowing costs of C300 000 were incurred during 20X5.
x All of these borrowing costs were incurred on a loan that was raised on 1 January 20X5
with its purpose being specifically for the construction of the hotel.
Required: Discuss how much of the interest may be capitalised during Halt Inn’s year ended
31 December 20X5 assuming that:
x The builders go on strike for a period of two months, during which no progress is made.
x The builders of the hotel had to wait for a month for the cement in the foundations to dry.
Solution 5: Suspension of capitalisation - delays in construction

Borrowing costs may not be capitalised during periods where active development has been stopped if
this delay is for an extended period (i.e. it is a long delay).
However, capitalisation of borrowing costs is not suspended during this period if the delay was a
necessary part of the construction process or due to substantial technical or administrative work.
x The two months during which the builders staged a strike is an extended delay that is neither
necessary for the construction process nor due to substantial technical nor administrative work.
Thus capitalisation of borrowing costs during this two-month period is suspended.
x The month during which active development was suspended so that the cement foundations could
dry is an extended delay but one that is a necessary part of the construction process. Thus we do
not suspend the capitalisation of borrowing costs incurred during this one-month period.
722 Chapter 14
5.1.3 Cessation of capitalisation (IAS 23.22 - .25)
Capitalisation of borrowing costs must end on cessation Capitalisation of BCs must

date, which is the date on which the asset is substantially cease when:
ready for its intended use or sale. x substantially all activities necessary
x to prepare the qualifying asset for its
For example, capitalisation would cease if the only work intended use or sale
x are complete.
that still remains includes routine administration work or
minor modifications (e.g. the painting of a new building) These principles are applied to each
part of a QA if the QA is made up of
to bring the asset to a useable or saleable condition. parts that can be used separately.
IAS 23.22 & .24 (reworded)
Please note that, after cessation date, the asset is technically no longer a qualifying asset as it
is now in the condition required for use or sale. As such, the criteria for capitalising
borrowing costs are no longer met and thus borrowing costs may not be capitalised.
For an asset completed in parts where each part is capable of being used separately, the
capitalisation of borrowing costs ceases on each part as and when each part is completed.
x An example of an asset that would be capable of being used or sold in parts would be an
office park, where buildings within the park are able to be used by tenants as and when
each building is completed.
x An example of an asset that would not be capable of being used or sold in parts is a
factory comprising a variety of plants (i.e. a variety of parts) but where the operation of
the factory will require full operation of these plants before manufacturing could begin
(i.e. all plants have to be complete and fully-functional before the factory could be used).
Example 6: Cessation of capitalisation - end of construction

Flabby Limited began construction of a block of flats on 1 January 20X5:
x The block of flats is to be leased out to tenants in the future.
x On 30 September 20X5, the building of the block was complete but no tenants could
be found.
x On 15 November 20X5, after lowering the rentals, the entire building was successfully
rented out to tenants.
Interest of C200 000 (at 10% on a C2 000 000 loan raised specifically for this construction) was
incurred during the 12-month period ended 31 December 20X5.
Required: Explain when the capitalisation of the interest should cease and journalise the interest.
Solution 6: Cessation of capitalisation - end of construction

Capitalisation should cease when the asset is substantially ready for its intended use or sale.
The construction was completed on 30 September 20X5 and it was leased to tenants from
15 November 20X5. Although no tenants could be found to occupy the flats between 30 September
20X5 and 15 November 20X5, the asset was ready to be leased to tenants on 30 September 20X5.
Capitalisation must therefore cease on 30 September 20X5 (because one of the three criteria for
capitalisation is no longer met: activity has ceased).
All subsequent interest incurred must be expensed.
Debit Credit
Finance costs (E) Given 200 000
Interest incurred
Building: cost (A) 200 000 x 9 / 12 150 000
Interest capitalised until completion date: 30/9/20X5
Chapter 14 723
5.2 Measurement of the amount capitalised (IAS 23.10 - .15)
The formula used to measure the borrowing costs that Measurement of borrowing
may be capitalised depends on the purpose of the costs to be capitalised
borrowings that are being used. depends on whether:
x the borrowings are specific; or
The borrowings being used could have been raised for: the borrowings are general.
x
x the ‘specific purpose’ of funding the construction,
acquisition or production of a qualifying asset (called specific borrowings) or;
x a ‘general purpose’ such as for buying inventory, paying off creditors and a multitude of
other purposes in addition to the construction, acquisition or production of a qualifying
asset (called general borrowings).
It is important to remember that whilst a bank overdraft facility is often used as general
purpose borrowings, it is also possible for a bank overdraft facility to be arranged specifically
for a qualifying asset. The particular circumstances should, therefore, always be considered
when deciding whether the borrowing is specific or general.
5.2.1 Measurement: specific loans (IAS 23.12 - .13)
All of the borrowing costs incurred on a specific loan Borrowing costs to be

during the construction period (period between capitalised on specific loans
commencement date and cessation date, and excluding are measured as:
any suspension period – these dates are explained above) x Borrowing costs incurred during the
construction period
are capitalised to a qualifying asset. x Less investment income earned
during the construction period.
If these funds are invested prior to the date they were
utilised, then any investment income earned during the construction period must be subtracted
from the borrowing costs incurred (e.g. interest incurred), in which case only the net amount
may be capitalised.
Although borrowing costs are not limited to interest expense, and investment income is not
limited to interest income, this text focuses on interest to simply explain the principles.
The borrowing costs on specific borrowings that must be capitalised would therefore be:
x total interest incurred on specific borrowings during the construction period:
capital borrowed x interest rate x period borrowed
x Less investment income earned on any surplus borrowings during the construction period:
amount invested x interest rate x period invested.
Example 7: Specific loans

Yahoo Limited borrowed C500 000 on 1 January 20X5 to fund the construction of a
building:
x The interest payable on the loan during 20X5 was C50 000 (calculated at 10%).
x All surplus borrowings during 20X5 were invested in a call account and earned
C24 000 interest during the year.
x No capital portion of the loan was repaid during the year ended 31 December 20X5.
x All criteria for capitalisation of borrowing costs were met on 1 January 20X5.
x The building is a qualifying asset and was not yet complete at 31 December 20X5.
Required: Show the related journals for the year ended 31 December 20X5.
Solution 7: Specific loans

Comment: This example shows that interest income is used to reduce the amount of borrowings that may be
capitalised when the borrowing is a specific borrowing.
724 Chapter 14

Finance costs (E) Given 50 000
Interest incurred on the loan first expensed
Bank/ debtors Given 24 000
Interest income (I) 24 000
Interest income earned on investment of surplus loan funds
Building: cost (A) W1 26 000
Portion of interest on the loan capitalised to the cost of the building
W1. Calculation of amount to be capitalised during the construction period C
Interest incurred during the construction period 500 000 x 10% 50 000
Investment income earned during the construction period Given (24 000)
Total to be capitalised 26 000
When calculating the interest income you may find that actual amounts invested can be used.
This happens when, for example, the expenditures are infrequent and/ or happen at the start or
end of a period. This means that the investment balance will remain unchanged for a period
of time. (See example 8).
Very often, however, average amounts invested need to be used instead of actual amounts
invested. This happens more frequently when the borrowing is a general borrowing, but can
apply to a specific borrowing where, for example, the expenditure is paid relatively evenly
over a period of time, with the result that the balance on the investment account (being the
surplus borrowings that are invested) is constantly changing. In this case, it is easier and
acceptable to calculate the interest earned on the average investment balance over a period of
time (rather than on the actual balance on a specific day). (See example 9).
The borrowing costs on specific borrowings to be capitalised could thus also be:
x total interest incurred on specific borrowings during the construction period:
capital borrowed x interest rate x period borrowed
x less investment income earned on any surplus borrowings during the construction period:
(investment o/ balance + investment c/ balance) / 2 x interest rate x period invested
Example 8: Specific loans – costs paid on specific days

Haha Limited raised a bank loan of C500 000 on 1 January 20X5 to construct a building,
a qualifying asset:
x Construction began on 1 January 20X5 when all criteria for capitalisation of
borrowing costs were met.
x The company paid construction costs of C400 000 on 1 March 20X5.
x The interest rate payable on the loan was 10%.
x Surplus funds were invested in a fixed deposit and earned interest at 6% per annum.
x No capital portion of the loan was repaid during 20X5.
Required: Calculate the borrowing costs to be capitalised during the year ended 31 December 20X5.
Solution 8: Specific loans – costs paid on specific days

Comment:
x The borrowings are raised 2 months before they were required. These surplus funds are invested
in January and February, the investment balance remaining stable at C500 000 over this period.
x On 1 March 20X5, however, payments totalling C400 000 are made, thus reducing the investment
balance to C100 000. This balance remains stable for the remaining 10 months.
x Since the expenditure is not incurred evenly over a period but is incurred on a specific day, the
interest income for the purposes of calculating borrowing costs to be capitalised is calculated using
the actual investment balances (C500 000 for 2 months and C100 000 for 10 months).
Chapter 14 725

Interest incurred on the loan is first expensed
Bank/ debtors W1 10 000
C
W1. Calculation of amount to be capitalised
Borrowing costs incurred during the construction period 500 000 x 10% x 12 / 12 50 000
Investment income earned during construction period 500 000 x 6% x 2 / 12 + (10 000)
(500 000 – 400 000) x 6% x 10/ 12
Capitalised borrowing costs 40 000
Example 9: Specific loans – costs paid evenly over a period

Hooray Limited borrowed C500 000 from the bank on 1 January 20X5 in order to
construct a building (a qualifying asset).
x Construction began: 1/1/20X5 (when all criteria for capitalisation of borrowing
costs were met).
x The interest rate payable on the loan was 10%.
x Construction costs of C400 000 were paid evenly between 01/03/20X5 and
31/12/20X5.
x Surplus funds are invested in a fixed deposit and earned interest at 6% per annum.
No capital portion of the loan was repaid during the year ended 31 December 20X5.
Required: Show the related journals for the year ended 31 December 20X5.
Solution 9: Specific loans – costs paid evenly over a period
Comment:
x Borrowings are raised 2 months before they were required. These surplus funds are invested for
Jan and Feb and the balance on this account for these 2 months remains stable at C500 000.
From March the amount invested gradually reduces as payments are made: the balance of
C500 000 on 1 March gradually decreases to C100 000 (C500 000 – C400 000) on 31 December.
x Since the payments are incurred evenly over this 10-month period, the interest income for the
purposes of the calculation of the borrowing costs to be capitalised may be calculated using the
average of these two balances (C500 000 and C100 000).
Finance costs (E) W1 50 000
Interest incurred on the loan is first expensed
Bank/ debtors W1 20 000
W1. Calculation of amount to be capitalised C
Borrowing costs incurred during the construction period 500 000 x 10% x 12 / 12 50 000
Investment income earned during construction period (500 000 x 6% x 2 / 12) + (500 000 (20 000)
+ 100 000) / 2 x 6% x 10/ 12
726 Chapter 14
Example 10: Specific loans – loan raised before construction begins

Yeeha Limited borrowed C500 000 from the bank on 1 January 20X5 to begin the
construction of a building (a qualifying asset).
x Construction began on 1 February 20X5.
x All criteria for capitalisation of borrowing costs were met on 1 February 20X5.
x The interest rate payable on the loan is 10%.
x The company paid construction costs of C400 000 on 1 March 20X5.
x Surplus funds are invested in a fixed deposit and earned interest at 6% per annum.
x No capital portion of the loan was repaid during the year ended 31 December 20X5.
Required: Calculate the amount of borrowing costs that may be capitalised.
Solution 10: Specific loans – loan raised before construction begins

Comment: Compare this to example 8, where the loan was raised and construction began on 1 January 20X5. In
this example, the loan is taken out on 1 February 20X5, being before construction begins. Thus, all criteria for
capitalisation are only met on 1 February 20X5 (commencement date). Both interest incurred and interest earned
before this date must be ignored for the purpose of calculating the portion of interest to be capitalised.

Finance costs (E) 500 000 x 10% x 12/ 12 50 000
Interest incurred on the loan first expensed
Bank/ debtors (500 000 x 6% x 2 / 12) + (500 000 – 400 000) x 6% x 10 / 12 10 000
Interest income 10 000
W1. Calculation of amount to be capitalised C
Interest incurred during the construction period 500 000 x 10% x 11 / 12 45 833
(i.e. excludes January interest expense)
Interest earned during the construction period (500 000 x 6% x 1 / 12) + (7 500)
(500 000 - 400 000) x 6% x 10 / 12
(i.e. excludes January interest income)
5.2.2 Measurement: general loans (IAS 23.14 - .15)
As the term suggests, a 'general loan' is used for many Borrowing costs to be
purposes. Thus, if we use a general loan to construct a capitalised on general loans
qualifying asset, we cannot simply capitalise all the are measured as:
interest incurred on this loan because not all the interest x Expenditures incurred
will be ‘directly attributable to the qualifying asset’. x Multiplied by the capitalisation rate
If the entity has used a general loan to construct a qualifying asset (QA), the finance costs
eligible for capitalisation are calculated as follows:
Finance costs eligible for capitalisation = Expenditure on the QA x Capitalisation rate
x The expenditure on the qualifying asset: For practical purposes, if the expenditure was not
incurred on the first day of a period, but is incurred evenly over this period (e.g. a month),
this expenditure may need to be averaged, for example:
Expenditure incurred evenly during the period
Average expenditure on QA =
2
The expenditures to which the capitalisation rate is applied must be net of any government
grants received (IAS 20), or progress payments received, relating to the asset.
Chapter 14 727
x The capitalisation rate: The capitalisation rate is the weighted average interest rate on the
general borrowings during that period:
Interest incurred on general borrowings during the period
Capitalisation rate =
Weighted average total general borrowings outstanding during the period
The capitalisation rate to be used is the weighted average interest rate on the general
borrowings during ‘the period’. IAS 23 does not clarify what is meant by ‘the period’ and
thus its meaning is open to interpretation. It is submitted that whilst ‘the period’ could
mean the financial period (e.g. 12 months), a more accurate answer may be achieved if the
actual construction period were used instead (this may be less than 12 months). However,
it may be impractical to calculate the rate for the relevant construction periods for each
qualifying asset and thus it may be necessary to simply calculate and use the rate relevant
to the financial period. This text assumes that ‘the period’ refers to the financial period.
Example 11: General loans – the effect of when payments are made
Bizarre Limited had a C500 000 7% existing general loan outstanding on 1 January 20X5
on which date it raised an additional general loan of C600 000 at an interest rate of 12.5%.
The terms of the loan agreement include the annual compounding of interest.
Bizarre Limited did not make any repayments on either loan during the year ended 31 December 20X5.
Construction on a building, a qualifying asset, began on 1 January 20X5.
The company incurred the following monthly amounts on the construction:
C per month
1 January – 31 July (7 months) costs paid evenly during this period 50 000
1 August – 30 November (4 months) costs paid evenly during this period 30 000
1 – 31 December (1 month) costs paid evenly during this period 100 000
Required:
A. Calculate the capitalisation rate.
B. Provide the journals for 20X5 assuming that the costs were paid evenly during each of the three
periods referred to above.
C. Provide the journals for 20X5 assuming that the total costs for each of the three periods referred to
above were incurred evenly during each month, but were paid at the end of each month.
D. Show the journals for 20X5 assuming that the total costs for each of the three periods referred to
above were incurred evenly during each month, but were paid on the first day of each month.
Solution 11A: General loans – the effect of when payments are made
Comment:
x There are two borrowings, both of which are general borrowings and therefore our capitalisation
rate is calculated as a weighted average interest rate.
x The loans are general loans and thus the formula is: ‘Capitalisation rate x Expenditures’.
x Since the borrowings are general, investment income is ignored when calculating how much to
capitalise.
Capitalisation rate (weighted average interest rate):
= interest incurred on general borrowings/ general borrowings outstanding during the period
= [(C500 000 x 7% x 12 / 12) + (C600 000 x 12.5% x 12 / 12)] / 1 100 000 total borrowings
= 10%
Solution 11B: General loans – payments are made evenly

Comment: Since the costs are paid evenly, we calculate the borrowing costs based on average
expenses: Capitalisation rate x Average expenditures.
Journals in 20X5: Debit Credit
Building: cost (A) See Note 1 570 000
Construction costs incurred: 50 000 x 7 + 30 000 x 4 + 100 000 x 1
Finance costs (E) 500 000 x 7% + 600 000 x 12.5% 110 000
Finance costs incurred
728 Chapter 14

Finance costs capitalised
Note 1: This journal would actually be processed separately for each and every payment but is shown here as
a cumulative journal for ease of understanding the ‘big picture’.
W1: Calculation of borrowing costs to be capitalised:
Period Accumulated Expenses Average Interest Accumulated

expenses: incurred cumulative capitalised expenses:
opening bal during the expenses closing bal
period
A B C D E
A + B/2 or +A+ 0 or C x % x m/12 = A + B + D (2)
A+B (1)
C C C C C
1 Jan – 31 July 0 350 000 (3) 175 000 (6) 10 208 (9) 350 000
1 Aug – 30 Nov 350 000 120 000 (4) 410 000 (7) 13 667 (10) 470 000
1 Dec – 31 Dec 470 000 100 000 (5) 520 000 (8) 4 333 (11) 598 208(12)
570 000 28 208
Calculations:
(1) B is divided by 2 if the payments occur evenly during the period /
B is added if the payments occur at the beginning of the period (i.e. B is not divided by 2) /
B is not added if the payments occur at the end of the period:
x this example involved even payments and thus B is divided by 2
(2) D is only added when the interest is compounded in terms of the loan agreement (31 Dec in this example)
(3) 50 000 x 7 = 350 000
(4) 30 000 x 4 = 120 000
(5) 100 000 x 1 = 100 000
(6) 0 + 350 000/2 = 175 000
(7) 350 000 + 120 000/2 = 410 000
(8) 470 000 + 100 000/2 = 520 000
(9) 175 000 x 10% x 7/12 = 10 208
(10) 410 000 x 10% x 4/12 = 13 667
(11) 520 000 x 10% x 1/12 = 4 333
(12) 470 000 + 100 000 + interest to date: 10 208 + 13 667 + 4 333 = 598 208
Solution 11C: General loans – payments are made at the end of each month
Comment: Since the expenditures are incurred at month-end, we calculate the borrowing costs to be
capitalised using the capitalisation rate as follows: Capitalisation rate x Actual expenditures (i.e. a more
accurate measurement is achieved if actual expenditures are used instead – this is important if the
difference between actual and average expenses is considered to be material).
Building: cost (A) 50 000 x 7 + 30 000 x 4 + 100 000 x 1 570 000
Construction costs incurred: NOTE 1
Note 1: This journal would actually be processed separately for each and every payment but is shown
here as a cumulative journal for ease of understanding the ‘big picture’.
Chapter 14 729
Solution 11C: Continued ...
Period Accumulated Expenses Average/ Actual Interest Accumulated

expenses: incurred cumulative capitalised expenses:
opening bal during the expenses @ 10% closing bal
A period C D E
B A + B/2 C x % x m/12 = A + B + D (2)
(or A+ B) (or A+ 0) (1)
C C C C C
31 January 0 50 000 0 0 50 000
28 February 50 000 50 000 50 000 417 100 000
31 March 100 000 50 000 100 000 833 150 000
30 April 150 000 50 000 150 000 1 250 200 000
31 May 200 000 50 000 200 000 1 667 250 000
30 June 250 000 50 000 250 000 2 083 300 000
31 July 300 000 50 000 300 000 2 500 350 000
31 August 350 000 30 000 350 000 2 917 380 000
30 September 380 000 30 000 380 000 3 167 410 000
31 October 410 000 30 000 410 000 3 417 440 000
30 November 440 000 30 000 440 000 3 667 470 000
31 December 470 000 100 000 470 000 3 917 595 835(3)
570 000 25 835
Calculations:
(1) This example involved payments at the end of the month. Thus, when calculating C, B is not added (C = A + 0)
x B is not added if the payments occur at the end of the period (this is relevant to this example)
x B is divided by 2 if the payments occur evenly during the period (not relevant in this example); or
x B is added in full if the payments occur at the beginning of the period (i.e. B is not divided by 2) (not
relevant in this example)
(3) 470 000 + 100 000 + 25 835 = 595 835 (interest accrues annually)
Solution 11D: General loans – payments are made at the beginning of each month
Comment:
x Since the expenditures are incurred at the beginning of each month, we calculate the borrowing
costs to be capitalised as follows:
Capitalisation rate x Actual expenditures
x In other words, a more accurate measurement is achieved if actual expenditures are used instead –
this is important if the difference between actual and average expenses is considered to be material.

Building: cost (A) 50 000 x 7 + 30 000 x 4 + 100 000 x 1 570 000
Construction costs incurred
Note 1: This journal would actually be processed separately for each and every payment but is shown here as a
cumulative journal for ease of understanding the ‘big picture’.
730 Chapter 14
Solution 11D: Continued ...

Period Accumulated Expenses Average Interest Accumulated

expenses: incurred during cumulative capitalised expenses:
opening bal the period expenses @ 10% closing bal
A B C D E
A + B/2 C x % x m/12 = A + B + D (2)
(or A+ B) (or A+ 0) (1)
C C C C C
1 January 0 50 000 50 000 417 50 000
1 February 50 000 50 000 100 000 833 100 000
1 March 100 000 50 000 150 000 1 250 150 000
1 April 150 000 50 000 200 000 1 667 200 000
1 May 200 000 50 000 250 000 2 083 250 000
1 June 250 000 50 000 300 000 2 500 300 000
1 July 300 000 50 000 350 000 2 917 350 000
1 August 350 000 30 000 380 000 3 167 380 000
1 September 380 000 30 000 410 000 3 417 410 000
1 October 410 000 30 000 440 000 3 667 440 000
1 November 440 000 30 000 470 000 3 917 470 000
1 December 470 000 100 000 570 000 4 750 600 585 (3)
570 000 30 585
Calculations:
(1) This example involved payments at the beginning of the month and thus B is added in full (C = A + B)
x B is added if the payments occur at the beginning of the period (i.e. B is not divided by 2)
x B is divided by 2 if the payments occur evenly during the period (not relevant to this example)
x B is not added if the payments occur at the end of the period (not relevant to this example)
(2) D is only added when interest is compounded per the loan agreement (31 Dec in this example)
(3) 470 000 + 100 000 + 30 585 = 600 585
Example 12: General loan: more than one general loan

Yipdeedoo Limited began construction on a qualifying asset on 1 January 20X1. The
construction was complete on 31 December 20X1.
x The company had the following general loans outstanding during the year:
Bank Loan amount Interest rate Date loan raised Date loan repaid
A Bank C300 000 15% 1 January 20X1 N/A
B Bank C200 000 10% 1 April 20X1 30 September 20X1
C Bank C100 000 12% 1 June 20X1 31 December 20X1
x The interest on the loans was paid for out of other cash reserves as it was charged to the loan.
x Details of the construction cost incurred are as follows:
Details Amount Date incurred Details
Laying a slab 60 000 1 January 20X1
Waiting for slab to cure 0 6 weeks (a normal process)
Purchase of materials 120 000 1 February 20X1
Labour costs 330 000 1 Feb - 31 Dec 20X1 incurred evenly over the period but
paid at the beginning of each month
Required:
a) Calculate the interest incurred for the year ended 31 December 20X1.
b) Calculate the weighted average interest rate (i.e. the capitalisation rate).
c) Calculate the interest to be capitalised.
d) Show the journal entries to account for the interest during the year ended 31 December 20X1.
Chapter 14 731
Solution 12: General loan: more than one general loan
Comment: This example illustrates the situation where there are various general loans utilised in the construction
of the qualifying asset. Also, there is a suspension period, however, capitalisation continues as it is necessary for the
construction process of the qualifying asset.
a) Interest incurred
A Bank 300 000 x 15% x 12 / 12 = 45 000
B Bank 200 000 x 10% x 6 / 12 = 10 000
C Bank 100 000 x 12% x 7 / 12 = 7 000
62 000
b) Weighted average interest rate:
Interest incurred during the year / Average general loans outstanding during the year:
62 000 / 458 333 = 13.5273%
Average loan balances outstanding during the period of construction (apportioned for time):
A Bank 300 000 x 12 / 12 = 300 000
B Bank 200 000 x 6 / 12 = 100 000
C Bank 100 000 x 7 / 12 = 58 333
458 333
c) Borrowing costs to be capitalised
Period Accumulate Expenses Average Interest Accumulated
d expenses: incurred during cumulative capitalised expenses:
opening bal the period expenses closing bal
A B C D E
=E A + B/2 C x % x m/12 A + B + D (2)
(or A+ B) (or A+ 0) (1)
C C C C C
1 January 0 60 000 (3)
60 000 (6)
676 (9)
60 000
1 February 60 000 150 000 (4) 210 000 (7) 2 367 (10) 210 000
1 Mar – 31 Dec 210 000 300 000 (5)
375 000 (8) 42 273 (11)
552 273
510 000 45 316
(1) B is divided by 2 if the payments occur evenly during the period.

B is added in full if the payments occur at the beginning of the period (i.e. B is not divided by 2) /
B is not added if the payments occur at the end of the period.
(3) Payments on 1 Jan: 60 000 (slab) (payment at the beginning of the period, so no averaging)
(4) Payments on 1 Feb: 120 000 (materials) + 330 000 / 11 (labour cost) = 150 000
(5) Payments on 1 March and evenly from then to 1 Dec: 330 000 – 30 000 (pd 1 Feb) (labour costs) = 300 000
(6) Jan costs on which int to be estimated: 0 (opening costs) + 60 000 (pmts made on 1 Jan) = 60 000
(7) Feb costs on which int to be estimated: 60 000 (opening costs) + 150 000 (pmts made on 1 Feb) = 210 000
(8) March – Dec costs on which int to be estimated: 210 000 (opening costs) + 30 000 (pmt on 1 March) +
(330 000 – 30 000 (Feb pmt) – 30 000 (March pmt))/2 (payments made evenly during the period) = 375 000
(9) 60 000 x 13.5273% x 1/12 = 676
(10) 210 000 x 13.5273% x 1/12 = 2 367
(11) 375 000 x 13.5273% x 10/12 = 42 273
d) Borrowing costs to be capitalised

Building: cost (A) 60 000 + 120 000 + 30 000 x 11 510 000
Bank/ liability Note 1 510 000
732 Chapter 14

Finance costs (E) Calculation (a) 62 000
Building: cost (A) Calculation (c) 45 316
Note 1: This journal would actually be processed separately for each and every payment but is shown here as a
cumulative journal for ease of understanding the ‘big picture’.
5.2.3 Measurement: foreign exchange differences
Foreign exchange differences on borrowing costs is a Capitalise foreign exchange

topic open to interpretation due to the wording of a differences between the:
particular sentence in the standard, which states that x average rate for the year, and
borrowing costs may include ‘exchange differences x the closing rate.
arising from foreign currency borrowings to the extent
that they are regarded as an adjustment to interest costs.’ See IAS 23.6 (e)
This wording appeared to mean that foreign exchange differences could only be capitalised if
they related to the interest element, and that any foreign exchange difference arising on the
principal amount owing would not be capitalised.
The IFRIC was asked to issue an interpretation because many argued that foreign exchange
differences on the principal amount should be capitalised. Despite the confusion, the IFRIC did not
think it was necessary to issue an interpretation, saying that the IFRS was clear enough. However, in
its deliberations, the IFRIC clarified the following (see educational footnote, E1, in the annotated
version of IAS 23, which refers to ‘IFRIC Update, January 2008’):
‘Some exchange differences relating to the principal may be regarded as an adjustment to interest
costs. Exchange differences may be considered as an adjustment to borrowing costs, and hence,
taken into account in determining the amount of borrowing costs capitalised, to the extent that the
adjustment does not decrease or increase the interest costs to an amount below or above,
respectively, a notional borrowing cost based on commercial interest rates prevailing in the
functional currency as at the date of initial recognition of the borrowing.’
In other words, this means that the total amount of borrowing costs relating to foreign
borrowings that may be capitalised should lie between the following 2 amounts:
a) the actual interest costs denominated in the foreign currency translated at the actual
exchange rate on the date on which the expense is incurred; and
b) the notional borrowing costs based on commercial interest rates prevailing in the
functional currency as at the date of initial recognition of the borrowing.
The IFRIC emphasised that ‘how an entity applies IAS 23 to foreign currency borrowings is a
matter of accounting policy requiring the exercise of judgement’. This means that whether the
above principles are applied is an accounting policy choice and should be applied
consistently.
The application of the principle above is illustrated in the following example.
Example 13: Foreign exchange differences

Deon Limited has a functional currency of LC. During the 20X0 financial year, Deon
decided to build a new corporate head-office, a qualifying asset.
Construction started on 1 January 20X0 and ended on 31 December 20X0.
Construction costs totalled LC8 000 000 during 20X0.
Chapter 14 733
Deon Limited secured foreign borrowings of FC1 000 000 for the construction of the building:
x The loan attracts interest at 5% accrued over the year.
x Interest rates available on similar borrowings in local currency as at the date of initial recognition
of the foreign loan were 10%.
x The capital plus all interest owing was repaid on 31 December 20X0.
x The foreign currency rates for the 20X0 year were as follows:
1 January 20X0 FC1 : LC5
31 December 20X0 FC1 : LC7
Average for 20X0 FC1 : LC6
Required: Calculate the amount of borrowing costs to be capitalised to the corporate head-office and
show all related journals for the year-ended 31 December 20X0.
Solution 13: Foreign exchange differences

Building: cost (A) Given 8 000 000
Bank/ liability 8 000 000
Bank FC1 000 000 x LC5 (SR at TD) 5 000 000
Foreign loan (L) 5 000 000
Foreign loan received, translated at spot rate on date loan received
31 December 20X0
Finance costs (E) FC1 000 000 x 5% x 12/12 x LC6 (AR 300 000
Interest payable over period of interest) 300 000
Forex loss: interest payable (E) FC1 000 000 x 5% x 12/12 x LC7 (SR at 50 000
Interest payable (L) YE) – LC300 000 (bal in this account) 50 000
Interest payable is translated at spot rate at year-end
Forex loss on loan principal (E) FC1 000 000 x LC7 (SR at YE) – 2 000 000
Foreign loan (L) LC5 000 000 (balance in this account) 2 000 000
Loan principal payable is translated at spot rate at year-end
Interest payable (L) Interest 300 000 + Forex loss 50 000 350 000
Foreign loan (L) Principal 5 000 000 + Forex loss 2 000 000 7 000 000
Bank FC1 050 000 x LC7 (SR at PD) 7 350 000
Payment of foreign loan: principal plus interest for the year
Building: cost (A) 100% of the interest is capitalised 350 000
Finance costs (E) (300 000) and 100% of the forex loss on 300 000
Forex loss on interest payable (E) the interest (50 000) is capitalised 50 000
Finance costs and related foreign exchange loss is capitalised
Building: cost (A) Maximum that may be capitalised: 150 000
Forex loss on interest payable (E) LC500 000 (a) – already capitalised (int 150 000
300 000 + forex loss on int 50 000)
A portion of the forex loss on the loan principal is capitalised: limited by
IAS 23.6(e)
(a) The maximum that may be capitalised is the notional interest = LC5 000 000 x 10% = LC500 000
Explanation:
x The forex loss on the loan principal (2 000K) may also be capitalised to the building, but only to the extent
that the total of the interest (300K) + forex loss on the interest (50K) + forex loss on the principal (2 000K)
does not exceed the notional interest that would have been charged had we raised a loan locally.
x Notional interest: Loan amt: 5 000 000 x local interest rate at the time we raised the loan: 10% = 500 000.
x Thus, we may not capitalise the full 2 350 000. Instead, we may capitalise our actual costs (interest + total
forex losses) up to the maximum of the notional interest of 500 000.
x Since we have already capitalised 350 000, we may only capitalise a further 150 000 (maximum: 500 000 –
already capitalised: 350 000)
734 Chapter 14
6. Deferred Tax Effect of Capitalisation of Borrowing Costs
The tax authorities generally allow deductions for interest in the period in which it is incurred.
This means that if interest (or part thereof) was capitalised to the cost of a qualifying asset, a
difference between the asset’s carrying amount (which includes the borrowing cost) and its
tax base (which will not include the borrowing costs) will arise in the year in which the asset
is brought into use. This difference will reverse over the life of the asset.
Example 14: Deferred tax on a qualifying asset (cost model): deductible

Cheerleader Limited built a plant (a qualifying asset) during 20X1. The costs incurred
were as follows:
x Construction costs: C300 000
x Interest on a specific loan: C100 000 (all incurred during the capitalisation period).
Other information:
x The asset was complete and available for use and brought into use from
1 October 20X1. It is to be depreciated straight-line over its estimated useful life of
5 years to a nil residual value.
x Surplus loan money was invested in a call account and earned interest income of
C10 000 evenly over a period of 5 months, 1 month of which was after construction
had ended.
x The profit for 20X1, before recording the information above, was C800 000 (fully
taxable).
x The tax authorities:
Levy income tax at 30%,
Tax interest income,
Allow the deduction of the interest incurred on the construction of an asset to be
deducted in the year in which the asset is brought into use,
Allow the deduction of the cost of the qualifying asset at 20% p.a., apportioned for
part of a year from the date on which it is brought into use.
Required: Journalise the current and deferred tax for the year ended 31 December 20X1
Solution 14: Deferred tax on a qualifying asset (cost model): deductible

Comment:
This example shows the integration of IAS 12 Income taxes with IAS 23 Borrowing costs, and the
current and deferred income tax where borrowing costs are capitalised to a deductible asset.
Journals:
Current tax expense for 20X1
Deferred tax expense for 20X1
Workings:

Interest incurred during the construction period Given 100 000
Investment income earned during the construction period 10 000 / 5 m x 4 m during the (8 000)
capitalisation period
Chapter 14 735

W2. Deferred tax table caused by plant (qualifying asset)
CA TB TD DT
O/balance 20X1 0 0 0 0
Construction Given 300 000 300 000
Borrowing costs W1 and Note 1 92 000 92 000
Tax deduction 0 (92 000)
Depreciation 392 000 x 20% x3/12 (19 600) 0 (26 220) Cr DT; Dr TE
Deduction 300 000 x 20% x3/12 0 (15 000)
C/balance 20X1 372 400 285 000 (87 400) (26 220) L
Note 1: The tax base relating to the borrowing costs starts off at C92 000 but is then reduced by
C92 000 because the total borrowing costs are allowed as a deduction now (in 20X1).
The net effect is that the tax base relating to borrowing costs at the end of the year is now nil
(because there are no future deductions that will be allowed in this regard).
W3. Calculation of current income tax C
Profit before tax and before adjustments Given 800 000
Add: interest income 10 000
Less: interest expense 100 000 total – 92 000 capitalised (8 000)
Less depreciation 392 000 x 20% x 3/12 (19 600)
Add back depreciation expense 19 600
Add back interest expense 8 000
Less interest incurred on asset Allowed as a deduction when brought into use (100 000)
Less tax deduction on plant 300 000 x 20% x 3/12 (15 000)
Comment: proof that the differences are simply temporary:
Effect of plant on accounting profits 400 000
Total depreciation over the periods: Construction costs: 300 000 + b/ costs: 92 000 392 000
Total interest expense over the periods: Interest incurred: 100 000 – 92 000 capitalised 8 000
Effect of plant on taxable profits 400 000
Total tax deduction on cost of plant Construction costs: 300 000 300 000
Total interest deduction on plant Interest incurred: 100 000 100 000
Example 15: Deferred tax on a qualifying asset (cost model): non-deductible

Use the same information in example 14 except that the tax authorities:
x levy income tax at 30%,
x tax interest income,
x allow the deduction of the interest incurred on the construction of an asset to be
deducted in the year in which the asset is brought into use, but
x do not allow the cost of this construction to be deducted.
Required: Journalise the current and deferred tax for the year ended 31 December 20X1
Solution 15: Deferred tax on a qualifying asset (cost model): non-deductible
Comment: This example shows the integration of IAS 12 Income taxes with IAS 23 Borrowing costs,
and the current and deferred income tax where borrowing costs are capitalised to a non-deductible asset
Current tax expense for 20X1
736 Chapter 14

31 December 20X1 continued ... Debit Credit
Income tax expense (E) W2: 27 600 – 1 380 26 220
Deferred tax expense for 20X1
Workings:

Interest incurred during the construction period Given 100 000
Investment income earned during construction period 10 000 / 5 m x 4 m constr period (8 000)
W2. Deferred tax table caused by plant (qualifying asset)
CA TB TD DT
O/balance: 20X1 0 0 0 0
Construction Given; Note 1 300 000 0 (300 000) 0 Exempt
Borrowing costs W1 and Note 2 92 000 92 000 0 0
Tax deduction W1 and Note 2 0 (92 000) (92 000) (27 600) Cr DT; Dr TE
Depreciation 392 000 x 20% x 3/12 (19 600) 0
- cost 300 000 x 20% x 3/12 (15 000) 0 15 000 0 Exempt
- b/costs 92 000 x 20% x 3/12 (4 600) 0 4 600 1 380 Dr DT; Cr TE
C/balance: 20X1 372 400 0 372 400 (26 220) L
Note 2: The tax base relating to the construction costs is nil since these are not allowed as a deduction.
Since the carrying amount is the cost of construction, a taxable temporary difference arises.
Since the taxable temporary difference arises on acquisition, it is a taxable temporary
difference that is exempt in terms of IAS 12.15. This is because the asset does not arise by
way of a business combination and at the time of the transaction (the acquisition of the
plant), neither accounting profits nor taxable profits are affected.
Note 3: The tax base relating to the borrowing costs starts off at C92 000 but is then reduced by
C92 000 because the total borrowing costs are allowed as a deduction now (in 20X1).
The net effect is that the tax base relating to borrowing costs at the end of the year is now nil
(because there are no future deductions that will be allowed in this regard).
Since the carrying amount is the cost of borrowing costs that are capitalised, a taxable
temporary difference arises.
This is a temporary difference which leads to deferred tax (i.e. it is not an exempt temporary
difference since it does not relate to a temporary difference that arises on acquisition of an asset).
W3. Calculation of current income tax C
Profit before tax and before adjustments Given 800 000

Add: interest income 10 000
Less: interest expense 100 000 total – 92 000 capitalised (8 000)
Less depreciation 392 000 x 20% x 3/12 (19 600)
Add back depreciation expense 19 600
Add back interest expense 8 000
Less interest incurred on asset Allowed as a deduction in full when brought into use (100 000)
Less tax deduction on plant Not deductible (0)
Chapter 14 737

Proof: proof that the differences are permanent in nature and therefore exempt from deferred tax:
Effect of plant on accounting profit 400 000

Total depreciation over the periods: Construction costs: 300 000 + b/ costs: 92 000 392 000
Total interest expense over the periods: Interest incurred: 100 000 – 92 000 capitalised 8 000
Effect of plant on taxable profits 400 000

Total tax deduction on cost of plant Not deductible 0
Total interest deduction on plant Interest incurred: 100 000 100 000
7. Disclosure (IAS 23.26)
The entity must disclose the following in the financial statements:

x the total amount of borrowing costs capitalised;
x the capitalisation rate used to calculate the borrowing costs for a general loan. See IAS 23.26
The amount of finance costs expensed in profit or loss must be presented on the face of the
statement of comprehensive income (this is an IAS 1 requirement – not an IAS 23
requirement). See IAS 1.82(b)
Company name
3. Finance costs 20X5 20X4

C C
Interest incurred Z Z
Less borrowing costs capitalised IAS 23 requirement (Y) (Y)
Finance cost expense IAS 1 requirement X X
Borrowing costs capitalised were measured using a capitalisation rate of 15%.
Net carrying amount: 01/01/X5 IAS 16 requirement C C

Gross carrying amount IAS 16 requirement A A
Acc depreciation IAS 16 requirement (B) (B)
Borrowing costs capitalised IAS 23 requirement Y Y

Other movements (e.g. depreciation) IAS 16 requirement Z Z
Net carrying amount: 31/12/X5 IAS 16 requirement C C

Gross carrying amount IAS 16 requirement A A
Acc depreciation IAS 16 requirement (B) (B)
Company name
20X5 20X4
Note C C
Profit before finance costs x x
Finance costs IAS 1 requirement 3. x x
Profit before tax x x
Income tax expense x x
Profit for the year x x
Other comprehensive income for the year x x
Total comprehensive income for the year x x
738 Chapter 14
8. Summary
IAS 23
Borrowing costs
Recognition: Expense Recognition: Asset

If not related to a qualifying asset If it relates to a qualifying asset and
meets all criteria for capitalisation
Borrowing costs that may be capitalised

x borrowing costs that relate to costs:
x directly attributable to the
x acquisition, construction or production of
x a qualifying asset and if
x future economic benefits are probable and
x costs can be reliably measured
Qualifying asset
x those that take a long time to get ready
Measurement
General borrowings Specific borrowings

x Capitalise borrowing costs during the x Capitalise the total amount of
construction period using the borrowing costs actually incurred
following formula: during the construction period
- capitalisation rate (CR) x x Less any investment income earned on
- the construction costs; the temporary investment of any
x but limit to the actual borrowing surplus borrowings during the
costs incurred construction period
x CR = weighted average borrowing
costs divided by the general
outstanding borrowings
x No investment income is deducted
from borrowing costs
x Actual borrowing costs capitalised
should not exceed actual interest
incurred
Construction period
Start Pause Stop

The commencement date The suspension period The cessation date
(an official IAS 23 term): (not a defined term): (not a defined term):
When: When construction is: When
x Activities are in progress x actively suspended x substantially all the
x Borrowing costs (e.g. interest x for a long period; activities are complete
are being incurred); Do not pause if the delay and
x Expenditure on constructing is short or if it is long but x the asset is thus
the asset is being incurred. yet necessary substantially ready for
its intended use or sale.
Disclosure
The amount of BCs capitalised IAS 23
The amount of BCs expensed IAS 1
For general loans only: the capitalisation rate IAS 23
Chapter 14 739
Some fiddly things to remember when measuring borrowing costs to be capitalised:
Measuring the borrowing costs to be capitalised is sometimes more fiddly than it first appears.
The basic questions that one needs to answer when measuring the borrowing costs to be
capitalised include:
x are the borrowings specific or general or is there a mix of both specific and general?
x is the borrowing a precise amount (e.g. a loan) or does it increase as expenditure is paid for
(e.g. a bank overdraft)?
x are the expenditures (on which interest is incurred) incurred evenly or at the beginning or end
of a period or at haphazard times during a period?
x how long are the periods during which capitalisation is allowed?
In considering whether the borrowings are specific or general or whether there is a mix of both
specific and general, remember that:
x where the borrowings are specific:
x you will need the actual rate of interest/s charged on the borrowing/s; and
x you will need to know if any surplus borrowings were invested upon which investment
income was earned (if so, remember to reduce the interest expense by the investment
income);
x where the borrowings are general:
x you will need the weighted average rate of interest charged (assuming there is more than
one general borrowing outstanding during the period); and
x you will need the actual expenditure.
In considering whether the borrowing is a precise amount (e.g. a loan) or whether it increases as
expenditure is paid for (e.g. a bank overdraft), bear in mind that:
x if the borrowing is a loan ( a precise amount), you will use the capital sum; and
x if the borrowing is an overdraft (a fluctuating amount), you will use the relevant/ actual
expenditures incurred on the construction of the qualifying asset and will need to know when
they were incurred (or whether they were incurred relatively evenly).
In assessing whether the expenditures (on which interest is incurred) are incurred evenly or at
the beginning or end of a period or at haphazard times during a period, bear in mind that:
x interest expense can be measured using average borrowing balances if the costs are incurred
evenly, whereas actual borrowing balances should be used (whether specific or general
borrowings) if costs are incurred at the beginning or end of a period; and
x if the investment income is interest, it should be measured using average investment balances
if the costs are incurred evenly, whereas actual investment balances should be used (if it is a
specific borrowing) if costs are incurred at the beginning or end of a period.
The construction period (during which capitalisation of borrowing costs takes place):
x starts on the commencement date:
borrowings may be outstanding (and incurring interest) before commencement date in which
case interest expense (and investment income on any surplus funds invested) up to
commencement date must be ignored when calculating the portion to be capitalised;
x ends on the cessation date:
borrowings may be outstanding (and incurring interest) after cessation date in which case
interest expense (and investment income on any surplus funds invested) after cessation date
must be ignored when calculating the portion to be capitalised; and
x is put on hold during a suspension period between these two dates:
borrowings may be outstanding (and incurring interest) during a suspension period in which
case interest expense (and investment income on any surplus funds invested) during this
period must be ignored when calculating the portion to be capitalised.
740 Chapter 14
Gripping GAAP Government grants and government assistance
Chapter 15
Government Grants and Government Assistance
Reference: IAS 20, SIC 10, IFRS 13 and IAS 12 (incl. any amendments to 1 December 2018)
Contents: Page
1. Introduction 743
2. Scope 743
3. Recognition, measurement and presentation of government grants 744
3.1 Overview 744
3.2 Grants related to immediate financial support or past expenses 745
3.2.1 Overview 745
3.2.2 Recognition 745
3.2.3 Measurement 746
3.2.4 Presentation 746
Example 1: Grant for past expenses 746
3.3 Grant related to future expenses 747
3.3.1 Overview 747
3.3.2 Recognition 747
3.3.3 Measurement 747
3.3.4 Presentation 747
Example 2: Grant for future expenses - conditions met over two years 747
3.4 Grants involving assets 748
3.4.1 Overview 748
3.4.2 Recognition and measurement of a grant of a non-monetary asset 749
3.4.2.1 Initial recognition and measurement of a non-monetary asset 749
Example 3: Grant is a non-monetary asset: measurement: fair 749
value or nominal amount
3.4.2.2 Subsequent recognition and measurement related to a non- 749
monetary asset
3.4.3 Recognition and measurement of a grant of a monetary asset 750
3.4.3.1 Initial recognition and measurement of a monetary asset 750
3.4.3.2 Subsequent recognition and measurement of a monetary asset 750
Example 4: Monetary grant related to a depreciable asset – 751
credit to income or asset
Example 5: Monetary grant is a package involving a non- 752
depreciable asset and future costs that are not
measurable
depreciable asset and future costs that are measurable
depreciable asset and a depreciable asset
3.4.4 Presentation of a grant related to assets 755
Chapter 15 741
Contents: Page
3.5 Grants related to loans 755
3.5.1 Overview of grants related to loans 755
3.5.2 Recognition of grants related to loans 755
3.5.3 Measurement of grants related to loans 755
3.5.4 Presentation of grants related to loans 756
Example 8: Grant related to a forgivable loan 756
Example 9: Grant related to a low-interest loan 757
3.6 Grants received as a package 759
Example 10: Grant is a package deal 759
4. Changes in estimates and repayments 760
Example 11: Grant related to expenses – repaid 761
Example 12: Grant related to assets – repaid 76
5. Deferred tax 763
5.1 Overview 763
5.2 Grants related to income 764
5.2.1 Grant for immediate financial support or past expenses: taxable 764
5.2.2 Grant for immediate financial support or past expenses: not taxable 764
5.2.3 Grant to assist with future expenses: taxable 764
Example 13: Deferred tax: grant relating to future expenses: taxable 764
5.2.4 Grant to assist with future expenses: not taxable 765
Example 14: Deferred tax: grant relating to future expenses: exempt 765
5.3 Grants related to assets 766
5.3.1 Grant related to assets: taxable 766
Example 15: Deferred tax: cash grant relating to asset – taxable 766
5.3.2 Grant related to assets: not taxable 768
Example 16: Deferred tax: Cash grant relating to asset – not taxable 769
6. Disclosure 770
Example 17: Disclosure of government grants 770
Example 18: Disclosure of government grants related to assets – the asset note 77
Example 19: Disclosure of government grants and assistance: a general note 772
7. Summary 773
742 Chapter 15
1. Introduction (IAS 20.2 - .4 & .6)
Government assistance is provided to encourage an Government is defined as:

entity to become involved in certain activities that it may
otherwise not have involved itself in (or it may even be x government;
x government agencies; and
used to discourage certain activities). x similar bodies;
x whether local, national or
Government assistance therefore provides incentives for international. IAS 20.3
businesses to engage in certain activities.
It is often provided to assist businesses in starting up. This obviously benefits the business but
also benefits the government through the creation of jobs and thus a larger base of taxpayers.
Government assistance is
Government assistance can come in many forms, for defined as:
example: grants of income, grants of a non-monetary x action by government
asset, low interest loans or even advice. These grants are x designed to provide an economic
often referred to by other names such as subsidies, benefit to
subventions and premiums. x a specific entity (or range of
entities) that
qualifies under certain criteria
From an accounting perspective, we split government xx excluding indirect benefits
assistance into: provided through action affecting
x ‘government grants’ (e.g. a grant of cash or another general trading conditions.
IAS 20.3 (reworded)
asset); and
x ‘other government assistance’ (e.g. the receipt of government advice).
Whereas government grants are recognised and disclosed, Government grants are
other government assistance (i.e. ‘government assistance’ defined as:
that does not meet the definition of a ‘government grant’) x government assistance that is a
x transfer of resources
will only be disclosed.
x in exchange for compliance with
conditions (past/ future) relating to
IAS 20, however, does not cover: government actions that operating activities of the entity
result in indirect benefits received by an entity. For instance, x excluding government assistance
a government may construct roads and provide electricity that cannot be reasonably valued
and transactions that cannot be
and water to areas that were previously underdeveloped: separated from the entity’s
these actions benefit the trading conditions of all entities normal trading transactions.
IAS 20.3 (reworded)
operating businesses in that area and are not provided to a
specific entity. See IAS 20.3
According to the definition, government grants only include government assistance in the
form of a transfer of resources that are in exchange for the entity meeting certain conditions
(see ‘government grant’ definition in the pop-up above). Furthermore, the term government
grants only includes government assistance an entity receives if:
x we can attach a value to it (e.g. we do not recognise ‘advice from government’ as a
government grant, because it is not possible to attach a value to it); and
x it can be distinguished from the normal trading transactions with the government. See IAS 20.3
2. Scope (IAS 20.2)
IAS 20 is not applied when dealing with:

x the special problems arising in accounting for government grants in financial statements reflecting
the effects of changing prices or in supplementary information of a similar nature; See IAS 20.2 (a)
x government actions that assist an entity to reduce its tax liability (e.g. a special dispensation
allowing it to calculate its taxable profit in a favourable manner, giving the entity tax credits, tax
holidays or reduced tax rates); See IAS 20.2 (b)
x government participation in the ownership of the entity; IAS 20.2 (c)
x government grants covered by IAS 41 Agriculture. IAS 20.2 (d)
Chapter 15 743
3. Recognition, Measurement and Presentation of Government Grants (IAS 20.7 - .38)
3.1 Overview (IAS 20.7 – .29)

Government assistance is split
into two categories:
Government grants are effectively a form of income
recognised in profit or loss. However, please note: x government grants:
x Only government assistance that meets the definition of - recognised and disclosed
a ‘government grant’ would potentially be recognised: x other government assistance:
- not recognised but disclosed.
The grant must involve a transfer of resources and these
must be in exchange for the meeting of certain conditions (see complete definition in the pop-up
in section 1) and
x a ‘government grant’, as defined, will only be recognised in profit or loss if it is ‘reasonably
assured’ that the conditions that the entity must meet in order to qualify for the grant will indeed
be met and that the grant will eventually be received. See IAS 20.3 & .7
The mere fact that a grant is received does not mean that we Government grants are only
can recognise the grant as income because we normally have recognised when there is:
to meet certain conditions to ‘earn’ the grant. Conversely, x reasonable assurance that the entity
meeting the pre-requisite conditions doesn’t always mean that x will comply with the conditions; and
See IAS 20.7
the grant will ever be received. Thus, there must be x the grants will be received.
reasonable assurance that both these recognition criteria will be met. See IAS 20.7
IAS 20 refers to the recognition of government grants on both the capital approach
(recognising it directly in equity, without first recognising it in profit or loss), and the income
approach. However, IAS 20 states that we may only use the income approach. See IAS 20.13
Government grants are
Recognising government grants on the income approach, recognised on the income
means that the grant must be recognised in profit or loss on basis:
a rational basis over the same periods in which the entity x in profit or loss (directly/ indirectly)
recognises as expenses the costs that the grant was intended x on a rational basis
to compensate. See IAS 20.12 x in the same period/s in which the
costs that the grant was intended
to reduce are expensed. See IAS 20.12
There are two ways in which the grant could be recognised
in profit or loss. Either by: We can recognise a grant
x recognising it directly as ‘grant income’, or in P/L by either:
x recognising it indirectly as income, by way of a x crediting income (direct income); or

‘reduced expense’, through crediting the cost that the x crediting asset/ expense (indirect
income). See IAS 20.24 & .29
grant was intended to subsidise (i.e. an asset, such as
plant, or an expense, such as wages) See IAS 20.24 and .29
IAS 20 refers to three categories of government grants: Grants related to assets are
defined as: IAS 20.3 reworded
x A grant related to an asset: This is a grant of either:
x a government grant
- a long-term (i.e. non-monetary) asset (e.g. a tangible
x with a primary condition requiring:
building or an intangible right); or - the qualifying entity to
- cash (i.e. monetary asset) that must be used to acquire - purchase, construct or otherwise
some sort of long-term asset. acquire long-term assets;
x A grant related to income: This is a grant of cash that x and may have a secondary condition/s
restricting:
does not involve the acquisition of an asset, but is - the type or location of the assets,
simply received as either: and/ or
- immediate financial support or compensation for - the periods during which the
past expenses; or as assets are to be acquired or held.
- compensation for future expenses to be incurred.
x A grant related to a loan: This is a grant that could either be: A grant related to income is
- a forgivable loan; or a defined as: IAS 20.3 reworded
- low-interest loan. x a government grant that is
x not a grant related to an asset.
744 Chapter 15
The form of the grant will affect its measurement. For example, a grant in the form of:
x a low-interest loan is measured in terms of IFRS 9 Financial instruments; See IAS 20.10A
x an actual non-monetary asset is measured at the asset’s Recognition, measurement &
fair value in terms of IFRS 13 Fair value measurement, presentation of government
or a nominal amount; See IAS 20.23 grants depends on whether:
x cash is measured at its cash amount. x the grant relates to income, for:
- immediate support/past expenses,
- future expenses;
The recognition, measurement and presentation of
x the grant relates to assets;
government grants will be discussed in respect of each of
x the grant relates to loans; or
these forms of grants: x the grant is a combination (a package)
x grants related to income
- grants related to immediate financial support or past expenses (section 3.2)
- grants related to future expenses (section 3.3)
x grants related to assets (i.e. long-term assets) (section 3.4)
x grants related to loans (section 3.5)
x grants received as a combinations of some of the above (grant packages) (section 3.6).
3.2 Grants related to immediate financial support or past expenses (IAS 20.20)
3.2.1 Overview
Grants are often offered to entities on a prospective basis, to encourage some future action.
However, it can happen that an entity qualifies for a government grant in retrospect (i.e. the
entity having met all conditions in the past), where there are no future conditions that the
entity still has to meet. These grants could come in the form of:
x immediate financial support or
x relief from past expenses or losses (i.e. the grant relates to expenses or losses already incurred).
3.2.2 Recognition (IAS 20.12, .20 - .22, .26 & .29) Grants for immediate
financial support/ past
In the case of a grant in the form of immediate financial expenses are recognised:
support or as relief from past expenses or losses, since the x in profit or loss
conditions have already been met, it is reasonably assured that - as a credit to expense; or
the grant will be received and thus the grant transaction must - as a credit to grant income
x when the grant is receivable.
be recognised. See IAS 20.7 See IAS 20.20 - .22
In terms of IAS 20’s income approach, we must recognise a relevant portion of the grant in profit or
loss on a systematic basis over the periods in which the entity expenses the costs that the grant
intended to compensate. See IAS 20.7 & .16
However, in the case of grants relating to immediate financial support, or relating to relief
from expenses or losses already incurred, the conditions have already been met and there are
thus no future costs to be incurred. For this reason, these types of grants are simply recognised
as income in the period it becomes receivable. See IAS 20.20 - .22
When recognising a grant for immediate financial support, we would credit grant income.
However, if the grant provides relief from past expenses or losses, we could either credit
grant income or credit the related expense (e.g. the grant could have been given to an entity
as compensation for a wage bill incurred in a prior year, in which case we could credit grant
income or credit the current year’s wages bill). See IAS 20.29
However, we must always remember to identify any further hidden conditions attaching to the
grant as this will obviously affect when to recognise the income. If there are indeed further
conditions, then we would have to first recognise the grant as a credit to a deferred income
account, where this will then make its way into profit or loss when the conditions are met and
the related costs are incurred. We may even need to simultaneously recognise a provision (or
disclose a contingent liability) for any future costs in meeting these conditions. See IAS 20.11
Chapter 15 745
3.2.3 Measurement (IAS 20.20) Grants for immediate

financial support/ past
expenses are measured:
Measurement of government grants related to income (or x at the amount
assets) is not specifically addressed by IAS 20, and grants are x received/ receivable. See IAS 20.20
thus simply measured at the amount received or receivable.
3.2.4 Presentation (IAS 20.29) Grants for immediate financial

support/ past expenses are
The benefit of the grant that relates to immediate presented:
financial support or to compensate for past expenses x in P/L,
must be presented in profit or loss, either as: x either as
- income (separate income line item
x income, presented either as: or part of ‘other income’); or
- a separate line item for grant income; or - reduction of the expense. See IAS 20.29
- part of ‘other income’; or as a
x reduction of the related expense. See IAS 20.29
A grant for immediate financial support does not relate to any particular expense and is thus
presented as income.
A grant to compensate for a past expense or loss that was recognised in a prior year, where it is a
recurring type of expense (e.g. electricity), may be presented as a reduction of that expense in the
current year (or as grant income, if preferred). However, if the past expense was a once-off expense
and thus has not recurred (perhaps a legal expense), the grant cannot be credited to an expense
(because it does not exist in the current year) and so it would simply be presented as income.
Example 1: Grant for past expenses

The government offered Giveme Limited a cash grant equal to 30% of certain specified
labour costs.
Giveme Limited incurred C30 000 of these specified labour costs during its year ended
31 December 20X0 and presented the government with an audited statement of expenses on
31 March 20X1 as proof thereof.
Required: Show Giveme Limited’s journals assuming the grant is considered receivable upon
presentation of the audited financial statements and:
A. the entity recognises the grant as income;
B. The entity recognises the grant as a reduction in the expenses.
Solution 1: Grant for past expenses

Part A Part B
31 December 20X0 Dr/ (Cr) Dr/ (Cr)
Wage expenditure (E) 30 000 30 000
Bank/ Wages payable (30 000) (30 000)
Labour costs incurred during 20X0
31 March 20X1
Grant income receivable (A) 30 000 x 30% 9 000 9 000
Grant income (I) (9 000) N/A
Wage expenditure (E) N/A (9 000)
Grant income for relief from past expenses is recognised, because the
audited statement of costs has been presented (a secondary condition
to incurring the costs) and thus it is now reasonably assured that the
grant will be received
Comment: In both cases, the grant is received in relation to past expenses and is therefore classified as ‘a
grant related to immediate financial support or past expenses’ and will therefore be recognised as grant
income as soon as it becomes receivable. In both Part A and Part B, the grant is recognised in profit or loss.
The only difference is in presentation: in Part A, the grant will be recognised as grant income and in Part B,
the grant will appear as a reduction in the related cost (wages).
746 Chapter 15
3.3 Grant related to future expenses (IAS 20.12 - .17 and .29)
3.3.1 Overview
It sometimes happens that the government gives an entity cash, to either help subsidise future
expenses that the entity is expecting to incur or even to encourage the entity to incur certain
expenses that it might have otherwise avoided. Such grants, as with all other grants, may
come with certain conditions, which need to be considered when deciding when to recognise
the grant income and how much to measure it at.
3.3.2 Recognition (IAS 20.12 & .17)
Government grants are recognised when the recognition criteria are met (i.e. it is reasonably
assured that the conditions will be met and thus that the grant will be received). See IAS 20.7
As soon as the recognition criteria are met, we will begin to recognise the grant:
x as income
x in profit or loss Grants for future expenses
x on a systematic basis over the periods in which are recognised:
Note
x the entity expenses the costs that the grant intends to x in profit or loss
- as a credit to expense; or
compensate. IAS 20.12 reworded
- as a credit to grant income
x when these related future costs
Grants that are to be used to subsidise certain future are expensed. See IAS 20.12 & .17
expenditure should thus be recognised in profit or loss Note: if a grant is received before the
when that related expenditure is incurred. IAS 20.12 & .17 costs are incurred, credit deferred
income (liability) before crediting P/L.
When recognising these grants in profit or loss, we could
either recognise it directly as income by crediting grant income or indirectly as income by
crediting the related expense instead. See IAS 20.29
As always, we must remember that there may be further conditions attaching to the grant and
we need to use our professional judgement when deciding when to recognise the income. If
we receive a grant before it is reasonably assured that the conditions will be met, or before the
related costs are incurred, we would have to first recognise the grant as a credit to a deferred
income account. This deferred grant income will then be transferred to profit or loss when the
conditions are met and the related costs are incurred.
Grants for future expenses
3.3.3 Measurement (IAS 20.12 & .17) are measured as follows:
x The portion of the amount
The entire grant for future expenses is measured at the received/receivable to be
recognised in P/L is measured
total amount of cash received, but the portion of this
x systematically
grant that is recognised as income in profit or loss is x over the period/s
measured on a basis that reflects the pattern in which the x that these future costs are
expenses are expected to be recognised. See IAS 20.12 & .17 expensed. See IAS 20.12
3.3.4 Presentation (IAS 20.29)

Grants for future expenses are
The benefit of a grant that relates to future expenses presented:
must be presented in profit or loss, either: x in P/L,
x as income, presented either as: x either as
- a separate line item for grant income; or - income (separate income line item
or part of ‘other income’); or
- part of ‘other income’; or - reduction of the expense. See IAS 20.29
x as a reduction of the related expense. See IAS 20.29
Example 2: Grant for future expenses - conditions met over two years
An entity receives a cash grant of C10 000 from the government to contribute 10% towards
future specified wages totalling C100 000 (future wages: 100 000 x 10% relief).
x The grant was received on 1 January 20X1 based on the fact that certain pre-conditions
were met in 20X0. All conditions attaching to the grant (with the exception of the
incurring of the future wages) had all been met on date of receipt.
Chapter 15 747
x The year-end is 31 December.

x C20 000 of the specified wages were incurred in 20X1 and C80 000 in 20X2.
Required: Show the journals assuming that the entity recognises government grants:
A. As a credit to grant income (directly as income);
B. As a credit to the related expense (indirectly as income).
Solution 2: Grant for future expenses - conditions met over two years
Part A Part B
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
Bank (A) 10 000 10 000
Deferred grant income (L) (10 000) (10 000)
Recognising a government grant intended to reduce future expenses
31 December 20X1
Wage expenditure incurred
Deferred grant income (L) C10 000 x C20 000 / C100 000 2 000 2 000
Grant income (I) (2 000) N/A
Recognising 20% of the grant in P/L since 20% of the costs that the
grant was intended to compensate have been incurred
31 December 20X2
Wage expenditure incurred
Deferred grant income (L) C10 000 x C80 000 / C100 000 8 000 8 000
Grant income (I) Recognised directly as income (8 000) N/A
Recognising 80% of the grant in P/L since 80% of the costs that the
grant was intended to compensate have been incurred
Comment: In this example, the conditions were met over 2 years and thus the deferred income was
amortised (transferred) to profit or loss over the 2 years, apportioned based on the expenditure incurred
per year relative to the total expenditure to be incurred.
x In Part A, the profit or loss is adjusted by recognising an income account; whereas
x In Part B, it is adjusted by reducing an expense account.
x Notice how the effect on overall profits is the same irrespective of the company policy.
3.4 Grants involving assets Grants relating to an asset

can come in different
3.4.1 Overview forms:
x a non-monetary asset
x a monetary asset that is to be used to
A grant involving an asset could take the form of the acquire a long-term asset, that is:
receipt of the actual non-monetary asset itself or could - depreciable; or
be in the form of a monetary asset (e.g. cash) that is to - non-depreciable.
be used to acquire a non-monetary asset. If we receive a monetary asset that has, as its
primary condition (or only condition), that it be used to acquire a long-term asset, then this
meets the definition of a ‘grant related to an asset’. See IAS 20.3
When dealing with grants that involve assets, we will find that the recognition and
measurement thereof is fairly inter-related and will be affected by whether the grant is
received as the non-monetary asset itself or whether the grant is received as a monetary asset.
The subsequent recognition and measurement as grant income in profit or loss is affected by
whether the related non-monetary asset is depreciable or non-depreciable.
748 Chapter 15
3.4.2 Recognition and measurement of a grant of a non-monetary asset

3.4.2.1 Initial recognition and measurement of a non-monetary asset (IAS 20.23-27)
If we received a grant of an asset that is a non-monetary A grant of a non-monetary

asset, we may measure it at the fair value of the asset or asset is
simply at a nominal amount for recording purposes (e.g. C1). x measured either at:
the FV of the asset; or
If we measure the transaction at the fair value of the a nominal amount (C1). See IAS 20.23
asset received, we account for the transaction by x The initial jnl, if at FV, is:
recognising: Dr: Asset: cost (A)
Cr: Deferred grant income (L)
x the non-monetary asset and x The initial jnl, if at a nominal
x deferred grant income. amt, is typically:
Dr: Asset: cost (A)
However, although not expressly stated in IAS 20, if we Cr: Grant income (P/L)
measure the transaction at a nominal amount (i.e. instead of
using fair value), it is submitted that we may need to account for the transaction by recognising the grant
income in profit or loss immediately (not recognising it first as deferred grant income). This is because
deferred grant income needs to be recognised as grant income in profit or loss as the underlying asset is
expensed or as the conditions of the grant are met. If there were no further conditions, given that the asset
is already measured at a nominal amount (and will thus not be further expensed by way of depreciation),
there is no point in deferring the recognition of the grant in profit or loss.
Example 3: Grant is a non-monetary asset: measurement: fair value or
nominal amount
A government grants an entity a licence to fish off the coast of Cape Town, South Africa.
The fair value of the licence is C50 000. There were no conditions attached to the grant.
Required: Show the journal entries assuming the entity chooses to measure the licence at:
A. its fair value.
B. a nominal amount of C1.
Solution 3: Grant is a non-monetary asset: measurement: fair value

Comment: Notice how, when measuring the asset at a fair value (Part A), the grant is first recognised as deferred grant
income. This deferred grant income will be transferred to profit or loss over the life of the intangible asset (as grant income or
as a reduction in the related amortisation expense). However, when recognising the asset at a nominal amount (Part B), we
immediately recognise the grant as income in profit or loss.
Part A Part B
Dr/ (Cr) Dr/ (Cr)
Fishing licence (A) Part A: FV (given) 50 000 1
Part B: Nominal amount (given)
Deferred grant income (L) (50 000) N/A
Grant income (I) N/A (1)
Recognising the licence granted by the government
3.4.2.2 Subsequent recognition and measurement related to a non-monetary asset

If the non-monetary asset was initially measured at the nominal amount paid, then it is submitted
that, assuming there were no further conditions attaching to the grant, the receipt of the non-
monetary asset should have been recognised immediately as grant income in profit or loss. In this
case, there would be no further subsequent recognition and measurement issues to consider.
However, if the non-monetary asset was initially measured at the asset’s fair value, then we
would have initially recognised the grant as deferred grant income (a liability).
Although the grant was initially recognised as deferred grant income, all grants must eventually be
recognised in profit or loss. This subsequent transfer of the deferred grant income to profit or loss
(debit: deferred grant income and credit grant income/ related expense) must be done in a way that
the grant income matches the pattern in which the asset is expensed. The subsequent recognition
and measurement of the grant is thus affected by whether the asset is depreciable or not depreciable.
Chapter 15 749
If the asset is depreciable, then the grant initially recognised as deferred grant income will be
subsequently recognised as income in profit or loss in a manner that reflects the pattern in
which the non-monetary asset is expensed. In other words, the grant income will be
recognised and measured at the same rate as the related depreciation charge.
If the non-monetary asset is not depreciable (e.g. the

A grant of a non-monetary
receipt of land), we will need to subsequently recognise asset, initially measured at
the grant as grant income in profit or loss as and when fair value, is subsequently
the related conditions are met. In other words, if all the recognised & measured in
conditions are met when the asset is received, the receipt P/L as follows:
of the asset would be recognised as grant income in If the asset is depreciable,
profit or loss immediately, whereas if, for example, half subsequently recognise in P/L as:
x grant income
of the conditions were subsequently met, then half of the x over the useful life of the asset.
deferred grant income would be subsequently recognised If the asset is non-depreciable,
as grant income in profit or loss and the balance would recognise in P/L as:
remain deferred until the remaining conditions are met. x grant income
x as and when conditions are met.
See IAS 20.12 & .15 & .17
The journal for subsequent recognition of deferred grant
income as income in profit or loss is:
x debit: deferred grant income (L), and
x credit: grant income (I).
3.4.3 Recognition and measurement of a grant of a monetary asset
3.4.3.1 Initial recognition and measurement of a monetary asset
If we receive a grant of an asset that is a monetary asset Grant of a monetary asset

(e.g. cash) to be used in relation to a non-monetary asset is measured as follows:
(e.g. to acquire or maintain a non-monetary asset), this x the cash amount
grant must be measured at the amount received or x received/ receivable.
receivable and be recognised either as deferred grant
income or as a reduction of the cost of the related non-monetary asset. See IAS 20.24
Note: If the related non-monetary asset is non- If monetary asset received is

depreciable, then the monetary grant may not be credited a grant related to an asset
to that non-monetary asset because the receipt of this then either journalise as:
grant must eventually be recognised as income in profit x Dr Cash; Cr Deferred income (L), or
x Dr Cash; Cr Asset: cost (but only if
or loss: if the non-monetary asset is not depreciable and the asset is depreciable).
yet the grant is recognised as a credit against the asset’s See IAS 20.24
cost, this grant will remain outside of profit or loss

forever (i.e. it will remain as a reduction to the asset’s cost). Thus, a monetary grant for a
non-monetary asset that is non-depreciable must be credited to deferred grant income (or
directly to grant income if all conditions attached to this grant are met).
3.4.3.2 Subsequent recognition and measurement of a monetary asset
As with all grants, we must eventually recognise the grant as income in profit or loss.
The subsequent recognition and measurement is affected by whether the grant of a monetary
asset was initially recognised as:
x a reduction to the cost of the related non-monetary asset; or
x deferred grant income.
If the monetary asset was initially recognised as a reduction in the cost of a depreciable non-
monetary asset, then no further journal is needed to recognise this grant as grant income in
profit or loss. This is because the grant will be automatically and indirectly recognised as
grant income in profit or loss (i.e. indirect income) by way of a reduced depreciation expense.
750 Chapter 15
If the monetary asset was initially recognised as deferred A grant of a monetary asset is
grant income, however, it will need to be subsequently subsequently recognised &
recognised as grant income in profit or loss. measured in P/L as follows:
x If the related non-monetary asset is depreciable, then If the related asset is depreciable,
we would recognise the deferred grant income as and the grant was initially credited to
deferred grant income, subsequently
grant income over the useful life of the asset (e.g. the
recognise in P/L as:
amount of grant income recognised in profit or loss x grant income or reduced expense
each year would match the rate of depreciation). (e.g. lower depreciation)
x If the related non-monetary asset is non-depreciable, x over the useful life of the asset.
then any deferred grant income initially recognised If the grant was initially recognised as a
must be subsequently recognised and measured as credit to the asset’s cost, then no journal
grant income in profit or loss as and when the would be needed to achieve the above.
conditions related to the grant are met. If the asset is non-depreciable,
recognise in P/L as:
x grant income
This subsequent recognition of the grant as income in
x as and when conditions are met.
profit or loss can be done either:
x directly, by crediting grant income; or
x indirectly, by crediting the related expense (e.g. depreciation).
Example 4: Monetary grant related to a depreciable asset
x credit to income or asset
The government grants an entity a cash sum of C12 000 on 1 January 20X1 to assist in
the acquisition of a nuclear plant.
x The nuclear plant was:
- acquired on 1 January 20X1 for C90 000,
- was available for use immediately,
- has a useful life of 3 years, and
- has a nil residual value.
x The grant was received after compliance with certain conditions in 20X0 (the prior year).
x All conditions attached to the grant, with the exception of the acquisition of the plant, had all been
met on date of receipt.
Required: Show the journals in the years ended 31 December 20X1, 20X2 and 20X3 assuming the entity:
A. does not credit the cost of the asset with the grant.
B. does credit the cost of the asset with the grant.
Solution 4: Monetary grant for a depreciable asset – credit to income or asset

Part A Part B
Bank (A) 12 000 12 000
Recognising a government grant intended to assist in the acquisition
of a nuclear plant
Nuclear plant: cost (A) 90 000 90 000
Bank (A) (90 000) (90 000)
Purchase of plant
Deferred grant income (L) N/A 12 000
Nuclear plant: cost (A) (12 000)
Recognising the government grant as a reduction of the plant’s cost
31 December 20X1
Depreciation: plant (E) A: (90 000 – 0) / 3 years 30 000 26 000
Nuclear plant: acc depr (-A) B: (90 000 – 12 000 – 0) / 3 years (30 000) (26 000)
Deferred grant income (L) 12 000 / 3 years 4 000 N/A
Grant income (I)/ Depreciation (E) (4 000)
Grant recognised in profit or loss over the life of the related plant
Chapter 15 751
Part A Part B
Grant income recognised on the same basis as plant depreciation
31 December 20X3
Grant income recognised on the same basis as plant depreciation
Comment:
x This example involves recording the receipt of a grant before we are able to recognise it in profit or loss. The example
thus shows that we initially recognise the receipt as deferred income (liability) until the conditions are met.
x Then the example shows that, once it is reasonably assured that the conditions will be met, the deferred grant
income must begin to be recognised in profit or loss in a way that matches the expensing of the related costs.
In this example, the related cost is the cost of acquiring the plant, so the grant is recognised in profit or loss
from the date that the plant is available for use (and thus the costs recognised in profit or loss as depreciation).
x From the date the plant is available for use (and thus depreciated), the entity can either:
- transfer the entire balance on the deferred grant income to the cost of the acquired non-monetary asset
(Part B: debit deferred income and credit plant), in which case the grant is automatically recognised in
profit or loss over the life of the asset by way of a reduced depreciation charge; or
- gradually transfer the deferred grant income to profit or loss over the life of the asset (Part A), in which
case it can present this either as
- a credit to grant income; or
- a credit to the depreciation expense (this will also appear as a reduced depreciation charge).
The effect on profit or loss is the same (C26 000) no matter which of these options the entity selects.
Example 5: Monetary grant is a package involving a non-depreciable asset and

future costs that are not measurable
The government granted an entity a cash sum of C1 000 000 on 1 January 20X1 to fund the
purchase of farming land. This was purchased on 31 March 20X1 for C1 000 000.
A further condition attached to this grant was that the entity must have in its employ, at all times during
the next 5 years, at least 50 employees from the local community. A reliable estimate of these future
costs has not been possible.
Required: Explain, with supporting journals, how the entity should recognise and measure this grant.
Solution 5: Monetary grant for a non-depreciable asset and future non-measurable costs
This cash grant was received to buy a non-monetary asset and to assist with future costs.
Normally there is a choice in how to recognise grants received to buy non-monetary assets:
x the grant could first be recognised as deferred income (liability) and then this deferred income could be
transferred out and recognised in profit or loss over the life of the asset, or
x the grant could first be recognised as a deduction against the non-monetary asset and then be recognised
indirectly in profit or loss over the life of the asset by way of a reduced depreciation expense.
But, since the land is non-depreciable, it would not be possible to choose between these two methods. Instead,
the grant received would first have to be recognised as deferred income, and then recognised as income when
the costs of meeting the condition are recognised in profit or loss. This would mean that, since the condition
relating to acquiring land has been met, the portion of the grant relating to the land acquisition could,
technically, now be recognised as income.
However, we are unable to calculate the portion of the grant that relates to the land acquisition because the grant
also assists with future costs that are not reliably measurable. In this case, since the grant is to assist with these
costs over a 5-year period, an appropriate method of recognising the grant as income is the straight-line basis
over the 5-years during which the employee costs will be recognised in profit or loss
752 Chapter 15
The journals for a grant for a non-depreciable asset and future expenses that are not reliably measurable:

Bank (A) 1 000 000
Deferred grant income (L) 1 000 000
Receipt of the government grant to be used to buy farm land & pay wages
31 March 20X1
Land (A) 1 000 000
Bank (A) 1 000 000
Purchase of farm land
31 December 20X1
Deferred grant income (L) 1 000 000 / 5 years x 9/12 150 000
Grant income (I) 150 000
Recognising the government grant over the 5-year period of meeting
the condition related to the grant: employment of 50 staff members
from the local community for a period of 5-years
Comment:
x Since we could not measure the cost associated with one of the two conditions, we could not separate the
grant into the portions relating to these two conditions. This also meant that the grant was best recognised as
income on the straight-line basis over the period that the second condition is met.

future costs that are measurable
The government grants an entity a cash sum of C600 000 on 1 October 20X1 to help fund the
purchase of a plot of land. The land was duly purchased on 14 November 20X1 for C1 700 000.
Another condition to the grant (the primary condition being the purchase of the land) is that the entity
must clear the land of alien vegetation. In order to satisfy this condition, the entity signed a contract with
a garden service company for a total cost of C300 000 (C100 000 was incurred and paid in December
20X1 and a further C200 000 incurred and paid in January 20X2).
Required: Show the journals, assuming the entity’s policy is to recognise grants as a credit to the asset.
Solution 6: Monetary grant for a non-depreciable asset and measurable future costs
Comment:
x IAS 20 states that the grant income must be recognised in a manner that matches the periods in which the costs to meet
the obligation are borne. However, this grant has two conditions: the purchase of land and the clearing of vegetation.
IAS 20 also states that we must take care ‘in identifying the conditions giving rise to costs and expenses which
determine the periods over which the grant will be earned’. It also states that ‘it may be appropriate to allocate part of a
grant on one basis and part on another. See IAS 20.18-19
x Thus, since there are 2 conditions, it may be appropriate to allocate part of the grant to each of these conditions,
measured based on their relative costs of C1 700 000 and C300 000. If so, the grant would be apportioned between the
acquisition of the land, C510 000 (C600 000 x C1 700 000 / C2 000 000), and the clearing of the land, C90 000.
Compare this example to example 5, where an allocation was not possible because the future costs were immeasurable.
x However, since land is non-depreciable, it would be recognised as grant income immediately (assuming that this
portion of the grant did not become repayable if the second condition was not met) and the remaining C90 000 would
be deferred and recognised as grant income and when the related costs are incurred. Please note, that although the
entity’s accounting policy is to recognise grants as a credit to the asset, this does not apply in the case of an asset that is
non-depreciable, because that would mean the grant would never be recognised in profit or loss.

Bank (A) 600 000
Government grant received to assist in the acquisition of land
14 November 20X1
Land: cost (A) 1 700 000
Bank (A) 1 700 000
Purchase of land
Chapter 15 753
14 November 20X1 continued … Debit Credit

Deferred grant income (L) C600 000 x C1 700 000 / C2 000 000 510 000
Recognising a portion of the grant as income when land is acquired
(condition 1 is met)
31 December 20X1
Clearing vegetation expense (E) Given 100 000
Bank (A) 100 000
Costs incurred in clearing alien vegetation from the land
Deferred grant income (L) C600 000 x C100 000 / C2 000 000 30 000
Recognising a portion of the grant as income as and when the costs of
clearing the vegetation are incurred (condition 2 is partially met)
31 January 20X2
Clearing vegetation expense (E) 200 000
Bank (A) 200 000
Costs incurred in clearing alien vegetation from the land
Deferred grant income (L) C600 000 x C200 000 / C2 000 000 70 000
Recognising the balance of the grant as income when the final costs of
meeting the secondary condition are incurred (condition 2 is met)

a depreciable asset
The government grants an entity a cash sum of C120 000 on 1 January 20X1, (due to certain pre-
conditions having been met in 20X0), to assist in the acquisition of land. A condition of the grant
is that the company builds a factory on the land:
x the land was acquired on 1 January 20X1 for C200 000 and is not depreciated;
x the factory was completed on 31 March 20X1 (total building costs of C900 000 were
paid in cash on this date), was available for use immediately and has a useful life of
3 years and a nil residual value.
The acquisition of the land was considered incidental to the cost of constructing the factory and thus the entity
did not consider it appropriate to recognise the grant based on two separate conditions.
Required: Show the journal entries in the year ended 31 December 20X1 assuming that the company’s
policy is to recognise grants as a credit to the asset.
Solution 7: Monetary grant involves a non-depreciable asset and a depreciable asset

Comment:
x This example deals with the situation where a grant was received with two conditions: the acquisition of a
non-depreciable asset and construction of a depreciable asset, but where the two stipulated conditions were
considered effectively to be one condition.
x Thus, the entire grant received will be recognised as income when the costs incurred in meeting the main condition
(construction of the factory) are recognised as expenses in profit or loss. In other words, the grant is recognised as
income over the life of the building. See IAS 20.18

Bank (A) 120 000
Government grant received to assist in the acquisition of land
1 January 20X1
Bank (A) 200 000
Purchase of land
31 March 20X1
Factory building: cost (A) 900 000
Bank (A) 900 000
Construction costs related to factory building, paid in cash
754 Chapter 15

Depreciation: factory building (E) (900 000 – 0) / 3 years x 9/12 225 000
Factory building: acc depreciation (-A) 225 000
Depreciation on factory
Deferred grant income (L) 120 000/ 3 yrs x 9/12 30 000
Deferred grant income amortised to profit or loss
3.4.4 Presentation of a grant related to assets (IAS 20.24)
Grants related to assets can be presented on the statement of financial position either:
x Gross, as deferred grant income, or
x Net, as a reduction of the carrying amount of the related non-monetary asset. See IAS 20.24
Although the presentation in the statement of financial position can be presented on either a
gross or net basis, the statement should ideally show the deferred grant income and the asset
acquired gross (i.e. separately).
The presentation in the statement of cash flows of the receipt of the grant is ideally shown
separately from the outflow relating to the acquisition of the related asset. See IAS 20.28
3.5 Grants related to loans (IAS 20.10 – .10A)
3.5.1 Overview of grants related to loans

A forgivable loan is defined as
Grants needs not be in the form of an asset – the grant a loan:
could consist of a waiver of debt or a cheap loan. These
are referred to as: x the repayment of which the lender
may waive
x forgivable loans, and
x assuming certain conditions are
x low-interest loans. met. IAS 20.3 Reworded
3.5.2 Recognition of grants related to loans (IAS 20.10 and .10A)
A forgivable loan from government is accounted for as a

government grant when there is reasonable assurance A low interest loan is a loan:
that the entity will meet the necessary conditions for the x at an interest rate that
repayment to be waived. IAS 20.10 (reworded) x is lower than market-related
interest rates. See IAS 20.10
The benefit of a low-interest loan received from
government is recognised as a grant in profit or loss in a manner that takes into account ‘the
conditions and obligations that have been, or must be, met when identifying the costs for
which the benefit of the loan is intended to compensate’. See IAS 20.10A
3.5.3 Measurement of grants related to loans Measurement of the related

grants:
A forgivable loan from government that is recognised as x Forgivable loan: measured as

a grant is measured at the amount that is reasonably amount reasonably assured of
assured of being forgiven (waived). See IAS 20.10 being waived.
x Low-interest loan: measured as the
A low-interest loan received from government must be difference between:
measured in terms of IFRS 9 Financial instruments. The the CA in terms of IFRS 9 &
benefit of the low-interest rate is recognised as a the amount received.
government grant, and measured at the difference between the carrying amount (measured in
terms of IFRS 9) and the actual loan proceeds received. See IAS 20.10A
Chapter 15 755
The amount of the grant is then ‘recognised in profit or loss on a systematic basis over the
period/s in which the entity recognises as expenses the costs for which the grant is intended to
compensate’. See IAS 20.16
3.5.4 Presentation of grants related to loans
Grants related to loans received from government could be presented as:

x Grant income; or
x A decrease in the interest expense (e.g. in the case of a low-interest loan).
Notice how the effect on overall profits will always be the same under either option.
Example 8: Grant related to a forgivable loan

A company receives a cash loan of C100 000 on 1 January 20X1:
x 40% of the loan is forgivable from the date on which certain conditions are met.
x Interest is charged at the market rate of 10% and is payable annually.
Required:
A. Show the journal entries for the year ended 31 December 20X1 assuming that the conditions had
all been met by 1 January 20X1.
B. Show the journal entries for the year ended 31 December 20X1 assuming that the conditions had
all been met by 30 September 20X1.
Solution 8A: Grant related to a forgivable loan – conditions met on receipt

Comment: Note how no interest is recognised on the portion of the loan that is forgiven.
Bank Given 100 000
Grant income (I) 40% x 100 000 40 000
Loan: government (L) 100 000 – 40 000 60 000
Government loan raised: 40% forgivable on date of receipt since all
conditions for waiving have already been met – therefore recognised as
income immediately
31 December 20X1
Interest expense (E) 100 000 x (100% - 40% forgiven) x 10% 6 000
Bank 6 000
Interest on only 60% of the government loan (the rest is ‘forgiven’)
Solution 8B: Grant related to a forgivable loan - conditions met later

Comment: Notice how the date on which the loan is forgiven (waived) affects the interest calculation:
x Interest is recognised on the original full amount of the loan up to the date on which the conditions are
met and a portion of the loan is forgiven.
x Thereafter, interest expense is recognised on the reduced loan balance.
Bank Given 100 000
Loan: government (L) 100 000
Government loan raised: 40% forgivable if certain conditions are met
30 September 20X1
Loan: government (L) 100 000 x 40% 40 000
40% of the loan is forgivable now that the conditions are met
31 December 20X1
Interest expense (E) 100 000 x 10% x 9 / 12 + 9 000
Bank (100 000 – 40 000) x 10% x 3/12 9 000
Interest on 100% of the government loan to 30 September and on 60%
after this date (40% of the loan having been waived)
756 Chapter 15
Example 9: Grant related to a low-interest loan

An entity receives a government loan of C100 000 on 1 January 20X1:
x interest of 8% is charged
x the market interest rate is 10%.
x the capital and interest is repayable in one single instalment on 31 December 20X3.
The entity does not intend to trade this loan and it was not designated as fair value through profit or
loss on acquisition. The loan is therefore measured at amortised cost.
Required:
A. Show the journal entries for the year ended 31 December 20X1 assuming that the low interest rate
was granted on certain conditions and that these conditions had all been met by 1 January 20X1.
B. Show the journal entries for the year ended 31 December 20X1 assuming that the low interest rate
was granted to meet general running costs over a 2-year period and that the company policy is to
recognise grants as a credit to income.
C. Show the journal entries for the year ended 31 December 20X1 assuming that the low interest rate
was granted to meet salary costs over a 2-year period and that the company policy is to recognise
grants as a credit to the related expense.
Solution 9: Grant related to a low-interest loan – general calculations
Comment: The amortised cost must be calculated per IFRS 9.

x Per IFRS 9, the future value of a loan payable in a single instalment is the principal amount (C100 000)
plus interest for n years (n = 3) at the coupon rate (coupon rate = 8%).
W1. Calculation of the instalment due on 31 December 20X3

Effective interest rate table using the actual rate of interest: 8%
Year Opening balance Interest charged Repayment Closing balance
20X1 100 000 8000 108 000
20X2 108 000 8640 116 640
20X3 116 640 9331 125 971
31/12/20X3 (125 971) 0
25 971 (125 971)
W2. Calculation of the present value of the instalment due on 31 December 20X3
Year Payments PV factor for 10% (mkt int rate) Present value
31/12/20X1 0 0.909091 0
31/12/20X2 0 0.826446 0
31/12/20X3 125 971 0.751315 1 / 1.13 = 0.751315 94 644
94 644
Or using a financial calculator: n = 3 i = 10 FV = 125 971 Comp PV = 94 644
W3. Effective interest rate table:

using the CA of the instrument (W2) and the market interest rate: 10%
Year O/balance Interest @ 10% Repayment C/ balance
20X1 (W2)
94 644 9 464 104 108
20X2 104 108 10 411 114 519
20X3 114 519 11 452 125 971
31/12/20X3 (125 971) 0
31 327 (125 971)
Solution 9A: Grant related to a low-interest loan: all conditions met

Bank Given 100 000
Loan: government (L) W2 94 644
Grant income (I) Amt received: 100 000 – CA: 94 644 5 356
Government loan raised at 8% interest when market rate is 10%. All
conditions to this low-interest rate loan were met on date of receipt so
the low-interest benefit is recognised in profit or loss immediately
Chapter 15 757

Interest expense (E) W3 9 464
Interest on the government loan calculated at the market interest rate
Comment:
x The effect on profit or loss will be as follows:
Interest expense over 3 years: 9 464 + 10 411 + 11 452 31 327
Grant income: recognised in full in 20X1 20X1: 5 356 (5 356)
25 971
Solution 9B: Grant related to a low-interest loan: conditions met later: credit to income
Bank Given 100 000
Deferred grant income (L) Amt received: 100 000 – CA: 94 644 5 356
Government loan raised at 8% interest when market rate is 10%.
Conditions to this low-interest loan were not met on date of receipt so
the low-interest benefit is first credited to deferred income
Deferred grant income (L) 5 356 / 2 years 2 678
Grant credited to income over the 2-year condition: first year met
Comment:
Interest expense over 3 years: 9 464 + 10 411 + 11 452 31 327
Grant income recognised in full: 20X1 – 20X2 20X1: 2 678 + 20X2: 2 678 (5 356)
25 971
Solution 9C: Grant related to a low-interest loan: conditions met later: credit to expense
Bank Given 100 000
Deferred grant income (L) Amt received: 100 000 – CA: 94 644 5 356
Government loan raised at 8% interest when market rate is 10%.
Conditions to this loan were not met on date of receipt so the low-interest
benefit is first deferred
Salary expense (E) 2 678
Grant credited to related expense over the 2 yr condition: first year met
Comment:
Interest expense over 3 years: (9 464 + 10 411 + 11 452 31 327
Decrease in salary expense 20X1: 2 678 + 20X2: 2 678 (5 356)
25 971
758 Chapter 15
3.6 Grants received as a package (IAS 20.19)
A grant may be received as a package deal, being a grant designed to provide financial relief
for a combination of items, for example:
x A portion of the grant may be cash to cover past expenses;
x A portion of the grant may be cash to cover immediate financial support;
x A portion of the grant may be cash to cover future expenses;
x A portion of the grant may be cash to cover the cost of an asset; and / or
x A portion of the grant may be a non-monetary asset.
Each of the abovementioned portions of the grant may also come with their own unique set of
conditions. Depending on the materiality of each of these portions, it may be more
appropriate to recognise each portion in the grant package on a different basis, depending
what the grant relates to (as explained in earlier sections and examples 5 - 7).
Each portion of a grant package is generally recognised separately, for example, the part of
the grant that relates to:
x past expenses should be recognised in profit or loss:
in the same period that the grant becomes receivable and conditions are met; See IAS 20.20
x general and immediate financial support should be recognised in profit or loss:
in the same period that the grant becomes receivable and conditions are met; See IAS 20.20
x future expenses should be recognised in profit or loss:
in a way that reflects the pattern of future expenses; and
x an asset should generally be recognised in profit or loss:
in a way that reflects the pattern of depreciation.
Example 10: Grant is a package deal

A company receives a cash grant of C120 000 on 1 January 20X1. The grant relates to 2
items:
x C30 000 is a cash sum as immediate financial support with no associated future costs;
x C90 000 is a cash sum to assist in the future acquisition of certain vehicles.
The vehicles were acquired on 2 January 20X1 for C210 000:
x The vehicles were available for use immediately.
x The vehicles each have a useful life of 3 years.
x The vehicles each have nil residual values.
With the exception of the purchase of the vehicles, all conditions attaching to the grant had all been met
on date of receipt.
The company policy is to recognise government grants as grant income.
Required: Show the journal entries in the year ended 31 December 20X1.
Solution 10: Grant is a package deal

Comment: Note how journal narrations are used to explain journal entries and provide additional detail.

Bank Total grant received = given 120 000
Grant income (I) Immediate financial support = income 30 000
Deferred grant income (L) Attached to a future condition = deferred 90 000
Recognising a government grant package deal:
x Portion of the grant relates to immediate financial support with no
conditions attached: recognise income immediately: 30 000
x Portion of the grant relates to acquiring an asset: deferred: 90 000
Chapter 15 759

Vehicles: cost (A) 210 000
Bank 210 000
Purchase of vehicles
31 December 20X1
Depreciation: vehicles (E) (210 000 – 0) / 3 years 70 000
Vehicles: accumulated depreciation (-A) 70 000
Depreciation of vehicles
Portion of grant income related to purchase of vehicles recognised on
the same basis as vehicle depreciation (i.e. over 3 years)
4. Changes in Estimates and Repayments (IAS 20.32 - .33)
A change in estimate may be required:

x If the grant is received after acquisition of a related asset (i.e. this may change the cost of
the asset in which case the depreciable amount will change if the grant is credited to the
asset’s cost account)
x If the grant is provided on certain conditions and these conditions are later breached
causing the grant to be retracted, requiring the entity to repay some or all of the grant.
Repayments of government
Where a change in estimate is caused by having to repay grants are accounted for as:
some of the grant, or the entire grant, the change in x changes in estimates (IAS 8)
estimate must be accounted for using IAS 8. x using the cumulative catch-up
method to account for any
If the grant relates to a depreciable non-monetary asset, additional depreciation that would
the cumulative additional depreciation on this asset that have been recognised had there
been no grant. See IAS 20.32
would have been recognised to date had the grant not
been received, is then recognised immediately as an expense. In other words, IAS 20 requires,
in the case of an effect on depreciation, that we use the cumulative catch-up method of
accounting for the change in estimate. See IAS 20.32
Where a grant becomes repayable, the treatment depends on whether the grant related to
expenses or assets.
If the original grant related to expenses, the repayment of the grant (credit bank) is:
x first debited against the balance in the deferred income account, if any; and
x then debited to profit or loss (if a further debit is required). See IAS 20.32
If the original grant related to an asset, the repayment of the grant (credit bank) is either:
x debited against the balance on the deferred income account, if any; or
x debited to the balance on the asset account. See IAS 20.32
If we have to repay a grant that related to a non-monetary asset, and as a result had to debit
the asset's cost account with the amount of the repayment, we will have effectively increased
its carrying amount. We thus need to check whether the asset's carrying amount has increased
above its recoverable amount.
If the asset’s carrying amount has increased above its recoverable amount, it will need to be
adjusted by processing an impairment loss. Please watch out for this! Impairments are
explained in more detail in Chapter 11. See IAS 20.33
760 Chapter 15
Example 11: Grant related to expenses – repaid

The local government granted a company C10 000 on 1 January 20X1 to assist in the
financing of mining expenses. The grant was conditional upon the company mining for a
period of at least 2 years.
The company ceased mining on 30 September 20X2 due to unforeseen circumstances.
The terms of the grant required that the grant be repaid in full, immediately.
Mining expenses incurred to date were as follows:
x 20X1: 80 000
x 20X2: 60 000
The company’s year-end is 31 December.
Required: Show the journal entries in 20X1 and 20X2:
A. Assume that the company recognises grants as deferred grant income.
B. Show how your answer to Part A would change if grants were recognised by reducing the related
expense instead.
Solution 11: Grant related to expenses – repaid

Comment: This example shows that when a grant is forfeited, the repayment is first debited to the deferred
income account, if it still has a balance, and any further debit required is then recognised in profit or loss.
x In Part A, the further debit is processed in profit or loss by recognising a reversal of income account;
x In Part B, the further debit is processed in profit or loss by recognising an expense.
Part A Part B
1 January 20X1 Dr (Cr) Dr (Cr)
Bank 10 000 10 000
Recognising a government grant intended to reduce future expenses
31 December 20X1
Mining expenses (E) 80 000 80 000
Bank/ Accounts payable (80 000) (80 000)
Mining expenditure incurred
Deferred grant income (L) 10 000 / 2 years x 1 year 5 000 N/A
Grant income (I) (5 000)
Recognising part of the grant in profit or loss since 1 of the 2-year
condition is met: recognised as income (part A)
Deferred grant income (L) 10 000 / 2 years x 1 year N/A 5 000
Mining expenses (E) (5 000)
Recognising part of the grant in profit or loss since 1 of the 2-year
condition is met: recognised as a reduced expense (part B)
30 September 20X2
Mining expenses (E) 60 000 60 000
Bank/ Accounts payable (60 000) (60 000)
Mining expenditure incurred
Deferred grant income (L) 10 000 / 2 years x 9 / 12 3 750 N/A
Recognising part of the grant in P/L since a further 9 months of the 2-
year condition is met: recognised as income (part A)
Deferred grant income (L) 10 000/2 years x 9 / 12 N/A 3 750
Mining expenses (E) (3 750)
Recognising part of the grant in P/L since a further 9 months of the 2-
year condition is met: recognised as a reduced expense (part B)
Chapter 15 761
Part A Part B
30 September 20X2 continued … Dr (Cr) Dr (Cr)
Deferred grant income (L) Balance in this acc: 10 000 – 5 000 – 3 750 1 250 N/A
Grant income reversed (E) 10 000 – 1 250 8 750
Bank 100% of the grant received is repayable (10 000)
Repayment of grant in full on cessation of mining (breach of
conditions): Pmt first reduces any deferred income balance and any
balance is recognised in P/L as a reduction of grant income
Deferred grant income (L) Balance in this acc: 10 000 – 5 000 – 3 750 N/A 1 250
Mining expense (E) 10 000 – 1 250 8 750
Bank 100% of the grant received is repayable (10 000)
Repayment of grant in full on cessation of mining (breach of
conditions): Pmt first reduces any deferred income balance and any
balance is recognised in P/L as an increase in expenses
Example 12: Grant related to assets – repaid

The local government granted a company C10 000 on 1 January 20X1 to assist in the
purchase of a manufacturing plant.
The grant was conditional upon the company:
x purchasing the plant, and
x manufacturing for a period of at least two unbroken years.
If the conditions of the grant were not met, the terms of the grant required that the grant be repaid in
full, immediately.
The plant was:
x purchased on 2 January 20X1 for C100 000; and was
x depreciated on the straight-line basis over its useful life of 4 years to a nil residual value.
Other information:
x The company ceased manufacturing on 30 September 20X2 due to unforeseen circumstances.
x The asset was not considered to be impaired and the company intended to resume manufacturing in
the next year.
Required:
Show the journal entries relating to the grant for the year ended 31 December 20X1 and up until 30
September 20X2 assuming that:
A. the company recognises grants as grant income.
B. the company recognises grants as a reduction of the cost of the related asset.
Solution 12: Grant related to assets – repaid
Comment: First of all, please notice, in both parts, that the deferred grant income is recognised in profit or
loss in a manner that reflects the period over which the cost of the asset is recognised as an expense even
though the condition was simply a 2-year condition.
x Part A shows that a grant that is forfeited must first be reversed out of the deferred income account,
assuming it has a balance, and any remaining debit is expensed. The principle behind the repayment of
the 10 000 in this example is the same as in example 11A: it is first debited to the ‘deferred grant
income acc’ (reversing any balance in this account) and any excess payment is then debited to a ‘grant
income reversed expense account’.
x In Part B, the deferred income account had no balance remaining on the date of repayment (since it had
all been transferred to the asset on 2 January 20X1), and therefore the full amount repaid was simply
debited to the cost of the asset.
x Notice that the effect on profit or loss is the same in each year irrespective of the policy applied.
762 Chapter 15
Part A Part B
Bank 10 000 10 000
Recognising a government grant
2 January 20X1
Plant: cost (A) 100 000 100 000
Accounts payable/ bank (100 000) (100 000)
Purchase of plant
Deferred grant income (L) N/A 10 000
Recognising grant income as a credit to the asset
31 December 20X1
Deferred grant income (L) A: 10 000 / 4 years x 12 / 12 2 500 N/A
Recognising 25% of the government grant since the grant relates to the
acquisition of an asset that is depreciated over 4 years
Depreciation: plant (E) A: (100 000 – 0) / 4 years x 12 / 12 25 000 22 500
Plant: acc depr (-A) B: (100 000 – 10 000 – 0) / 4 years x 12 / 12 (25 000) (22 500)
30 September 20X2
Deferred grant income (L) A: 10 000 / 4 years x 9 / 12 1 875 N/A
Recognising 9 months of the remaining 75% of the government grant
to the date of repayment of the grant
Deferred grant income (L) A: Bal in this acc: 10 000 – 2 500 – 1 875 5 625 N/A
Grant income reversed (E) A: 10 000 – 5 625 4 375
Bank A: 100% of the grant received is repayable (10 000)
Repayment of the full grant required (10 000) when mining ceased
(breach of conditions), first reducing the balance on the deferred
income account (5 625) and then expensing the rest (4 375)
Plant: cost (A) B: debit to asset (since originally credited) N/A 10 000
Bank B: 100% of the grant received is repayable (10 000)
Repayment of the full grant due to breach of the grant condition
31 December 20X2
Depreciation: plant (E) A: (100 000 – 0) / 4 years x 12/ 12 25 000 22 500
Plant: acc depr (-A) B: (100 000 – 10 000 – 0) / 4 years x 12/ 12 (25 000) (22 500)
Depreciation of plant (the plant is idle from 30 September 20X2 but
depreciation does not cease)
Depreciation: plant (E) B: 10 000 / 4yrs x 2 yrs N/A 5 000
Plant: acc depr (-A) (5 000)
Extra cumulative depreciation that would been expensed on this extra
plant cost is now recognised (IAS 8: cumulative catch-up method)
5. Deferred Tax
5.1 Overview
The deferred tax consequences of receiving a government grant depend on a variety of factors:
x if the government grant is exempt from tax; or
x where a grant relates to the acquisition of an asset, whether tax deductions (e.g. wear and
tear) will be granted on this underlying asset.
Chapter 15 763
These consequences will be discussed under the following headings:

x Grants related to income:
– for immediate financial support or past expenses,
– for future expenses; and
x Grants related to assets.
5.2 Grants related to income
5.2.1 Grant for immediate financial support or past expenses: taxable
If the grant for immediate financial support is taxable, it will:

x be recognised as income, in full, in profit before tax (accounting purposes); and
x be recognised as income, in full, in taxable profit (taxation purposes).
Since the grant forms part of both sums, there will be no deferred tax consequences at all.
5.2.2 Grant for immediate financial support or past expenses: not taxable (i.e. exempt)
If the grant of immediate financial support is exempt from tax, it will:

x be recognised as income, in full, in profit before tax (accounting purposes); but will
x never be recognised as income in taxable profit (taxation purposes).
The amount received will thus cause a permanent difference in the current tax calculation.
Since the difference is permanent and not temporary, there will be no deferred tax
consequences.
5.2.3 Grant to assist with future expenses: taxable
If the grant related to future expenses is taxable upon receipt, it will:

x be recognised as income in profit before tax (accounting records) in future years; but
x be recognised as income in taxable profit (taxation purposes) now.
The accounting treatment of a grant such as this would have given rise to deferred grant
income (a liability account). The treatment of this for deferred tax purposes is the same as that
for income received in advance i.e. there is a carrying amount but the tax base will be zero.
Since the carrying amount and tax base differ and since this difference will reverse in future
periods when the deferred grant income is recognised as grant income in the accounting
records, the difference is said to be a temporary difference. Since we have a temporary
difference, we have deferred tax to account for.
Example 13: Deferred tax: grant relating to future expenses: taxable

On 1 January 20X1, an entity received a government grant of C10 000 in cash, after having
successfully complied with certain conditions in 20X0. The grant was received for the
purpose of contributing towards 10% of future specified wages that must total C100 000.
Thus, all conditions attaching to the grant (with the exception of the incurrence of the future wages) had
all been met on date of receipt.
In 20X1, the entity's profit before tax was C100 000, after incurring C20 000 of the required wages.
The grant received is taxable in the year in which it is received at a tax rate of 30%.
Required: Show the tax journals for the year ended 31 December 20X1.
Solution 13: Deferred tax: grant relating to future expenses: taxable

Comment: For deferred tax purposes, it does not matter whether the grant income is recognised indirectly
by being recognised as a credit against the expense or directly by being credited to a separate income
account. This is because deferred tax is based on the asset and liability balances in the SOFP.
764 Chapter 15
Solution 13: Deferred tax: grant relating to future expenses: taxable

Income tax expense: income tax (E) W1 32 400
Current tax payable (L) 32 400
Current income tax for 20X1 estimated
Deferred tax: income tax (A) W2 2 400
Tax expense: income tax (P/L) 2 400
Deferred tax on deferred grant income
W1: Current income tax 20X1

C
Profit before tax Given: (X – wages: 20 000 + grant income: 2 000 = 100 000) 100 000
Less grant income recognised Grant: 10 000 x Conditions met: 20 000 / 100 000 (wages) (2 000)
Add taxable grant income Grant is fully taxable when received 10 000
Current income tax 32 400
W2: Deferred income tax

Deferred grant income
Balance: 1/1/20X1 0 0 0 0
Grant income deferred (10 000) 0 10 000
2 400 Dr DT Cr TE
Grant income recognised 2 000 0 (2 000)
(1)
Balance: 31/12/20X1 (8 000) 0 8 000 2 400 A
(1) TB = CA – any amount which will not be taxable in future periods (the entire carrying amount will not be
taxable in future periods as it is taxable now), therefore TB = 0.
5.2.4 Grant to assist with future expenses: not taxable (i.e. exempt)
The grant received will initially be recognised as deferred grant income (a liability account).
If the grant is exempt from tax, however, the tax base for this liability will immediately (on
grant date) be nil (the tax base representing the portion that will be taxed in the future).
This therefore creates a temporary difference on initial recognition (which affects neither
accounting profit nor taxable profit). Such temporary differences are exempt from deferred
tax in terms of IAS 12 (i.e. there will be no deferred tax journal entries). See IAS 12.15
When calculating current income tax, remember that any grant income included in profit
before tax that is not taxable will need to be reversed, because that income is exempt from
tax. This will lead to the presentation of a reconciling item in our tax rate reconciliation.
Example 14: Deferred tax: grant relating to future expenses: exempt

Use the information in example 13 but assume that the grant is exempt from tax (i.e. it is
not taxable).
Required: Show the tax journals for the year ended 31 December 20X1.
Solution 14: Deferred tax: grant relating to future expenses: exempt

Income tax expense: income tax (E) W1 29 400
Current tax payable (L) 29 400
Current income tax for 20X1 estimated
Chapter 15 765
W1: Current income tax C

Profit before tax Given: (X – wages: 20 000 + grant income: 2 000 = 100 000) 100 000
Less grant income recognised Grant: 10 000 x Conditions met: 20 000 / 100 000 (wages) (2 000)
Add taxable grant income Nil – exempt from tax 0

Deferred grant income
Balance: 1/1/20X1 0 0 0 0
Grant income deferred (10 000) 0 10 000 0 Exempt: IAS 12.15
Grant income recognised 2 000 0 (2 000) 0 Exempt: IAS 12.15
(1)
Balance: 31/12/20X1 (8 000) 0 8 000 0 Exempt: IAS 12.15
(1) TB = CA – the amount that will not be taxed in future periods (the entire carrying amount will not be
taxable in future periods as it is exempt)
Comment: Note that in ex. 13, the tax base was also nil but the temporary difference was not exempt.
x In example 13, the tax base is nil because the grant had immediately been recognised as taxable income
(and was thus included in taxable profit).
x In example 14, it is the initial tax base that is nil: the tax base is nil because no portion of the grant will
ever be taxed. Thus the resulting temporary difference, which arose on initial recognition, did not affect
taxable profits. It also did not affect accounting profits (debit bank, credit deferred income liability).
Where a temporary difference arises on initial recognition that affects neither accounting profit nor
taxable profit, the temporary difference is exempted from deferred tax. See IAS 12.15
5.3 Grants related to assets

5.3.1 Grants related to assets: taxable
Deferred tax will arise if the grant relating to an asset is taxable. This is irrespective of
whether the government grant is recognised as deferred grant income or as a credit against the
carrying amount of the asset:
x If it is credited to deferred grant income (liability), deferred tax will arise on this liability
account (similar to example 13) and the related asset account (e.g. plant).
x If it is credited to the related asset account, deferred tax will arise solely on this asset
account (and remember that depreciation will now be lower than if a deferred grant
income account had been created).
Example 15: Deferred tax: cash grant relating to asset: taxable
A company receives C12 000 from the government on 1 January 20X1 to help buy a plant.
x The grant was received after compliance with certain conditions in 20X0 (the prior year).
x All conditions attached to the grant, with the exception of the acquisition of the plant,
had all been met on date of receipt.
The plant:
x was acquired on 2 January 20X1 for C90 000;
x was available for use immediately, has a useful life of 3 years and has a nil residual value.
The tax rate is 30% and the tax authorities tax the grant as income in the year of receipt and allow the
cost of the plant (i.e. 90 000) to be deducted over 5 years.
Profit before tax (correctly calculated) was C100 000 for 20X1.
There are no other temporary differences, exempt income or non-deductible expenses other than those
Required: Show the tax journals and tax expense note for the year ended 31 December 20X1, assuming:
A. The company has a policy of recognising government grants as deferred grant income.
B. The company has a policy of recognising government grants as a credit to the related asset.
766 Chapter 15
Solution 15: Deferred tax: cash grant relating to asset – taxable
Comments in general:
x This example involves the grant being taxable and the related plant being deductible. It compares the
situation where the grant is:
credited to deferred income (finally recognised in profit or loss as grant income); and
credited to the asset (finally recognised in profit or loss as a reduced depreciation charge).
x Either way, the grant is recognised in profit or loss over a period of time and the grant income will also
be recognised in taxable profit. Since this can only lead to possible temporary differences (no exempt
income), no rate reconciliation will be required in the tax expense note.
W1: Current income tax Part A Part B

Profit before tax Given: (X – depr + grant income = 100 000) 100 000 100 000
Less grant income in profit 15A: 12 000 / 3 yrs; 15B: not applicable (4 000) 0
Add depreciation in profit 15A: 90 000 / 3yrs; 15B: (90 000 – 12 000) / 3yrs 30 000 26 000
Less wear and tear 15A & 15B: 90 000 / 5 years (18 000) (18 000)
Add taxable grant income Total grant taxable when received 12 000 12 000
Taxable profit 120 000 120 000
Current income tax Taxable profit x 30% 36 000 36 000
W2: Deferred tax for 15A only:

Comment: In 15A, there are 2 deferred tax workings that will be required because there are two balances
affected by the grant: 1) deferred grant income, and 2) the plant purchased.
W2.1 DT on deferred income CA TB TD DT

Balance: 1/1/20X1 0 0 0 0
Grant income deferred (12 000) 0 12 000
(1) 2 400 Dr DT Cr TE
Grant income recognised 4 000 0 (4 000)
(2)
Balance: 31/12/20X1 (8 000) 0 8 000 2 400 Asset
(1) Grant income recognised in 20X1: 12 000 x 1/3 (recognised at year end)
(2) TB = CA – any amount which will not be taxable in future periods (the entire carrying amount will not be
taxable in future periods as it is taxable now – P.S. this means it affects taxable profit and thus the
resulting temporary difference of 12 000 is not an exempt temporary difference).
W2.2 Deferred tax on plant CA TB TD DT

Balance: 1/1/20X1 0 0 0 0
Purchase 90 000 90 000 0 0
(1) (2)
Balance: 31/12/20X1 60 000 72 000 12 000 3 600 Asset
(1) Depreciation: (90 000 – RV: 0) / 3 years x 12/12 = 30 000

(2) Deduction (wear and tear): 90 000 / 5 years = 18 000
W3: Deferred tax for 15B only:

Comment: There is no deferred tax working for deferred grant income as no deferred grant income was
raised: the grant received was simply credited to the related asset (plant). The deferred tax will therefore
arise purely from the plant.
W3.1: Deferred tax on plant CA TB TD DT

Balance: 1/1/20X1 0 0 0 0
Purchase 90 000 90 000 0 0
Grant received (12 000) 0 12 000
(1) (2)
Balance: 31/12/20X1 52 000 72 000 20 000 6 000 Asset
(1) (90 000 - 12 000 – RV: 0) / 3 years x 12/12 =26 000

(2) Deduction (wear and tear): 90 000 / 5 years = 18 000
Chapter 15 767
Journals: Part A Part B

Tax expense: income tax (E) W1 36 000 36 000
Current income tax payable (L) (36 000) (36 000)
Deferred tax: income tax (A) 15A: W2.1; 15B: N/A 2 400 N/A
Tax expense: income tax (E) (2 400) N/A
Deferred tax: income tax (A) 15A: W2.2; 15B: W3.1 3 600 6 000
Tax expense: income tax (E) (3 600) (6 000)
Deferred tax on plant
Disclosure:
Company name
Part A Part B
5. Income taxation expense C C
x Current W1 or journals 36 000 36 000
x Deferred W2 & 3 or journals (6 000) (6 000)
Tax effects of:
x Profit before tax 100 000 x 30% 30 000 30 000
x Reconciling items 0 0
Tax expense charge per statement of comprehensive income 30 000 30 000
Effective tax rate 30 000 / 100 000 30% 30%
5.3.2 Grants related to assets: not taxable (i.e. exempt)
The grant received will initially be recognised as a credit to the related asset (e.g. the plant
cost account) or a credit to deferred grant income.
If the grant is exempt from tax, however, the tax base for this credit will immediately be nil
(the tax base representing the portion that will be taxed in the future).
This therefore creates a temporary difference on initial recognition, which affects neither
accounting profit nor taxable profit. Temporary differences that arise on initial acquisition
and affect neither accounting profit nor taxable profit are exempt from deferred tax in terms
of IAS 12.15 (i.e. there will be no deferred tax journal entries).
Thus, grants that are not taxable (i.e. exempt from income tax) will not lead to deferred tax
because the resulting temporary differences are exempt from deferred tax.
The only deferred tax which will result is in the difference between depreciation (calculated
on the cost of the asset and ignoring the grant received) and the related tax deductions.
When calculating the current income tax, remember that any grant income included in profit
before tax by way of a reduced depreciation charge will lead to a permanent difference. In
other words, the reduction in depreciation will appear in the tax expense note as a reconciling
item.
768 Chapter 15
Example 16: Deferred tax: Cash grant relating to asset: not taxable
Use the same information as in example 15 except that the tax authorities:
x Do not tax the receipt of the grant; and
x Allow the deduction of the cost of the plant (i.e. 90 000) over 5 years.
Required: Show the tax journals and the tax expense note for the year ended 31 December 20X1
assuming that the company has the policy of recognising government grants as a credit to the related
asset (i.e. as in example 15B)
Solution 16: Deferred tax: cash grant relating to asset: not taxable
Journals
Tax expense: income tax (E) W1 32 400
Current income tax payable (L) 32 400
Deferred tax: income tax (A) W2 3 600
Tax expense: income tax (E) 3 600
Disclosure:
Entity name
20X1
5. Income taxation expense C
x Current W1 32 400
x Deferred W2 (3 600)
Tax expense per the statement of comprehensive income 28 800
Tax effects of:
x Profit before tax 100 000 x 30% 30 000
x Exempt temporary difference:
- depreciation reduction due to exempt grant 4 000 (W2) x 30% (1 200)
Tax expense charge per statement of comprehensive income 28 800
Effective tax rate 28 800 / 100 000 28.8%
Workings:
20X1
W1: Current income tax C
Profit before tax Given: (X – depr + grant income = 100 000) 100 000
Add depreciation (90 000 – 12 000) / 3yrs 26 000
Less wear and tear 90 000 / 5 years (18 000)
Add taxable grant income Nil – exempt from tax 0
W2: Deferred tax: plant CA TB TD DT

Balance: 1/1/20X1 0 0 0 0
Purchase 90 000 90 000 0 0
(1)
Grant received (12 000) 0 12 000 0 Exempt
(2) (2)
Depreciation/ deduction (26 000) (18 000)
- Cost (3)
(30 000) (18 000) 12 000 3 600 Dr DT Cr TE
- Grant (4)
4 000 0 (4 000) (5)
0 Exempt
Balance: 31/12/20X1 52 000 72 000 20 000 3 600 Asset
Chapter 15 769
Calculations supporting W2:

(1) The credit to the asset is exempt income from a tax perspective: since the credit affects neither
accounting profit nor taxable profit, the temporary difference is exempt from deferred tax.
(2) (90 000 - 12 000 – RV: 0) / 3 years x 12/12 = 26 000
(3) Depreciation on cost: (90 000 – RV: 0) / 3 years x 12/12 = 30 000
(4) Depreciation reduced due to exempt grant income: 12 000 / 3 years x 12/12 = 4 000
(5) The reduction in the depreciation charge of 4 000, which is caused by the grant, results in a further
exemption in the opposite direction (it is simply the ‘unwinding’ of the original exemption of
12 000 that will occur over the 4 years).
6. Disclosure (IAS 20.39)
The following issues must be disclosed:

x Accounting policy regarding both recognition and method of presentation, for example:
- Government grants are recognised in profit or loss over the period to which the grant
applies and in a manner that reflects the pattern of expected future expenditure; and
- The grant is presented as a decrease in the expenditure to which it relates (or: the
grant is presented as a separate line item: grant income);
x The nature and extent of government grants recognised in the financial statements;
x An indication of other forms of government assistance not recognised as government
grants but from which the entity has benefited directly (e.g. low- or no-interest loans and
assistance that cannot reasonably have a value placed upon them); and
x Unfulfilled conditions and other contingencies attached to recognised government grants.
Example 17: Disclosure of government grants

A government grant of C250 000 is received at the beginning of 20X4.
The grant was provided to help finance distribution costs over the 2-year period ended
31 December 20X5.
Required:
A. Prepare an extract of the statement of comprehensive income and related notes for the year ended
31 December 20X5 assuming that the entity recognises grants as grant income and discloses it in
the ‘other income’ line item together with rent income of C25 000 in 20X5 and C45 000 in 20X4.
B. Show how the note disclosure would change if the company recognised the grant as a reduction of
the related expense, where the following costs were incurred:
x Cost of sales: C800 000 (20X4: C900 000)
x Distribution costs: C315 000 (20X4: C325 000)
x Administration costs: C210 000 (20X4: C300 000)
C. Show the disclosure of the grant in the statement of financial position at 31 December 20X5.
Solution 17A: Grant credited to income – SOCI disclosure

Entity name
20X5 20X4
Notes C’000 C’000
Revenue x x
Other income 40 150 170
Cost of Sales/Admin/Distribution/Other 41 x x
Finance costs 42 x x
Profit before tax 43 x x
770 Chapter 15
Entity name
2.15 Government grants:
Government grants are recognised in profit or loss:
x on a rational basis, over the period/s that
x matches grant income with the costs that they were intended to compensate.
Government grants are recognised when there is reasonable assurance that:
x the conditions of the grant will be complied with; and
x the grant will be received.
Government grants are presented as grant income
20X5 20X4
40. Other income
C’000 C’000
Rent income 25 45
Government grant 50 125 125
Other income per the statement of comprehensive income 150 170
Solution 17B: Grant credited to expense – SOCI note disclosure

Entity name
Notes to the financial statement
20X5 20X4
41. Costs by function C’000 C’000
Cost of distribution 190 200
Total 315 325
Less government grant 50 (125) (125)
Cost of administration 210 300
1 200 1 400
Further adjustments to the disclosure in Ex 17A:
x There would be no grant income of C125 000 in the ‘other income note’.
x The last line of the ‘accounting policy note’ (see Ex 17A) would read the following instead:
Government grants are presented as a reduction of the related expense/ asset.
Solution 17C: Grant credited to expense – SOFP disclosure
Irrespective of whether the entity presented the grant as a reduction of the expense or as grant income,
the following would be disclosed in the statement of financial position.
Entity name
20X5 20X4
LIABILITIES C’000 C’000
Deferred grant income 0 125
Example 18: Disclosure of government grants related to assets – the asset note
A government grant of C250 000 is received at the beginning of 20X4.
The grant was provided to help finance the costs of an existing plant.
x The plant’s accumulated depreciation is C300 000 at 01/01/20X4 (cost: C900 000).
x The plant has a remaining life of 2 years and a nil residual value.
x Depreciation is provided on the straight-line method.
Required: Show the disclosure in the property, plant and equipment note for the year ended
31 December 20X5 assuming that the company recognises grants as a reduction of the related asset.
Chapter 15 771
Solution 18: Disclosure of a grant related to assets in the asset note
Entity name
20X5 20X4
20. Property, plant and equipment C’000 C’000
Plant:
Net carrying amount – 1 January 175 600
Gross carrying amount – 1 January 650 900
Accumulated depreciation – 1 January (475) (300)
Grant received 50 - (250)

Depreciation (CA: 600 – GG: 250 – RV: 0) / 2 years (175) (175)
Net carrying amount – 31 December 0 175

Gross carrying amount – 31 December 650 650
Accumulated depreciation – 31 December (650) (475)
Example 19: Disclosure of government grants and assistance: a general note

Read the disclosure requirements provided in IAS 20.39 carefully.
Required: Prepare a skeleton note entitled ‘government grants and assistance’ that you believe will
ensure that all the general disclosure requirements are met.
Solution 19: Disclosure of government grants and assistance: a general note
Entity name
20X5 20X4
50. Government grants & assistance C C
Nature:
Cash government grants have been received in return for … (e.g. mining in the …area).
Extent:
The amounts of the grant have been presented (select one of the following):
as grant income (included in other income/ as a separate line item on the face of the
statement of comprehensive income)
as a deduction against the …expense (see note …)
as a deduction against the… asset in property, plant and equipment (see note …).
Unfulfilled conditions:
The unfulfilled conditions at reporting date are as follows:
…e.g. 'The company must mine for a further 12 years'.
There is no evidence to suggest that this condition will not be met (or give details of any evidence
that suggests that the unfulfilled conditions will probably not be met).
Other government assistance that is unrecognised :
Other government assistance from which the company has directly benefited includes … (e.g. a
government procurement policy that requires that the government buy 50% of all … from us).
Contingent liabilities:
If the company fails to meet the conditions of the grant recognised in note …, the company will be
liable to repay C….. of the grant. These conditions must be met over the next … years, after which
the company will no longer be exposed to this risk.
772 Chapter 15
7. Summary
Government assistance
Government grants Other government assistance

Monetary grants, for example: Where value cannot be reasonably allocated, for
Forgivable loans, or cash to be used to: example:
x Purchase an asset x Free technical advice
x Pay for current/future expenses
x Reimbursement of past costs/ losses Transactions that can’t be separated from
x Financial assistance (e.g. low-interest loan) normal trading activities, for example:
x Government procurement policy that accounts
Non-monetary grants, for example: for a portion of sales
x Land, or
x Licence to operate The other forms of government assistance not
recognised as government grants
Recognised Recognised
Yes No
When there is reasonable assurance that the:
x entity will comply with the conditions, and
x grant will be received
Recognition
x recognised in profit or loss

x over the period the related costs are expensed
Disclosed Disclosed
Yes Yes
Disclosure requirements: Government grants & other assistance

1. The accounting policy re:
Recognition:
Government grants are recognised in profit or loss:
x on a rational basis,
x over the periods thatmatches grant income with the costs that they were intended to
compensate
x when reasonably sure that:
the conditions of the grant will be complied with; and
the grant will be received.
Presentation:
x as a reduction of cost of the asset OR
x as grant income/ deferred income OR
x as reduction of expense/ deferred income
2. The nature and amount of grants recognised
3. Other government assistance not recognised
4. Unfulfilled conditions/ contingencies in respect of the grant
Chapter 15 773
Presentation: Government grants
Credit to income Credit to the related expense or asset
Initial journals: Government grants
Non-monetary Monetary
Debit: x Bank
Debit: x Non-monetary asset (e.g. land): FV
AND
Credit: x Bank (nominal amount, if any); AND Credit: x Income (deferred/
Asset
realised) OR
x Grant income (deferred or realised): acquired
x Asset
(fair value – nominal amount)
OR
Credit: x Income (deferred/
Future
realised) OR
expenses
x Expense
OR
Credit: x Income (realised) OR Past expense/
x Expense loss or
immediate
OR assistance
Credit: x Loan AND
x Income (deferred/ Loans
realised)
Measurement: Government grants
Non-monetary Monetary
x Fair value of asset granted OR x Fair value of asset granted
x Nominal amount paid (if any) (i.e. cash amount received or receivable)
Failing the conditions: Government grants

Repay the grant/ part thereof
Change in estimate (IAS 8)

Cumulative catch-up method
Grant i.r.o asset: indirect method only Other

Debit: Asset: cost (bal) Debit: Deferred income (L)
Credit: Bank Expense (balancing)
Credit: Bank
AND
Debit: Depreciation
Credit: Asset: acc depr
774 Chapter 15
Gripping GAAP Leases: lessee accounting
Chapter 16
Leases: Lessee Accounting
Main References: IFRS 16 (with any updates to 10 December 2018)
Contents: Page
1. Introduction 777
2. IAS 17 – almost history 777
3. The new IFRS 16 – a brief overview 778
4. Scope 778
5. Identifying whether we have a lease 778
5.1 Overview 778
5.2 Is the asset identified? 779
5.2.1 Identification can be explicit or implicit 779
Example 1: Identified asset – explicit or implicit 779
5.2.2 Assets are not ‘identified’ if supplier has substantive right of substitution 779
Example 2: Identified asset – substantive right of substitution 780
5.2.3 Portions of assets can be identified 780
Example 3: Identified asset – capacity portions 780
5.3 Do we have the right to ‘control the use’ of the identified asset? 781
5.3.1 Overview 781
5.3.2 The right to obtain substantially all the economic benefits 782
Example 4: Substantially all the economic benefits – primary & by-products 782
Example 5: Substantially all the economic benefits – portion payable to lessor 783
5.3.3 The right to direct the use 783
Example 6: Right to direct the use – ‘how and for what purpose’ is 784
predetermined
Example 7: Right to direct the use: ‘how and for what purpose’ is 785
predetermined
5.3.3.2 Decisions restricted to operations and maintenance 785
5.3.3.3 Protective rights 785
Example 8: Right to control the use with protective rights and 786
maintenance
5.4 Flowchart: analysing the lease definition 787
6. Separating the lease components in a contract 787
Example 9: Allocating consideration to the lease and non-lease components 789
7. Combining contracts 789
8. Recognition exemptions (optional simplified approach) 790
8.1 Overview 790
8.2 Low-value asset leases and the simplified approach 790
Example 10: Exemptions and low-value assets 791
8.3 Short-term leases and the simplified approach 792
Example 11: Exemptions and short-term leases 792
9. Recognition and measurement – necessary terminology 793
9.1 Overview 793
9.2 Lease term 793
Example 12: Lease term – basic application 79
Example 13: Lease term – option to extend: theory 79
9.3 Lease payments 797
9.3.1 Overview 797
9.3.2 Fixed payments 798
9.3.3 Variable lease payments 798
9.3.4 Exercise price of purchase options 799
9.3.5 Termination penalties 799
9.3.6 Residual value guarantees 799
9.3.7 Summary of the calculation of lease payment 799
9.4 Discount rate 800
Chapter 16 775
Contents: Page
10. Recognition and measurement – the simplified approach 800
Example 14: Leases under the recognition exemption (simplified approach) 800
11. Recognition and measurement – the general approach 801
11.1 Overview 801
11.2 Initial recognition and measurement 801
Example 15: Initial measurement of lease liability and right-of-use asset 803
11.3 Subsequent measurement – a summary overview 804
11.4 Subsequent measurement of the lease liability 805
11.4.1 Overview 805
11.4.2 The effective interest rate method 805
Example 16: Lease liability – subsequent measurement 805
Example 17: Lease liability – initial and subsequent measurement (advance
lease payments) 807
11.5 Subsequent measurement of the right-of-use asset 808
11.5.1 Overview 808
11.5.2 Subsequent measurement of the right-of-use asset: in terms of the cost model 808
Example 18: Right-of-use asset – subsequent measurement: depreciation 809
Example 19: Right-of-use asset – subsequent measurement: impairments 810
11.5.3 Subsequent measurement of the right-of-use asset: in terms of revaluation model 811
11.5.4 Subsequent measurement of the right-of-use asset: in terms of fair value model 811
11.6 Subsequent measurement - remeasurements due to changing lease payments 811
Example 20: Remeasurement - change in lease term 812
11.7 Subsequent measurement - lease modifications 813
Example 21: Lease modification – scope decreases resulting in partial termination 814
12. Tax consequences 815
12.1 Overview 815
12.2 Tax treatment of leases 815
12.3 Accounting for the tax consequences where the lease is accounted for using the 816
simplified approach
12.3.1 From a tax-perspective, the lessee is renting the asset (the lease meets the 816
definition of ‘rental agreement’ or ‘part (b) of the ICA definition’
Example 22: Lease under simplified approach – tax consequences 817
12.3.2 From a tax-perspective, the lessee owns the asset (the lease meets the 819
definition of ‘part (a) of the ICA definition’)
12.4 Accounting for the tax consequences where the lease is accounted for using the 819
general approach
12.4.1 From a tax-perspective, the lessee is renting the asset (the lease meets the 819
definition of ‘rental agreement’ or ‘part (b) of the ICA definition’
Example 23: Lease under general approach – tax consequences 820
12.4.2 From a tax-perspective, the lessee owns the asset (the lease meets the 822
definition of ‘part (a) of the ICA definition’)
12.5 Accounting for the tax consequences involving transaction taxes (VAT): lease 822
meets ‘part (b) of the ICA’ definition
Example 24: Lease under general approach - with VAT (basic) 824
Example 25: Lease under general approach - with VAT 825
12.6 Accounting for the tax consequences involving transaction taxes (VAT): lease 827
meets the definition of a ‘rental agreement’
13. Presentation and disclosure requirements 828
13.1 Presentation 828
13.1.1 Presentation in the statement of financial position 828
13.1.2 Presentation in the statement of comprehensive income 829
13.1.3 Presentation in the statement of cash flows 829
13.2 Disclosure 829
14. Summary 832
776 Chapter 16
1. Introduction
A lease transaction involves one party (the lessor) that grants the right to use an asset to
another party (the lessee). In other words, a lease is characterised by the right of use of an
asset that is granted by a lessor (the owner of the asset) to a lessee (the user of the asset). This
chapter explains how to account for leases from the lessee’s perspective and the next chapter
explains how to account for the lease from the lessor’s perspective. In the rest of this chapter,
reference to the ‘entity’ may be assumed to refer to the lessee.
The long-awaited new standard on leases, IFRS 16 Leases, was issued during 2016, replacing the
previous standard on leases, IAS 17 Leases, and its three related interpretations (IFRIC 4, SIC15 and
SIC 27). Although IFRS 16 is only effective for periods beginning on or
after 1 January 2019, early application is possible. Even if an entity does IFRS 16 must
not choose early application, the implications of the new IFRS 16 are so be applied to:
significant that it is advisable to prepare early for its implementation. periods starting
on/ after 1 Jan 2019.
Before we proceed with how to apply IFRS 16, a little history is needed
so as to understand, in broad brush-strokes, the effects of the change from IAS 17 to IFRS 16.
2. IAS 17 – almost history
Under IAS 17 Leases, an entity entering into a lease as a lessee must The ‘old’ IAS 17
decide whether the lease should be accounted for as a finance lease accounts for leases
or as an operating lease. This decision is based on the substance of based on their
classification as:
the lease agreement (i.e. rather than its legal form). Based on its
x operating (expensed); or
substance, the entity, as lessee, would account for the lease as: x finance leases (on the
x a finance lease if it concluded that the agreement effectively balance sheet/
involved purchasing the asset (e.g. the entity did not expect to capitalised asset &
liability).
return the asset to the lessor); or
x an operating lease if it concluded that the substance of the agreement effectively involved
a true borrowing of the asset (i.e. in essence, the entity would, at the end of the lease,
expect to return the asset, in working order, to the lessor).
When accounting for a finance lease (i.e. a lease, the substance of which suggested the asset was
actually purchased rather than borrowed), the lessee would immediately recognise the item
being leased as an asset and recognise the future lease instalments as a liability. On the other
hand, when accounting for an operating lease (i.e. a lease, the substance of which suggested the
asset was truly borrowed), the lessee would simply recognise the lease instalments as an
expense, as and when they were incurred. This meant that, in the case of an operating lease, the
entity would not recognise the asset and nor would it recognise, as a liability, its obligation to
pay future lease instalments. The fact that the obligation to pay future lease instalments would
not appear as a liability in the lessee’s financial statements is referred to as ‘off-balance sheet
financing’ and was the core reason behind the need to replace IAS 17.
The fact that IAS 17 offers these two different lease classifications (finance and operating
leases), has enabled entities to structure each of their lease contracts so that they would be
accounted for as either an operating lease or finance lease, depending on the specific outcome
that the entity desired. This ability to 'manipulate’ the situation has been causing users
concern for many years on the basis that the financial statements are not transparent. In fact,
in March 2016, the IASB estimated that leases around the world amounted to US$3.3 trillion,
with ‘over 85% of these leases labelled as ‘operating leases’ and are not recorded on the
balance sheet.’1 It has also been estimated that some retailers have off-balance sheet debt that
is 66 times the debt currently reflected on the balance sheet. 2
1. Shining the light on leases; by Hans Hoogervorst, IASB Chairman; IFAC Global Knowledge Gateway; 22 March 2016
2. On balance, companies would rather not show debt; by James Quinn; The Telegraph; 13 January 2016
Chapter 16 777
3. The new IFRS 16 – a brief overview
The new IFRS 16 requires that, with the exception of the scope exclusions (see section 4) and
also the optional simplifications involving short-term leases and low-value asset leases (see
section 5), the lessee must recognise the lease by recognising: The ‘new’ IFRS 16
x a ‘right-of-use’ asset; and accounts for leases on
x a lease liability. See IFRS 16.22 the balance sheet
(similar to a finance lease in
the ‘old’ IAS 17).
This means that the right to use the underlying leased asset (right-of-use
asset) and the obligation to pay the related lease instalments (lease liability) will appear in the lessee’s
statement of financial position (i.e. the lease is recognised ‘on balance sheet’).
4. Scope (IFRS 16.3-4)
IFRS 16 applies to all leases, except for leases involving:

a) the exploration for or use of non-regenerative resources (e.g. oil and gas);
b) biological assets within the scope of IAS 41;
c) service concession arrangements within the scope of IFRIC 12;
d) licences of intellectual property granted by a lessor falling within the scope of IFRS 15; and
e) rights under a licensing agreement falling within the scope of IAS 38 Intangible Assets, for
example, films, videos, plays, patents and copyrights. See IFRS 16.3
A lessee involved in the lease of any intangible asset other than a right under a licensing
agreement (referred to in (e) above) may choose whether or not to apply IFRS 16 See IFRS 16.4.
5. Identifying whether we have a lease (IFRS 16.9-16 and B9-B33)
5.1 Overview Contract inception

is the earlier of
Before we apply IFRS 16, we must be sure that a lease exists. In order the:
for a lease to exist, it must obviously meet the definition of a lease x Date of a lease
(see IFRS 16 Appendix A and also the flowchart below). agreement; and
x The date of commitment
This lease definition requires that we have a contract. This contract need by the parties to the
principal terms and
not be in writing and the lease could even be just a part of the contract, but conditions of the lease.
without a contract, there is no possibility that a lease exists. If we decide IFRS 16 App A
that a contract exists, we must analyse it – at contract inception – for evidence that the lease definition is
met. Therefore, we assess if the contract, or part thereof, has given the entity (the customer) the right to
use an asset for a certain period of time in exchange for consideration. If this is the case, we would
conclude that there is a lease and that the entity is considered to be a lessee. IFRS 16 App A
IFRS 16 elaborates on this lease definition, explaining that although the definition refers simply to:
x ‘an asset’, this asset must be ‘identified’; and
x the entity having the ‘right to use’ this asset, this ‘right to use’ the asset must translate into
the ‘right to control the use’ of that asset. See IFRS 16.9
A lease is defined as:

x a contract, or part of a contract,
x that conveys
the right to use
an asset
x for a period of time
x in exchange for consideration.
IFRS 16 App A
IFRS 16 expands on this to clarify that:
The asset must be an The entity must have a

See IFRS 16.9
‘identified asset’ ‘right to control the use’ of the asset See IFRS 16.9
778 Chapter 16
5.2 Is the asset identified?

5.2.1 Identification can be explicit or implicit The asset must be identified:
x Can be explicitly/ implicitly identified.

It does not matter if the asset is identified explicitly or x Can be a portion, if it:
implicitly. In other words, the contract might name a is physically distinct; or
specific asset (explicit identification) or a specific asset reflects substantially all the asset’s
could simply be implied through it being made available capacity
to the entity (implicit identification). See IFRS 16.B13 x An asset is not identified if the supplier
has a substantive right to substitute it.
Example 1: Identified asset – explicit or implicit
Entity A, a manufacturer of luxury sports cars, enters into a contract with Entity B, in terms of
which Entity B will manufacture and supply engine components to Entity A over 5 years.
The engine components have a unique design and thus, for Entity B to be able to manufacture these
components for Entity A, Entity B designs, constructs and installs a specialised plant on Entity A’s
premises. The contract does not specify that Entity B must use this specialised plant, but there are no
practical alternatives for Entity B other than to use this plant.
Entity B’s newly constructed plant will be used exclusively in the manufacture of these specialised
components, and, due to the specialised nature thereof, this plant will not be able to be used for any
other purpose after the end of the contract, and will need to be dismantled.
Required: Explain whether there is an identified asset.
Solution 1: Identified asset – explicit or implicit

We have an ‘asset’: the plant. However, it must be ‘identified’. Since the plant is not specified in the
contract, it means it has not been explicitly identified. However, this does not automatically mean that
there is no identified asset. This is because the asset may be identified explicitly or implicitly.
In this case, the plant is identified implicitly due to the fact that Entity B has no option but to construct the plant
in order to fulfil its contractual obligations (the plant was designed with the sole purpose of manufacturing the
required engine components because there were no alternative plants that Entity B could have used).
Before concluding that the plant is an identified asset, we need to consider if Entity B has a substantive right to
substitute it. Given that the plant is specifically designed for the manufacture of the engine components, it is
unlikely that Entity B would have the practical ability to substitute the plant for another plant and unlikely that it
would benefit financially from doing so (section 5.2.2 explains how to prove whether substitution rights exist).
Thus, assuming that Entity B does not have substantive rights to substitute the asset, we conclude that
the specialised plant is an identified asset.
Note: Even if we prove that the specialised plant is an identified asset, it does not yet mean that a lease
contract exists, and thus that this contract should be accounted for as a lease. For the lease definition to be
met (specifically, proving that there is a ‘right to use’ the asset), we still need to prove that Entity A has
the ‘right to control the use’ of the plant - which was not the case in this example.
5.2.2 Assets are not ‘identified’ if supplier has substantive right of substitution
An asset that is specified (explicitly or implicitly) would The supplier’s right to
not be identified if the supplier thereof has the substitute an asset is
‘substantive right to substitute’ assets throughout the substantive if the supplier:
period of use. See IFRS 16.B14 x has the practical ability to substitute; &
x would benefit economically if it
A supplier’s right to substitute assets is considered substituted the asset.
substantive only if:
If the substitution right is substantive,
x the supplier has the practical ability to substitute the
the asset is not identified and thus there
asset (e.g. if the asset is not particularly specialised in
is no lease.
nature and thus the supplier has a variety of suitable
assets on hand that it could provide or use as an If it is difficult to determine if the right
alternative asset), and to substitute is substantive, we assume it
x the supplier would benefit economically if it is not substantive See IFRS 16.B14 & .B19
substituted the asset (i.e. the benefit of substituting the

asset exceeds the cost of substitution). See IFRS 16.B14
Chapter 16 779
The fact that a contract may allow, or may even require, a supplier to substitute one asset for
another in the event that it needs repairs, maintenance or an upgrade, should not be interpreted as
the supplier having the substantive right to substitute an asset for purposes of assessing whether
the lease definition is met. See IFRS 16.B18
If it is difficult to determine if a supplier’s right to substitute is substantive or not, we must assume that
the ‘substitution right is not substantive’. See IFRS 16.B19
Example 2: Identified asset – substantive right of substitution

Adaptation of IFRS 16.IE2
Entity A is a small retailer of trendy sunglasses and Entity B owns a shopping centre.
Entity A enters into a 3-year contract with Entity B to use 16 square metres in the shopping
centre for a stand that Entity A will use to display its sunglasses.
The contract specifies that Entity A has the right to use 16 square metres on the second floor of the
shopping centre, but the terms of the contract also allow Entity B to move the stand to a variety of other
suitable areas within the shopping centre.
Since it is just a space that is being rented and the stand is not permanently fixed in place, there are
minimal costs involved in the event that the stand must be moved.
Required: Explain whether there is an identified asset.
Solution 2: Identified asset – substantive right of substitution

Although the contract explicitly identifies the asset in the contract, the asset having been identified as a
particular space (16 square metres), and even stipulating exactly where this space is situated in the
shopping centre (on the second floor), this space can be changed by Entity B (the supplier) at any time.
The right to change the space is what is referred to as the supplier’s right to substitute the asset.
Since Entity B (supplier) has the right to substitute the asset, we need to assess whether the supplier’s
right to substitute the asset is substantive (i.e. whether the supplier has the practical ability to substitute
the asset and whether the supplier would benefit economically from substituting the asset).
In this case, there are a variety of suitable places in the shopping centre that could be used to house
Entity A’s kiosk and thus Entity B has the practical ability to substitute the space currently allocated on
the second floor for another space elsewhere.
Since the kiosk is not permanently fixed in place and there are minimal costs in moving it, substituting
the space for another space, if and when required, enables Entity B to make ‘most effective use of the
space’ in the shopping centre, and thus maximise its profitability. Thus, Entity B would benefit
economically from substituting the space if and when circumstances warranted it.
Conclusion:
There is no identified asset because Entity B has the right to substitute the asset (the space) and this
right to substitute is substantive because Entity B has the practical ability to substitute and would
benefit economically from the substitution.
5.2.3 Portions of assets can be identified

An identified asset could be just a portion of an asset if the portion is physically distinct. An
identified asset cannot, however, simply be a portion of the asset’s capacity, unless the portion of
the asset’s capacity is physically distinct or if the portion of the capacity is substantially all of the
asset’s capacity. See IFRS 16.B20
Example 3: Identified asset – capacity portions

Adaption of IFRS16.IE3B
Entity A enters into a contract with Entity B in terms of which Entity B will supply a certain
quantity of oil each day to Entity A. The contract stipulates that the supply of oil will be
delivered to Entity A using Entity B’s oil pipeline. In terms of the contract, the quantity of oil to be
delivered on a daily basis constitutes 20% of the capacity of the oil pipeline.
Required:
Explain whether there is an identified asset.
780 Chapter 16
Solution 3: Identified asset – capacity portions

The contract explicitly identifies the pipeline that will be used to deliver the oil to Entity A. However,
the delivery volumes required by Entity A are such that only 20% of the pipeline’s capacity will be
used. Thus, the asset to be used is actually a ‘capacity portion’ rather than a physically distinct asset.
Since we are dealing with a capacity portion, we must analyse whether the capacity portion is
physically distinct or, if not, whether it represents substantially all of the asset’s capacity.
Although the actual pipeline is physically distinct, the 20% capacity requirement does not represent a
physically distinct portion of the pipeline.
Thus, since the capacity portion of the asset is not physically distinct, we consider whether the capacity
reflects substantially all of the capacity of the pipeline.
In this case, we are told the portion that will be used represents only 20% of the total capacity and thus
we conclude that the capacity portion does not reflect substantially all of the capacity of the pipeline.
Conclusion: There is no identified asset because we are dealing with a capacity portion that is neither
physically distinct nor representative of substantially all of the capacity of the asset.
5.3 Do we have the right to ‘control the use’ of the identified asset?
We have the right to control
5.3.1 Overview the use of an identified asset
if, during the period of use, we
The lease definition includes the requirement that the have the right to:
entity must have a ‘right to use’ the asset. x obtain substantially all the economic
benefits from the use of the asset; and
The standard then clarifies that for there to be ‘a right to x direct the use of the asset.
use’, it means that the entity needs to have the ‘right to IFRS 16.B9 reworded
control the use of the asset’.
As explained above, this ‘right to control the use of the asset’ is established if two criteria are
met:
x the entity must have the ‘right to obtain substantially all the economic benefits’ and
x the ‘right to direct the use’.
This ‘right to direct the use’ of the asset will need to be established if the entity has the ‘right to
direct how and what for purpose’ the asset will be used. As there are a variety of similar, but very
distinct terms, it may be useful to you to see the interrelationship of these terms diagrammatically.
‘Right to use’ the asset (section 5.1) IFRS 16.App A

The lease definition refers to a few items including a
x ‘right to use’ the asset
‘Right to control the use’ of the asset (section 5.3) IFRS 16.9
IFRS 16.9 clarifies that:
‘right to use’ the asset = ‘right to control the use’ of the asset
The ‘right to control the use’ exists if the entity has the following two rights:
Right to obtain substantially all the AND Right to direct the use (section 5.3.3)
economic benefits (section 5.3.2) IFRS 16.B9 (a) IFRS 16.B9 (b)
This right exists if the entity has following right:
IFRS 16.B24
Right to direct how and for what purpose the asset is used
The entity (customer) has this right if it:
x can decide how and for what purpose the asset is used; OR
x cannot decide this because the ‘how and what for’ is predetermined. but it can operate the asset; OR
x cannot decide this because the ‘how and what for’ is predetermined. but the entity designed the
asset AND it is this design that is the reason why the ‘how and what for’ is predetermined’
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5.3.2 The right to obtain substantially all the economic benefits (IFRS 16.B21-23)
When trying to establish that an entity (customer) has the ‘right to control the use’ of the asset, one of
the two criteria that needs to be met is that the entity (customer) must have the ‘right to obtain
substantially all the economic benefits’ from the use of the asset during the period of use.
When assessing whether the entity (customer) has the right to these benefits, it does not matter whether it
can obtain these benefits directly or indirectly. This means that the entity could obtain the benefits from
using the leased asset (direct usage) or, for example, sub-leasing the asset (indirect usage). The phrase
‘all the economic benefits’ refers to the benefits from both the primary output and also any secondary
output (i.e. it includes the inflows expected from, for example, the sale of by-products). See IFRS 16.B21
When assessing whether the entity (customer) has the The right to obtain
‘right to obtain substantially all the economic benefits’ substantially all the benefits:
from the use of the asset, we limit our assessment to the x Include direct and indirect benefits
scope of the customer’s rights as defined in the contract. x Consider only the total benefits
See IFRS 16.B21 possible in context of the scope of the
contracted right of use
In other words, it is obvious that, if an entity (customer) has
x The requirement to refund/pay part of
the exclusive and unconditional use of an asset throughout a the benefits to the lessor/third party
particular period, this entity would have the right to all the is ignored. See IFRS 16.B21-23
economic benefits from the use of the asset during that period. However, the entity does not always have
exclusive use of an asset.
For example: A contract provides an entity (the customer) with the right to use a truck for three
years, but only within the city limits (that means, the truck cannot be used to deliver goods
outside of the city). When assessing whether the customer has the ‘right to obtain substantially all
the benefits’ we must consider the benefit the customer obtains, in relation to the total economic
benefits from utilising the truck within the city limits. We would not consider the benefit that the
entity obtains, in relation to the total economic benefits that would have been possible if the
customer was able to use the truck outside of the city limits. See IFRS 16.B21-22
Example 4: Substantially all the economic benefits – primary & by-products
Adaptation of IFRS 16.IE9A
Entity A (customer) enters into a contract with Entity B (supplier).
Entity B owns a wind farm that it uses to generate electricity (green energy).
Entity B, as the owner of the farm, receives the tax benefits relating to the cost of constructing the farm
(i.e. the tax authorities allow Entity B to deduct the cost of the farm against its taxable profits).
In terms of the contract, Entity A buys Entity B’s entire supply of green energy, and since Entity A is
using green energy, it also receives renewable energy credits.
Required: Identify the primary and by-products in this scenario and conclude whether Entity A obtains
substantially all the economic benefits from the wind farm and, assuming all other criteria are met,
whether it should thus conclude that it holds the wind farm as a right-of-use asset.
Solution 4: Substantially all the economic benefits – primary & by-products

There are three benefits referred to in the scenario:
x the electricity (the primary product),
x the renewable energy credits (a by-product) and
x the tax benefits (a by-product).
Entity A has the rights to all the electricity and the renewable energy credits (the primary product and
one of the by-products), but it does not have the rights to the tax benefits (the other by-product).
However, the electricity and the renewable energy credits actually represents 100% of the economic
benefits from the right of use of the asset because the tax benefits (the by-product to which it does not
have the right), is not related to the use of the asset but rather to the ownership of the asset.
Conclusion:
Entity A has the right to obtain substantially all the benefits from the wind farm and thus, assuming all
other criteria are met, it should conclude that it holds the wind farm as a right-of-use asset.
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The fact that the contract may require the entity (customer) to pay the supplier some of the
benefits earned from using the asset does not mean that the customer has not obtained
substantially all the economic benefits from using the asset. Instead, when assessing whether we
have the ‘right to receive substantially all the benefits’, we consider the gross benefits received by
the entity (not the benefits net of any portion thereof that must be paid over to the lessor or any
third party). If any portion of the benefits are to be paid to the supplier, or some other third party,
this portion is simply accounted for as part of the consideration paid for the lease. See IFRS 16.B23
This is an important point since it prevents entities from structuring their lease contracts in such a
way that they can avoid meeting the definition of a lease, and thus avoid having to account for
them on the balance sheet. In other words, entities could otherwise have structured their contracts
such that the lease payments were simply based on a percentage of revenue (e.g. 30% of revenue)
and then concluded that, since they only retained a portion of the revenue (e.g. the balance of
70% of revenue), they did not have the right to substantially all the economic benefits.
Example 5: Substantially all the economic benefits – portion payable to lessor
A contract states the lease payments are C1 000 per month and that Entity A (the customer) may
retain only 90% of the revenue from the use of the asset, after paying 10% thereof to the lessor.
Required: Explain whether the customer has the right to obtain substantially all the economic benefits.
Solution 5: Substantially all the economic benefits – portion payable to lessor

The fact that Entity A (the customer) only has the right to retain 90% of the benefits does not mean that
it does not have the right to receive all the economic benefits. Instead, we conclude that the customer
has the right to receive 100% of the revenue and that the lease consideration includes the fixed lease
payments of C1 000 and the variable lease payments equal to 10% of the revenue.
We have the right to direct the
5.3.3 The right to direct the use
use of an asset:
5.3.3.1 Overview x if we have the right to direct how and
for what purpose the asset is used; or
When trying to prove that an entity (customer) has the x if the ‘how and for what purpose’ is
already pre-determined, and:
‘right to control the use’ of the asset, one of the two we have the right to operate the
criteria that needs to be met is that the entity (customer) asset (or direct others in this regard)
must have the ‘right to direct the use of the asset’. we designed the asset and its design
predetermines the ‘how and for what
purpose’ See IFRS 16.B24
We would conclude that the entity (customer) has the
‘right to direct the use of the asset’ in any one of the following three situations:
x If the entity (customer) ‘has the right to direct how and for what purpose the asset is used’. For
example, the entity using a factory may be able to decide what products will be manufactured in
the factory, when certain products will be manufactured and who the entity will supply.
x If the relevant decisions about ‘how and for what purpose the asset is used’ are pre-
determined (i.e. neither the entity (customer) nor the supplier can make these decisions; for
example, the use may be stated in the contract), but the entity (customer) has the ‘right to
operate the asset’ (or has the right to be able to instruct others on how the asset should be
operated). For example, the contract between an entity (the customer) and the supplier over
the use of a power plant stipulates the quantity and timing of power required to be produced.
However, the customer has the right to make decisions regarding the operation of the plant.
x If the relevant decisions about ‘how and for what purpose the asset is used’ is somehow
already pre-determined (i.e. neither the entity (customer) nor the supplier can make these
decisions), but the entity (customer) ‘designed the asset’ (or parts of the asset) and where this
design ‘predetermines how and for what purpose the asset will be used’. For example: due to
the specialised nature of its manufacturing process, an entity (the customer) provides the
supplier with a detailed design of the plant that it requires and that is capable of only being
used in the customer’s manufacturing process. See IFRS 16.B24 & B26
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These situations can be illustrated in the flowchart below:
the customer has the ‘right to direct how and for what purpose the asset is used’:,
right to direct the use
The entity (customer)
of the asset if:

The relevant decisions about ‘how and for what purpose’ the asset is used is predetermined, but:
has the
x but the customer has the right to operate the asset.
The relevant decisions about ‘how and for what purpose’ the asset is used is predetermined, but:
x the customer designed the asset (or parts thereof) and
x it is this design that predetermines the ‘how and for what purpose’.
Example 6: Right to direct the use: ‘how and for what purpose’ is predetermined
Adaptation of IFRS 16.IE6
Entity A enters into a contract with Entity B where Entity B will transport Entity A’s cargo
from South Africa to Australia. The volume of cargo to be transported is such that it
requires the exclusive use of a ship. The contract specifies the cargo to be transported, the dates the
cargo will be transported, the detailed route that the ship will take and that Entity B will both operate
the ship and be responsible for all maintenance and safety aspects. The ship is specified in the contract.
Required:
a) Explain whether Entity A has the right to direct the use of the ship.
b) Assuming all other criteria are met, explain whether the contract contains a lease.
Solution 6: Right to direct the use: ‘how & for what purpose’ is predetermined
a) Entity A (customer) does not have the right to direct the use of the asset because it does not have
the right to direct how and for what purpose the ship will be used: the details regarding the dates
and route that will be taken (the ‘how’) and the details of the cargo to be transported (the ‘purpose’)
are specified in the contract. Since the decisions regarding how and for what purpose the ship are
pre-determined in the contract, we must analyse whether Entity A either operates the ship or
designed the ship. In this case, Entity A neither operates the ship nor designed the ship.
Conclusion: Since the decisions regarding how and for what purpose the ship will be used are
predetermined in the contract, and since Entity A neither operates the ship nor designed the ship, we
conclude that Entity A does not have the right to direct the use of the ship.
b) Since Entity A does not have the right to direct the use of the ship, it automatically means that it
does not have the right to control the use of the asset. Since Entity A does not have the right to
control the use of the asset, the contract does not involve a lease.
For your interest:
In part (b), we are told to simply assume that all other criteria were met. However, an explanation
regarding these other criteria follows:
x Is there an identified asset? In this case, the ship is explicitly specified in the contract and there
appears to be no evidence that the supplier has a substantive right to substitute the ship with another
ship. We thus conclude that there is an identified asset.
x Does Entity A (customer) have the right to substantially all the economic benefits from the use of the ship
during the period of the use? In this case, there is so much cargo being transported that it will occupy the
entire ship and thus no other parties can obtain any benefit from the use of the ship during this period of use,
with the result that we conclude that Entity A has the right to substantially all of these benefits.
x Before we conclude that there is a lease, there must be an identified asset and Entity A must control
the use of the ship. Although there is an identified asset and although Entity A has the right to
substantially all the economic benefits during the period of use, Entity A does not have the right to
direct the use of the ship and thus Entity A does not have the right to control the use of the ship.
Hypothetically, if we had concluded that Entity A had the right to direct the use of the ship, since it
also had the right to substantially all the economic benefits, we would have concluded that it had the
right to control the use of an identified asset and would thus have concluded that the ship was leased.
However, even if we had been able to conclude that the contract included the lease of a ship, we would
not necessarily have accounted for the lease on balance sheet since the use of the ship appears to be for
one trip only and would thus have involved the right to use the ship for a period of less than a year, in
which case Entity A would have had the option to expense the lease instead (see section 8).
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Example 7: Right to direct the use: ‘how and for what purpose’ is predetermined
Entity A (customer) enters into a contract with Entity B, whereby Entity A will acquire the
nuclear power generated by Entity B. Entity B owns and is the exclusive operator of the
nuclear power plant. However, this plant was specially designed by Entity A.
Required:
Explain whether Entity A has the right to direct the use of the asset and, assuming all other criteria are
met, whether the nuclear plant is leased by Entity A.
Solution 7: Right to direct the use – ‘how & for what purpose’ is predetermined
Entity B operates the plant and thus Entity A, on the face of it, appears not to have anything to do with
directing the use of the plant. However, the reality is that neither the customer nor the supplier can
actually decide to change the ‘how and for what purpose’ (i.e. how the asset is used or for what purpose
the asset is used). This is because the specialised nature of the plant predetermines this:
x the ‘how’ is very technical and thus there is only one way to operate this plant and
x the ‘for what purpose’ is clearly the production of power.
The decisions regarding the ‘how and for what purpose’ are thus ‘predetermined’.
When decisions are predetermined, we must then consider whether the customer operates the asset or
designed it and whether it was this design that predetermined these decisions.
In this case, Entity A (the customer) does not operate the plant but it had designed the plant for the
supplier and it is this design that predetermines how and for what purpose the asset is used. This fact is
thus used as evidence that the entity (customer) has, in effect, the right to direct the use of the asset.
Conclusion:
Entity A has the right to ‘direct the use’ of the nuclear power plant and thus, assuming all other criteria
are met, it should conclude that it holds the nuclear power plant under a lease.
5.3.3.2 Decisions restricted to operations and maintenance

Contracts can grant either the customer or supplier the decision-making rights regarding the
operation and/or maintenance of an asset. However, although decisions regarding the operation
and maintenance of an asset have a direct impact on whether or not the use of the asset will be
efficient, they have no bearing on who has the ‘right to direct how and for what purpose’ the
asset is used.
In fact, in most cases, the converse is true: the decisions regarding ‘how and for what purpose’
the asset is used will have a bearing on the decisions needed to be made regarding the operation
(and maintenance) of the asset.
The only time that we should consider who has the right to operate the asset is if the decisions
regarding ‘how and for what purpose’ the asset is used are predetermined. See IFRS 16.B27
5.3.3.3 Protective rights
When assessing whether an entity (customer) has the right to direct the use of the asset, we may
come across certain restrictions. These restrictions are termed protective rights.
Protective rights are ignored if they are merely designed, for example, ‘to protect the supplier’s
interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance
with laws or regulations’.
Protective rights come in many forms, such as limiting the usage of the asset for safety reasons, or
requiring that the customer follows certain ‘operating practices’ in order to ensure longevity of
the asset etc.
Protective rights are terms and conditions that generally simply ‘define the scope of the
customer’s right of use, but do not, in isolation, prevent the customer from having the right to
direct the use of the asset’. See IFRS 16.B30
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Example 8: Right to control the use with protective rights and maintenance
Adaptation of IFRS 16.IE6B
Entity A enters into a contract with Entity B for the right to the exclusive use of a passenger train to
be used along a specified train route.
Entity A will be able to make all the decisions regarding when to operate the train, who it will use to operate it
and how many passengers will be transported.
However, the contract specifies that Entity A may not carry more than 1 000 passengers at a time and may not
operate the train for more than a 1 200 km per day.
The contract also specifies that Entity B will be exclusively responsible for repairs and maintenance of the train
(including the scheduling of when maintenance takes place). If any of the train carriages requires maintenance or
a repair, Entity B will substitute the train carriage with an alternative.
Required:
Indicate whether Entity A has the right to control the use of the train and thus, assuming all other
criteria are met, whether it should conclude that the train is leased.
Solution 8: Right to control the use with protective rights and maintenance
In order to decide whether Entity A (customer) has the right to control the use of the train, we must
establish whether the entity has the:
x right to substantially all the economic benefits; and
x the right to direct the use of the asset.
Entity A has exclusive use of the train along a specified route. As such, within the scope of this
contract, Entity A has the right to substantially all the economic benefits from the use of the train.
The fact that Entity A can operate the train is not relevant when assessing whether it has the right to
direct the use of the train because merely being able to operate an asset does not mean that one is able
to make the decisions regarding ‘how and for what purpose’ the asset will be used (we only consider
whether the entity can operate the asset if the decisions regarding ‘how and for what purpose’ the asset
is used are predetermined).
What is relevant is that Entity A can decide when and whether to operate the train, how far to travel
(within limits) and how many people to transport (within limits), thus suggesting that Entity A is able
to direct how and for what purpose the train will be used, which means it has the right to direct the use
of the train.
The fact that Entity B (supplier) puts restrictions on how many passengers it may carry in one trip and
how many kilometres may be travelled in one day are simply protective rights (i.e. they are protecting
Entity’s B investment in its train). These protective rights simply define the scope of Entity A’s right to
use the train and do not detract from Entity A’s right to decide how and for what purpose the train is
used. We thus ignore Entity B’s rights, because they are protective rights
Similarly, the fact that Entity B is responsible for scheduling and carrying out maintenance and repairs does not
mean that Entity A does not have the right to direct the use of the train. In fact, the converse is true: the
decisions made by Entity A regarding how and for what purpose the train will be used (e.g. to travel 1 200 km
per day carrying the maximum passenger load) affects how often the train will require maintenance and repairs.
Thus, we conclude that Entity A has the right to direct the use of the train.
Since Entity A has the right to substantially all the economic benefits and has the right to direct the use
of the train, we conclude that it has the right to control the use of the asset. If all other criteria are met,
we would conclude that Entity A is leasing the train from Entity B.
For your interest:
One of the other criteria that would need to be met before concluding that the contract involves a lease
is that the asset must be identified. In this case, the train is explicitly identified in the contract and is
thus an identified asset. The fact that the supplier may substitute the train or parts thereof with another
train in the event that the identified train requires repairs or maintenance is not considered to be a
substantive right to substitute the train.
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5.4 Flowchart: analysing the lease definition
Lease definition:
x A contract, or part of a contract,
x that conveys the right to use an asset
x for a period of time
x in exchange for consideration IFRS 16 App A.
Is there a contract? No
Yes
Is there an identified asset? No

Some guidelines:
It must either be explicitly identified in the contract or be implicitly
identified when made available to us (see section 5.2.1).
We would not consider it to be an identified asset if the supplier has a
substantive right to substitute the asset.
If we’re not sure if the supplier’s right to substitute is substantive, we
assume that it is not substantive (see section 5.2.2).
If it is identified, is it the entire asset or is it just a portion of the asset?
If it is a portion, it must either be a physically distinct portion, or if it’s a
capacity portion (that is not physically distinct), it must reflect
substantially all the capacity (see section 5.2.3).
There is no lease
Yes
Do we have the right to ‘control the use’ of the asset throughout the
No
period of use?
Core guideline – the 2 requirements: Further guidelines:
Do we have the right to obtain substantially all We consider
the economic benefits from the use of the x only the economic benefits within the
identified asset throughout the period of use? scope of the contract
See IFRS 16.B9(a)
(see section 5.3.2) x the direct and indirect benefits (e.g.
through using or sub-leasing the asset)
AND
Do we have the right to direct the use of the We have this right if:
identified asset throughout the period of use? x we can decide ‘how and for what
See IFRS 16.B9(b)
(see section 5.3.3) purpose’ the asset is used.
x if these decisions are predetermined,
we may conclude we have this right if:
we can operate the asset (or tell
others how to operate it), or
we designed the asset for the
supplier and the design dictates
how and for what purpose the
asset will be used
Yes
There is a lease
6. Separating the lease components in a contract (IFRS 16.12-16 and .B32-B33)
It can happen that a contract deals only with a lease and that this lease involves only one
underlying asset. However, a contract could deal with many aspects, including the lease of
more than one asset, and may even contain aspects that are not lease-related.
If a contract contains one or more lease components, each lease component must be
accounted for separately. A lease component refers to a right to use an underlying asset that
meets certain criteria (see pop-up on the next page).
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Furthermore, if a lease contract also includes non-lease A separate lease component is

components, any non-lease component must be accounted a right to use an underlying
for separately from the lease component/s. asset where:
x the lessee can benefit from the asset
These non-lease components must be accounted for in on its own (or with other readily
terms of the relevant standard. available resources ), and
x the asset is not highly dependent on/
However, a lessee may choose to apply what is referred interrelated with the other assets in
the contract. IFRS 16.B32 (reworded)
to as the practical expedient, wherein the lessee does
not bother to separate the non-lease component from the lease component. This is explained
under step 2 below.
Our first step, however, is to identify each lease component:
If a contract involves the lease of a number of underlying assets, we would identify the right
to use each asset as a separate lease component if both of the following two criteria are met:
x the entity (lessee) is able to obtain the benefit from using that asset separately from other
assets (or, if other resources are needed to be able to use that asset, then only if these
resources ‘are readily available to the lessee’) See IFRS 16.B32(a); and
x the asset is not highly interrelated with or dependent on the other assets in the contract (e.g.
if the entity could choose not to lease the asset and if this choice would not significantly
affect its right to use the other assets in the contract, then it suggests that these underlying
assets are not highly interrelated or dependent on each other). See IFRS 16.B32(b)
Please note that, when analysing a contract, we assess whether it ‘contains a lease for each
potential separate lease component’. See IFRS 16.B12
Our second step is to allocate the consideration to each component of the contract:
If a contract contains multiple components, with at least one lease component (e.g. the contract
contains two lease components, or it contains a lease component and a non-lease component), we
must allocate the consideration to each of these components. This allocation is done on the basis of:
x the relative stand-alone price of each lease component; and
x the aggregate stand-alone price of the non-lease components. See IFRS 16.13
Allocating consideration to
The stand-alone prices are based on the price that the lessor separate lease components and
would charge the entity (lessee) if it supplied that non-lease components:
component on a separate basis. If an observable price is not x is based on the relative stand-alone
readily available, then the entity would simply estimate it. prices (observed or estimated)
See IFRS 16.14 x of each lease component and non-lease
The portion of the consideration that is allocated to component
each lease component will be accounted for in terms of x unless the entity chooses the practical
expedient (not to separate non-lease
IFRS 16 and the portion that is allocated each of the components – in which case the
non-lease components will be accounted for in terms consideration is simply allocated
of the relevant standard. See IFRS 16.16 between separate lease components)
See IFRS 16.13-16
If a lease contains more than one lease component, there is no choice but to account for each lease
component separately, but a practical expedient exists in the case of non-lease components.
Although it is recommended that lease components and any non-lease components be separately
accounted for, this is not compulsory. Instead, a practical expedient exists which allows the lessee
not to bother separating the non-lease components. In this case, a lease component and any related
non-lease component would be accounted for as one single lease component.
The option to apply the practical expedient is an accounting policy that the entity (lessee) may
choose on a class of asset basis (i.e. it may wish to apply the practical expedient to its leased
vehicles but may choose not to apply it to its leased machinery). However, the practical
expedient shall not apply to embedded derivatives that meet the criteria of paragraph 4.3.3 of
IFRS 9 Financial Instruments. See IFRS 16.15
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Example 9: Allocating consideration to the lease and non-lease components

Adaptation KPMG First Impressions: IFRS 16 Ex 8
Entity A (lessee) enters into a one-year contract over a plant. The lessor undertakes to insure
the plant and to maintain it by having it serviced every month. The contract stipulates that the payments
are C12 000 for the year, of which C2 000 relates to the annual insurance and C3 600 relates to the
provision of the monthly services.
Similar insurance provided by third parties would normally cost C2 000 per year and the cost for the
monthly services would normally be C5 000 per year. The price to rent a similar plant for a year
(without the additional maintenance services and insurance) is C10 000.
Required: Identify the components of the lease and calculate the amount of consideration that should
be allocated to the lease component/s.
Solution 9: Allocating consideration to the lease and non-lease components

This contract provides Entity A with the right to use one asset (a plant) and monthly maintenance
services. Although the contract states that part of the consideration also includes the provision of
insurance, the insurance is not a good or service from which Entity A benefits (the lessor benefits from
the insurance) and thus the provision of insurance is not a separate component of the contract and is
disregarded when allocating the consideration to the components of the lease.
The right to use the plant represents a lease component. The provision of the maintenance services does
not represent the right to use an asset and is thus a non-lease component.
The total consideration is allocated based on the stand-alone price per lease component and the aggregate stand-
alone prices of the non-lease components (in this case there is only one non-lease component) as follows:
Stand-alone prices
Allocation of annual contractual consideration:
C
Stand-alone prices for the non-lease component/s Given – maintenance only 5 000
Stand-alone price for the lease component Given – plant 10 000
Total stand-alone prices 15 000
Annual contractual consideration allocated as follows: 12 000
x Non-lease component C12 000 x 5 000 / 15 000 4 000
x Lease component C12 000 x 10 000 / 15 000 8 000
The consideration allocated to the non-lease component (C4 000) is expensed as maintenance. The
consideration allocated to the lease component (C8 000) is accounted for in terms of IFRS 16 (i.e.
using the simplified approach (see section 8 and 10) or using the general approach (see section 11)).
Note that the allocation of the consideration is based on the stand-alone prices, and not the payments
stipulated in the contract.
For your interest:
If the stand-alone price of the plant was not observable, we would estimate it. One way of estimating it
would be as a balancing amount: Total consideration C12 000 – Stand-alone price of non-lease
component C5 000 = Estimated stand-alone price of lease component: C7 000
7. Combining contracts (IFRS 16.B2)
If an entity (lessee) enters into more than one contract with the same counterparty (or related
parties of the counterparty) (i.e. if the entity is effectively contracting with the same person in
all the contracts), these contracts must be accounted for as a single contract if any one of the
x The assets in each contract would, together, meet the description of a single lease
component.
x The amount of consideration payable in terms of one contract would be dependent on the
price or performance of another contract.
x The contracts can only be understood if one considers them together (i.e. as a package)
and they are negotiated as a package.
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8. Recognition exemptions (optional simplified approach) (IFRS 16.5-.8 & IFRS 16.B3-.B8)
8.1 Overview (IFRS 16.5-8) The exemptions:

IFRS 16 offers an optional, simplified approach to lessees involved x are optional
in short-term leases and leases of low-value assets. It refers to this x are available to:
approach as an optional ‘recognition exemption’. An entity that Short-term leases; &
chooses this simplified approach does not recognise a right-of-use Low-value asset leases.
asset and lease liability (i.e. it does not recognise the lease ‘on x offer a simpler approach
balance sheet’), but simply expenses the lease instalments instead that involves:
expensing the lease
(i.e. the lease would be accounted for in much the same way as an
using SL (normally)
‘operating lease’ is currently accounted for in terms of IAS 17).
Entities choosing this simplified approach would recognise the lease instalments either as an expense
on the straight-line basis (SL basis) over the period of the lease, or may expense it using another
systematic basis if it is ‘more representative of the pattern of the lessee’s benefit’. See IFRS 16.6
8.2 Low-value asset leases and the simplified approach (IFRS 16.8 & .B3-B8 & .BC100)
In the case of a lease of a low-value asset, the entity may choose to Low-value asset
apply the ‘simplified approach’ (i.e. expensed instead of ‘on balance leases & the
sheet’) on a lease-by-lease basis. See IFRS 16.8 simple approach:
x The choice to opt for
The assessment of whether or not an asset is considered to have a the simpler approach is
available on a ‘lease-by-
low value is based on its value when it was new. It is not based in lease’ basis
any way on the leased asset’s current age or value. See IFRS 16.B6 x Value of asset assessed
on its value when new.
Furthermore, no consideration is given to whether or not the asset’s x Examples: phones, PC’s,
value is material to the lessee – in other words, this assessment is tablets etc (not cars).
not entity-specific. See IFRS 16.B4 x Exemption not available if
leased asset to be sub-
leased. See IFRS 16.8 & B4-B8
IFRS 16 suggests that low-value assets could include, for example,
‘tablet and personal computers, small items of office furniture and telephones’ but would
normally not include items such as vehicles, because vehicles typically do not have a low
value when new. See IFRS 16.B6 & B8
The IASB’s thoughts on low-value assets
The ‘basis of conclusions’ (included in IFRS 16) explains that, during the discussions in 2015 when
originally proposing this low-value asset exemption, the IASB agreed that a rough rule of thumb of
US$5 000 or less would qualify the asset as a low-value asset.
However, this amount must not be misinterpreted to be a ‘hurdle rate’ because it was only raised in discussions
and is not included in the body of the IFRS. Obviously, this amount would also have no relevance over time due
to the effects of inflation and would be difficult to apply by entities that do not operate in US dollars and
whose currency exchange rates fluctuate significantly.
However, the buying power of $5 000 at the time of the discussions suggested that the types of assets that
would be considered to be ‘low-value assets’ would include items such as ‘tablets and personal computers, small
items of office furniture and telephones’.
Interestingly, the fact that their discussions referred to this one specific amount ($5 000) highlights that
the thinking behind the application of the low-value exemption was that the value of the asset should not be
considered in relation to the entity’s circumstances (i.e. it is not an entity-specific measure). Instead, a large
multi-national business and small corner bakery should both arrive at the same conclusion as to whether a
leased asset is a low-value asset or not. See IFRS 16.B3-B5 & IFRS 16.BC100
An asset can only be considered to have a low value if it also meets the following criteria:
x The lessee can benefit from either:
using it on its own, or
using it together with other readily available resources; and
x It is not highly dependent on or highly interrelated with other assets. IFRS 16.B5 (reworded)
790 Chapter 16
In addition to the abovementioned two criteria, if a lessee intends to sub-lease an asset (i.e. an
entity that is a lessee but becomes – or intends to be – a lessor over the same leased asset), the
entity, as lessee, may never account for the head lease as a low-value asset (i.e. the head lease
must be recognised on the balance sheet (as a right-of-use asset and lease liability), even if it
involves an asset that would otherwise have been described as having a low value). See IFRS 16.B7
Example 10: Exemptions and low-value assets
Consider the following non-related leases:
Lease A. An entity entered into a lease (as a lessee) over a new personal computer with a value of
$4 000. The retailer regards amounts greater than $2 000 to be material.
Lease B. An entity entered into a lease (as a lessee) over a second-hand computer with a current value
of $2 000 and a new value of $20 000.
Lease C. An entity entered into a lease (as a lessee) over a new tablet with a value of $2 000. The
entity intends to lease this asset to an employee.
Lease D. An entity entered into 5 separate leases (as a lessee). The first lease is over a new factory
machine with a value of $2 000. The machine is a baseline machine that comes without an
engine and certain key components, all of which must be acquired from other suppliers. The
second lease involved the lease of the new engine, with a value of $5 000. The remaining
three leases involved the three key components needed for the machine to function. Each of
the components had a value, when new, of $3 000.
Required: For each of the leases referred to above, briefly explain whether the leased asset (the
underlying asset) is a low-value asset and thus whether the lease could be accounted for in terms of the
simplified approach (i.e. whether or not the low-value asset recognition exemption is available).
Solution 10: Exemptions and low-value assets

Lease A. This lease falls beneath the threshold of $5 000 mentioned in the basis of conclusions.
However, this amount is not a ‘hurdle rate’, but simply a rough guideline. Thus, we simply
note that it is below the threshold, suggesting that it may be a low-value asset.
We are told that the retailer regards amounts above $2 000 to be material and would thus
consider the computer’s value ($4 000) to be material. However, if something is material, it
does not mean that it is ‘high-value’ – it could still be considered to be a low-value asset. This
is because the assessment of whether the leased asset has a low value must be based on the
absolute amount, meaning that it is not assessed based on its value relative to what the entity
considers material. Thus, the information regarding the entity’s materiality levels is irrelevant.
Since IFRS 16 lists ‘personal computers’ as a possible example of a low-value asset, and
since there is no evidence provided to the contrary, it seems that this is simply an average,
relatively low value personal computer and thus the recognition exemption would be
available when accounting for this lease. The entity can thus choose to expense this lease.
Lease B. Both the current value and the value when new are provided. However, we ignore the current value
and focus on the value when new, despite the asset being second-hand. The value when new is
$20 000, which is above the $5 000 threshold mentioned in the ‘basis of conclusions’. Although this
threshold is not a definitive ‘hurdle rate’, it suggests that it may not be a low-value asset.
We then look at the nature of the asset as well. The underlying asset is a computer, but
although IFRS 16 lists ‘personal computers’ as one of the examples of a low-value asset, it
can happen that a personal computer is a high-end and unusually expensive computer. If the
value of this computer ($20 000) is higher in value than the average cost of new personal
computers, then this asset would not qualify for the exemption.
Lease C. The lease would not qualify for the exemption, even if the underlying asset is a low-value
asset, because the entity intends to sub-lease the asset. IFRS 16.B7 specifically prohibits the
use of the recognition exemption if the underlying asset will/ may be sub-leased.
Lease D. The 5 individual leases cannot be considered separately. Although each appears to have a
relatively low value, the lessee cannot benefit from the use of any one of the leased assets
separately – they are all highly interrelated. Together, these leased assets appear to have a
high value and thus the exemption would not be available.
Chapter 16 791
8.3 Short-term leases and the simplified approach (IFRS 16.8 & Appendix A)
In the case of a short-term lease (a defined term – please see pop up Short-term leases
alongside), the choice of applying the simplified approach must ‘be & the simple
made by class of underlying asset to which the right of use relates’. In approach:
other words, the choice made in respect of short-term leases (i.e. to x The choice to opt for the
expense, or recognise ‘on balance sheet’) is an accounting policy simpler approach is available
by ‘class of asset’ (it’s an
choice that must be applied consistently to that entire class of asset. accounting policy choice).
For example, if we have a right to use a delivery vehicle, we x Lease term = 12m/less from
commencement date & lease
would have to decide what our accounting policy is with regard may not include purchase option.
to accounting for short-term leases of delivery vehicles: either,
we would account for all short-term leases of delivery vehicles ‘on balance sheet’ , or account
for all short-term leases of delivery vehicles in terms of the exemption (i.e. using the
simplified approach). Thus, an entity may choose to recognise as an expense all short-term
leases relating to delivery vehicles but, at the same time, it may choose to recognise on
balance sheet all short-term leases relating to office equipment. See IFRS 16.8
A short-term lease is defined as:
x A lease that, at the commencement date, has a lease term of 12 months or less.
x A lease that contains a purchase option is not a short-term lease. IFRS 16 App A
The lease term is defined as: The commencement date of the

lease is defined as:
x the non-cancellable period for which the lessee has
the right to use an underlying asset x the date on which a lessor
x together with periods covered by an option to: x makes an underlying asset available for use
by a lessee. IFRS 16 App A
extend the lease, if the lessee is reasonably certain to
exercise that option
terminate the lease, if the lessee is reasonably certain not
to exercise that option. IFRS 16 App A (slightly adapted)
Notice that the definition of a short-term lease is fairly self-explanatory, but that it contains
two further defined terms: ‘lease term’ and ‘commencement date’. The application of all three
defined terms is best explained by way of example.
Example 11: Exemptions and short-term leases
Consider the following non-related leases involving delivery vehicles:
Lease A. Entity A enters into a lease where the contractual terms result in a lease term of 6 months,
with no option to purchase.
Lease B. Entity A enters into a lease where the contractual terms result in a non-cancellable lease term
of 12 months, plus an option to extend the contract for a further 6-month period. Given that
the rentals in the extended 6-month period would be significantly below market value,
management concludes that it is reasonably certain that the entity will exercise its option to
extend the contract to the full 18-months.
Lease C. Entity A enters into a lease where the contract terms result in a non-cancellable lease term of
12 months, plus a further 6 months during which Entity A may, at any stage, choose to
cancel the contract. Management considers the cancellation penalty to be insignificant and
thus concluded that it was not ‘reasonably certain that it would not exercise the termination
option’ (i.e. it was possible that the entity could exercise its option to terminate.
Required: For each of the leases above, briefly explain whether the lease would meet the definition of
a short-term lease and whether it would thus qualify for the option to apply the recognition exemption.
Solution 11: Exemptions and short-term leases

General comment: Even if a lease over an asset meets the definition of a short-term lease, it would not
be accounted for in terms of the recognition exemption (i.e. in terms of the simplified approach) unless
the lessee has elected as its accounting policy to always apply the recognition exemption to that
specific class of assets in the event that the lease is a short-term lease.
792 Chapter 16
Lease A. This lease meets the definition of a short-term lease, since it is shorter than 12 months and includes
no purchase option. Thus, the lease costs will be expensed, assuming Entity A has adopted the
accounting policy of accounting for short-term leases of delivery vehicles under the recognition
exemption.
Lease B. This lease does not meet the definition of a short-term lease. The definition of a ‘lease term refers to
the non-cancellable period, which in this case is 12 months and would thus seem to qualify the lease
as a short-term lease. However, the definition of ‘lease term’ also includes any optional extension
periods that are reasonably certain of being exercised. In this case, there is an option to extend for a
further 6 months and management believes, given the economics of the lease, that it is reasonably
certain the option will be exercised. Thus, the lease term is 18 months (non-cancellable period: 12m
+ reasonably certain extension period: 6m). Thus, the lease is not a short-term lease (the lease term
is not 12 months or less) and this means that it does not qualify for the recognition exemption. The
lease must be recognised ‘on balance-sheet’ instead.
Lease C. This lease meets the definition of a short-term lease. When calculating the lease term, we include
both the non-cancellable period and any further cancellable periods (i.e. periods during which the
lessee could terminate the contract), but only if it is reasonably certain that the lessee would not
exercise its cancellation option. Since Entity A is not reasonably certain that it would not cancel the
contract, this cancellable period is excluded from the lease term. The lease term is thus 12 months
and meets the definition of a short-term lease. The lease costs will thus be expensed (assuming
Entity A’s accounting policy is to account for short-term leases of its vehicles under the recognition
exemption).
9. Recognition and measurement – necessary terminology (IFRS 16.9-16 and .B9-B33)
9.1 Overview
Recognition of leases:
There are two options regarding the recognition of leases. x General approach: on-balance sheet
Either the lease qualifies for the optional recognition x Simplified approach: off-balance
exemption and the entity chooses this option (the sheet
simplified approach to accounting for a lease), or the lease (only if short-term lease or a low-
value asset). (See section 8)
is recognised on balance sheet (the general approach).
Before we explain how to recognise and measure leases under each of these approaches, there
are a few core terms which are explained below.
9.2 Lease term (IFRS 16.18-21 & .B34-B41)
A lease term is defined as:
A lease term starts on the commencement date. The x the non-cancellable period for
commencement date is the date that the lessor makes the which a lessee has the right to use
leased asset available for use by the lessee. IFRS 16.B36 and App. A an underlying asset,
x together with periods covered by:
The length of the lease term itself is the non-cancellable period an option to extend the lease if
during which the entity has the right to use the asset. It includes the lessee is reasonably certain
to exercise that option; &
any rent-free periods that the lessor may give to the lessee.
an option to terminate the lease
if the lessee is reasonably certain
However, the lease term may, under certain circumstances,
not to exercise that option.
also include an optional renewal period or possibly even IFRS 16 App A (slightly reworded)
cancellable periods (periods during which the lessee may

terminate the contract). This is explained below.
If the entity (lessee) has the option to extend the lease (an optional renewal period), and it is
reasonably certain that it will choose to extend the lease, then the lease term will also include
these further extension periods (non-cancellable period + renewal periods). See IFRS 16.18(a)
If the entity (lessee) has the option to terminate the lease (an optional cancellable period), but it is
reasonably certain that it will not terminate the lease, then this further ‘cancellable period’ would be
included in the lease term. In other words, by contrast, if there is a further period during which the
entity has the option to terminate the lease, and it is likely that the entity will terminate the lease
during this period, then this period – from the date that the termination becomes possible – is not
included in the lease term. See IFRS 16.18(b)
Chapter 16 793
Please note that, if a lease contains an optional cancellable period, the lessee only considers
including this cancellable period if it is only the lessee that has the option to terminate. In other
words, if the lessor also has the option to terminate the lease during this ‘cancellable period’,
we must not consider including this period in the lease term, even if the lessee also has this
option and is reasonably certain that it will not exercise it. See IFRS 16.B35
Please also note that the estimation of the lease term would not be altered in the event that
certain periods during the lease term are rent-free (i.e. the fact that certain of the periods may
be rent-free is irrelevant when estimating the lease term). See IFRS 16.B36
The lease term is calculated as the total of the following:
Non-cancellable period xxx

Extension periods (renewal periods): only if reasonably certain to exercise the renewal option xxx
Cancellable periods: only if reasonably certain that it won’t exercise the cancellation option xxx
Example 12: Lease term – basic application

Entity A (lessee) enters into a lease over a plant.
Consider the following scenarios:
Scenario 1. The lease is non-cancellable for a period of 3 years from commencement date, after which
Entity A then has the option to extend the lease for a further 2 years. Entity A is reasonably
certain that it will exercise the renewal option (e.g. Entity A believes there is an economic
incentive to renew the lease).
Scenario 2. The lease is non-cancellable for a period of 3 years from commencement date after which
Entity A then has the option to extend the lease for a further 2 years. Entity A is reasonably
certain that it will not exercise the renewal option (e.g. Entity A believes there is no
economic incentive to renew the lease).
Scenario 3. The lease is for a 10-year period during which the first 7 years is non-cancellable. At the
end of the 7-year period, Entity A has the option to terminate the lease. Entity A is
reasonably certain that it will exercise the termination option (e.g. Entity A believes there
is an economic incentive to terminate the lease).
end of the 7-year period, Entity A has the option to terminate the lease. Entity A is
reasonably certain that it will not exercise the termination option (e.g. Entity A believes
there is no economic incentive to terminate the lease).
end of the 7-year period, both Entity A and the lessor have the option to terminate the
lease. Entity A is reasonably certain that it will not exercise the termination option (e.g.
Entity A believes there is no economic incentive to terminate the lease).
Required: Calculate lease term for each of the scenarios above.
Solution 12: Lease term – basic application
Scenario 1: Lease term = 5 years
Calculation: Lease term = non-cancellable period: 3 yrs + Optional extension period: 2 yrs = 5 years
Explanation: The optional extension period is included because Entity A (lessee) is reasonably certain
that it will exercise the option to extend the lease.
Calculation: Lease term = non-cancellable period: 3 yrs + Optional extension period: N/A = 3 years
Explanation: The optional extension period is excluded because Entity A (lessee) is not reasonably
certain that it will exercise the option to extend the lease.
Calculation: Lease term = non-cancellable period: 7 yrs + Optional cancellable period: N/A = 7 years
Explanation: The optional cancellable period is excluded since it is only included if there is reasonable
certainty that the option to cancel (terminate) the lease would not be exercised. However,
in this case, Entity A (lessee) is reasonably certain that it will exercise its option to cancel.
794 Chapter 16

Calculation: Lease term = non-cancellable period: 7 yrs + Optional cancellable period: 3 yrs = 10 years
Explanation: The optional cancellable period is included because we include it if we are reasonably
certain that we would not exercise our option to cancel (terminate) the lease. In this case,
Entity A (lessee) is reasonably certain that it will not wish to cancel the lease.
Calculation: Lease term = non-cancellable period: 7 yrs + Optional cancellable period: 0 yrs = 7 years
Explanation: The optional cancellable period is excluded. Although we normally include the
cancellable periods if we are reasonably certain that the option to cancel (terminate) will
not be exercised, and in this case, Entity A (lessee) is reasonably certain that it will not
wish to cancel the lease, the cancellable period is excluded because the lessor also has the
option to cancel the lease during this period.
When deciding whether it is reasonably certain that the entity (lessee) would exercise an
option to extend (a renewal option), or an option to terminate a lease (termination/ cancellation
option), we must consider all relevant facts and circumstances that might provide the
necessary economic incentives. For example:
x significant penalties: if an option to terminate involves the payment of a significant
penalty, this may be a sufficient economic incentive not to terminate;
x the importance of the underlying asset to the entity: if an underlying asset is critical to the entity’s
operations, being of such a specialised nature that it will be needed beyond the non-cancellable
period, this may be sufficient evidence that the lessee would choose to exercise an option to extend,
or would choose not to exercise an option to terminate (depending on the available options);
x significant leasehold improvements or initial installation costs: if the lessee has incurred
significant costs to install or improve an underlying leased asset, this may be sufficient
evidence that the lessee would choose to exercise an option to extend, or would choose not
to exercise an option to terminate (depending on the available options)
x below market-rentals: if an option to extend a lease would result in lower than market-
related lease payments during an optional extension period, this may provide a sufficiently
large economic incentive to choose to extend the lease. See IFRS 16.19 and .B37
It is important to be aware that significant professional judgement is required when analysing
all these facts and circumstances. However, estimating the lease term is a critical part of
accounting for a lease. The correct determination of the lease term is important because:
x it will be used to decide whether the lease is a short-term lease and thus whether it
qualifies to be recognised as an expense (in terms of the simplified approach offered by
the ‘recognition exemption’); and
x it will be used to determine which payments to include in the measurement of the lease
liability (which will then also affect the measurement of the related right-of-use asset).
Example 13: Lease term – option to extend: theory
Entity A (lessee) enters into a lease over a plant. The lease is non-cancellable for 3 years
from commencement date, after which Entity A may extend the lease for a further 2 years.
x The lease rentals charged in the first year are market-related and will escalate at a rate of 10% pa,
with the result that the rentals in the last 2 years are expected to exceed market-related rentals.
x The plant must be installed by the lessee at the beginning of the lease and this installation cost is
considered to be significant.
x Entity A uses the plant to manufacture products that it expects will be in demand for at least 10 years.
x The cost of negotiating the lease over another plant from another supplier at the end of the initial 3-
year period is expected to be insignificant.
Required:
Calculate lease term and provide a brief explanation justifying your calculation.
Chapter 16 795
Solution 13: Lease term – option to extend: theory

Answer: The lease term is 5 years calculated as:
Non-cancellable period 3 years + Extension period that is reasonably certain: 2 years = 5 years
Explanation: When estimating the lease term, we must assess all relevant facts and circumstances that
may provide the lessee with the economic incentive to exercise an option to extend or exercise an
option to terminate the contract.
In this case, the lessee has the option to extend the contract.
x The lease rentals during the ‘optional 2-year extension period’ are expected to be higher than
market-related rentals and thus do not provide the lessee with an economic incentive to extend the
lease. However, we must consider all other facts and circumstances as well (see below).
x The lessee expects to need the use of this plant (or a replacement plant) for a period well beyond
the expiry of the possible 5-year term of the lease, thus providing an incentive to extend the lease.
x Since the entity needs to use the plant, or a replacement plant, for more than 3 years, it will mean
that if the entity does not renew the lease, it will need to source another plant. Although the cost of
negotiating the lease of another plant is expected to be insignificant, which does not constitute an
incentive to extend the lease, the cost to install the replacement plant will be a significant cost. The
significant extra installation costs provide a significant economic incentive to extend the lease.
Thus, on balance, it is submitted that the entity would be reasonably certain to renew the contract and
thus that the optional extension period should be included in the calculation of the lease term.
Please note:
Your solution could have argued that the lease term was 3 years and thus that the entity would be
reasonably certain not to extend the lease since the lease rentals would exceed market-related lease
rentals. In practice, one would have to consider whether the excessive lease rentals were outweighed by
the significant cost of installing a replacement part or vice versa.
Since the calculation of the lease term involves estimating whether it is reasonably certain that
the entity (lessee) will exercise its option to renew or that it will not exercise its option to
terminate the lease, the entity (lessee) is required to reassess these estimations if and when:
x there is a significant event or change in circumstances;
x that is within its control; and
x may affect whether the entity may be reasonably certain to exercise or not to exercise an
option that was or was not previously included in the lease term. See IFRS 16.20
Just as we did when originally estimating the lease term (i.e. at the commencement of the
contract), we must consider all relevant facts and circumstances that may create an economic
incentive for the entity (lessee) to change its original decision regarding whether it is
reasonably certain that it would exercise or not exercise an option.
For example, at commencement date, we may have concluded that it appeared reasonably
certain that we would exercise an option to extend the lease but, during the course of the
lease, something happens that makes it uneconomical for us to extend the lease. In other
words, under the new circumstances, it now appears reasonably certain that we will not
exercise our option to extend and thus, the revised estimate of the lease term is shorter than
the original estimate.
We must revise our estimated lease term whenever there is a change in facts or circumstances
that would alter the reasonable certainty of our decision to exercise/not exercise our options
(whether our options are to extend or terminate the lease).
Since the lease term has a bearing on the payments that are considered to be lease payments
for purposes of measuring the lease liability (and related underlying right-of-use asset), a
change in the lease term will require adjustments to the measurement of the lease liability and
the right-of-use asset. Please see example 20 for an example that shows the adjustment
necessary due to a change in lease term. See IFRS 16.39
796 Chapter 16
9.3 Lease payments (IFRS 16.26-28 and Appendix A)
9.3.1 Overview
Lease payments is a defined term (see definition below). The definition of lease payments
differs slightly from the perspective of a lessee or lessor. In the case of a lessee, the definition
of the term lease payments refers to five possible categories of payments, which may or may
not be included in the lease payments, depending on the circumstances:
x Fixed lease payments
x Variable lease payments that are dependent on an index or rate
x Exercise price of purchase options
x Termination penalties
x Amounts due in terms of residual value guarantees. See IFRS 16.27
The term lease payments is defined as:
Payments made by a lessee to a lessor relating to the right to use an underlying asset during the lease term,
comprising the following:
(a) fixed payments (including in-substance fixed payments), less any lease incentives;
(b) variable lease payments that depend on an index or a rate;
(c) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and
(d) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option
to terminate the lease.
For the lessee:

x Lease payments also include amounts expected to be payable by the lessee under residual value guarantees.
x Lease payments do not include payments allocated to non-lease components of a contract, unless the lessee
elects to combine non-lease components with a lease component and to account for them as a single lease
IFRS 16 App A (slightly reworded)
component (see the practical expedient of IFRS 16.15).
There is a slightly different variation on this definition when being applied by a lessor (see chapter 17).
Apart from each of these five categories, which may or may not be included in the lease
payments (and which will be discussed in more detail below – see sections 9.3.2 to 9.3.6), it is
also important to note that a contract could involve payments for the right to use a variety of
different underlying assets, each of which may meet the definition of a separate lease
component and may even involve payments for non-lease components.
If a contract involves payments for the right to use a variety of different assets, we would need
to determine which of these rights meet the definition of a separate lease component. If we
then find that we have more than one lease component in the contract, we must remember that
each of these lease components must be accounted for as a separate lease. Since each of these
must be accounted for as a separate lease, we will need to calculate the lease payments
relevant to each of these lease components.
Furthermore, the contract may also include payments relating to non-lease components (e.g.
the contract may require payments in return for the provision of services – since the provision
of a service is not the provision of a right to use an asset, this aspect of the contract would not
meet the definition of a lease and would thus be referred to as a non-lease component).
Payments that are made in respect of non-lease components should not be included in the
calculation of lease payments, unless the lessee has opted to apply the practical expedient
whereby it need not bother separating the payments for the lease component from the
payments for any non-lease components.
See section 6 for a detailed explanation of the allocation of the consideration among separate
lease components.
Chapter 16 797
9.3.2 Fixed payments Fixed payments are

defined as:
Fixed payments is a defined term (see definition alongside). x Payments made by a lessee to
a lessor
This definition essentially includes all payments that are made x for the right to use
in return for the right to use an asset, with the exception of all an underlying asset
variable lease payments (see section 9.3.3 below). x during the lease term,
x excluding variable lease pmts.
IFRS 16 App A
Although fixed payments are included in the calculation of lease
payments, IFRS 16 requires that, when calculating the lease payments, we deduct from the fixed
payments any amounts that may have been received by (or be receivable from) the lessor to
incentivise the lessee to enter the lease. These receipts are called
lease incentives, which is yet another defined term (see alongside). Lease incentives are
See IFRS 16.27(a) defined as:
Fixed payments also include payments referred to as in-substance x pmts made by a lessor to
a lessee associated with
fixed payments, which are simply payments that appear to contain a lease, or
variability but are, in substance, unavoidable (e.g. where there is, in x the reimbursement or
theory, a variety of payments that the lessee could make, but where assumption by a lessor of costs
‘only one of these sets of payments is realistic'). See IFRS 16.B42 of a lessee. IFRS 16 App A
9.3.3 Variable lease payments

Variable lease pmts are
Another category is variable lease payments, which is also a defined as:
defined term (see definition alongside). Before we look at the x the portion of payments made
definition of a variable lease payment, it is important to take note by a lessee to a lessor
that not all variable lease payments will be included in the x for the right to use an
calculation of lease payments. This will be explained in a moment. underlying asset during the
lease term
In terms of the definition, variable lease payments also refers x that varies because of changes
to payments that are made in return for the use of the asset, but in facts or circumstances after
the commencement date,
there are two important differences from a fixed payment:
variable payments are payments that are expected to vary, but x other than the passage of
time. IFRS 16 App A
must vary due to various facts or circumstances that will
change after commencement of the lease. For example:
x A lease payment that is based on a percentage of the revenue generated by a leased asset
would be a variable lease payment. This is because, since the revenue generated by the
asset will only arise after commencement date, we cannot, at commencement date, know
the amount of the payment that will be due.
x Similarly, lease payments that will be based on an index or rate (e.g. lease rentals that will
be adjusted for the changes in the consumer price index or changes in the bank lending
rates) are variable payments, since the future changes in the index or rate would not be
known at commencement date.
x Conversely, lease payments that will increase at a fixed rate per year are not variable lease
payments. This is because, although the lease payments will vary from one year to the
next (e.g. the lease payment may be set to increase by 10% per year), this variance is not
due to a change in the facts or circumstances arising after commencement date. This rate is
known at commencement date. Since these payments do not meet the definition of variable
lease payments, they would meet the definition of fixed lease payments.
Let us now return our attention to whether variable lease payments will be included in the calculation
of lease payments. The definition of lease payments includes only those variable payments that vary
in line with an index or a rate (e.g. lease rentals that will increase over time in tandem with the
consumer price index). Thus, variable payments that depend on, for example, the level of revenue
generated from the leased asset, would not be considered to be a lease payment.
It is interesting to note that, since the measurement of the lease liability is based on the present
value of the lease payments, and since the lease payments include variable lease payments
that vary based on an index or rate, the lease liability will require constant remeasurement
(i.e. each and every time that the index or rate changes).
798 Chapter 16
In other words, if lease payments include variable lease payments, the amount of the variable
lease payment that must be included in the calculation of the present value of the lease
payments must be based on the relevant index or prevailing rate at the commencement of the
lease. When the relevant index changes, we will need to recalculate the variable lease
payment, which will then alter the lease payments. This, in turn, will change the measurement
of the lease liability. This is explained in detail in section 11.6.
For example: A variable lease payment may start at C1 000 per year, to be increased each year at the
rate of change of CPI. On commencement date, we include C1 000 per year as the variable lease
payment in the initial measurement of the lease liability. However, in the next year, when CPI
increases by 10%, the new amount of the variable lease payment is C1 100, and this latter amount
must be included in the lease payment calculation, which will require a remeasurement of the lease
liability.
9.3.4 Exercise price of purchase options
If the lessee also has an option to purchase the leased asset, then the total lease payments must
include the exercise price of this purchase option, but only if the lessee is reasonably certain it
will exercise this option.
9.3.5 Termination penalties
If the lessee has an option to terminate the lease, then any termination penalties must be
included in the total lease payments, but only if the lessee is reasonably certain it will exercise
this option. In other words, we would only include the termination penalty if it was reasonably
certain that it would exercise the option to terminate the lease and thus that the expectation
that the lease would be terminated had also been factored into the calculation of the lease term.
9.3.6 Residual value guarantees A residual value

guarantee is defined as:
The term ‘residual value guarantee is also a defined term x a guarantee made to a lessor
(see definition alongside). If the lessee guarantees to the x by a party unrelated to the lessor
x that the value (or part thereof)
lessor that the underlying asset will have a certain minimum x of an underlying asset at the end
value at the end of the lease, then any amount that is of a lease
expected to be payable as a result of this residual value x will be at least a specified
guarantee would be included as a lease payment. amount. IFRS 16 App A (slightly reworded)
For example, if the lessee guarantees that the underlying asset will have a value of C100 at the
end of the lease, but at commencement of the lease, the lessee actually believes the asset will
have a value of only C20, then the lessee must include in the calculation of its lease payment
an amount of C80, due to the fact that it has provided a residual value guarantee but expects
there to be a shortfall in the value of the physical asset of C80, which it will have to ‘pay in’ in
order to settle with the lessor at the end of the lease term.
9.3.7 Summary of the calculation of lease payments
Thus, the total lease payments are calculated as follows:
The lease payments are calculated as the total of the following:
x Fixed payments (including in-substance fixed payments) less lease incentives xxx
x Variable payments (only those that vary with an index on rate) xxx
x Exercise price for a purchase option (only if reasonably certain to exercise the option) xxx
x Penalties for a termination option (only if lease term calculated on the assumption that the xxx
entity will exercise this option)
x Amounts expected to be payable in terms of residual value guarantees xxx
Chapter 16 799
9.4 Discount rate (IFRS 16.26)
The measurement of the lease liability is based on the present value of the lease payments,
calculated using an appropriate discount rate. There are two rates that may be used as the
appropriate discount rate:
x The interest rate implicit in the lease; or
x The lessee’s incremental borrowing rate.
The discount rate that we should ideally use is the interest rate implicit in the lease agreement.
However, this rate is not always readily determinable by the lessee because, in order to calculate it
(being the rate that causes the present value of the lease payments and unguaranteed residual value to
equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor), we
would require knowledge of the lessor’s circumstances. For example, it assumes that the lessee has
knowledge of the lessor’s initial direct costs. If the lessee cannot ‘readily determine’ the implicit
interest rate, it may use its incremental borrowing rate instead. We expect that the lessee would
normally use the incremental borrowing rate.
The interest rate implicit in the lease A lessee’s incremental borrowing rate
is defined as: is defined as:
x The rate of interest that causes: x the rate of interest the lessee would have to pay
x the present value of (a) the lease payments and x to borrow over a similar term, and with similar
(b) the unguaranteed residual value security,
to equal x the funds necessary to obtain an asset of a
x the sum of (i) the fair value of the underlying similar value to the right-of-use asset
asset and (ii) any initial direct costs of x in a similar economic environment.
IFRS 16 App A
the lessor. IFRS 16 App A
The unguaranteed residual value Initial direct costs

is defined as: are defined as:
x That portion of the residual value of x incremental costs of obtaining a lease
the underlying asset, x that would not have been incurred if the lease
x the realisation of which by a lessor is had not been obtained
not assured or except for such costs incurred by a
is guaranteed solely by a party related to manufacturer/dealer lessor in connection with a
the lessor. IFRS 16 App A finance lease. IFRS 16 App A
10. Recognition and measurement – the simplified approach (IFRS 16.6)
If the lease involves a low-value asset or is a short-term lease, the lease may be accounted for in
terms of the recognition exemption (if the entity chooses to apply this option). This optional
recognition exemption is a simplified approach to accounting for the lease. See section 8 for a
detailed explanation on when this recognition exemption may be used.
The simplified approach is:
If the lease is to be accounted for under the optional recognition Expense lease pmts over the
exemption, it means that the costs are recognised as an expense lease term using straight-line
Is very similar to how operating leases
in profit or loss, and measured on a straight-line basis over the were accounted for per IAS 17 Leases
lease term (or using some other systematic basis). (See also section 8)
This process of accounting involves debiting the lease expense with an amount reflecting the lease
payments recognised over the lease term on the straight-line basis, crediting the bank with the lease
payments actually made, and recognising any difference as a lease payable or prepaid. See IFRS 16.6
Example 14: Leases under the recognition exemption (simplified approach)

Entity A leases a computer from Entity B for a period of 24 months. This lease qualifies as
a lease of a low-value asset, and thus qualifies for the recognition exemption. Entity A
chooses to apply the recognition exemption to this lease.
800 Chapter 16
The lease payments are C1 000 per month for the first year and C1 300 per month for the second year.
The lease commenced on 1 April 20X1. Entity A has a 31 December year-end.
Required: Show the journal entries in Entity A’s general journal.
Solution 14: Leases under the recognition exemption (simplified approach)
Comment:
x Since the recognition exemption is applied to this lease, the lease rentals are recognised as an
expense on the straight-line basis over the lease term of 2 years.
x This means we must recognise the lease expense at C1 150 per month (see calculation below).
x Since the lease payments differ from the lease expense, it results, in this example, in a payable that
reverses by the end of the lease.
Calculations: (1 000 x 12 + 1 300 x 12) ÷ 24 months = C1 150 per month

Lease expense (low-value asset) (E) C1 150 x 9 m 10 350
Bank (A) C1 000 x 9 m 9 000
Lease payable (L) Balancing 1 350
Lease of computer under the optional simplified approach
31 December 20X2
Lease expense (low-value asset) (E) C1 150 x 12 m 13 800
Bank (A) C1 000 x 3 m + C1 300 x 9 m 14 700
Lease payable (L) Balancing 900
31 December 20X3
Lease expense (low-value asset) (E) C1 150 x 3 months 3 450
Bank (A) C1 300 x 3 months 3 900
Lease payable (L) Balancing 450
11. Recognition and measurement – the general approach (IFRS 16.22-46)
11.1 Overview
A lease that does not qualify for the recognition exemption (i.e. is not a low-value asset, or
short-term lease) must be accounted for ‘on balance-sheet’. This means that we must
recognise a right-of-use asset and a lease liability.
11.2 Initial recognition and measurement
A lease, which is not accounted for in terms of the recognition exemption, will be accounted
for at commencement date by recognising:
x a right-of-use asset, and
x a lease liability. See IFRS 16.22 Initial measurement of
lease liability:
The lease liability is initially measured, at commencement x PV of lease payments
date, at the present value of the unpaid lease payments on x that are still payable at
commencement date,
this date (i.e. it would exclude any lease payments that are x discounted using either the implicit
paid in advance or had been prepaid). interest rate or the lessee’s
incremental borrowing rate
See IFRS 16.26
The discount factor used would either be the implicit interest
rate or, if this is not readily determinable, the lessee’s incremental borrowing rate (as explained in
section 9.4, it will be more likely that a lessee would use its incremental borrowing rate). See IFRS 16.26
Chapter 16 801
The right-of-use asset is initially measured at its cost, where this cost includes the following:
x The initial measurement of the lease liability; Initial measurement of
right-of-use asset:
x Lease prepayments made on/ before commencement date;
x Lease liability (initial measurement)
x Any initial direct costs incurred by the lessee; and x Initial direct costs
x The provision for any estimated future costs to dismantle x Prepaid lease payments
and remove the underlying asset, restore the site on which x PV of estimated future costs (to
dismantle, remove or restore)
it was situated or restore it to a predetermined condition
x Less lease incentives received.
(i.e. we include the initial measurement of a provision for See IFRS 16.24
such future costs), unless the obligation for these future

costs arose because the underlying asset was used to make inventories;
x Less any lease incentives received. See IFRS 16.24
Let us look at each of the above bullet-points in a bit more detail and also consider how these
would appear as journal entries.
Initial measurement of the lease liability: The lease liability is generally the primary cost in
acquiring the right to use the asset and thus the initial measurement of this liability is included
in the cost of the right-of-use asset.
Lease liability (initial PV) Debit Credit
Right-of-use asset: cost (A) xxx
Lease liability (L) xxx
PV of lease liability is part of the cost of the RoU asset
Lease prepayments: When calculating the cost of the right-of-use asset at commencement date, we
must remember that any lease payments that were already made, either on or before commencement
date, will obviously not be part of the lease liability (which will constitute inter-alia, the remainder of
the lease payments to be paid), so we add these payments, if any, to the cost of the right-of-use asset.
Prepaid lease rentals Debit Credit
Right-of-use asset: cost (A) Prepaid lease rentals (e.g. xxx
Bank (A) rentals payable in advance xxx
Prepaid lease rental (paid on or before commencement date)
is part of the cost of the RoU asset
Initial direct costs: Any initial direct costs (being the incremental costs of obtaining the lease
that would not have been incurred had the lease not been obtained e.g. directly related legal
costs) are also considered to be part of the cost of the right-of-use asset. See IFRS 16.24
Initial direct costs Debit Credit
Right-of-use asset: cost (A) Initial direct costs paid/payable xxx
Bank/ Payable etc (A/L) xxx
Initial direct costs paid or payable is part of cost of RoU asset
Provision for future costs: If the contract requires the lessee, at the end of the lease, to dismantle the
asset, restore the asset or restore the site on which it was situated, then the lessee has a contractual
‘obligation’. The lessee must recognise the obligation for these future costs as a provision (in terms
of IAS 37) and it does so when the obligation is incurred (sometimes this obligation arises merely by
signing the lease contract and sometimes the obligation is incurred/ increases as the underlying asset
is used). The initial measurement of this provision (i.e. the present value of the expected future
outflows) is added to the cost of the right-of-use asset (debit right-of-use asset; credit provision) (per
IFRS 16 Leases). However, if the obligation for these future costs is incurred as a result of the
underlying asset being used to make inventories, then the obligation for these future costs would be
included in the cost of inventories instead (debit inventory asset; credit provision). See IFRS 16.24 (d)
P.S. The above principle of including the initial measurement of the provision in the cost of the
related asset also applies to property, plant and equipment (debit PPE; credit provision). See IAS 16.16 ©
Provision for obligation to dismantle or restore Debit Credit
Right-of-use asset: cost (A) PV of future costs to restore, xxx
Provision (L) dismantle etc xxx
Provision for future costs is part of the cost of the RoU asset
802 Chapter 16
Lease incentives: These are defined as ‘the payments made by the lessor to the lessee associated with
the lease, or the reimbursement or assumption by a lessor of the costs of the lessee’.
Lease incentives would thus include outright receipts from the lessor, (e.g. received to simply
incentivise the lessee to enter into the lease) and also receipts from the lessor that constitute refunds
of costs, relating to the lease, that the lessee has already paid for.
The lessee does not have to actually receive an amount for there to be a lease incentive: the lessor
could undertake to pay certain of the lessee’s costs on the lessee’s behalf.
All lease incentives received or receivable are credited to the cost of the right-of-use asset. However,
we must be careful not to reduce the cost of the asset by receipts or receivables that are not actually
lease incentives. For example, a receipt of a reimbursement from a lessor for leasehold
improvements (e.g. the painting of a leased building) is not considered to be a lease incentive (it does
not relate directly to the lease), and should thus not be accounted for as a reduction in the cost of the
right-of-use asset (building): the leasehold improvements would be expensed, and the related
reimbursement would be accounted for as a reduction in this expense.
Lease incentives (receipts and refunds) Debit Credit
Bank/ Receivable etc (A) Reimbursements received/ xxx
Right-of-use asset: cost (A) receivable – relating to lease xxx
Reimbursement received (a lease incentive) included as a
reduction to the cost of the asset
Example 15: Initial measurement of lease liability and right-of-use asset

Adaptation of IFRS 16.IE13 Part 1
On 1 January 20X1, Entity A (the lessee) enters into a lease over a building, for a non-
cancellable period of four years, with Entity B (the lessor).
x The lease payments include five fixed lease payments of C10 000, with the first
payment of C10 000 payable in advance on 1 January 20X1 and the remaining four
payments of C10 000 payable annually in arrears, starting on 31 December 20X1.
x In addition, Entity A is required to pay 10% of the revenue generated from the use of
the building per year, payable annually in arrears. Entity A expects to generate revenue
of C80 000 per year from the use of the building.
x In order to obtain the lease, Entity A incurred initial direct costs of C4 000 (which it
only paid in 20X2) of which C1 000 was received as a reimbursement from the lessor.
x Entity A also paid for leasehold improvements (painting of the building) of C8 000,
70% of which were also received as a reimbursement by the lessor.
x The appropriate discount rate is 10%.
Required: Using Entity A’s general journal, show the journals to account for the initial recognition of
the lease on 1 January 20X1.
Solution 15: Initial measurement of lease liability and right-of-use asset

Journals:
Right-of-use asset: cost (A) Balancing 41 699
Lease liability (L) W1.1 or W1.3: PV of lease pmts payable 31 699
Bank (A) Given: Lease pmt in advance 10 000
Initial recognition of lease of building (including a lease pmt in adv.)
Right-of-use asset: cost (A) Given 4 000
Accounts payable (L) 4 000
Initial direct costs incurred in connection with lease of building

Right-of-use asset: cost (A) 1 000
Reimbursements of initial direct costs received from lessor
Chapter 16 803

Painting of leased building (P/L: E) Given 8 000
Bank (A) 8 000
Leasehold improvements in connection with lease of building
Bank (A) 8 000 x 70% 5 600
Painting of leased building (P/L: E) 5 600
Reimbursements of leasehold improvements received from lessor
Workings:
W1.1: Present value of lease liability – at 1 January 20X1
The PV of the lease payments, using a financial calculator:
n = 4 i = 10% PMT = -10 000
COMP PV ...
and your answer should be: 31 699!
Comment:
x Leasehold improvements and related reimbursements incurred by the lessee are not included when
accounting for a right-of-use asset and lease liability (Journals 4 and 5).
x The initial direct costs are capitalised to the right-of-use asset but have nothing to do with the
measurement of the lease liability (Journal 2).
x The lease payments that are based on a percentage of revenue are variable lease payments but,
since they do not vary in line with an index or rate, they are not included in the calculation of lease
payments (as defined) and are thus not included in the measurement of the lease liability. These
variable lease payments will simply be expensed when they are incurred.
x There were 5 fixed lease payments of C10 000 each, but yet the lease liability was calculated based
on only 4 fixed lease payments. This is because the first lease payment was paid in advance and
thus is not part of the liability at commencement date. This first lease payment, paid in advance, is
accounted for as part of the right-of-use asset though (Journal 1).
x The reimbursement of a portion (C1 000) of the initial direct costs is regarded as a lease incentive,
as it is a payment by the lessor to the lessee in order to refund costs incurred in securing the lease
(Journal 3). Note that the reimbursement for the leasehold improvement is not a lease incentive, as
it relates to the improvements effected by the lessee, and is thus not related directly to the lease
11.3 Subsequent measurement – a summary overview
A lease that is accounted for under IFRS 16’s general approach is accounted for ‘on-balance
sheet’, with the result that a lease liability and right-of-use asset will be recognised.
x The initial recognition and measurement at commencement date of both these elements
was explained in section 11.2.
x The subsequent measurement, after commencement date, of both elements is as follows:
the lease liability is accounted for under the effective interest rate method, which
means that it is increased by an amount recognised as interest and decreased by the
lease payments; and
the right-of-use asset is depreciated and tested for impairments, normally under the
cost model, although the revaluation model or fair value model may, under certain
circumstances, be used instead.
The subsequent measurement of the lease liability and right-of-use asset may also involve
remeasurement adjustments, or lease modification. This happens if there is a reassessment,
lease modification or a revision to the in-substance fixed lease payments. See IFRS 16.36
More detail regarding the subsequent measurement of each of these elements can be found in:
x Section 11.4 – subsequent measurement of a lease liability
x Section 11.5 – subsequent measurement of a right-of-use asset
x Section 11.6 – subsequent measurement involving remeasurements
x Section 11.7 – subsequent measurement involving lease modifications
804 Chapter 16
11.4 Subsequent measurement of the lease liability
11.4.1 Overview Subsequent measurement of

lease liability:
The lease liability is initially measured at the present x Amortised cost (increase by
value of the unpaid lease payments at commencement interest and decrease by payments)
date, discounted at either the interest rate implicit in the x May need to be remeasured if there
is a subsequent change to the lease
lease or, if this is not readily determinable, then at the payments. See IFRS 16.36 & .39
lessee’s incremental borrowing rate. Irrespective of which

rate is used, it is must be the rate applicable at commencement date. See section 11.2 for more
detail on the initial measurement.
The subsequent measurement of the lease liability is at amortised cost i.e. using the effective
interest rate method.
11.4.2 The effective interest rate method
The effective interest rate method is often described as apportioning the lease payments between
interest expense and a reduction in the lease liability but, effectively, it means that we:
x increase the lease liability with the interest on the liability (i.e. unwinding the discounting
that occurred at initial measurement) and recognise this interest as an interest expense; and
x we decrease the lease liability by the lease payments.
The journals we would process are as follows:

Debit Credit
Finance cost - lease (P/L: E) xxx
Interest on lease liability calculated using the EIR method
Bank (A) xxx
Lease payments made
Example 16: Lease liability – subsequent measurement

Use the same information that was contained in the previous example (summarised in the
block below for your convenience) together with the following additional information:
x On 1 January 20X1, Entity A (the lessee) entered into a lease over a building, for four years.
x The lease payments include five fixed lease payments of C10 000 each, with the first being payable in
advance on 1 January 20X1 and the remaining four fixed lease payments of C10 000 each being
payable in arrears (with the first such payment being due on 31 December 20X1).
x Entity A is also required to pay 10% of the revenue generated from the use of the building per year,
payable in arrears. At commencement date, Entity A expected to generate revenue of C80 000 per year.
x In order to obtain the lease, Entity A incurred initial direct costs, in 20X1, of C4 000 of which C1 000
was received as a reimbursement by the lessor, in 20X1. These initial costs were paid in 20X2.
x The appropriate discount rate (lessee’s incremental borrowing rate) was 10% at commencement date.
x Entity A generated revenue from the use of the building of C70 000 in 20X1 and C60 000 in 20X2
and paid the variable lease payments on due date.
x Entity A paid the initial direct costs of C4 000, (which were incurred in 20X1), in 20X2.
The implicit interest rate was not readily determinable and thus the entity uses its incremental borrowing rate.
The incremental borrowing rates were as follows:
01 January 20X1: 10%
31 December 20X1: 11%
Required: Show the journals to account for the subsequent measurement of the lease liability, and the
variable lease payments in Entity A’s general journal for 20X1 and 20X2 assuming that Entity A has a
31 December financial year-end.
Chapter 16 805
Solution 16: Lease liability – subsequent measurement

Comments:
x At 1 January 20X1, the incremental borrowing rate was 10%. Although the incremental borrowing rate
changes over the lease period, we continue to use the rate that applied at commencement date.
x The lease liability at commencement date was initially measured at its present value, discounted at 10%, of
C31 699 (see W1 and journals in the prior example, example 15).
x The variable lease payments that did not vary based on an index or rate, and were thus not included in the
calculation of lease payments as defined, are expensed as they are incurred.
x There are 2 lease payments in 20X1: C10 000 paid in advance, on commencement date, and thus excluded from the initial
measurement of the lease liability, and another C10 000 paid in arrears, on 31 December 20X1.

Finance cost - lease (P/L: E) W1 3 170
Lease liability (L) 3 170
Interest on lease, based on the effective interest rate method
Lease liability (L) Given (paid in arrears) 10 000
Bank (A) 10 000
Lease payment – fixed lease payment (was included in the liability and
thus when it is paid, it reduces the liability)
Variable lease payment (P/L: E) C70 000 x 10% 7 000
Bank (A) 7 000
Lease payment – variable lease payment (was not included in the
liability and thus is expensed when it is paid or incurred)
31 December 20X2
Lease liability (L) Given (paid in arrears) 10 000
Bank (A) 10 000
Lease payment – fixed lease payment (was included in the liability and
thus when it is paid, it reduces the liability)
Variable lease payment (P/L: E) C60 000 x 10% (paid in arrears) 6 000
Bank (A) 6 000
Lease payment – variable lease payment (was not included in the
liability and thus is expensed when it is paid or incurred)
Account payable (L) Given 4 000
Bank 4 000
Initial direct cost that was incurred in 20X1 but paid in 20X2
Workings:
W1: Lease liability – effective interest rate table: as at 1 January 20X1 (payments in arrears)
Years Balance (start) Interest at 10% Lease payments Balance (end)
20X1 (1) 31 699 (2) 3 170 (10 000) 24 869
20X2 24 869 2 487 (10 000) 17 356
20X3 17 356 1 736 (10 000) 9 092
20X4 9 092 908 (10 000) 0
8 301 (40 000)
Notes:
(1) Although lease payments for the purpose of measuring the lease liability include fixed lease payments, we only include
lease payments that are payable on commencement date (i.e. we exclude lease payments that are paid on or before
commencement date).
Thus, although this lease involves 5 fixed lease payments, the first one is paid on commencement date and thus
only 4 fixed lease payments are included in the initial measurement of the lease liability of C31 699 (see W1.1 in
previous example) and thus
only 4 lease payments appear in the effective interest rate table (see W1 in this example).
(2) For the present value of the liability calculation, please see W1.1 in the prior example, example 15.
806 Chapter 16
Example 17: Lease liability – initial and subsequent measurement

(advance lease payments)
Entity A (lessee) entered into a contract with Entity B (lessor) to lease a plant. The lease
was for a non-cancellable period of five years. Entity A is required to make five lease instalments of
C20 000 each, payable annually in advance, with the first payment due on 1 January 20X1
(commencement date). The implicit interest rate was 16%.
Required:
a) Show the journals to account for the lease liability in Entity A’s general journal for each year
affected assuming that Entity A has a 31 December financial year-end. Ignore all journals relating
to the subsequent measurement of the asset.
b) Calculate the lease liability balance to be included in the statement of financial position and the
lease interest expense to be included in the statement of comprehensive income for the years ended
31 December 20X1 to 31 December 20X4.
Solution 17: Lease liability - initial and subsequent measurement (advance lease payments)
Comments:
x The initial measurement of the lease liability includes only those lease payments that are payable on
commencement date (thus it excludes lease payments that were made on or before commencement
date). This means that the lease liability on commencement date is the present value of only 4 lease
payments, since it excludes the first lease payment that was made on commencement date.
x The right-of-use asset includes both the initial measurement of the lease liability (present value of
the 4 lease payments) plus the advance lease payment that was paid on commencement date.
a) Journals:
Right-of-use asset: cost (A) W1 75 964
Bank (A) 20 000
Initial recognition and measurement of lease
31 December 20X1
1 January 20X2
Lease liability (L) Given (paid in advance) 20 000
Bank (A) 20 000
Lease payment – fixed lease payment
31 December 20X2
1 January 20X3
Bank (A) 20 000
31 December 20X3
1 January 20X4
Bank (A) 20 000
Chapter 16 807

1 January 20X5
Bank (A) 20 000
b) Balances at year end 20X5 20X4 20X3 20X2 20X1

Lease liability 0 20 000 37 242 52 105 64 918
Lease interest expense 0 2 758 5 137 7 187 8 954
Workings:
W1: Lease liability – present value of lease payments payable on commencement date
The PV of the lease payments , using a financial calculator:
x n = 4 i = 16% PMT = -20 000
COMP PV ... and your answer should be: 55 964
W2: Lease liability – effective interest rate table: as at 1 January 20X1 (payments in ADVANCE)
Year (1) Balance (start) Interest at 10% Lease payments Balance (end)
20X1 (2) 55 964 8 954 64 918
20X2 64 918 (20 000) 44 918
44 918 7 187 52 105
20X3 52 105 (20 000) 32 105
32 105 5 137 37 242
20X4 37 242 (20 000) 17 242
17 242 2 758 20 000
20X5 20 000 (20 000) 0
24 036 (80 000)
11.5 Subsequent measurement of the right-of-use asset
11.5.1 Overview Subsequent measurement

of a RoU asset:
The right-of-use asset is normally accounted for in terms x Normally in terms of the cost model
but may use the revaluation model
of a cost model (per IFRS 16) in which case it is or fair value model depending on
depreciated and tested for impairments (in terms of the circumstances. See IFRS 16.29 &.34-35
IAS 36 Impairment of assets). On occasion it may also be subjected to a remeasurement
adjustment due to a remeasurement of the lease liability.
Although the right-of-use asset is normally measured in terms of the cost model, it may be
accounted for in terms of the revaluation model (per IAS 16) or fair value model (per IAS 40)
instead, depending on the asset being leased.
11.5.2 Subsequent measurement of the right-of-use asset: in terms of the cost model
As mentioned, the right-of-use asset is normally measured in Subsequent measurement

of a RoU asset in terms of
terms of the cost model described in IFRS 16. Subsequent the cost model:
measurement of the right-of-use asset in terms of this cost x Cost – Acc Depr – Acc Imp Losses
model will mean that its carrying amount will be: x Adjusted for liability remeasurements
See IFRS 16.30
x Cost (per IFRS 16 Leases)
x Less subsequent accumulated depreciation (similar to IAS 16’s depreciation)
x Less accumulated impairment losses (per IAS 36 Impairment of assets);
x Adjusted for remeasurements made to the lease liability (per IFRS 16 Leases). See IFRS 16.30
808 Chapter 16
IFRS 16 explains that this cost model is effectively the same cost model used in IAS 16 Property,
plant and equipment, since the right-of-use asset is initially measured at cost and then depreciated
and tested for impairments in terms of IAS 36 Impairment of assets. However, although the cost
model is essentially the same as the cost model described in IAS 16, the cost model used for a right-
of-use asset has been slightly ‘tweaked’. This tweaking affects the measurement of cost and the
measurement of depreciation.
Depreciation of a RoU
asset:
The initial cost of a right-of-use asset is stipulated in
x Starts: commencement date
IFRS 16 Leases (see section 11.2). This initial cost will be x Method: to reflect pattern in which
subsequently remeasured (adjusted) if and when the lease FEB from the RoU asset is expected
liability requires remeasurement during the course of the lease to be consumed (normally SL)
(see section 11.3). See IFRS 16.23-24 & .30 x Period: from commencement date to
earlier of the end of useful life of
With regard to depreciation, the principle in IFRS 16 Leases the RoU asset or end of lease
term (if ownership is not expected
is the same as that in IAS 16 Property, plant and equipment in to transfer)
that the depreciation method must reflect the pattern in which end of useful life of the
the future economic benefits (FEBs) of the right-of-use asset underlying asset (if ownership is
expected to transfer) See IFRS 16.31-32
will be consumed (thus the straight-line method is normally
appropriate). However, differences arise in terms of when depreciation starts and the depreciation period.
The depreciation of a right-of-use asset starts from Commencement date is
commencement date (see pop-up alongside). defined as
x The date the lessor makes
This differs from depreciation per IAS 16, where an item of x the underlying asset
property, plant and equipment is depreciated starting from the x available for use by a lessee.
See IFRS 16 App A
date that it first becomes available for use. The
commencement date may not necessarily be the same date as the date on which the asset first
becomes available for use. For example: the lessor may make an asset available for use to the lessee
on 1 January, but the lessee may still need to install the asset, where the installation is then complete
on 1 May. In terms of IFRS 16, this right-of-use asset would be depreciated from 1 January
(commencement date) and not from 1 May (the date it first became available for use, which is the
date that would be used by IAS 16).
The period of depreciation differs slightly as well. Whereas IAS 16’s cost model requires that an
item of property, plant and equipment be depreciated over its useful life, the depreciation period of
IFRS 16’s cost model is dependent on the circumstances regarding expected ownership:
x If ownership transfers, or if there is a purchase option that the lessee is reasonably certain it will
exercise (i.e. if the expected exercise of this purchase option is also reflected in the measurement
of the lease payments, and thus in the measurement of the lease liability and thus also in the cost
of the right-of-use asset), then the depreciation period is from commencement date to:
the end of the underlying asset’s useful life.
x If ownership of the asset is not expected to transfer to the lessee at the end of the lease (e.g. there
are either no purchase options or the lessee does not expect to exercise them), the depreciation
period of the right-of-use asset is from commencement date to the earlier of:
the end of the right-of-use asset’s useful life, and
the end of the lease term. See IFRS 16.32
Example 18: Right-of-use asset – subsequent measurement: depreciation
On 1 January 20X1, commencement date, an entity has a right-of-use asset with a cost of
C10 000 (measured at the present value of the future lease payments payable on this date).
The underlying asset, a machine, has a useful life of 10 years. The lease covers a period of 5 years.
Scenario 1: Ownership of the lease transfers at the end of the lease term.
Scenario 2: The lease term is neither renewable nor cancellable. There are no purchase options.
Scenario 3: The lease term is neither renewable nor cancellable but the contract includes a purchase
option at the end of the 5th year that the lessee is reasonably certain it will exercise
Required: For each of the scenarios, show the general journal entries to account for the depreciation
for the year ended 31 December 20X1.
Chapter 16 809
Solution 18: Right-of-use asset – subsequent measurement: depreciation

Scenario 1:
Depreciation – right-of-use asset (P/L: E) 10 000 ÷ 10 years 1 000
Right-of-use asset: acc. depreciation (-A) 1 000
Depreciation of right-of-use asset (RoU asset) – depreciation over the
useful life of the underlying asset because ownership transfers
Scenario 2:
Depreciation of right-of-use asset: depreciation over the shorter of the
right-of-asset’s useful life (10 years) and the lease term (5 years) because
ownership does not transfer and there are no purchase options
Scenario 3:
Depreciation of right-of-use asset : depreciation over the useful life of the asset
since there is a purchase option that we are reasonably certain will be exercised
(the lease payments will have included the exercise price of the purchase price)
When testing a right-of-use asset for impairment, we follow IAS 36 Impairment of assets.
This means that we follow the same process that we used when we tested, for example, items
of property, plant and equipment for impairment. Please see chapter 11 for further details.
Example 19: Right-of-use asset – subsequent measurement: impairments

On 1 January 20X1, commencement date, an entity has a right-of-use asset with a cost of
C10 000 (measured at the present value of the future lease payments payable on this date).
This right-of-use asset is depreciated on the straight-line basis over the lease term of 5 years.
At 31 December 20X2, this asset is found to have a recoverable amount of C3 000.
Required: Using the general journal show the journals to account for the information provided for the
financial years ended 31 December 20X1, 20X2 and 20X3.
Solution 19: Right-of-use asset – subsequent measurement: impairments

Right-of-use asset: cost (A) Given 10 000
Initial recognition and measurement of lease and right-of-use asset (RoU)
31 December 20X1
Depreciation of right-of-use asset
31 December 20X2
Impairment – right-of-use asset (P/L: E) CA (10 000 – 2 000 – 2 000) 3 000
Right-of-use asset: acc. impairment loss (-A) Less RA: 3 000 3 000
Impairment of right-of-use asset
31 December 20X3
Depreciation – right-of-use asset (P/L: E) (10 000 – 2 000 – 2 000 – 3 000) ÷ 1 000
Right-of-use asset: acc. depreciation (-A) (5 – 2 ) remaining years 1 000
810 Chapter 16
11.5.3 Subsequent measurement of the right-of-use asset: in terms of revaluation model

If the right-of-use asset is an asset that falls within a class of property, plant and equipment to
which the lessee applies the revaluation model, then the lessee may choose to measure all
right-of-use assets falling within this class of property, plant and equipment using the
revaluation model (i.e. this is an accounting policy choice). See IFRS 16.29 & .35
11.5.4 Subsequent measurement of the right-of-use asset: in terms of fair value model
If the right-of-use asset is an asset that is investment property and if the lessee applies the fair
value model to its investment property, then the lessee must measure the right-of-use asset in
terms of the fair value model (per IAS 40) (i.e. there is no choice in this case). See IFRS 16.29 & .34
11.6 Subsequent measurement - remeasurements due to changing lease payments

If there is a change in the lease payments (e.g. the lease Remeasurements:
term changes, thus resulting in extra lease payments being
included in the measurement of the lease liability or there x if there is a subsequent change in the
lease payments that affects the
was a purchase option that was perhaps not previously measurement of the lease liability (LL)
considered reasonably certain of being exercised but is x A remeasurement adjustment to the
now reasonably certain of being exercised, or vice versa), LL generally requires the same
then we must remeasure the lease liability to reflect this. adjustment to the RoU asset.
See IFRS 16.36 & .39
The remeasurement adjustment that is made to the lease liability will also be made to the
right-of-use asset, if the adjustment reflects an increase in the lease payments (i.e. thus
increasing the lease liability and right-of-use asset).
Remeasurement adjustment – increase in lease payments Debit Credit
Right-of-use asset (A) xxx
Remeasurement of lease liability and right-of-use asset due to
an increase in lease payments
However, if the adjustment reflects a decrease in the lease payments, thus requiring a decrease in the
lease liability, then the adjustment to the right-of-use asset (i.e. decreasing the asset) will be limited
to the extent of the asset’s carrying amount, with any excess recognised as an expense in profit or
loss. In other words, if the remeasurement adjustment exceeds the asset’s carrying amount, we
simply reduce the asset’s carrying amount to zero and the excess adjustment (that would otherwise
drop the asset’s carrying amount below zero) is recognised as an expense in profit or loss instead.
See IFRS 16.39
Assuming that the decrease in the lease liability did not decrease the carrying amount of the
right-of-use asset below zero, we would process the following entry:
Remeasurement adj. – decrease in lease payments Debit Credit
(CA of RoU asset does not drop below 0)
Right-of-use asset (A) Xxx
a decrease in lease payments
If the decrease in the lease liability decreased the carrying amount of the right-of-use asset
below zero, we would process the following entry:
Remeasurement adj. – decrease in lease payments Debit Credit
(CA of RoU drops below 0)
Right-of-use asset (A) Carrying amount xxx
Lease remeasurement income (P/L: I) Balancing xxx
a decrease in lease payments that resulted in a decrease in
the lease liability that exceeded the asset’s carrying amount
Chapter 16 811
When remeasuring the lease liability, we calculate the present value of the revised remaining
lease payments at the date of the reassessment and will either have to use a revised discount
rate or the original discount rate.
We must use a revised discount rate if the lease payments change due to:
x a change in the estimated lease term, or
x a change in the assessment of whether an option to purchase will be exercised or not (e.g. if we
did not believe it was reasonably certain that a purchase option would be exercised, then the
purchase price would not have been included in the lease payments, but if the situation changes
and we now believe that a purchase option will be exercised, then the purchase price needs to be
included in the lease payments). See IFRS 16.40
We must use the original discount rate if the remaining lease payments change due to:
x a change in the amount expected to be payable in terms of a residual value guarantee or
x a change in the variable lease payments that vary based on an index or rate
x unless the above changes resulted from a change in a floating interest rate, in which case a
revised discount rate is used instead. See IFRS 16.42-43
When using a revised discount rate, the revised discount rate must either reflect the interest
rate implicit over the remainder of the lease term (assuming this can be determined) or the
lessee’s incremental borrowing rate at the date of the reassessment. See IFRS 16.41
Example 20: Remeasurement - change in lease term
Entity A (lessee) enters into a lease over a building on 1 January 20X1.
The lease covers a 4-year non-cancellable period at the end of which the lessee has the
option to extend the lease for a further 3 years.
The lease payments will be C10 000 per annum for the first 4 years and C8 000 per annum during the
extra 3 years, should the lessee opt to extend the contract. The lease payments are all payable in arrears.
At 1 January 20X1 (the commencement of the lease), the lessee felt it was reasonably certain that it
would not extend the lease. However, the facts and circumstances at 31 December 20X2 made it
reasonably certain that the lease would be extended for the extra 3 years.
The implicit interest rate is not known and thus the entity uses the incremental borrowing rate. The
incremental borrowing rate is as follows:
01 January 20X1: 10%
Required: Journalise the change in lease term on 31 December 20X2.
Solution 20: Remeasurement - change in lease term

Right-of-use asset (A) Revised PV C32 218 – CA (current PV) C17 356 14 862
Remeasurement of lease due to change in lease payments caused by a change
in the lease term, thus PV calculated using revised discount rate
Explanation:
At 1 January 20X1, the lease term was originally estimated to be 4 years (i.e. excluding the optional extension period), at
which point the incremental borrowing rate was 10%. The lease liability at commencement is thus initially measured at its
present value of C31 699 (see W1).
At 31 December 20X2, the total lease term is revised to be 7 years (i.e. including the optional extension period). This
means, at this date, instead of the remaining lease term being 2 years (4 years – 2 years), the remaining lease term is now
5 years (7 years – 2 years).
x At this date, the actual carrying amount of the lease liability, being its present value based upon the original lease term
and discount rate, is C17 356 (W1).
x At this date, the revised present value of the lease liability, based on the revised lease term and the revised discount rate,
is C32 218 (W2).
This means the increase in the lease term causes an increase in the lease liability of C14 862 (C32 218 – C17 356). Thus, after
processing all the usual journals relating to the lease liability for the year ended 31 December 20X2 (i.e. interest expense of
C2 487 and lease payment of C10 000), its carrying amount of C17 356 must be increased by C14 862 to C32 218.
812 Chapter 16
Workings:
W1: Lease liability – effective interest rate table: ORIGINAL as at 1 January 20X1
Year Balance (start) Interest at 10% Lease payments Balance (end)

20X1 (W1.1) 31 699 3 170 (10 000) 24 869
20X2 24 869 2 487 (10 000) 17 356
20X3 17 356 1 736 (10 000) 9 092
20X4 9 092 908 (10 000) 0
8 301 (40 000)
W1.1: Present value of lease liability – at 1 January 20X1
The PV of the lease payments, calculated with a financial calculator:
n = 4 i = 10% PMT = -10 000
COMP PV ...
Your answer should be: 31 699!
W2: Lease liability – effective interest rate table: REVISED at 31 December 20X2
Year Balance (start) Interest at 12% Lease payments Balance (end)

20X3 (W2.1) 32 218 3 866 (10 000) 26 084
20X4 26 084 3 130 (10 000) 19 214
20X5 19 214 2 306 (8 000) 13 520
20X6 13 520 1 622 (8 000) 7 142
20X7 7 142 858 (8 000) 0
11 782 (44 000)
W2.1: Present value of lease liability – at 31 December 20X2
The PV of the lease payments, calculated with a financial calculator:
i = 12% CF0 = 0 CF1-2 = -10 000 CF3-5 = -8 000
COMP PV ...
and your answer should be: 32 218!
Comment: The incremental borrowing rate at 31 December 20X1 was given but was irrelevant as we do not
continually remeasure the liability using revised discount rates.
We use the original discount rate on commencement date to initially measure the lease liability and then we use the
revised discount rate on 31 December 20X2 because we are remeasuring the lease liability due to a change in lease
payments that was caused by a change in the lease term. See IFRS 16.40(a)
11.7 Subsequent measurement - lease modifications (IFRS 16.44-46)

Lease modifications are changes to the original terms and A lease modification is
conditions of a lease, where either the original scope is changed defined as:
x a change in scope of a lease,
(e.g. adding the right-to-use another asset) or the original x or the consideration for a lease,
consideration is changed (e.g. changing a fixed payment to a x that was not part of the original
payment that varies with changes in the CPI index). terms and conditions of the lease
For example,
Modifications are either accounted for as: x adding or terminating the right to
x separate leases, or as use one or more underlying
assets, or
x remeasurements of the existing lease. x extending or shortening the
contractual lease term. IFRS 16.App A
A modification will be accounted for as a separate lease if:
x the scope has been increased by adding the right-to-use another asset; and
x the consideration increases by an amount that reflects the stand-alone price for the
additional right-to-use asset/s (adjusted to reflect the circumstances of the particular
contract). See IFRS 16.44
If the modification is accounted for as a separate lease:
x we recognise a new right-of-use asset and lease liability; and
x we do not make any adjustments to the original lease.
Chapter 16 813
Worked example: Lease modification – separate lease

Entity A (lessee) enters into a 4-year lease over a truck. During the first year of the lease,
Entity A’s business begins to flourish, and it thus renegotiates the lease to include a second
truck, effective from the beginning of the second year. The second truck will be leased at a market-
related lease rental, which the lessor adjusted downwards slightly due to the fact that Entity A was a
pre-existing customer.
This modification involves an increase in the scope due to the right-to-use another asset (a second
truck) and the increase in the consideration substantially reflects the stand-alone price of this additional
right-to-use asset. Thus, this modification is accounted for as a separate lease: Entity A recognises a
right-to-use asset and a lease liability. No adjustment is made to the original lease.
If a modification does not meet the criteria to be accounted for as a separate lease, then we
account for it, at the effective date of the modification, as follows:
x allocate the modified consideration to the lease components and non-lease components
(using the same principles as always);
x determine the lease term of the modified contract (use the same principles as always);
x remeasure the lease liability to reflect the present value of the modified lease payments,
present valued using a revised discount rate, being either:
the revised implicit interest rate over the remainder of the term or
the lessee’s incremental borrowing rate at the effective date of the modification (if the
revised implicit rate is not readily determinable). See IFRS 16.45
The above remeasurement is accounted for as follows:

x if there was a decrease in the scope that resulted in a ‘partial or full termination of the
lease’, we will recognise a profit or loss on the partial or full termination:
adjust the lease liability
adjust the right-of-use asset; and
profit or loss on the partial or full termination of the lease (balancing amount). See IFRS 16.46 (a)
x in all other cases (e.g. where there has been an increase in the scope without an appropriate
increase in consideration), there will be no profit or loss recognised, and we simply:
adjust the lease liability
adjust the right-of-use asset (by the same amount we adjusted the liability). See IFRS 16.46 (b)
Example 21: Lease modification –

scope decreases resulting in partial termination
Entity A (lessee) enters into a lease over two trucks on 1 January 20X1.
x The lease covers a 4-year non-cancellable period.
x The lease payments will be C220 000 per annum payable in arrears.
x The fair value of each truck is C350 000 (C700 000 for two).
x The right-to-use the trucks is depreciated on the straight-line basis over the lease term of 4 years.
x At 1 January 20X2, the original lease is amended to include only one truck, effective immediately.
- The lease payments will now be C110 000 per annum, in arrears.
- The remaining lease term remains unchanged at 3 years (original 4 yrs – 1 yr).
- The fair value of the remaining right-of-use truck on the effective date of modification
(1 January 20X2) is C280 000.
Required: Provide the journal entry required to account for the lease modification on 1 January 20X2.
Solution 21: Lease modification – scope decreases resulting in partial termination

Comment:
x The scope of the lease decreases and causes the partial termination of the contract. Separate adjustments will
thus need to be made both the lease liability and the right-of-use assets, which will thus result in the
recognition of a profit or loss on partial termination.
x We derecognise half of the depreciated right-of-use asset, carrying amount C262 500
(Cost: 350 000 – AD: 350 000 / 4 x 1)
x We remeasure the lease liability to be C280 000. This is based on the revised lease payments over the
remaining lease term (3 yrs) using the revised implicit interest rate of 8,687% (see below)
814 Chapter 16
x The liability balance prior to the modification was C548 784 (W1) and thus the remeasurement to C280 000
(W2) requires a debit of C268 784 (C548 784 - C280 000).
x Since we reduce the asset by C262 500 and reduce the liability by C268 784, we recognise a gain on the partial
termination of C6 284
x The implicit interest rate in the original contract is 9,826344%
PV = -700 000 N = 4 PMT = 220 000 Comp I = 9,826344%
x The implicit interest rate in the modified contract is 8,687602%
PV = -280 000 N = 3 PMT = 110 000 Comp I = 8,687602%
W1: Effective interest rate table: lease liability – ORIGINAL CONTRACT

Date Interest (9,826344%) Instalment Liability balance
1 January 20X1 700 000
31 December 20X1 68 784 (220 000) 548 784
31 December 20X2 53 925 (220 000) 382 709
31 December 20X3 37 606 (220 000) 200 315
31 December 20X4 19 685 (220 000) 0
180 000 (880 000)
W2: Effective interest rate table: lease liability – REVISED CONTRACT

Date Interest (8,687602%) Instalment Liability balance
1 January 20X2 280 000
31 December 20X2 24 325 (110 000) 194 325
31 December 20X3 16 882 (110 000) 101 207
31 December 20X4 8 793 (110 000) 0
50 000 (330 000)
Journal

Lease liability (L) 548 784 – 280 000 268 784
Right-of-use asset: cost (A) 700 000 x 50% 350 000
Right-of-use asset: acc depr (-A) 700 000 / 4yrs x 1yr x 50% 87 500
Gain on partial lease termination 6 284
Modification of a lease that led to partial termination
12. Tax consequences
12.1 Overview Instalment credit

agreement (ICA) is
To understand the current and deferred tax consequences of defined as:
a lease, we need to first understand the consequences of the x any agreement
lease in terms of the tax legislation relevant to the country x where goods (corporeal, movable
in which the entity operates. goods or machinery/plant,
whether movable/immovable)
x are supplied:
12.2 Tax treatment of leases
a) under sale where a stated sum
will be paid in future, either in
In South Africa, the tax authorities look only at the legal total/ in instalments (part (a)
form of the lease, and do not consider the substance thereof. of ICA definition), or
To this end, the income tax treatment of leases per the South b) under a lease of at least 12
months and lessee accepts
African Income Tax Act (IT Act) is interrelated with the
full risk of destruction of the
two definitions in the South African Value-Added Tax Act goods (part (b) of ICA
(VAT Act): definition).
x ‘instalment credit agreement’ (ICA) and See s1 of VAT Act (significantly summarised)
x ‘rental agreement’.
See definitions to the right and on the next page.
Chapter 16 815
If we have a lease (regardless of recognition approach), we will need to assess whether it meets:
x part (a) of the VAT Act’s definition of an ‘instalment credit
agreement’, Rental agreement is
x part (b) of the VAT Act’s definition of ‘instalment credit defined as:
agreement’, or x a lease agreement other than that
in part (b) of ICA definition.
x the VAT Act’s definition of a ‘rental agreement’. See s1 of VAT Act (significantly summarised)
If the lease meets either the definition of a ‘rental agreement’ or the definition of ‘part (b) of the
ICA definition’ (per the VAT Act), then the tax authorities effectively view the asset as still
belonging to the lessor and merely rented to (borrowed by) the lessee.
As a result, the tax authorities will neither allow the lessee a For tax purposes, if
deduction of allowances on the cost of the asset nor will it the lease meets
allow the deduction of interest on the lease liability. Instead, x ‘part (a) of the ICA’ definition in
the lessee will only be allowed to deduct the lease payments the VAT Act,
when incurred/ paid (in terms of section 11(a) of the ITA). then the lessee is assumed to own
the asset and thus:
However, if the lease payments paid in cash include a lease x asset: tax base = future
payment that has been prepaid, then this prepayment will be deductions (e.g. wear & tear)
allowed as a deduction on the following basis: x liability: tax base = liability bal
in terms of EIR method
x It relates to lease payments that were due to be paid in the
first 6 months of the following year, or
For tax purposes, if
x If then this prepayment is added together with all other the lease meets the
prepayments and the total prepayments are less than definition of:
R100 000, then all prepayments will be allowed as a x a ‘rental agreement’ or
deduction. See South African Tax Act S11(e) and S23H x ‘part (b) of the ICA’ definition
in the VAT Act,
If the lease meets the definition per ‘part (a) of the ICA then the lessee is assumed not to
definition’ (per the VAT Act), then the tax authority views the own the asset, and thus:
asset as belonging to the lessee. In other words, the tax authority x asset: nil tax base
views the asset as having been purchased by the lessee (the lease x liability: nil tax base (except
where there is VAT in case of part
agreement is simply financing the lessee’s purchase of the asset). (b) of ICA definition – see later...)
As a result, the tax authority will allow the lessee to deduct an allowance (wear and tear)
based on the cost of the asset (cash value per the VAT Act) and will allow the deduction of
finance costs on the lease liability (calculated using the effective interest rate method).
12.3 Accounting for the tax consequences where the lease is accounted for using the
simplified approach
If the lease is recognised by the lessee ‘off-balance sheet’ (i.e. the simplified approach), the entity
does not recognise a right-of-use asset and lease liability but simply recognises the lease payments as
an expense, calculated using the straight-line method (or another systematic basis). The process of
straight-lining the lease payments may lead to the recognition of a lease payable (liability) or a lease
prepayment (asset).
12.3.1 From a tax-perspective, the lessee is renting the asset Simplified approach
& it’s a ‘lease’ from
(the lease meets the definition of ‘rental agreement’ or a tax perspective:
‘part (b) of the ICA definition ) Current tax: adjust profit
before tax as follows:
If the lease is recognised by the lessee ‘off-balance sheet’ (i.e. using x add back:
the simplified approach), and the tax authority believes the lease lease payment expenses
meets the definition of a ‘rental agreement’ or that it meets ‘part (b) of x deduct:
the ICA definition’ (i.e. if the tax authority views the lessee as simply lease payments i.e. cash pmts
borrowing/ leasing the asset), then the accounting treatment and tax Deferred tax: arises on CA
of Expense prepaid/ payable
treatment will be similar.
(TB = nil)
816 Chapter 16
This is because the accountant will expense the lease payments (simplified approach) and the
tax authority will allow the deduction of the lease payments (although possibly limited by
section 23H in the ITA, if there has been a prepayment of the lease instalments – see
section 12.2). In other words, both the accountant and tax authorities ‘agree’ that the entity
does not have a leased asset or a lease liability.
However, there is a slight difference between the accounting treatment and tax treatment described
above. The accounting treatment may result in a lease prepayment/ payable in the accounting
records due to the straight-lining of the lease expense:
x If the straight-lining results in a lease prepaid (asset) or payable (liability), deferred tax
arises on the resultant temporary difference (the asset/ liability has a carrying amount but
its tax base is nil).
x If the straight-lining does not lead to the recognition of a lease prepaid/ payable, then
deferred tax will not arise.
Example 22: Lease under simplified approach – tax consequences

Abbey Limited entered into a 2-year lease on 1 April 20X1, as the lessee, over a machine
that is considered to be a low-value asset. Abbey chooses to account for the lease of this
asset in terms of the recognition exemption (i.e. using the simplified approach).
x Neither Abbey nor the lessor are registered VAT vendors.
x The following payments are due per the lease agreement:
The first year of the lease: C2 000 per month
The second year of the lease: C3 000 per month
Variable lease payment: C1 per unit of output sold, payable at 31 December each year.
x Abbey sold 300 units in the 3 months between 1 January 20X3 to 31 March 20X3, 1 000 units in
20X2 and 1 500 units in 20X1 (1 April – 31 December 20X1).
Required:
A. Journalise the lease for the years ended 31 December 20X1, 20X2 and 20X3. Ignore tax.
B. Journalise the current tax for the years ended 31 December 20X1, 20X2 and 20X3, assuming the
following additional information:
x Profit before tax and before any of the lease-related journals is C100 000 in all years
x There are no temporary or permanent differences other than those evident in the information.
x The tax authority allows the lease instalments as a deduction when paid.
x The tax rate is 30%.
C. Journalise the deferred tax for the years ended 31 December 20X1, 20X2 and 20X3, assuming the
same information provided above.
Solution 22A: Lease under simplified approach – journals (tax ignored)

Calculations:
x Total lease payments = (C2 000 x 12 months + C3 000 x 12 months) = C60 000.
x Straight-lining of the lease payments (assumed there was no other systematic basis that was
preferable) = C60 000 ÷ 24 months = C2 500 per month
Low-value lease expense (P/L: E) C2 500 x 9 22 500
Lease payable (L) Balancing (originating) 4 500
Bank (A) C2 000 x 9 18 000
Fixed lease payments on low-value asset expensed on the straight-
line method under the recognition exemption
Variable lease payment expense (P/L: E) 1 500 x C1 1 500
Bank (A) 1 500
Variable lease payments are expensed
31/12/20X2
Lease payable (L) Balancing (reversing) 3 000
Bank (A) C2 000 x 3 + C3 000 x 9 33 000
Chapter 16 817
31/12/20X2 continued … Debit Credit

Variable lease payment expense (P/L: E) 1 000 x C1 1 000
Bank (A) 1 000
31/12/20X3
Lease payable (L) Balancing (reversing) 1 500
Bank (A) C3 000 x 3 9 000
Variable lease payment expense (P/L: E) 300 x C1 300
Bank (A) 300
Please note: The journals above have been summarised on an annual basis but the payments are
monthly and thus, in reality, they would have been processed monthly.
Solution 22B: Lease under simplified approach – current income tax

20X1 20X2 20X3
Journals Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Income tax expense (P/L: E) W1 24 150 19 800 27 210
Current tax payable: income tax (L) (24 150) (19 800) (27 210)
Current income tax for the year
W1: Current income taxation 20X1 20X2 20X3
Profit before tax and before lease expenses 100 000 100 000 100 000
Low-value asset lease expense (22 500) (30 000) (7 500)
Variable lease payment expense (1 500) (1 000) (300)
Temporary differences - movement:
Add back: Low-value asset lease exp. Per above 22 500 30 000 7 500
Add back: Variable lease payment exp. Per above 1 500 1 000 300
Less: lease instalments paid 20X1: (18 000 + 1 500) (19 500) (34 000) (9 300)
20X2: (33 000 + 1 000)
20X3: (9 000 + 300)
Taxable profit 80 500 66 000 90 700
Current income tax Taxable profit x 30% 24 150 19 800 27 210
Comment: The final profit before tax could have been given instead, in which case we would not have
needed to first deduct the lease expense to calculate profit before tax.
Solution 22C: Lease under simplified approach – deferred tax

Comment:
x Since the tax authority is treating this lease as a ‘rental agreement’ or a ‘lease agreement’ as defined in the ‘part
(b) of the ICA definition’ in the VAT Act, they simply grant the lease instalments as deductions when they are
paid, and thus there will be no tax base for the lease payable (the payable arising from having straight-lined the
lease payments) that arises in the accounting records. (Remember that the tax base of a liability is the carrying
amount of the liability less the amount allowed as a deduction in the future. Since the entire carrying amount of
the lease payable will be allowed as a tax deduction in the future, when it is paid, the tax base is nil)
x This example deals with an expense payable and thus a comparison of the carrying amount of the expense
payable and the nil tax base leads to a deferred tax asset.
x Had the lease rentals been prepaid instead, it would have resulted in a deferred tax liability.
20X1 20X2 20X3

Journals Dr/(Cr) Dr/(Cr) Dr/(Cr)
Deferred tax: income tax (A) W1 1 350 (900) (450)
Income tax expense (P/L: E) (1 350) 900 450
Deferred income tax arising on the low-value lease payable
818 Chapter 16

Lease payable
amount Base difference tax
Balance: 1/1/X1 0 0 0 0
Adjustment (balancing) (4 500) 1 350 Dr DT; Cr TE
Balance: 31/12/X1 (4 500) 0 4 500 1 350 Asset
Adjustment (balancing) 3 000 (900) Cr DT; Dr TE
Balance: 31/12/X2 (1 500) 0 1 500 450 Asset
Adjustment (balancing) 1 500 (450) Cr DT; Dr TE
Balance: 31/12/X3 0 0 0 0
12.3.2 From a tax-perspective, the lessee owns the asset

(the lease meets the definition of ‘part (a) of the ICA
If the lease is recognised by the lessee ‘off-balance sheet’ (i.e. Simplified approach
the simplified approach), and the tax authority believes the lease & the lessee ‘owns’
meets the definition of ‘part (a) of the ICA definition’ (i.e. the the asset from a
lessee is deemed to own the asset), then the accounting treatment tax perspective:
and the tax treatment would differ. Current tax: adjust profit
x add back:
This is because the accountant is expensing the lease payments lease payment expenses
on the straight-line method, thus potentially resulting in a lease x deduct:
prepaid/ payable, whereas the tax authority treats the lessee as wear and tear allowance
being the owner of the asset and will thus allow the lessee to finance costs (using EIRM)
deduct wear and tear and finance costs (using the effective Deferred tax: arises on CA
interest rate method). of Expense prepaid/ payable
(TB = future W&T and finance
Thus, since the accountant may have a carrying amount for a cost deductions)
lease payable/ prepaid, the tax bases would be different amounts since they would reflect the
future deductions relating to wear and tear and the future deductions of finance costs. Since
the carrying amount and tax base would differ, temporary differences will arise on which
deferred tax must be recognised.
12.4 Accounting for the tax consequences where the lease is accounted for using the
general approach
If the lease is recognised by the lessee ‘on-balance sheet’ (i.e. the general approach), the
entity would recognise:
x an asset (subsequently depreciated and impaired), and
x a lease liability, on which interest is expensed.
12.4.1 From a tax-perspective, the lessee is renting the asset

(the lease meets the definition of ‘rental agreement’ or ‘part (b) of the ICA)
If the lease is recognised by the lessee ‘on-balance sheet’ (i.e. General approach &
the general approach), and the tax authority believes the lease it’s a ‘lease’ from a
meets the definition of a ‘rental agreement’, or that it meets ‘part tax perspective:
(b) of the ICA definition’ (i.e. it believes that the lessee is simply
Current tax: adjust profit
borrowing/ leasing the asset), then the accounting treatment and
the tax treatment will differ.
x add back: depreciation &
interest expense and
This is because, whereas the accountant recognises a right-of-use
x deduct: the lease payments
asset and a lease liability, the tax authority will only allow the
deduction of the lease payments, subject to section 23H (ITA) Deferred tax: arises on
limitations, in the event that there has been a prepayment (see x CA of RoU asset (TB = nil) &
section 12.2). In other words, the tax authority does not x CA of LL (TB = nil)
‘recognise’ that the entity has an asset and a lease liability.
Chapter 16 819
Therefore, the accountant will have a:

x carrying amount for the asset, for which there is a nil tax base (the tax base of an asset
represents the future tax deductions on that asset, and since the tax authority does not
accept that the lessee has an asset, there will be no future tax deductions allowed), and a
x carrying amount for the liability, for which there is a nil tax base (the tax authority does
not accept that the lessee has a liability and will thus not allow the deduction of the
finance costs incurred on the liability).
Since the carrying amounts and tax bases of the right-of-use asset and lease liability differ,
temporary differences arise on which deferred tax will be recognised.
Example 23: Lease under general approach – tax consequences

Dave Limited leases equipment from Maeve Limited in terms of a 6-year non-cancellable
lease agreement. Details are as follows:
x The commencement date is 1 January 20X4;
x There are 6 instalments of C166 744 each, paid annually in arrears (i.e. on 31 December);
x The present value of the lease payments, discounted at the lease’s implicit interest rate, of 9%, is C748 000;
x Dave Limited depreciates the right-of-use asset at 25% per annum on the straight-line basis.
The following tax-related information also applies:
x Profit before tax, and before any adjustments relating to the information above, is C800 000;
x There are no differences between accounting profit and taxable profit other than those evident from
the information given;
x The local South African tax authority recognises this lease as a ‘rental agreement’ in terms of
part (b) of the definition of an ‘instalment credit agreement’ in the South African VAT Act and
thus only allows the lease instalment as a deduction when paid;
x The tax rate is 30%;
x No VAT is included in the lease (Maeve Limited does not charge VAT).
Required:
A. Prepare the journals for the year ended 31 December 20X4 in Dave Limited’s books.
B. Repeat Part A assuming the lease was entered into on 1 March 20X4 (not on 1 January 20X4) and
thus that the first instalment will be payable on 28 February 20X5 (not on 31 December 20X4).
Solution 23: Lease under general approach – tax consequences

Ex 23A Ex 23B
01/01/20X4 Dr/ (Cr) Dr/ (Cr)
Right-of-use asset: cost (A) 748 000 748 000
Lease liability (L) PV of lease payments (given) (748 000) (748 000)
Right-of-use asset and lease liability recognised on commencement date
31/12/20X4
Finance cost - lease (P/L: E) A:748 000 x 9% x 12/12 67 320 56 100
Lease liability (L) B: 748 000 x 9% x 10/12 (67 320) (56 100)
Interest payable on the lease to year-end, measured using EIRT (W1)
Lease liability (L) A: Given 166 744 N/A
Bank (A) B: 1st instalment only paid in 20X5 (166 744) N/A
Payment of instalment
Lease liability (L) A: W1: 166 744 – 58 372 108 372 155 524
Lease liability: current portion (L) B: W1: 166 744 – 67 320 x 2/12 (108 372) (155 524)
Transfer of current portion of liability – i.e. the portion of the liability balance
at year-end that will be paid within the next 12 months (i.e. instalments due in
next 12 months – interest accrued on these instalments) (See comment below)
Depreciation – right-of-use asset (P/L: E) A: 748 000 x 25% x 12/12 187 000 155 833
Right-of-use asset: acc. depreciation (-A) B: 748 000 x 25% x 10/12 (187 000) (155 833)
Income tax expense (P/L: E) W2 189 977 240 000
Current tax payable: income tax (L) (189 977) (240 000)
Current tax payable for the year
820 Chapter 16
Ex 23A Ex 23B
31/12/20X4 continued … Dr/ (Cr) Dr/ (Cr)
Deferred tax: income tax (A) W3 26 273 63 580
Income tax expense (P/L: E) (26 273) (63 580)
Deferred tax asset arising on the lease
Comment: Although not specified by IFRS 16, IAS 1 (para 60) requires that the lease liability be separated into
its current and non-current portions.
W1: Effective interest rate table: lease liability

Date Interest (9%) Instalment Liability balance
1 January 20X4 748 000
31 December 20X4 67 320 (166 744) 648 576
31 December 20X5 58 372 (166 744) 540 204
31 December 20X6 48 618 (166 744) 422 078
31 December 20X7 37 987 (166 744) 293 321
31 December 20X8 26 399 (166 744) 152 976
31 December 20X9 13 768 (166 744) 0
252 464 (1 000 464)
W2: Current income taxation Ex 23A Ex 23B

Profit before depreciation and interest on lease Given 800 000 800 000
Depreciation Per jnl (187 000) (155 833)
Interest expense Per jnl (67 320) (56 100)
Profit before tax 545 680 588 067
Temporary differences:
Add back: Per jnl
Depreciation on RoU asset 187 000 155 833
Interest expense Per jnl 67 320 56 100
Less:
Lease instalment paid A: Given B: 1st instalment not yet paid (166 744) (0)
Taxable profit 633 256 800 000
Current income tax payable Taxable profit x 30% 189 977 240 000
Comment: The profit before tax could have been given after it had been adjusted for the lease transaction in
which case depreciation and finance charges would not still need to be subtracted.
W3.1: Deferred tax – Part A only

Lease on-balance sheet CA TB TD DT
Balance: 1/1/20X4 0 0 0 0
x Right-of-use asset 0(1) 0(4) 0 0
x Lease liability 0(1) 0(4) 0 0
Adjustment Balancing: 0 – 26 273 (dr deferred tax, cr tax exp) 26 273
Balance: 31/12/20X4 (87 576) 0 87 576 26 273 A
x Right-of-use asset 561 000(2) 0(4) (561 000) (168 300) L
x Lease liability (648 576) (3) 0(5) 648 576 194 573 A
Calculations:
1) CA on 01/01/20X4: Nil: the lease was not in existence at the end of 20X4.
2) CA on 31/12/20X4: Right-of-use asset: cost: 748 000 – acc depreciation: 187 000 = 561 000
3) CA on 31/12/20X4 Lease liability: from effective interest rate table = 648 576
4) The TB of the asset is the amount allowed as a deduction in the future. This will amount to nil because the
tax authority believes the lease meets ‘part (b) of the ICA definition’, with the result that the tax authority
will not allow any deductions relating to the cost of the asset (The tax authority does not agree the entity
owns an asset but rather that it is simply borrowing an asset).
5) The TB of the liability is its CA (648 576) less the amount allowed as a deduction in the future. The tax
authority will allow all instalments as a deduction, so the full CA will be allowed as a deduction.
Thus, the TB = CA: 648 579 – Portion of CA allowed as a deduction in future: 648 579 = 0
Note: there were no VAT implications – to see VAT implications please see example 24 and 25.
Chapter 16 821
W3.2: Deferred tax – Part B only

Lease on-balance sheet CA TB TD DT
Balance: 1/1/20X4 0 0 0 0
x Right-of-use asset 0(1) 0(4) 0 0
x Lease liability 0(1) 0(4) 0 0
Adjustment Balancing: 0 – 63 580 (dr deferred tax, cr tax exp) 63 580
Balance: 31/12/20X4 (211 933) 0 211 933 63 580 A
x Right-of-use asset 592 167(2) 0(4) (592 167) (177 650) L
x Lease liability (804 100) (3) 0(5) 804 100 241 230 A
Calculations:
1) CA on 01/01/20X4: Right-of-use asset & lease liability: Nil: the lease did not exist at the end of 20X4.
2) CA on 31/12/20X4: Right-of-use asset: cost: 748 000 – acc depreciation: 155 833 = 592 167
3) CA on 31/12/20X4: Lease liability: Because the year-end does not coincide with the annual lease periods,
you cannot pick this figure off directly from effective interest rate table, thus we calculate it: 748 000 +
interest accrued: 67 320 x 10/12 – instalment paid to date: nil = 804 100
4) The TB of the asset: is the amount deductible in the future. This will amount to nil because the tax authority
believes that the lease meets the definition of ‘part (b) of the ICA definition’, with the result that the tax
authority will not allow any deductions relating to the cost of the asset (the tax authority does not agree that
the entity owns an asset but rather that it is simply renting an asset).
5) The TB of the liability: is its CA (804 100) less the amount allowed as a deduction in the future. Since the
tax authority allows the deduction of all instalments, the full CA will be deductible and thus the TB is: CA:
804 100 – Portion of CA allowed as a deduction in future: 804 100 = 0
12.4.2 From a tax-perspective, the lessee owns the asset

(the lease meets the definition of ‘part (a) of the ICA definition’)
If the lease is recognised by the lessee ‘on-balance sheet’ (i.e. the general approach), and the
tax authority believes the lease meets the definition of ‘part (a) of the ICA definition’ (i.e. the
lessee owns the asset), then the accounting treatment and the tax treatment would be similar.
As mentioned above, the entity would recognise:

x an asset, (subsequently depreciated and impaired), and
x a lease liability, on which interest is expensed.
In the case of a lease that meets the definition of part (a) of the ICA definition per the VAT
Act, the tax authority ‘agrees’ that the lessee has an asset, the cost of which will be allowed as
a tax deduction (i.e. wear and tear) and that the lessee has a liability for the cost of financing
the acquisition of the asset, where these finance costs will be allowed as a tax deduction using
the same effective interest rate method used by the accountant.
Although the carrying amount and tax base have the possibility of being the same, temporary
differences would arise if the rate of the tax deduction (wear and tear) granted by the tax
authority differs from the depreciation rate. This is because the carrying amount of the asset
and the tax base thereof would then differ. This is very similar to the tax treatment of an item
of property, plant and equipment.
12.5 Accounting for the tax consequences involving transaction taxes (VAT): lease
meets ‘part (b) of the ICA’ definition
In South Africa, a lease would be subject to an upfront payment of VAT if the lease meets
certain requirements in the definition of an ‘instalment credit agreement’ per the VAT Act. If
met, the lessor would be required to charge and pay over VAT on the cash selling price of the
underlying asset at the time of signing the lease contract. While the vendor (lessor) is required
to make an upfront payment of the VAT to the tax authority, the lessor may potentially have
to wait a relatively long time to recover this VAT from the customer (lessee).
822 Chapter 16
Should the lessor be required to make an advance payment of VAT, the lessor can recover
this VAT from the lessee in one of two ways: the lessor may require the lessee to pay the
VAT to the lessor at commencement date, or the lessor may include the VAT in the lease
instalments (the lessee will be paying the VAT to the lessor gradually over the lease term).
If the lessee is a registered vendor for VAT purposes and if it uses The VAT effect on DT
the right-of-use asset to make taxable supplies, the lessee may for a lease under the
general approach (on-
then be able to immediately claim the entire VAT amount from balance sheet):
the tax authority. This would mean that the right-of-use asset, CA/TB with VAT: notice effect
which is initially measured at cost, must exclude the VAT. of VAT being claimable/ not
claimable:
However, if the VAT is not claimable (e.g. if the lessee is not a x Asset:
VAT vendor or the asset is a motor car, for which VAT is not - CA = excl VAT (if claimable),
- CA = incl VAT (if not claimable)
claimable, or if the asset is used in the production of exempt - TB = nil
supplies), then the right-of-use asset must include the VAT. x Liability:
- CA = incl VAT
If the lease contract requires the lessee to pay the VAT to the - TB = (total unpaid instalments/
lessor, upfront on commencement date, then the lease payments total instalments) x total VAT
(if VAT claimable)
and thus the lease liability will not include VAT (as the definition - TB = nil (if VAT not claimable)
of lease payments excludes payments made on or before
commencement date).
However, if the lessee is not required to pay the VAT to the lessor upfront, then it means that the
lease payments will include VAT and so will the lease liability, (being the present value of the lease
payments).
Assuming that the tax authority recognises the lease as a lease in terms of ‘part (b) of the ICA
definition’, it would mean that, when claiming deductions for the lease payments in the calculation
of taxable profit for the year, the lessee would have to be careful to remove the VAT included in
these payments (otherwise the lessee would effectively be claiming the VAT as a deduction for
income tax purposes when the VAT had already been claimed back as a VAT input). However, if
the lessee was not able to claim the VAT back, then the lessee would be allowed to deduct the full
lease payment (inclusive of VAT) when calculating its taxable profits.
When removing the VAT from lease payments, we apply section 23C of the ITA.
Section 23C requires VAT to be removed in proportion to the amounts of the lease payment
relative to the amount of the total lease payments in the lease:
Instalment – (Total VAT x Instalment )
Total instalments
So far, the discussion has served to explain the impact on the calculation of the taxable profit
and thus current income tax if the lease contract includes VAT (and compares the situation
where the lessee is able to claim the VAT back and where the lessee is not able to claim the
VAT back). However, there are also deferred tax consequences.
Let us consider, for example, a lease that includes VAT, (that the lessee can claim back):
x that is recognised by the accountant ‘on-balance sheet’ (i.e. the general approach), and
x for which the the tax authority allows the deduction of the lease payments (where the tax
authority does not see the lessee as having an asset and liability).
In this example, there will be a:

x Carrying amount for the right-of-use asset but the tax base of this asset will be nil:
The tax base of an asset represents the future deductions that will be granted on that asset.
Since this lease is recognised as a ‘lease agreement’ per the ITA, the tax authority will
only allow the deduction of the lease payments made – it does not believe the lessee has
acquired an asset and thus it will not allow any deductions relating to that asset (TB = 0).
Chapter 16 823
x Carrying amount for the lease liability but the tax base of this liability will represent only
the VAT included in the carrying amount of the liability:
This is because the tax base of a liability is the portion of the carrying amount that the tax
authority will not allow as a deduction. Since the carrying amount of the lease liability
represents the full lease instalments owing and the tax authority allows the deduction of
the lease instalments paid but does not allow the deduction of the VAT included in the
instalments (because the lessee was able to claim the VAT back as a VAT input credit),
the tax base of the liability represents the VAT that is included in the liability’s carrying
amount because this will not be allowed as a deduction.
On commencement date, the tax base of the lease liability will be the entire VAT portion.
This tax base then gradually decreases to nil over the lease period, in proportion to the
lease instalments paid.
In summary, in the above example, the impact of the VAT is as follows:

x In the current income tax calculation:
The part of the payment allowed as a deduction by the tax authority is calculated as:
Instalment – (Total VAT x ) Instalment
Total instalments
x In the deferred income tax calculation:
The tax base is calculated as follows:
Total VAT in the lease liability x Remaining instalments
Total instalments
Example 24: Lease under general approach - with VAT (basic)
Braithwaite Limited leases an asset as a lessee.
The lease agreement is for 4 years, and requires annual arrear lease payments of C39 907 (including
VAT at 15%). The present value of the lease payments, discounted at the lessee’s incremental borrowing rate of
10% is C126 500.
Braithwaite is a VAT vendor and is able to claim the VAT back as a VAT input credit.
Required:
A. Journalise the initial capitalisation of the right-of-use asset and lease liability.
B. Calculate the lease liability’s tax base for each year of the lease term.
Solution 24A: Lease under general approach – with VAT – initial measurement
Journal: Year 1 Debit Credit
Right-of-use asset: cost (A) 126 500 x 100/115 (excl VAT) 110 000
VAT receivable (A) VAT input credit claimable 16 500
Lease liability (L) PV of the lease payments (incl VAT) 126 500
Recognising the leased asset, the VAT input asset and the liability
Solution 24B: Lease under general approach – with VAT – tax base
Calculation of the lease liability’s tax base C
Total VAT at beginning of year 1 126 500 x 15/115 16 500

Movement (4 125 )
Tax base at end of year 1 [(39 907 x 3 years) ÷ (39 907 x 4 years)] x 16 500 12 375
Movement (4 125)
Movement (4 125)
Movement (4 125)
Tax base at end of year 4 [(39 907 x 0 years) ÷ (39 907 x 4 years)] x 16 500 0
824 Chapter 16
Comment:
In the case of a VAT vendor:
x the liability tax base is: (Total instalments still to be paid / total instalments) x VAT (i.e. the tax base
represents the VAT remaining)
x the true cost of the asset is its cost less the VAT which may be claimed back from the tax authority.
Example 25: Lease under general approach - with VAT

V Limited, which has a 31 December year end, entered into a lease agreement over a
machine on 1 January 20X1, as the lessee:
Finance charges at 10% Payments Liability
01 Jan 20X1 126 500 Incl VAT at 15%
31 Dec 20X1 12 650 (39 907) 99 243
31 Dec 20X2 9 924 (39 907) 69 260
31 Dec 20X3 6 926 (39 907) 36 279
31 Dec 20X4 3 628 (39 907) 0
(159 628 )
x The profit before tax is C200 000, in each of the 4 years, after correctly taking the lease into account.
x V Limited depreciates the machine over the lease term.
x The tax rate is 30%.
x There are no other temporary or permanent differences.
Required:
Prepare the current and deferred income tax journals for V Limited for all 4 years.
Solution 25: Lease under general approach - with VAT
Comment:
x Notice how the introduction of VAT now creates a tax base for the liability (W2). Compare this to
example 23 where VAT was ignored and the tax base was therefore nil.
x There are a number of ways in which the tax authority may deal with the VAT. The tax base of
the asset and liability depend entirely on the relevant tax legislation
Journals: 20X1 20X2 20X3 20X4

Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
31 December
Income tax expense(P/L: E) W1 61 310 60 493 59 592 58 605
Current tax payable: income tax (L) (61 310) (60 493) (59 592) (58 605)
Current income tax payable
Deferred tax: income tax (A) W4 1 310 493 (408) (1 395)

Income tax expense (P/L: E) (1 310) (493) 408 1 395
Deferred income tax
W1: Current income tax 20X1 20X2 20X3 20X4
Profit before tax 200 000 200 000 200 000 200 000
Add back expenses
x Finance cost – lease 12 650 9 924 6 926 3 628
x Depreciation on right-of-use asset (a) 27 500 27 500 27 500 27 500
Less tax-deductions
x Lease payments (b) (35 782) (35 782) (35 782) (35 782)
Taxable profit 204 368 201 642 198 644 195 346
Current tax TP x 30% 61 310 60 493 59 592 58 605
Chapter 16 825
Calculations:
(a) Depreciation: (126 500 x 100 / 115 – RV: 0) / 4 years x 12/12 = 27 500
(b) Tax deduction: Lease payment – proportional amount of VAT
= 39 907 – (126 500 x 15 / 115 x 39 907 / 159 628) = 39 907 – 4 125 per year = 35 782
W2: Tax base working:
W2.2: Tax base – right-of-use asset

The tax authorities do not recognise the asset (i.e. they ‘see’ lease payments only)
W2.2: Tax base – lease liability

1/1/20X1: 126 500 X 15/115 = 16 500
31/12/20X1: [(35 782 X 3) ÷ (35 782 X4)] x 16 500 = 12 375
31/12/20X2: [(35 782 X 2) ÷ (35 782 X4)] x 16 500 = 8 250
31/12/20X3: [(35 782 X 1) ÷ (35 782 X4)] x 16 500 = 4 125
31/12/20X4: [(35 782 X 0) ÷ (35 782 X4)] x 16 500 = 0
W3: Carrying amount working:
W3.1: Carrying amount – right-of-use asset

31/12/20X1: [Cost on 1 January 20X1: 110 000 – Depreciation in 20X1: 27 500] = 82 500
31/12/20X2: [CA on 1 January 20X2: 82 500 – Depreciation in 20X2: 27 500] = 55 000
31/12/20X3: [CA on 1 January 20X3: 55 000 – Depreciation in 20X3: 27 500] = 27 500
31/12/20X4: [CA on 1 January 20X4: 27 500 – Depreciation in 20X4: 27 500] = 0
W3.2: Carrying amount – lease liability

Given in the question (see effective interest rate table)
W4: Deferred tax CA TB TD DT

(W3) (W2)
Balance: 1/1/20X1 (0) (0) 0 0
x Right-of-use asset 0 0
x Lease liability (0) (0)
Adjustment Jnl: debit deferred tax, credit tax expense NOTE 1 1 310
Balance: 31/12/20X1 (16 743) (12 375) 4 368 1 310 A
x Right-of-use asset 82 500 0
x Lease liability (99 243) (12 375)
Adjustment Jnl: debit deferred tax, credit tax expense NOTE 1 493
Balance: 31/12/20X2 (14 260) (8 250) 6 010 1 803 A
Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (408)
Balance: 31/12/20X3 (8 779) (4 125) 4 650 1 395 A
Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (1 395)
Balance: 31/12/20X4 0 0 0 0
x Right-of-use asset 0 0
x Lease liability 0 0
Notes:
1. The direction and amount of the journal are balancing (DT: opening balance – closing balance).
2. The total tax expense (current tax + - deferred tax adjustment) is 60 000, being 30% of profit before tax
826 Chapter 16
12.6 Accounting for the tax consequences involving transaction taxes (VAT): lease
meets the definition of a ‘rental agreement’
If the lease meets the definition of a ‘rental agreement’, the lessor would be required to pay
VAT on the lease payments as they are paid (i.e. the lessor is not required to pay the VAT on
the entire lease upfront on commencement date). From the lessee perspective, each lease
instalment includes VAT. The lessee will be able to claim from the tax authorities the VAT
that is included in each of the lease instalments paid (assuming the lessee uses the underlying
right-of-use asset to make taxable supplies).
The VAT effect on DT
In this case (where the lessee can claim the VAT), the lease for a lease under the
payments claimed by the lessee as a deduction for income general approach (on-
tax purposes must exclude VAT. The lease payments that balance sheet):
CA/TB with VAT: notice effect of
will be allowed as a deduction for income tax purposes will VAT being claimable/ not
be: instalment (consideration) x 100/115. claimable:
x Asset:
If VAT is not claimable, the lease payments claimed by the lessee - CA = excl VAT (if claimable),
as a deduction for income tax purposes will be inclusive of VAT. - CA = incl VAT (if not claimable)
- TB = nil
x Liability:
When the lease payments include VAT, the measurement of - CA = incl VAT (PV!)
the lease liability will be inclusive of VAT. - TB = PV of VAT (if claimable)
- TB = nil (if VAT not claimable)
The deferred tax consequences are better illustrated by way of an
example: consider a lease that includes VAT (that the lessee can claim back), where this lease:
x is recognised by the accountant ‘on-balance sheet’ (i.e. the general approach), and
x is treated by the tax authority as a ‘rental agreement’.
In this example, there will be a:

x Carrying amount for the right-of-use asset (which will exclude the VAT because the
VAT was claimable and will be recognised as a separate VAT asset).
The tax base of this right-of-use asset will be nil:
This is because the tax base of an asset represents the future deductions that will be granted on
that asset.
Since this lease is recognised as a ‘rental agreement’ per the VAT Act, the tax authority will
only allow the deduction of the lease payments made; no capital allowances will be granted as it
does not believe the lessee has an asset (thus TB of the asset = 0).
x Carrying amount for the lease liability (this will be the present value of the VAT
inclusive lease payments).
The tax base of the liability will be the present value of the VAT included in the lease liability.
This is because the tax base of a liability is the portion of the carrying amount that the tax
authority will not allow as a deduction for income tax purposes.
The carrying amount of the lease liability represents the full lease instalments owing,
inclusive of VAT.
Since the lessee can claim the VAT back when it makes the lease payments, the tax
authority will not allow the deduction of the VAT included in the lease payments when
calculating taxable income. Only the portion of the liability’s carrying amount, net of
VAT, is deductible in the future.
Because the tax base of a liability is the portion of the liability that will not be allowed as
an income tax deduction, the tax base is the VAT included in the liability.
As the lease liability is measured at its present value, the tax base will reflect the present
value of the VAT included in the carrying amount of the lease liability.
Chapter 16 827
In summary, the impact of the VAT is as follows:

x In the current income tax calculation:
The part of the payment allowed as a deduction by the tax authority is calculated as:
Instalment x 100/115
x In the deferred income tax calculation:
The tax base of the right-of-use asset will be nil and
The tax base of the lease liability will be the present value of the VAT included in
the lease liability (if the lessee can claim it back – if the lessee cannot claim the
VAT, the tax base is nil).
13. Presentation and disclosure requirements (IFRS 16.47-60)
13.1 Presentation (IFRS 16.47-50)
13.1.1 Presentation in the statement of financial position
Where there is a lease that has been recognised on-balance sheet (i.e. the general approach),
the statement of financial position will include the right-of-use asset and the lease liability.
The right-of-use asset may be:

x presented separately on the face of this statement; or
x disclosed in the notes to the financial statements, in which case the right-of-use asset must
be included in the line-item of the asset that it would be classified as if it were owned (e.g.
right-of-use asset where the underlying asset is plant would then be included in the
property, plant and equipment line-item). See IFRS 16.47
Exception: A right-of-use asset that meets the definition of investment property must always
be presented in the investment property line-item – it may never be presented within the right-
of-use assets line-item. See IFRS 16.48
The lease liability may be:
x presented separately on the face of this statement; or
x disclosed in the notes, in which case the notes would need to indicate which line-item/s in
the statement of financial position include the lease liability.
Where there is a lease that has been recognised off-balance sheet (i.e. the simplified approach),
the statement of financial position may include an expense payable or expense prepaid. The
expense payable would be included in the ‘trade and other payables’ line-item whereas an
expense prepaid would be included in the ‘trade and other receivables’. See IAS 1.54 (h) & (k)
Although not a requirement in IFRS 16, the lease liability should be separated into its current
and non-current portions, unless the entity presents its liabilities in order of liquidity. See IAS 1.60
Happy Limited
Statement of financial position (extracts) 20X5 20X4
As at 31 December 20X5 Note C C
ASSETS
Non-current assets
Right-of-use assets 15 xxx xxx
Investment property (if a property is leased, it must be included here) xxx xxx
Non-current portion of lease liability 16 xxx xxx
Current liabilities
Current portion of lease liability 16 xxx xxx
828 Chapter 16
13.1.2 Presentation in the statement of comprehensive income
There are a number of expenses that may arise from the recognition of a lease, whether the
lease was recognised on-balance sheet (general approach) or off-balance sheet (simplified
approach). Although many of these require separate disclosure (see section 13.2), it is only the
expenses arising from a lease recognised on-balance sheet that require separate presentation:
x The finance costs arising from the lease must be presented separately from the
depreciation on the right-of-use asset; and
x This finance costs arising from the lease must be included in the finance costs line-item
and be presented separately as a component thereof.
Happy Limited
Statement of comprehensive income (extracts) 20X5 20X4
Profit before finance charges (the depreciation is included here) xxx xxx
Finance charges (the finance cost from the lease is included here) 3 (xxx) (xxx)
Profit before tax 4 xxx xxx
13.1.3 Presentation in the statement of cash flows

The cash paid when paying a lease payment must be separated into its constituent parts and
presented separately as follows:
x The cash payment that reduces the principal portion of the liability must be presented
under financing activities; and
x The cash payment that represents the interest charged on the liability must be presented in
the section under which interest payments are normally presented (if the entity is a
financial institution, it must present the interest payment under operating activities but in
all other cases, entities may choose between presenting it under operating activities or
financing activities). See IFRS 16.50 and IAS 7.33
If a lease payment has not been included in the measurement of the lease liability, the cash payments
must be presented under operating activities. This would thus include cash payments relating to:
x Short-term lease payments that were accounted for off-balance sheet;
x Low-value asset lease payments that were accounted for off-balance sheet; and
x Variable lease payments that do not vary in line with an index or rate. See IFRS 16.50 (c)
13.2 Disclosure (IFRS 16.51-60)
The disclosure requirements are extensive and thus, only the main aspects are explained in this
text. Obviously, the general principle to apply is to disclose enough information such that the
users will have a sound basis upon which ‘to assess the effect that leases have on the financial
position, financial performance and cash flows of the lessee’. See IFRS 16.51
Lessees must have one single note that discloses all information regarding the lease that is not
already presented elsewhere in the financial statements. Where information has been
presented elsewhere, this note must include the relevant cross-reference so that users can find
this other information easily. See IFRS 16.52
The following items must be presented in this note, which must ideally be in a tabular format:
x Depreciation on the right-of-use asset, by class of asset (e.g. the depreciation on the right-
of-use asset relating to a plant should be presented separately from the depreciation on the
right-of-use asset relating to vehicles)
x Lease interest expense
x Short-term lease expense (recognised in terms of the simplified approach)
x Low-value asset lease expense (recognised in terms of the simplified approach)
x Variable lease payments that were not included in the measurement of the lease liability (i.e.
variable lease payments that do not vary in tandem with an index or rate would be disclosed here)
Chapter 16 829
x Rent income from subleasing a right-of-use asset

x Total cash outflow for leases
x Additions to right-of-use assets
x The carrying amount of the right-of-use asset at year-end, listed separately by class of
underlying asset. See IFRS 16.53-54
It is important to note that, even if one of the above items (e.g. lease interest) has been
capitalised to another asset, this must still be included in the abovementioned note. See IFRS 16.54
If a right-of-use asset is an investment property, then it will need to comply with the
disclosure requirements in terms of IAS 40 Investment properties. As a result, although
details regarding this lease must be presented in the single lease note, we will not need to
present the following for a right-of-use asset that is an investment property:
x Depreciation on the right-of-use asset
x Rent income earned on sub-leasing the right-of-use asset
x Additions to the right-of-use asset
x The carrying amount of the right-of-use asset at the end of the year. See IFRS 16.56
If the right-of-use asset is measured in terms of the revaluation model, then the lease note
must also include disclosure of the following information required by IAS 16:
x the effective date of the revaluation;
x whether an independent valuer was involved;
x for each revalued class of property, plant and equipment, the carrying amount that would
have been recognised had the assets been carried under the cost model;
x the revaluation surplus, indicating the change for the period and any restrictions on the
distribution of the balance to shareholders. See IFRS 16.57 and IAS 16.77
The lease note must also include a ‘maturity analysis’ for any lease liability. This maturity
analysis must be presented separately from the ‘maturity analyses’ of other financial
liabilities. The maturity analysis must be in accordance with the requirements of
IFRS 7 Financial instruments: disclosures, and, in this regard, the analysis must show the
remaining contractual maturities and include a description of how the entity manages the
related liquidity risks. See IFRS 16.58 and IFRS 7.39 &.B11
The lease note must also include ‘additional qualitative and quantitative information about its
leasing activities’ that are necessary to enable the users to assess the impact of the leases on
the entity’s financial position, performance and cash flows. For example, the following
information would typically be considered useful:
x the nature of the lessee’s leasing activities;
x future cash outflows to which the lessee is potentially exposed that are not reflected in the
measurement of lease liabilities. This includes exposure arising from:
variable lease payments
extension options and termination options
residual value guarantees
leases not yet commenced to which the lessee is committed
x restrictions or covenants imposed by leases. IFRS 16.59 (extract, slightly reworded)
The information to be disclosed regarding the potential future cash flows to which the entity is
exposed as a result of variable lease payments, extension options and termination options and residual
value guarantees (see above) can be found in IFRS 16.B49, B50 and B51 respectively. In this regard,
the type of information to be disclosed includes, for example, the reasons for using variable lease
payments, their size relative to fixed lease payments, options to extend a lease that have not been
included in the measurement of the lease liability, the reasons why a lessee has given a residual value
guarantee and the amount to which the lessee is exposed in terms of the residual value risk.
If a short-term lease or a lease over a low-value asset has been accounted for in terms of the
recognition exemption (i.e. the simplified approach), then this fact must be presented.
830 Chapter 16
An example of a typical lease note is presented below:
Happy Limited
3. Lease note
Plant Vehicles Total
3.1 Right-of-use assets C C C
Carrying amount – beginning of year xxx xxx xxx
Depreciation (xxx) (xxx) (xxx)
Impairments (xxx) (xxx) (xxx)
Additions xxx xxx xxx
Remeasurement due to reassessment of lease payments xxx (xxx) (xxx)
Carrying amount – end of year xxx xxx xxx
The right-of-use asset relating to vehicles are measured under the cost model but the right-of-use assets relating
to plant are measured under the revaluation model. In this regards, the effective date of the last revaluation is
….., and was performed by valuer who is ……. (independent/ not independent of the entity). Had the right-of-
use asset over plant been measured under the cost model, its carrying amount would have been C……
The revaluation surplus relating to the right-of-use asset over plant ……(increased/ decreased) during the year
by an amount of C…… and now has a balance of C….., over which there are ….. (no restrictions on the
distribution to shareholders/ the following restrictions over the distribution to shareholders….).
Undiscounted
amounts
3.2 Maturity analysis of future lease payments C
Due in 20X2 xxx
Due in 20X3 xxx
Due in 20X4 xxx
Due in 20X5 xxx
Total xxx
The related liquidity risks are managed in the following way: …..
3.3 Income relating to leases C

Rent income from sub-leasing right-of-use assets xxx
3.4 Other expenses relating to leases not included elsewhere in this note C
Finance cost - lease (included in the finance cost line-item) xxx
Variable lease payment expense xxx
Short-term lease expense xxx
Low-value asset lease expense xxx
Happy Limited elected to apply the recognition exemption to low-value asset leases relating to
computers and to short-term leases relating to vehicles (the latter is an accounting policy choice applied
to all short-term leases relating to vehicles).
3.5 Total cash outflows relating to leases C

Cash outflows relating to leases (xxx)
Cash inflows from sub-leasing xxx
3.6 Additional qualitative and quantitative information regarding leases

There are a number of leases that have not yet commenced but to which the entity is committed. Details
thereof are as follows:….
Future cash outflows to which the entity is exposed but which have not been included in the
measurement of the lease liability involve….. (e.g. an extension option). This has not been included in
the measurement of the lease liability on the basis that the entity is not reasonably certain of exercising
this option. The reason why the entity is not reasonably certain it will exercise this option is because
…. (e.g. the future leases are expected to be well above the expected market-related leases).
Chapter 16 831
14. Summary
Leases are accounted for by lessees either using the
General approach; or
Simplified approach i.e. the optional recognition exemption, which is available to:
x low-value assets and
x short-term leases (can only be applied to a short-term lease of an asset if the
accounting policy is to apply the recognition exemption to short-term leases of
that class of asset)
General approach Simplified approach

Recognise on-balance sheet: Recognise off-balance sheet
x Right-of-use asset
x Lease liability
Effect on profit or loss: Effect on profit or loss:
Expenses will include: Expenses will include:
x Finance cost (interest) on lease x Lease payments expensed (over the lease-term,
x Depreciation/ impairment on right-of use asset generally using the SL method)
x Variable lease pmts that do not vary with x Variable lease pmts that do not vary with
index/rate index/rate
General approach
Right-of-use asset (RoU asset) Lease liability (LL)

Measurement model: Measured under:
x Cost model (Cost – AD&AIL +/- Remeasurement x Amortised cost model (i.e. effective interest
adjustments rate method)
x Fair value model (if investment property) x CA reflects PV of future ‘lease payments’
x Revaluation model (if PPE & RoU asset is a class
of PPE that is measured in terms of RM and Initial measurement (at PV of future lease
entity chooses to apply the RM to this RoU asset) payments) … Lease payments (LPs) include:
Initial measurement (at cost): x Fixed payments (including in-substance fixed
x Initial measurement of lease liability pmts) less lease incentives receivable
x Plus indirect costs x Variable LPs that vary with index/rate
x Plus Prepaid lease payments x Residual value guarantees
x Plus Estimated costs to dismantle/ remove/ x Exercise price of purchase options that are
restore reasonably certain will be exercised
x Minus Lease incentives received x Termination penalties if termination is
Depreciation: reasonably certain this option will be exercised
x Starts commencement date
x Method reflects pattern in which FEB from RoU Discount rate:
asset expected to be consumed x implicit interest rate or
x Useful life: If ownership x lessee’s incremental borrowing cost
transfers/ is expected to transfer (e.g.
purchase option & reasonably certain that Subsequent measurement:
lessee will exercise it) then use UL of x Add interest (effective interest rate method)
underlying asset x Less payments
not expected to transfer, then use shorter of x Remeasurement adjustments (up/down) due to a
lease term or UL of RoU asset change in lease payments (not a lease
Impairments: per IAS 36 Impairment of assets modification – lease modifications are accounted
Remeasurements (up/down) due to a for as separate lease contracts)
remeasurement of the LL caused by change in LPs
(if remeasurement decreases the LL and the
remeasurement adj will exceed the RoU asset’s CA,
then excess is recognised in P/L)
832 Chapter 16
Gripping GAAP Leases: lessor accounting
Chapter 17
Leases: Lessor Accounting
Contents: Page
1. Introduction 834
2. Lease classification 836
Example 1: Lease classification 837
3. Finance Leases 838
3.1 Overview – basic overview of recognition 838
3.2 Overview – various defined terms and their measurements 838
3.2.1 Gross investment and net investment in a lease 838
Example 2: Finance lease – gross investment in the lease 839
3.2.2 Interest rate implicit in the lease 839
Example 3: Finance lease – implicit interest rate & net investment in the lease 839
3.2.3 Initial direct costs 842
Example 4: Finance lease – includes initial direct cost 843
3.2.4 Fair value 845
Example 5: Finance lease – initial recognition journal (basic) 845
3.3 ‘Manufacturer/ dealer lessors’ versus ‘non-manufacturer dealer lessors’ 846
3.3.1 Overview 846
3.3.2 Non-manufacturer/ dealer lessor 847
3.3.3 Manufacturer/ dealer lessor 847
Example 6: Finance lease – manufacturer/ dealer 848
3.4 Two methods to record a finance lease: gross method or net method 850
3.4.1 Overview 850
3.4.2 If the lessor is a manufacturer or dealer 851
Example 7: Finance lease: lessor is a manufacturer or dealer 851
3.4.3 If the lessor is neither a manufacturer nor a dealer 855
Example 8: Finance lease: lessor is not a manufacturer or dealer 856
3.5 Lease payments receivable in advance or in arrears 859
Example 9: Finance lease: lease payments receivable in advance 859
3.6 Lease payments receivable during the year 862
Example 10: Finance lease – lease payments receivable during the period 862
3.7 Disclosure of a finance lease 865
3.8 Tax implications of a finance lease 866
Example 11: Finance lease deferred tax: no s 23A limitation, VAT ignored 867
Example 12: Finance lease deferred tax: s 23A limitation, VAT ignored 869
Example 13: Finance lease deferred tax: (manuf./ dealer): s 23A limit, ignore VAT 871
4. Operating Leases 874
4.1 Recognition of an operating lease 874
4.2 Measurement of an operating lease 874
Example 14: Operating lease – recognition and measurement 874
4.3 Tax implications of an operating lease 875
Example 15: Operating lease – tax implications 876
4.4 Disclosure of an operating lease 878
Example 16: Operating lease – disclosure 879
5. Lease involving both land and buildings 880
5.1 Separate classification of the elements 880
Example 17: Lease of land and building 881
5.2 How to allocate the lease payments to the separate elements: land and building 881
Example 18: Lease of land and building 882
5.3 Land and buildings that are investment properties 883
6. Change in classification: modifications versus changes in estimates 883
7. Transaction Taxes (e.g. VAT) 885
7.1 The effect of transaction taxes on a finance lease 885
Example 19: Finance lease with transaction taxes (VAT) 885
7.2 The effect of transaction taxes on an operating lease 887
7.2.1 Input VAT, s 23C and Interpretation Note 47 887
Example 20: Operating lease with tax and VAT 888
8. .Summary 890
Chapter 17 833
1. Introduction
IFRS 16 Leases was issued during 2016 and replaces the Lessors classify leases
previous standard on leases IAS 17 Leases, together with its as either finance or
three related interpretations (IFRIC 4, SIC 15 and SIC 27). operating leases:
IFRS 16 is only effective for periods beginning on or after x if significant risks and rewards
1 January 2019, but early application is possible. of ownership
- transferred: finance lease
When applying IFRS 16, lessees are no longer required to - not transferred: operating
See IFRS 16.61
classify leases as either finance or operating leases. However,
IFRS 16 still requires lessors to make this classification. In other words, in terms of IFRS 16, the
lessor continues to first classify its leases as either operating or finance leases, accounting for each of
these differently. This is quite interesting because it means that the method of accounting from the
lessee and lessor perspective is not always ‘symmetrical’. For instance, a lessor involved in an
operating lease agreement continues to recognise the leased asset in his statement of financial
position, and yet, the lessee in this lease agreement will also recognise this same asset in his
statement of financial position (as a right-of-use asset). This is a contentious area in the new IFRS 16
and was the subject of much debate leading up to its publication.
A lease is defined as:
When a lessor accounts for a lease, it first classifies it as
either an operating or finance lease. It does this by assessing x a contract, or part of a contract,
the substance of the lease, rather than its legal form. When x that conveys the right to use an
assessing the substance of the lease agreement, we assess asset
whether or not substantially all the risks and rewards of x for a period of time in exchange
for consideration. IFRS 16 App A
ownership transfer from the lessor:
x if they transfer, then the substance of the agreement is that it is really a sale agreement
in which financing has been provided by the lessor: this is a finance lease; or
x if they do not transfer, then the substance of the agreement is that it is a ‘true lease’:
this is an operating lease. See IFRS 16.62
Many of the definitions that are relevant when accounting for a lease in the books of a lessee
are the same definitions used when accounting for a lease in the books of a lessor. However,
there are a few definitions that differ slightly and a few extra that are relevant only to lessors.
Some of these are listed below. Please revise all other definitions provided in chapter 16,
being the chapter on lessees.
The following definitions apply only to lessors:
A finance lease (from the perspective of a lessor) is defined as a lease that:

x transfers
x substantially all the risks and rewards incidental to ownership
x of an underlying asset. IFRS 16 App A
An operating lease (from the perspective of a lessor) is defined as a lease that:

x does not transfer
x substantially all the risks and rewards incidental to ownership
x of an underlying asset. IFRS 16 App A
The gross investment in the lease is defined as the sum of:

x the lease payments receivable by a lessor under a finance lease; and
x any unguaranteed residual value accruing to the lessor. IFRS 16.App A
The net investment in the lease is defined as

x the gross investment in the lease,
x discounted at the interest rate implicit in the lease.IFRS 16. App A
834 Chapter 17
Unearned finance income is defined as the difference between:

a) the gross investment in the lease; and
b) the net investment in the lease. IFRS 16.App A
The following definition applies to both lessees and lessors but differs slightly from the
lessor’s perspective:
The term lease payments (LPs) is defined as:

Payments made by a lessee to a lessor relating to the right to use an underlying asset during the lease term,
comprising the following:
(a) fixed payments (including in-substance fixed payments), less any lease incentives;
(b) variable lease payments that depend on an index or a rate
(c) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option;
(d) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option
to terminate the lease
For the lessor:

x Lease payments also include residual value guarantees provided to the lessor:
by the lessee,
a party related to the lessee or
a third party unrelated to the lessor
that is financially capable of discharging the obligations under the guarantee.
x Lease payments do not include payments allocated to non-lease components. IFRS 16 App A (slightly reworded)
There is a slightly different variation on this definition when it is being applied by a lessee (see ch 16).
Some of the other important definitions that you have already covered when studying leases
from the perspective of lessees (chapter 16) are listed below. These definitions are the same
whether we are looking at the lease from the perspective of the lessee or the lessor.
The lease term is defined as: The commencement date of the

lease is defined as:
x the non-cancellable period for which the lessee has the
right to use an underlying asset x the date on which a lessor
x together with periods covered by an option to: x makes an underlying asset available for use
by a lessee. IFRS 16 App A
extend the lease if the lessee is reasonably certain to
exercise that option
terminate the lease if the lessee is reasonably certain
not to exercise that option. IFRS 16 App A (slightly adapted)
The interest rate implicit in the lease is defined as:

x the rate of interest that causes the sum of:
(a) the PV of the lease payments plus (b) the PV of the unguaranteed residual value
x to be equal to the sum of:
IFRS 16 App A (reworded slightly)
(a) the fair value of the underlying asset plus (b) any initial direct costs of the lessor.
The residual value guarantee is defined as:

x a guarantee made to the lessor
x by a party unrelated to the lessor
x that the value (or part of the value) of an underlying asset at the end of the lease
x will be at least a specified amount. See IFRS 16.App A
The unguaranteed residual value is defined as:

x that portion of the residual value of the underlying asset, the realisation of which by the lessor
x is not assured or is guaranteed solely by a party related to the lessor. IFRS 16.AppA
Initial direct costs are defined as:

x incremental costs of obtaining a lease
x that would not have been incurred if the lease had not been obtained,
x except for such costs incurred by a manufacturer or dealer lessor in connection with a finance lease.IFRS 16.App A
Chapter 17 835
2. Lease Classification (IFRS 16.61-66)
From a lessor’s perspective, there are two types of leases: The type of
x finance leases and lease depends
x operating leases. on whether or
not risks and rewards
What differentiates the one type from the other is whether the of ownership have been
transferred:
lease transfers substantially all the risks and rewards of ownership
of the underlying asset. x if yes: finance lease
x if not: operating lease.
If the risks and rewards:

x are transferred from the lessor, the substance of the transaction is a sale rather than a true
lease: a finance lease;
x are not transferred from the lessor to the lessee, the substance of the transaction is a true
lease: an operating lease.
When assessing whether risks and rewards transfer, we must look If any one of these
examples are met,
to the contract’s substance rather than its legal form. Guidance as
it is:
to whether risks and rewards are transferred is given in IFRS 16 by
way of a list of examples of situations that individually, or in x normally a finance lease.
combination, could lead to a lease being classified as a finance Note: this list is not
lease: exhaustive.
a) the lease transfers ownership of the asset to the lessee by the

end of the lease term;
b) the lessee has the option to purchase the asset at a price that is expected to be lower than
the fair value at the date the option becomes exercisable, such that it is reasonably
certain, at the inception of the lease, that the option will be exercised;
c) the lease term is for the major part of the economic life of the asset, even if title is not
transferred;
d) at the inception of the lease, the present value of the lease payments amounts to at least
substantially all of the fair value of the asset; and
e) the leased assets are of such a specialised nature that only the lessee can use them
without major modifications. IFRS 16.63 (extract)
Please note that the above list is not exhaustive. Just because a lease agreement is
characterised by some of the elements above does not, therefore, automatically imply that we
are dealing with a finance lease: if it is clear from other features that the lease does not
transfer substantially all risks and rewards incidental to ownership, the lease is classified as an
operating lease. For example, this may be the case if the contract transfers ownership of the
asset at the end of the lease, but it will be transferred in exchange for a variable payment that
will be based on its fair value at the end of the lease term. See IFRS 16.65
Besides these examples, the standard gives a few extra indicators that might suggest that a
lease is a finance lease. The indicators suggested are:
a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee;
b) if gains or losses from the fluctuation in the fair value of the residual accrue to the lessee
(e.g. in the form of a rent rebate equalling most of the sales proceeds at the end of the
lease);
c) if the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent. IFRS 16.64 (Extract)
The use of these guidance examples is best illustrated with an example.
836 Chapter 17
Example 1: Lease classification

Company A signs a contract leasing a vehicle to Company B:
x The commencement date is 1 January 20X4 and the lease term is for 4 years.
x The lease payments are C10 000 per annum, payable in arrears.
x There is no option of renewal (of the lease agreement) and no option to purchase.
x The interest rate implicit in the lease is 10%.
x The fair value of the motor at 1 January 20X4 is C31 700.
x The lease does not transfer ownership of the vehicle to Company B.
x The useful life of the vehicle is 5 years.
Required: Discuss whether the lease contract should be classified as a finance or operating lease.
Solution 1: Lease classification

We consider the substance of the scenario by assessing whether the lease transfers substantially all the
risks and rewards of ownership. In this regard, we can look to the examples provided in IFRS 16.63-64
for guidance – however, it is not an exhaustive list of indicators.
a) Does ownership of the vehicle transfer to the lessee (Co. B) by the end of the lease? No
b) Does the lessee (Co. B) have an option to purchase the vehicle at a price expected to be
lower that the fair value at the date the option became exercisable? No
c) Is the lease term for the major part of the economic life of the vehicle? (see conclusion) Yes
d) At the inception of the lease, does the present value of the lease payments amount to at
least substantially all of the fair value of the leased asset (i.e. the vehicle)? (W1) Yes
e) Is the vehicle of such a specialised nature that only the lessee (Co. B) can use it, without
major modifications? No
f) Is there an option to extend the lease for a second period at a rental substantially below
market rental? No
Conclusion:
Overall, although legal ownership does not transfer, and there is no option to purchase the asset at the end of the
lease term, and not even an option to renew the lease, the lease term is a major part of the economic life of the
vehicle (4yrs / 5 years = 80%) and, at inception of the lease, the present value of the lease payments amounts to
substantially all the fair value of the vehicle (31 698 / 31 700 =99%). It is thus submitted that the lease transfers
substantially all the risks and rewards of ownership and thus the lease should be classified as a finance lease.
(Note: only one of the above conditions need to be met for the lease to be classified as a finance lease).
W1: Present value of lease payments relative to fair value at inception

Conclusion: At inception, the present value is C31 698 (W1.1) and the fair value is C31 700 (given)
and thus the present value amounts to substantially all the fair value of the asset.
W1.1: Present value of the future lease payments at inception
Date Amount Paid Present value factor (see W1.2) Present value
31/12/20X4 10 000 0.909091 9 091
31/12/20X5 10 000 0.826446 8 264
31/12/20X6 10 000 0.751315 7 513
31/12/20X7 10 000 0.683013 6 830
31 698
W1.2: Present value factors for interest rate of 10%
Present value factor = [1/(1+10%)] n ….. Where: n = number of years/periods
W1.3: Alternative calculation of present values using a financial calculator
The PV of the MLPs could be calculated with a financial calculator instead as follows:
x n = 4 i = 10% PMT = -10 000
x COMP PV ... and your answer should be: 31 698!
Chapter 17 837
3. Finance Leases (IFRS 16.67-80)
3.1 Overview – basic overview of recognition

When accounting for a finance lease in the books of a lessor, we must remember that the
substance of the lease is that the underlying asset has been sold and that the lessor is providing
financing to the lessee (customer) for this sale. Thus, this asset must be derecognised and the
amount owed to the lessor by the lessee must be recognised as a receivable. See IFRS 16.67
The initial journal entry, in its simplest form, is as follows:
Debit Credit
Lease receivable (also called ‘net investment in the finance lease’) xxx
Carrying amount of the underlying asset (e.g. PPE) xxx
Sale of PPE in terms of a finance lease
After this, the lessor earns interest on the receivable over the lease term (because the lessor is
providing finance to the lessee). See IFRS 16.75 This increases the lease receivable as follows:
Debit Credit
Lease receivable (Net investment in the finance lease) xxx
Interest income on finance lease xxx
Interest income earned on finance lease receivable
After this, the lessor receives lease payments from the lessee, decreasing the lease receivable:
Debit Credit
Bank xxx
Receipt of lease payment from lessee reduces the lease receivable
Notice: At commencement date, when the lessor begins

recognising the finance lease, the lessor derecognises the Under a finance lease, a
lessor does NOT depreciate
underlying asset (i.e. the asset that is now being leased by the asset
the lessee), which also obviously means that depreciation
x because the asset is derecognised!
on this asset also ceases. The lessor derecognises the asset
because, by definition, when accounting for a finance lease, the significant risks and rewards relating
to owning the asset are transferred to the lessee (see the very first journal above).
3.2 Overview – various defined terms and their measurements
3.2.1 Gross investment and net investment in a lease The net investment (NI)
in the lease is defined as
The receivable (referred to above) is also referred to as the x the gross investment in the lease,
x discounted at the interest rate
‘net investment in the lease’. This ‘net investment’ is a implicit in the lease. IFRS 16. App A
defined term (see definition alongside) and is essentially the P.S. If we look at the definition of
present value of the ‘gross investment in the lease’. ‘implicit interest rate’ (see 3.2.2),
we can also say the ‘NI’ is:
The term ‘gross investment in the lease’, is yet another defined x the FV of the underlying asset plus
x indirect costs of the lessor.
term. If we look carefully at this definition, we can see that the
‘gross investment’ is the total undiscounted amount of:
x the future lease payments (remember the definition of lease payments includes guaranteed
residual values, amongst other items – see section 1 for the full definition) plus
x any unguaranteed residual value – the portion of the
The gross investment
residual value of the asset the realisation of which is not (GI) in the lease is
guaranteed to the lessor. defined as the sum of:
x the lease payments receivable by
In other words, the gross investment represents the total of the a lessor under a finance lease; and
expected gross inflows (including whatever is left of the asset at x any unguaranteed residual value
IFRS 16.App A
the end of the lease term). accruing to the lessor.
838 Chapter 17
It is important to note that, from the lessee’s perspective, any unguaranteed residual value is
not included in the measurement of the lease liability; but that, from a lessor’s perspective, it
is included in the measurement of the lease liability (because it is included in the calculation
of the gross investment in the lease – see definition on prior page).
Example 2: Finance lease – gross investment in the lease
Company A (lessor) signs a contract leasing a plant to Company B (lessee):
x Co A classifies the lease as a finance lease.
x The commencement date is 1 January 20X0 and the lease term is 10 years.
x The lease payments receivable by Co A are C33 000 per annum, payable in arrears.
x Co A expects the plant to have a residual value of C110 000 at the end of the lease term.
x Co B (lessee) has guaranteed the asset will have a residual value of C66 000 (thus there
is a portion of the residual value that is unguaranteed: C44 000.
Required: Calculate the gross investment in the lease.
Solution 2: Finance lease – gross investment in the lease

Gross investment:
x Lease payments 396 000
- Fixed lease payments C33 000 x 10 payments 330 000
- Guaranteed residual value Given 66 000
x Unguaranteed residual value Total RV 110 000 – Guaranteed RV: 66 000 44 000
440 000
3.2.2 Interest rate implicit in the lease The interest rate implicit
in the lease is defined as:
As mentioned above, the net investment is the present
x the rate of interest that causes
value of the gross investment. the sum of:
(a) the PV of the lease pmts plus
When measuring this present value, we discount the gross
(b) the PV of the unguaranteed
amounts using the interest rate implicit in the lease (see residual value
definition in section 1). x to be equal to the sum of:
(a) the fair value of the
This implicit interest rate is the rate that makes the: underlying asset plus
x present value of gross investment, (i.e. the PV of the lease (b) any initial direct costs of the
payments and any unguaranteed residual value), equal lessor. IFRS 16 App A (reworded slightly)
x the sum of the asset’s fair value plus any initial direct costs incurred by the lessor.
Yet another way of putting it, is the implicit interest rate is the rate that makes:
x the net investment equal
x the sum of the asset’s fair value plus any initial direct costs incurred by the lessor.
Example 3: Finance lease – implicit interest rate & net investment in the lease
This example continues from the previous example. Use the information provided in the
example above, together with the following additional information:
x The carrying amount and fair value of the plant on commencement date is C220 000.
x The initial direct costs incurred by the lessor were nil.
Required:
A. Calculate the interest rate implicit in the lease.
B. Using the implicit interest rate, calculate the net investment in the lease.
C. Journalise the initial recognition of the lease.
D. Journalise the subsequent measurement of the lease in the year ended 31 December 20X0 and show
the journals in the year ended 31 December 20X9 (the last year of the lease) assuming the asset was
returned with a value of C110 000.
E. Show the journals in the year ended 31 December 20X9 assuming that the asset was returned with a
value of C50 000 and thus that the lessee had to contribute cash of C16 000 (remember that the
lessor guaranteed to return the asset with a residual value of C66 000).
Chapter 17 839
Solution 3A: Finance lease – implicit interest rate

Answer: Implicit interest rate = 12,174776%
Comment:
x The implicit interest rate is the rate that makes the
PV of the lease payments plus the PV of the unguaranteed residual value equal
the fair value of the asset plus any initial direct costs.
x The previous example gave us the lease payments and unguaranteed residual values (C440 000)
whereas this example gave us the fair value (C220 000) and the initial direct costs (C0).
x The carrying amount of the asset is irrelevant when calculating the implicit interest rate. We use
the fair value of the asset instead. In this example, the fair value equalled the carrying amount.
Calculation of the implicit interest rate, using a financial calculator:
PV = fair value + initial direct costs = 220 000 + 0 = -220 000
PMTS = lease payments (excluding guaranteed residual values) (1) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual value + unguaranteed residual value (2) = 66 000 + 44 000 = 110 000
Compute i = 12,174776%
(1) The definition of ‘lease payments’ includes ‘guaranteed residual values’, but we leave this out of the
amount that we ‘input’ into the calculation as the ‘PMT’.
This is because the PMT that we input into this calculation must be the payment that occurs in
each and every one of the years (33 000): since the ‘guaranteed residual value’ will only be
received once, at the end of the lease term, this ‘guaranteed residual value’ is input as part of
the future value amount ‘FV’
(2) From the lessor’s perspective, ‘FV’ reflects the future expected value of the underlying asset, whether
it is an unguaranteed or guaranteed residual value (i.e. we include 100% of the residual value).
Solution 3B: Finance lease – net investment in the lease

Answer: Net investment in lease = C220 000
Comment:
x One way of calculating our ‘net investment’, is to start with our gross investment, and then present
value this (being the lease payments and the unguaranteed residual values - see prior example 2)
To calculate the present value of the gross investment, we then need to know what the implicit
interest rate is (calculated in the previous example 3A). This calculation is shown below (requires
a financial calculator).
x On the other hand, the implicit interest rate is the rate that makes the net investment equal the sum of the
fair value and any initial direct costs. Thus, there are two ways of calculating our net investment:
Net investment = FV: 220 000 + initial direct costs: 0 = 220 000
Net investment = Gross investment, discounted at the Implicit interest rate (see calc below)
Alternative calculation of the net investment, using the gross investment and the implicit interest
rate, using a financial calculator:
The NI is the present value of the GI, meaning that it is the PV of the lease payments that are receivable
at the end of every year for 10 years (PMTS = 33 000 and N = 10) plus the PV of the single lease
payment representing the guaranteed lease payment at the end of the 10 th year (C66 000) plus the PV pf
the single unguaranteed residual value at the end of the 10 th year (C44 000), where the latter two
amounts are input into the calculation as the residual value at the end of the lease term, reflected as the
future value (FV = C66 000 + C44 000 = C110 000).
FV = guaranteed residual values + unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = Sol 3A = 12,174776%
Compute PV = C220 000
840 Chapter 17
Solution 3C: Finance lease – initial recognition journal (basic): CA = FV

Comment:
x When initially recognising the finance lease, the lessor derecognises the underlying asset (at its
carrying amount) and recognises a receivable, measured at the ‘net investment in the lease’.
x In this case the carrying amount of the asset equalled its fair value (and there were no initial direct
costs), with the result that the credit to derecognise the asset at its carrying amount (220 000)
equalled the recognition of the receivable measured at the net investment of the lease (220 000).
x This meant that there was no profit to be recognised on the initial recognition of the finance lease.
Lease receivable (net investment) (A) W1 220 000
Plant: carrying amount Given 220 000
Initial recognition at commencement date of sale of plant via a FL
Solution 3D: Finance lease – subsequent measurement journals

Comment:
x After initial recognition of the lease receivable, measured at the NI (i.e. present value of the gross
investment, the latter being the sum of the LPs and Unguaranteed RV), the lease receivable is
measured at amortised cost, thus increased by the interest income, calculated using the effective
interest rate method, and decreased by the payments received.
x This example required you to show the journals relating to the subsequent measurement of the
lease receivable in the first and last year of the lease. The journals in the years in-between would
follow the same format as the two journals shown in the first year of the lease (see below).
31/12/20X0 (first year of lease) Debit Credit

Lease interest income (P/L: I) 26 785
Interest income on the FL
Bank Given & W1 33 000
Lease receivable (net investment) (A) 33 000
Lease payment received from the lessee
31/12/20X9 (last year of lease) Debit Credit

Bank Given & W1 33 000
Plant: cost Actual residual value 110 000
Lease receivable (net investment) (A) Given 143 000
Lease payment received from the lessee plus return of the asset
W1: Effective interest rate table Finance income: Lease pmts plus Receivable balance
at 12,174776% unguaranteed RV
1 January 20X0 220 000
31 December 20X0 26 785 (33 000) 213 785
31 December 20X1 26 028 (33 000) 206 812
31 December 20X2 25 179 (33 000) 198 991
31 December 20X3 24 227 (33 000) 190 218
31 December 20X4 23 159 (33 000) 180 377
31 December 20X5 21 960 (33 000) 169 337
31 December 20X6 20 616 (33 000) 156 953
31 December 20X7 19 109 (33 000) 143 062
31 December 20X8 17 417 (33 000) 127 480
31 December 20X9 15 520 (33 000) 110 000
Residual value that is guaranteed (66 000) 44 000
Residual value that is unguaranteed (44 000) 0
220 000 (440 000)
(a) (b) (c)
Chapter 17 841
Notes:
(a) Finance income: the total of this column represents the unearned finance income at the start of the
lease and shows how this income is expected to be earned over the lease period.
(b) Lease pmts & unguaranteed RV (Gross Investment in Finance Lease: GI): the total of this column
represents the gross investment in the lease (the total amounts actually receivable from the lessee)
and shows how we expect to receive them over the lease period. The last payment includes the
cash payment that will be received from the lessee together with the receipt of the asset at the value
guaranteed by the lessee (i.e. at its guaranteed residual value): 33 000 + 66 000 = 99 000, after
which we reflect the portion of the expected residual value that was unguaranteed, of C44 000.
(c) Receivable balance (Net Investment in Finance Lease: NI): This column shows the present value
of the future lease payments (the portion of the principal sum that the lessee (debtor) will owe at
the end of each year of the lease plus the unguaranteed residual value, if any, that the underlying
asset is expected to have at the end of the lease).
Solution 3E: Finance lease – subsequent measurement journals

Comment:
x If the lessee returns the asset with a value (C50 000) that is less than its guaranteed residual value
(C66 000), the lessee will have to contribute cash to make up the difference between the asset’s
actual value upon its return and its guaranteed valued (in this case C66 000 – C50 000 = C16 000).
x Thus, the last lease payment from the lessee will be C49 000, being the sum of the fixed pmt
(C33 000) and the pmt in terms of the residual value guarantee (C66 000 – C50 000 = C16 000).

Lease receivable (net investment) (A) W1 in Sol 3D 15 520
Bank LP received 33 000 + Receipt in 49 000
terms of RV guarantee: 16 000
Plant: cost Actual residual value 50 000
Lease receivable (net investment) (A) 127 480 + 15 520 (W1) 143 000
Loss on finance lease (P/L: E) Unguaranteed RV 44 000
Lease payment received from the lessee plus return of the asset, asset
returned at less than guaranteed RV
3.2.3 Initial direct costs
If the lessor incurs costs to obtain the lease, and if these were incremental costs that would not
have been incurred had the lease not been obtained these would normally be called ‘initial
direct costs’. However, there is an exception. The exception is that, if these incremental costs
were incurred by a lessor that is a manufacturer or dealer,
Initial direct costs are
then we would not call them ‘initial direct costs’ because defined as:
initial costs incurred by ‘manufacturer/ dealer lessors’ are
expressly excluded from the definition of ‘initial direct x Incremental costs of obtaining
a lease
costs’ (see definition alongside).
x that would not have been incurred
if the lease had not been obtained,
This distinction between a lessor that is a ‘manufacturer/ x except for such costs incurred by
dealer’ and a lessor that is a ‘non-manufacturer/dealer’ is a manufacturer/dealer lessor
very important because it determines whether these initial in relation to a finance lease.
costs meet the definition of ‘initial direct costs’ or not. IFRS 16 App A (reworded slightly)
If the costs do meet the definition of ‘initial direct costs’, then they are taken into account
when calculating our implicit interest rate (look at this definition again) and thus they will
also affect the measurement of our net investment (i.e. our receivable).
If the costs do not meet the ‘definition of ‘initial direct costs’ (i.e. because they were incurred
by a ‘manufacturer/ dealer lessor’), these costs would thus not be included in our implicit
interest rate and would not be included in our net investment. Instead, these ‘so-called initial
direct costs’, would simply be expensed.
842 Chapter 17
The differentiation between ‘manufacturer/ dealer lessors’ and ‘non-manufacturer/dealer

lessors’ is covered in more detail in section 3.3. In the meantime, however, it is sufficient to
know that:
x A lessor that is a ‘manufacturer or dealer’ is one who normally sells the underlying asset
in the lease and thus, the substance of the lease is that he is considered to be selling
inventory and providing finance.
x A lessor that is ‘neither a manufacturer nor dealer’ is one who does not normally sell the
underlying asset in the lease and thus the substance of the lease is that he is simply
providing finance.
When accounting for the initial direct costs incurred by a ‘manufacturer/ dealer lessor’, the
justification for excluding the initial costs from the definition of ‘initial direct costs’ and thus
excluding it from the calculation of the implicit interest rate and the net investment
(receivable) and expensing it instead, is that, the initial direct costs are considered to be a cost
related to the sale of the goods and should be expensed at the same time that we recognise the
cost of sale expense and sales income.
The following examples assume that the lessor is a ‘non-manufacturer/dealer lessor’.
Example 4: Finance lease – includes initial direct costs

This example uses the same information provided in the previous two examples
(summarised below for your convenience), except we now assume that the initial direct
costs incurred by the lessor (a non-manufacturer/ dealer lessor) were not nil, but were
C10 000 instead:
x Co A (lessor) classifies the lease over a plant as a finance lease.
x The lease term is 10 years.
x Co A expects the plant to have a residual value of C110 000 at the end of the lease term.
Co B (lessee) has guaranteed the asset will have a residual value of C66 000 (thus there
is a portion of the residual value that is unguaranteed: C44 000.
x The carrying amount and fair value of the plant on commencement date is C220 000.
x The initial direct costs incurred by the lessor were C10 000.
Required:
A. Calculate the interest rate implicit in the lease.
B. Using the implicit interest rate, calculate the net investment in the lease.
C. Journalise the initial recognition of the lease
D. Journalise the subsequent measurement of the lease in the year ended 31 December 20X9 (the
last year of the lease) assuming that the asset was returned at its full residual value of C110 000.
Solution 4A: Finance lease – implicit interest rate (with initial direct costs)
Answer: Implicit interest rate = 11,267746%
Comment:
x The implicit interest rate is the rate that makes the
x The previous examples (examples 2 and 3) did not involve initial direct costs.
Calculation of the implicit interest rate, using a financial calculator:
PV = fair value + initial direct costs = 220 000 + 10 000 = -230 000
PMTS = lease payments (excluding guaranteed residual values) = fixed payment = 33 000
FV = guaranteed residual value + unguaranteed residual value = 66 000 + 44 000 = 110 000
Compute i = 11,267746%
Chapter 17 843
Solution 4B: Finance lease – net investment in the lease (with initial direct costs)
Answer: Net investment in lease = C230 000
Comment:
x We can calculate the net investment (NI) by starting with our gross investment (GI), and then
present value this using the implicit interest rate (IRR) of 11,267746% (see solution 4A). Whereas
the implicit interest rate changes from the prior examples (because of the initial direct costs), the
gross investment remains unchanged from the prior examples:
lease payments: C33 000 x 10 fixed payments + C66 000 guaranteed residual value
unguaranteed residual value: C44 000
x However, since the implicit rate is the rate that makes the net investment equal the sum of the fair
value and any initial direct costs, we could simply calculate the NI as this sum. Thus, there are two
ways of calculating our net investment:
Net investment = FV: 220 000 + initial direct costs: 10 000 = 230 000
Net investment = Gross investment, discounted at the implicit interest rate (see calc below)
Alternative calculation of the NI, using the GI and the IRR, using a financial calculator:
i = implicit interest rate = see solution 4A = 11,267746%
Solution 4C: Finance lease – initial recognition journal (with initial direct costs)
Comment:
x When initially recognising the finance lease, the lessor derecognises the underlying asset (at its
carrying amount) and recognises a receivable, (measured at the ‘net investment in the lease’).
x In this example, the lessor incurred initial direct costs, which are included in the ‘net investment in
the lease’ (NI). The contra entry is bank (or a payable). The initial direct costs are expensed if the
lessor was a manufacturer/ dealer. See section 3.3, dealing with manufacturer/ dealer lessors.

Lease receivable (net investment) (A) Sol 4B 230 000
Bank Given 10 000
Solution 4D: Finance lease – subsequent measurement journals

Comment:
x After initial recognition of the lease receivable, initially measured at the NI (i.e. present value of
the gross investment, the latter being the sum of the LPs and Unguaranteed RV), the lease
receivable is measured at amortised cost.
x Measurement at amortised cost means that the lease receivable will be increased by the interest
income, calculated using the effective interest rate method, and decreased by the payments
received. The fact that there were initial direct costs incurred by the lessor is simply built into the
implicit interest rate and does not affect any of the principles followed.

Bank W1 33 000
Plant: cost Given 110 000
Lease receivable (net investment) (A) 128 519 + 14 481 (W1) 143 000
Lease payment received from the lessee plus return of the asset
844 Chapter 17
W1: Effective interest rate table Finance income: Lease pmts plus Receivable
at 11,267746% unguaranteed RV balance
1 January 20X0 230 000
31 December 20X0 25 916 (33 000) 222 916
31 December 20X1 25 118 (33 000) 215 033
31 December 20X2 24 229 (33 000) 206 263
31 December 20X3 23 241 (33 000) 196 504
31 December 20X4 22 142 (33 000) 185 646
31 December 20X5 20 918 (33 000) 173 564
31 December 20X6 19 557 (33 000) 160 120
31 December 20X7 18 042 (33 000) 145 162
31 December 20X8 16 357 (33 000) 128 519
31 December 20X9 14 481 (33 000) 110 000
220 000 (440 000)
Notes: (a) (b) (c)
(a) Finance income: the total of this column represents the unearned finance income at the start of the
(b) Lease pmts + Unguaranteed RV: this column represents the gross investment in the lease (GI)
(c) Receivable balance: this column represents the net investment in the lease (NI). In other words,
this column shows the present value of the future lease payments (the portion of the principal sum
that the lessee (debtor) will owe at the end of each year of the lease plus the unguaranteed residual
value, if any, that the underlying asset is expected to have at the end of the lease.
3.2.4 Fair value
When calculating the implicit interest rate and the net investment in the lease, we have used
the term ‘fair value’.
When using the term ‘fair value’ in context of IFRS 16 Leases, we do not apply IFRS 13 Fair
value measurement. Instead, fair value for the purposes of IFRS 16 is simply ‘the amount for
which an asset could be exchanged, or a liability settled, between knowledgeable, willing
parties in an arm’s length transaction’. See IFRS 16.App A & IFRS 13.6
If the fair value of the underlying asset does not equal its carrying amount at commencement
date, then a profit or loss will arise on commencement of the lease. How we account for this
profit depends on whether the lessor is a ‘manufacturer/dealer lessor’ or a ‘non-
manufacturer/dealer lessor’. Manufacturer/dealer lessors are explained in section 3.3.
The following example assumes the lessor is a non-manufacturer/dealer lessor.
Example 5: Finance lease – initial recognition journal (basic)

This example follows on from the prior example – there is no new information except that
the fair value on commencement date is C244 200 and not C220 000.
Required:
Show the journals to account for the finance lease in the lessor’s general journal for the year ended
31 December 20X0.
Solution 5: Finance lease – initial recognition journal: CA ≠ FV with direct costs

Comment:
x The fair value on commencement date is C244 200 and thus does not equal the carrying amount of the asset.
This has no impact on the gross investment (the lease payments and unguaranteed residual value remain
unchanged). It does, however, affect the calculation of the implicit interest rate and net investment.
Chapter 17 845
x The implicit interest rate in this example is now 9,301512% (W1)

This is because the implicit interest rate is the rate that makes the
The previous examples (examples 2, 3 and 4) involved a different fair value.
x Net investment in lease in this example is now C254 200 (W2)
Remember, this net investment can be calculated in one of two ways:
Net investment = FV: 244 200 + initial direct costs: 10 000 = 254 200
Net investment = Gross investment, discounted at the implicit interest rate (see W2 below)
Journals

Lease receivable (net investment) (A) W2 or: 244 200 + 10 000 254 200
Bank Given: initial direct costs 10 000
Profit on finance lease commencement (P/L: I) 24 200
Lease receivable (net investment) (A) 254 200 x 9,301512% 23 644
Bank Given 33 000
W1: Implicit interest rate, calculated using a financial calculator:
PV = fair value + initial direct costs = 244 200 + 10 000 = -254 200
Compute i = 9,301512%
W2: Net investment: alternative calculation using GI and IIR, and using a financial calculator:
i = implicit interest rate = W1 = 9,301512%
3.3 ‘Manufacturer/ dealer lessors’ versus ‘non-manufacturer dealer lessors’
3.3.1 Overview
The essential difference between a ‘manufacturer/dealer lessor’ and a ‘non-manufacturer
dealer lessor’ can be summed up as follows:
x A lessor that is a ‘manufacturer or dealer’ is one who normally sells the underlying asset and
thus, the substance of the lease is that he is effectively selling inventory and providing finance.
x A lessor that is ‘neither a manufacturer nor dealer’ is someone who does not normally sell the
underlying asset and thus the substance of the lease is that he is simply providing finance (often
called a ‘financier lessor’).
Assessing whether a lessor is a ‘manufacturer or dealer’ or a ‘non-manufacturer/dealer’ is
important because it has a direct impact on how we account for the initial recognition of the
lease and it also affects the measurement of the lease because it will affect whether the initial
direct costs are expensed or included in the calculation of the implicit interest rate and net
investment in the lease (i.e. whether they are capitalised to the receivable).
All prior examples were prepared on the basis that the lessor was a ‘non-manufacturer/dealer lessor’.
846 Chapter 17
3.3.2 Non-manufacturer/ dealer lessor

If the lessor is not a manufacturer/ dealer, then it means that the lessor’s normal operating activities
do not revolve around dealing in (selling) goods that he has manufactured or purchased. In this case,
it means that the asset that the lessor ‘sold’ under the finance lease will not be inventory. Instead, the
asset would be, for example, an item of property, plant and equipment. Thus, if the carrying amount
of the underlying asset and the receivable differ, then we would simply account for this difference as
a profit or loss on sale of the asset (e.g. if a receivable exceeds the asset’s carrying amount, then we
would recognise a profit on sale):
Debit Credit
Carrying amount of the underlying asset (e.g. PPE) xxx
Profit on sale of asset (e.g. PPE) xxx
Sale of PPE in terms of a finance lease at a profit
Thus, a finance lease from the perspective of a lessor who is neither a manufacturer nor dealer, is
regarded simply as the sale of an asset (other than inventory) where financing has been provided to
the lessee to facilitate the sale. Thus, although a profit or loss may arise on the initial recognition of
the lease, the only other lease income recognised is interest income.
The other aspect to remember (explained in section 3.2.3 and example 4) is that, if the lessor is
neither a manufacturer nor dealer, any incremental costs incurred in obtaining the lease will meet the
definition of ‘initial direct costs’. Since ‘initial direct costs’ are included in the definition of how we
calculated the ‘implicit interest rate’, these costs will be included in the measurement of the ‘net
investment in the lease’ (the receivable). Thus, this will also have an effect on the measurement of
the interest income thereafter (since the interest income on the lease is measured by applying the
implicit interest rate to the receivable balance).
The aspects of a finance lease
to be recognised in P/L depend
3.3.3 Manufacturer/ dealer lessor on whether the lessor:
If the lessor is a manufacturer/ dealer, it means his x Is a manufacturer/dealer:
- sales and interest income
normal operating activities involve dealing in (selling)
- cost of sales and initial costs expense
goods that he has either manufactured/ purchased. Thus, x Is not a manufacturer/dealer:
the asset ‘sold’ under the finance lease is inventory. - interest income
- P/L on sale of the asset (if applicable)
When we derecognise the asset (inventory), it thus also
means that we must recognise a cost of sales expense.
The cost of sales expense must be measured at:
x cost of the underlying asset (or carrying amount if different to cost)
x less the present value of any unguaranteed residual value. See IFRS 16.71(b)
It also means that we must recognise revenue on the sale. The revenue from the inventory sold in
terms of a finance lease must be measured at:
x the lower of the fair value of the underlying asset or
x the present value of the lease payments, discounted at a market interest rate. See IFRS 16.71(a)
Another aspect to remember is, if the lessor is a ‘manufacturer/ dealer lessor’, the initial incremental
costs that it incurs at the time of obtaining the lease are explicitly excluded from the definition of
‘initial direct costs’. Thus, these costs will not be included in the calculation of the implicit interest
rate and will not be included in the net investment (i.e. will not be capitalised to the receivable).
Instead, these initial costs must be expensed in P/L. This was explained in section 3.2.3. See IFRS 16.App A
In summary, a finance lease from the perspective of a lessor who is a manufacturer or dealer,
is actually regarded as a sale of inventory where financing has been provided to the lessee to
facilitate the sale. Thus, the lessor recognises revenue from sales (sales income) as well as the
interest income on such a lease, and of course, it also recognises the cost of sales expense and
initial incremental costs incurred at the commencement of the lease.
Chapter 17 847
Example 6: Finance lease – manufacturer/ dealer

This example follows on from the prior example – there is no new information except that
the lessor is a manufacturer/ dealer. The example is repeated below for your convenience:
x Co A (lessor) classifies the lease over inventory as a finance lease.
x The lease term is 10 years.
x Co A expects the inventory to have a residual value of C110 000 at the end of the lease
term. Co B (lessee) has guaranteed the asset will have a residual value of C66 000 (thus
there is a portion of the residual value that is unguaranteed: C44 000.
x The carrying amount of the inventory on commencement date is C220 000 (cost).
x The fair value of the inventory on commencement date is C244 200.
x Initial legal fees incurred by the lessor were C10 000.
Required: Journalise the finance lease in the lessor’s records for the year ended 31 December 20X0.
Solution 6: Finance lease – manufacturer/ dealer
Comment:
x The fair value on commencement date is C244 200 and thus does not equal the carrying amount of the
asset. This has no impact on the gross investment (the lease payments and unguaranteed residual value
remain unchanged). It does, however, affect the calculation of the implicit interest rate and net investment.
x The lessor in this example is a manufacturer/ dealer and thus:
The fact that the fair value of the asset (C244 200) exceeds the carrying amount (cost) of the asset
(C220 000) will be recognised as a gross profit of C24 200 by recognising revenue and a cost of sale
(compare this to example 5 where the profit was recognised as a net profit on sale of an item of PPE).
However, notice that:
- the revenue is measured at C227 356 (C244 200 – C16 844), not C244 200; and
- the cost of sale is measured at C203 156 (C220 000 – C16 844), not C220 000.
The revenue from the sale is measured at the lower of the fair value (C244 200) and the present value
of the lease payments (C227 356) (W4)
The cost of sale is measured at the carrying amount of the underlying asset less the present value of
the unguaranteed residual value (this measurement has been shown using 2 journals). This present
value cannot be expensed as cost of sales because it must be capitalised to the lease receivable (Lease
receivable = PV of lease payments + PV of unguaranteed residual value). (W3)
The initial legal fees are expensed. This is because the definition of ‘initial direct costs’ excludes any
incremental costs incurred if the lessor is a manufacturer/dealer lessor. This means that any
incremental costs incurred by a manufacturer/dealer lessor are excluded from the calculation of the
implicit interest rate and thus excluded from the net investment (receivable).
x The implicit interest rate in this example is now 10,078261% (W1)
x Net investment in lease (lease receivable) in this example is now C244 200
(PV of lease payments 227 356 + PV of unguaranteed residual value 16 844 = 244 200)
Remember, this net investment can be calculated in one of two ways:
Net investment = FV: 244 200 + initial direct costs: 0 (N/A) = 244 200
Net investment = Gross investment, discounted at the implicit interest rate (W2)
Journals

Initial direct cost expense (P/L: E) Given 10 000
Bank 10 000
Cost of sales (P/L: E) Given, but see jnl adj. below 220 000
Inventory (-A) 220 000
Revenue (P/L: I) Lower of FV of the inventory: 244 200 227 356
& the PV of the LPs: 227 356
Lease receivable (net investment) (A) PV of the URV (W3) 16 844
Cost of sales (P/L: E) 16 844
Initial recognition of the finance lease at commencement date
(manufacturer/dealer)
848 Chapter 17

Lease receivable (net investment) (A) 244 200 x 10,078261% or W5 24 611
Interest income on the finance lease of 244 200 (227 356 + 16 844)
W1: Implicit interest rate, calculated using a financial calculator:

PV = fair value + initial direct costs (N/A) = 244 200 + 0 = -244 200
Compute i = 10,078261%
W2: Net investment: alternative calculation using GI and IIR, and using a financial calculator:
W3: PV of unguaranteed residual value, calculated using a financial calculator:
FV = unguaranteed residual value (given) = 44 000
N = the period at the end of which we will receive the future value = 10
W4: PV of lease payments, calculated using a financial calculator:
FV = guaranteed residual value = 66 000
W5: Effective interest rate table Finance income: Lease pmts plus Receivable balance
at 10,078261% unguaranteed RV
1 January 20X0 244 200
31 December 20X0 24 611 (33 000) 235 811
31 December 20X1 23 766 (33 000) 226 577
31 December 20X2 22 835 (33 000) 216 412
31 December 20X3 21 811 (33 000) 205 222
31 December 20X4 20 683 (33 000) 192 905
31 December 20X5 19 441 (33 000) 179 347
31 December 20X6 18 075 (33 000) 164 422
31 December 20X7 16 571 (33 000) 147 993
31 December 20X8 14 915 (33 000) 129 908
31 December 20X9 13 092 (33 000) 110 000
220 000 (440 000)
Notes (a) (b) (c)
(a) Finance income: The total of this column shows the unearned finance income at the start of the
(b) Lease pmts + Unguaranteed RV: This column shows the gross investment in the lease (GI)
(c) Receivable balance: This column shows the net investment in the lease (NI). In other words, this column
shows the present value of the future lease payments: the portion of the principal sum the lessee (debtor)
will owe at the end of each year of the lease plus the unguaranteed residual value, if any, that the
underlying asset is expected to have at the end of the lease.
Chapter 17 849
3.4 Two methods to record a finance lease: gross method or net method
3.4.1 Overview
There are two methods whereby a lessor can record a finance lease:
x the gross method or
x the net method.
An entity may choose which method it wishes to adopt. All prior examples have used the net
method because they are perhaps simpler to visualise, but the gross method provides more
detail, which becomes useful when preparing the disclosure (see section 3.7).
If the gross method is adopted, then we use two accounts to reflect the carrying amount of
our receivable asset (net investment in lease):
x The ‘gross investment in lease’ account (GI account): The gross method
recognises the
This account has a debit balance and reflects the gross investment in lease receivable
the investment, measured at the sum of the undiscounted: by using two accounts:
- lease payments (see previous definitions), plus the x gross investment
- unguaranteed residual value (see previous definitions). account (GI) (A); and an
x unearned finance income
This gross investment account is then decreased over the lease account (UFI) (-A)
term by the lease payments received (including the guaranteed
residual value) and then by any unguaranteed residual value.
x The ‘unearned finance income’ account (UFI account):
This account has a credit balance and is set-off against the ‘gross investment account’ so that our
net lease receivable to be presented the statement of financial position is measured at an amount
equal to the ‘net investment in the lease’ (GI – UFI = NI).
This UFI account is amortised to profit or loss as interest income over the lease term (i.e. the
UFI account is decreased over the lease term by the interest income earned).
The balance on this account, at any one time, can also be measured by subtracting from the
balance in the ‘gross investment in lease’ account the ‘net investment in the lease’ (i.e. PV of the
lease payments + PV of the unguaranteed residual value, discounted at the implicit interest rate).
If the net method is adopted, then we only use one account to reflect the carrying amount of
our lease receivable (net investment in lease): The net method
recognises the
x The ‘lease receivable’ account (net investment in the lease’): lease receivable
This account is measured at the present value (discounted at the by using one account:
interest rate implicit in the lease) of the: x net investment (NI).

- lease payments (a defined term); plus the Where NI = GI - UFI
- unguaranteed residual value.
This receivable account equals the ‘gross investment in the lease’ less ‘unearned finance income’:
Receivable = NI = GI – UFI.
This receivable account (net investment account) is adjusted over the lease term as follows:
- Increased by interest income earned (debit the lease receivable account), and
- Decreased by lease payments received and by any unguaranteed residual value
(credit the lease receivable account).
The choice of method obviously involves different journal entries, however, under both
methods the overall effect on the assets, liabilities and income will be the same and the
disclosure requirements will be the same.
We will now illustrate the difference between these two methods for a lessor that is a ‘non-
manufacturer/ dealer’ and then for a lessor that is a ‘manufacturer dealer’.
850 Chapter 17
3.4.2 If the lessor is a manufacturer or dealer
As was explained previously, lessors who are manufacturers or dealers that are offering
finance leases are effectively offering financed sales as opposed to cash sales. Since the
finance lease is considered to be a sale that has been financed, our journals must account for
the sale, cost of sale, interest income and the receipt of the lease payments.
Using the gross method:
Jnl 1. Dr Finance lease receivable: gross investment (LPs and URVs receivable) (A)
Cr Finance lease receivable: unearned finance income (-A)
Cr Sales revenue (P/L: I)
Jnl 2. Dr Cost of sales (P/L: E)
Cr Inventory (A)
Jnl 3. Dr Bank (A)
Cr Finance lease receivable: gross invest. (LPs received) (A)
Jnl 4. Dr Finance lease receivable: unearned finance income (-A)
Cr Finance income (interest income earned) (P/L: I)
Using the net method:
Jnl 1. Dr Finance lease receivable: net investment (PV of GI) (A)
Cr Sales revenue (P/L: I)
Jnl 2. Dr Cost of sales (P/L: E)
Cr Inventory (A)
Jnl 3. Dr Bank (A)
Cr Finance lease receivable: net investment (A)
Jnl 4. Dr Finance lease receivable: net investment (A)
Cr Finance income (interest income earned) (P/L: I)
Just as a reminder, when accounting for a finance lease in the books of a manufacturer/dealer,
the key items are measured as follows:
x sales revenue:
is measured at the lower of (a) the fair value of the asset or (b) the present value of the
lease payments, computed using a market interest rate;
x interest income:
should be measured at (a) the rate implicit in the agreement, (or (b) the market interest
rate if the present value of the lease payments is less than the fair value of the asset
sold), multiplied by the cash sales price of the asset sold;
x any costs incurred in securing or negotiating the lease (initial direct costs):
are simply expensed at the time that the sales revenue is recognised.
Example 7: Finance lease: lessor is a manufacturer or dealer

Lemon Tree Limited is a dealer in machines, which it sells for cash or under a finance lease.
Lemon Tree sold only one machine (purchased on 1 January 20X1 for C250 000), in 20X1. The
machine was sold under a finance lease (cash sales price: C320 000), the terms of which were:
x commencement date: 1 January 20X1
x lease period: 5 years
x lease payments (LPs): C100 000, annually in arrears, payable on 31 December of each year.
The implicit interest and market interest rate applicable is 16,9911%.
Required: Prepare Lemon Tree's journals for each of the years ended 31 December 20X1 to 20X5:
A. Using the gross method.
B. Using the net method.
C. Prepare Lemon Tree Limited’s disclosure for the year ended 31 December 20X1. Ignore comparatives.
Ignore tax.
Chapter 17 851
Solution 7: Finance lease: lessor is a manufacturer or dealer

Comment: Calculate interest on prior year’s receivable’s balance if LPs are in arrears & coincide with year-end.
W1: Analysis of total amount receivable C

Future lease payments (FLPs) 500 000
- Future payments (FLPs) etc Fixed payments: 100 000 x 5 + Variable payments: 0 + 500 000
Purchase option payments: 0 + Penalty payments: 0)
- Future guaranteed residual value Not applicable in this example 0
Plus unguaranteed residual value Not applicable in this example 0
Gross investment in lease (GI) 500 000
Selling price (net investment) (SP) Lower of FV & PV of lease payments, both 320 000 320 000
Cost of asset Given 250 000
Gross profit Balancing = SP: 320 000 – CP: 250 000 70 000
Total unearned finance income (UFI) Balancing = GI: 500 000 – SP: 320 000 180 000
W2: Effective interest rate method Finance income: Lease pmts plus Receivable
16.9911% unguaranteed RV balance
01 Jan X1 320 000
31 Dec X1 54 372 (100 000) 274 372
31 Dec X2 46 618 (100 000) 220 990
31 Dec X3 37 549 (100 000) 158 539
31 Dec X4 26 938 (100 000) 85 477
31 Dec X5 14 523 (100 000) 0
180 000 (500 000)
Notes: (a) UFI (b) GI (c) NI
(a) The total of this column represents the unearned finance income (UFI) at the commencement of the lease
and shows the periods in which this income is expected to be earned over the lease term.
(b) The total of this column represents the gross investment in the lease (GI in finance lease) at the commencement of the
lease, being the total amounts receivable from the lessee (i.e. the lease pmts and unguaranteed residual value) at gross
amounts, and shows the periods in which we expect to receive them over the lease term.
(c) The balance reflected in this column represents the present value of the future lease payments plus the
present value of the unguaranteed residual value, if any (nil in this case). This balance reflects the lease
receivables balance, otherwise known as the net investment in the finance lease (NI).
Solution 7A: Journal entries (Gross method)

Bank (A) 250 000
Purchase of inventory
Cost of sale (P/L: E) 250 000
Cost of inventory (machine) sold under finance lease
Finance lease receivable: gross investment (A) W1 500 000
Finance lease receivable: unearned finance income (-A) W1 180 000
Sale (P/L: I) W1 320 000
Finance lease entered into, cash sales price of C320 000 and 5 years of
arrear lease payments of C100 000 each
31/12/20X1
Bank (A) 100 000
Finance lease receivable: gross investment (A) 100 000
Lease payment received under finance lease
Finance lease receivable: unearned finance income (-A) W2: EIRT 54 372
Lease finance income (P/L: I) 54 372
Interest income earned at 16.9911%, (effective int. rate table: FI column)
31/12/20X2
Bank (A) 100 000
852 Chapter 17
31/12/20X2 continued… Debit Credit

Interest income earned at 16.9911% ( effective int. rate table: FI column)
31/12/20X3
Bank (A) 100 000
Interest income earned at 16.9911% (effective int. rate table: FI column)
31/12/20X4
Bank (A) 100 000
31/12/20X5
Bank (A) 100 000
Solution 7B: Journal entries (Net method)

Bank (A) 250 000
Cost of inventory (machine) sold under finance lease (dealer)
Finance lease receivable: net investment (A) W1: (500 000 – 180 000) 320 000
Sale (P/L: I) 320 000
Finance lease entered into and related sale (dealer), recognised on
commencement date - measured at the net investment (i.e. gross
investment of C500 000 discounted at the implicit interest rate)
31/12/20X1
Bank (A) 100 000
Finance lease receivable: net investment (A) 100 000
Finance lease receivable: net investment (A) W2: EIRT: FI column 54 372
Interest income earned at 16.9911% , (effective int. rate table: FI column)
31/12/20X2
Bank (A) 100 000
Chapter 17 853
31/12/20X2 continued… Debit Credit

31/12/20X3
Bank (A) 100 000
31/12/20X4
Bank (A) 100 000
31/12/20X5
Bank (A) 100 000
Lemon Tree Limited

as at 31 December 20X1
20X1
Non-current assets Notes C
Finance lease receivable 30/1 220 990
Current assets
Finance lease receivable LP due next year: 100 000 – future interest 30/1 53 382
income included in this LP: 46 618
Lemon Tree Limited

20X1
28. Profit before tax C
Profit before tax has been stated after taking into account the following separately
disclosable items:
x Profit or loss on sale of asset under a finance lease (manufacturer/ dealer) See W1 70 000
x Finance income on net investment in lease See Jnls/ W2 54 372
x Income from variable lease payments that do not depend on an index or rate 0
Other lease payments 0
854 Chapter 17
Lemon Tree Limited

Notes to the financial statements (extracts) continued…
20X1
30. Net investment in finance lease (finance lease receivable) C
Carrying amount – beginning of year 0
Net investment of new leases commenced during current year Per jnls 320 000
Finance income Per jnls 54 372
Lease payments received Per jnls (100 000)
Lease modifications 0
Carrying amount – end of year See W2/ note 31: NI 274 372
31. Maturity analysis of future lease payments Gross Unearned Net

receivable investment finance investment
(undiscounted) charges (discounted)
Future lease payments expected to be received: C C C
in 20X2 100 000 14 523 85 477
in 20X3 100 000 26 938 73 062
in 20X4 100 000 37 549 62 451
in 20X5 100 000 46 619 53 381
after 20X5 (all lease pmts after 20X5 shown in total) 0 0 0
Future lease payments (FLPs) 400 000 125 628 274 372
Unguaranteed residual value (URV) 0 0 0
Total (FLPs + URV) 400 000 125 628 274 372
(a) (b = a – c) (c)
Comments
a) This column shows the FLPs expected at each reporting date (and in total), all undiscounted.
b) This column shows the UFI contained in each FLP (and in total), measured at reporting date. It is a
balancing amount: Gross amount (a) – discounted amount (c)
c) This column shows the PV of each FLP (and in total), measured at reporting date.
3.4.3 If the lessor is neither a manufacturer nor a dealer For a lessor who is
neither
As already explained, lessors who are neither manufacturer nor manufacturer/dealer:
dealer are financing a sale of assets to customers, but their business is x recognise only interest
mainly to earn finance income. These lessors derecognise their income
assets, recognise a lease receivable and then simply recognise interest income. Thus, if the lessor is
not a manufacturer or dealer, the basic journals will be as follows:
Using the gross method:
Jnl 1. Dr Finance lease receivable: gross investment (instalments receivable) (A)
Cr Finance lease receivable: unearned finance income (balancing) (-A)
Cr Asset disposed of under the finance lease (cost or carrying amount) (A)
Jnl 2. Dr Bank (instalment received) (A)
Cr Finance lease receivable: gross investment (A)
Jnl 3. Dr Finance lease receivable: unearned finance income (-A)

Cr Finance income (finance income that has been earned) (P/L: I)
Using the net method:

Jnl 1. Dr Finance lease receivable: net investment (i.e. PV of GI) (A)
Cr Asset disposed of under the finance lease (cost or carrying amount) (A)
Jnl 2. Dr Bank (instalment received) (A)

Cr Finance lease receivable: net investment (A)
Jnl 3. Dr Finance lease receivable: net investment (A)

Cr Finance income (finance income that has been earned) (P/L: I)
Chapter 17 855
Just as a reminder, when accounting for a finance lease in the books of a ‘non-
manufacturer/dealer’, the key items are measured as follows:
x Lease receivable:
The initial net lease receivable is measured at the present value of both the lease payments
(which includes the guaranteed residual value) and the unguaranteed residual.
x Interest income:
Interest income is measured by multiplying the interest rate implicit in the agreement
by the balance in the lease receivable account.
x Implicit interest rate:
Initial direct costs (i.e. to secure or negotiate the lease) are added to the lease receivable
and are thus already included when calculating the implicit rate (this will reduce the
interest income recognised over the period of the lease).
Example 8: Finance lease: lessor is not a manufacturer or dealer

Orange Tree Limited is neither a dealer nor a manufacturer. Orange Tree entered into an
agreement under which Orange Tree leased a machine to Beanstalk Limited.
Orange Tree purchased this machine on 1 January 20X1 at a cost of C210 000. The lease is a finance
lease, the terms of which are as follows:
x lease term: 3 years
x lease payments: C90 000, annually in arrears, payable on 31 December of each year
x the residual value (100% guaranteed): C10 000, payable on 31 December 20X3.
The interest rate implicit in the agreement is 15.5819%.
The asset had a nil residual value at the end of the lease term.
Required: Prepare the journals for each of the years ended 31 December 20X1 to 20X3 in
Orange Tree Limited’s books (the books of the lessor):
A. Using the gross method.
B. Using the net method.
C. Prepare the disclosure for the year ended 31 December 20X1 in the financial statements of
Orange Tree Limited. Ignore comparatives.
Ignore tax.
Solution 8: Finance lease: lessor is not a manufacturer or dealer

Comment: Interest income is calculated on the receivable balance at year-end when instalments are in
arrears and coincide with the year-end.

Total future lease payments 90 000 x 3 years 270 000
Guaranteed residual value Given 10 000
Gross investment 280 000
Finance income 280 000 – 210 000 70 000
W2: Effective interest rate table Finance income: Lease pmts plus Receivable
at 15.5819% unguaranteed RV balance
1 January 20X1 210 000
31 December 20X1 32 722 (90 000) 152 722
31 December 20X2 23 797 (90 000) 86 519
31 December 20X3 13 481 (100 000) 0
70 000 (280 000)
(a) UFI (b) GI (c) NI
Comments: For explanation of (a) ; (b) and (c), please see example 7 (W2).
856 Chapter 17
Solution 8A: Journals: gross method

Machine: cost (A) Given 210 000
Bank (A) 210 000
Purchase of machine (asset acquired for purposes of leasing it out)
Finance lease receivable: gross investment (A) W1) 280 000
Finance lease receivable: unearned finance income (-A) W1) 70 000
Machine: cost (A) W1) 210 000
Finance lease entered into over a machine costing C210 000;
Total receivable: C280 000 (90 000 x 3yrs + 10 000 residual value)
31/12/20X1
Bank (A) 90 000
Lease payment received
Lease finance income (I) 32 722
Interest income earned, (effective interest table: FI column)
31/12/20X2
Bank (A) 90 000
31/12/20X3
Bank (A) 90 000 + 10 000 100 000
Lease payment received (cash pmt increased due to guaranteed residual
being 10 000 but the asset having a residual value of nil
Solution 8B: Journals: net method

Machine: cost (A) Given 210 000
Bank (A) 210 000
Purchase of machine
Finance lease receivable: net investment (A) W2 (a) 210 000
Machine: cost (A) W2(c) 210 000
Finance lease entered into over a machine costing C210 000
31/12/20X1
Bank (A) 90 000
Chapter 17 857
31/12/20X1 continued .. Debit Credit

Finance lease receivable: net investment (A) W2: EIRT 32 722
31/12/20X2
Bank (A) 90 000
31/12/20X3
Bank (A) 90 000 + 10 000 100 000
Lease payment received (cash pmt increased due to guaranteed residual
being 10 000 but the asset having a residual value of nil)

Comment:
When doing disclosure on the face of the Statement of Financial Position it is usually easier to draw up the note first
and then do the disclosure on the face with the information from the note.
Orange Tree Limited

20X1
Finance lease receivable 30/1 86 519
Current assets
Finance lease receivable LP due next year: 90 000 – future interest income 30/1 66 203
included in this LP: 23 797 (per EIRT/ jnls)
Orange Tree Limited

20X1
disclosable items:
x Finance income on net investment in lease Per jnl / W2 32 722
30. Net investment in finance lease (finance lease receivable)

Carrying amount – beginning of the year 0
Net investment of new leases commenced during the current year Per jnls 210 000
Lease payments received Per jnls (90 000)
Finance income Per jnls 32 722
Carrying amount – end of year See W2/ note 31:NI 152 722
858 Chapter 17
Orange Tree Limited

Gross Unearned Net
31. Maturity analysis: future lease payments receivable investment finance investment
Future lease payments expected to be received: C C C
- in 20X2 90 000 12 133 77 867
- in 20X3 100 000 25 145 74 855
Total (FLPs + URV) 190 000 32 278 152 722
(a) (b = c – a) (c)
Comments: For explanation of (a) ; (b) and (c), please see solution 7C (note 31).
3.5 Lease payments receivable in advance or in arrears
All previous examples have dealt with lease payments that Whether instalments are
are receivable in arrears, but these may be receivable in in advance or arrears
advance instead. The very first lease payment received in is an important point when:
advance will reduce the principal balance owing (i.e. it will xcalculating interest income using
only reduce the principal balance owing by the lessee and the EIR Table; and
will not include a repayment of interest). xdisclosing the finance lease
receivable
If the lease payments are receivable at the end of a period
(arrears), the balance owing by the lessee (debtor) at the end of that period (i.e. the receivable
balance, or net investment in finance lease) will simply be the portion of the original principal
sum that he still owes to the lessor (i.e. the balance of the cash sum that he would have paid
had he bought the asset instead of leased it under a finance lease): the receivable balance will
not include any interest.
If, however, the lease payments are received in advance or when the lessee does not make an
lease payment on due date, the balance owing by the lessee (receivable) at the end of the
period will include not only the remaining principal sum still owing by the lessee (e.g. present
value of future lease payments) but also the interest owing between the date of the last lease
payment made and the end of the period.
Depending on whether the lease payments are payable in advance or in arrears will also affect
the disclosure of the finance lease receivable in the notes to the financial statements, since the
gross investment in the finance lease must be reconciled to the present value of the future
lease payments (principal outstanding) – which is now no longer equal to the balance on the
finance lease receivable account (net investment in the finance lease).
Example 9: Finance lease: lease payments receivable in advance

Pear Tree Limited is neither a dealer nor a manufacturer. Pear Tree Limited entered into an
agreement in which Pear Tree leased a machine to Giant Limited (cost C210 000). The
lease is a finance lease, the terms of which are as follows:
x lease payments: C80 000, annually in advance, payable on 1 January of each year
x guaranteed residual value: C10 000, payable on 31 December 20X3;
x interest rate implicit in the agreement: 18.7927%.
Required:
A. Prepare the journals for Pear Limited in each of the years affected.
B. Prepare the disclosure for Pear Limited for the year ended 31 December 20X1 . Ignore tax.
Chapter 17 859
Solution 9A: Finance lease: lease payments receivable in advance
Comment: Interest is calculated on the commencement daters opening balance adjusted for the lease
payment when lease payments are in advance and coincide with the start of the financial year.

Guaranteed residual value Given 10 000
Finance income 250 000 – 210 000 40 000
01 January 20X1 210 000
01 January 20X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January 20X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January 20X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 (250 000)
Journals
Debit Credit
1/1/20X1
Bank (A) 210 000
Purchase of machine
Machine: cost (A) W1 210 000
Finance lease entered into over machine costing C210 000; total
receivable: C250 000 (80 000 x 3 years + 10 000 residual value)
Bank (A) 80 000
Finance lease lease payment received
31/12/20X1
Finance lease receivable: unearned finance income (-A) 24 431
Interest income earned, (effective interest table, W2)
1/1/20X2
Bank (A) 80 000
Finance lease payment received
31/12/20X2
860 Chapter 17

Bank (A) 80 000
31/12/20X3
Bank (A) 10 000
Finance lease instalment received
Solution 9B: Finance lease - disclosure
Pear Tree Limited

Notes 20X1
Non-current assets C
Finance lease receivable: capital receivable 30/1 74 431
Current assets
Finance lease receivable: capital receivable LP due next year: 80 000 – current 30/1 55 569
income included in this LP: 24 431
Finance lease receivable: interest receivable W2 30/1 24 431
Pear Tree Limited

20X1
disclosable items:
x Finance income on net investment in lease 24 431
30. Net investment in finance lease

Net investment of new leases commenced during current year 210 000
Lease payments received (80 000)
Finance income 24 431
Carrying amount – end of year 154 431
Comments: Notice that the 3 carrying amounts in the SOFP (74 431 + 55 569 + 24 431) add up to C154 431.
31. Maturity analysis: future lease payments Gross Unearned Net

Future lease payments expected to be received C C C
x in 20X2 80 000 0 80 000
x in 20X3 90 000 15 569 74 431 (1)
Total (FLPs + URV) 170 000 15 569 154 431
(a) (b = c – a) (c)
Comments: For explanation of (a) ; (b) and (c), please see solution 7C (note 31).
Calculations:
(1) 80 000/(1.187927) + 10 000/(1.187927) 2
Chapter 17 861
3.6 Lease payments receivable during the year

Lease payments during
the year:
Lease payments may be receivable during the year rather than
on either the first or last day of the year. You can deal with this x this occurs when the year-end
does not coincide with the lease
by drawing up the effective interest rate table as follows: payment dates
x plot all the payments on the dates on which they fall due. x therefore plot the lease payments
x the portion of the interest earned for each reporting period on the EIR Table and apportion
can then either be shown within this table (see W2 in interest
example 10) or can be apportioned in a separate calculation.
Example 10: Finance lease – lease payments receivable during the period
Avocado Tree Limited is a dealer in machines.
x It entered into an agreement to lease a machine to Giant Limited.
x Avocado Tree Limited purchased the machine on 1 July 20X1 at a cost of C100 000.
x The cash sales price of this machine is C210 000.
x The lease is a finance lease, the terms of which are as follows:
- commencement date: 1 July 20X1
- lease term: 5 years
- lease payments: C60 000, annually in advance, payable on 1 July of each year
- interest rate implicit in the agreement: 21.8623%.
Required:
A. Prepare the journals for Avocado for each of the years ended 31 December that are affected.
B. Disclose the above for the year ended 31 December 20X1 in Avocado Tree’s books. Ignore tax.
Solution 10A: Finance lease - receipts during the period - journals

Guaranteed residual value Not applicable in this example 0
Selling price (net investment) Given 210 000
Gross profit 210 000 – 100 000 110 000
Finance income 300 000 – 210 000 90 000
1 July 20X1 210 000
1 July 20X1 (60 000) 150 000
31 Dec 20X1 32 793 x 6/12 16 397 166 397
1 July 20X2 32 793* x 6/12 16 396 (60 000) 122 793
31 Dec 20X2 26 845 x 6/12 13 423 136 216
1 July 20X3 26 845 x 6/12 13 422 (60 000) 89 638
31 Dec 20X3 19 598 x 6/12 9 799 99 437
1 July 20X4 19 598 x 6/12 9 799 (60 000) 49 236
31 Dec 20X4 10 764 x 6/12 5 382 54 618
1 July 20X5 10 764 x 6/12 5 382 (60 000) 0
(*) Rounded to allow the table to equal zero 90 000 300 000
Note: If payment occurs during the period, we must apportion the interest income to the correct period. The table
above has been adapted to show this apportionment and extract the correct year-end closing balances. This is not
necessary though (i.e. the table could be drawn up as in previous examples and the calculation of the apportionment
could simply be shown in the journals instead).
1/7/20X1
Bank (A) 100 000
862 Chapter 17

Inventory sold under finance lease
1/7/20X1
Sale (P/L: I) W1 210 000
Sale of machine under finance lease
Bank (A) 60 000

31/12/20X1
Lease finance income (P/L: I) W2: 16 397 16 397
Finance income earned, effective interest rate table
1/7/20X2
Bank (A) 60 000
31/12/20X2
Lease finance income (P/L: I) W2: 16 396 + 13 423 29 819
Finance income earned, effective interest rate table:
1/7/20X3
Bank (A) 60 000
31/12/20X3
1/7/20X4
Bank (A) 60 000
31/12/20X4
1/7/20X5
Bank (A) 60 000
31/12/20X5
Lease finance income (P/L: I) W2: 5 382 5 382
Chapter 17 863
Solution 10B: Finance lease – receipts during the period - disclosure
Avocado Tree Limited

20X1
Finance lease receivable: capital 30/1 122 793
Current assets
Finance lease receivable: capital 30/1 27 207
Finance lease receivable: interest 30/1 16 397
Avocado Tree Limited

20X1
disclosable items:
x Finance income on net investment in lease 16 397
30. Net investment in finance lease
Net investment of new leases commenced during current year 210 000
Lease payments received (60 000)
Carrying amount – end of year 166 397
Comments: Notice that the 3 carrying amounts in the SOFP (122 793 + 27 207 + 16 397) add up to C166 397.
31. Maturity analysis of future lease payments Gross Unearned Net

Future lease payments expected to be received:
x in 20X2 60 000 5 648 54 352 (1)
x in 20X3 60 000 15 399 44 601 (2)
x in 20X4 60 000 23 401 36 599 (3)
x in 20X5 60 000 26 967 30 033 (4)
Future lease payments (FLPs) 240 000 (73 603) 166 397
Total (FLPs + URV) 240 000 (73 603) 166 397
(1) 60 000/1.2186320,5
(2) 60 000/1.2186321,5
(3) 60 000/1.2186322,5
(4) 60 000/1.2186323,5
Summary: Finance leases (lessor perspective)
Is it a finance lease?
YES, if substantially all risks and rewards of ownership have transferred (see examples in IFRS 16.63-65)
If a manufacturer/ dealer: If not a manufacturer/ dealer:

x Derecognise the asset (inventory) x Derecognise the asset
x Recognise 2 types of income: finance income & sales x Recognise 1 type of income: finance income
x Recognise initial direct costs as expense up-front x Recognise initial direct costs as part of cost of
(initial direct costs are excluded from the lease receivable (included in the GI and thus
definition of GI and thus affects the implicit affects the implicit interest rate, which will
interest rate, causing interest income to increase) cause interest income to decrease)
864 Chapter 17
3.7 Disclosure of a finance lease (IFRS 16.89-94)
The disclosure requirements are extensive but the general principle to apply is to disclose enough
information so that users will have a sound basis upon which ‘to assess the effect that leases have
on the financial position, financial performance and cash flows of the lessor’. See IFRS 16.89
The following items must be disclosed by a lessor, ideally in a tabular format:
x The profit or loss on the sale of the asset under a finance lease
x Finance income earned on the net investment in the lease
x Income from any variable lease payments that are not linked to an index or rate (i.e.
income from variable lease payments that were not included in the measurement of the
net investment in the lease). See IFRS 16.90-91
In addition to the above note, which was ideally provided in a tabular format, the following
disclosures are also required (the following disclosures need not be in tabular format):
x a maturity analysis showing the undiscounted lease payments that are expected to be
received after reporting date, showing the payments that are expected to be received:
- within 5 years after reporting date on a ‘per annum basis’, and
- after 5 years from reporting date as a ‘total’ (although you can obviously also present
this on a ‘per annum’ basis instead if you prefer).
x a reconciliation between the undiscounted lease payments (i.e. the total of the future lease
payments per the maturity analysis referred to above) and the net investment in the lease,
where the reconciliation must show the following as reconciling items:
- unearned finance income, and
- unguaranteed residual value;
x additional qualitative and quantitative information about its leasing activities that would
enable users ‘to assess the effect that leases have on the financial position, financial
performance and cash flows of the lessor’, including, for example:
- ‘the nature of the lessor’s leasing activities’; and
- ‘how the lessor manages the risk associated with any rights it retains in underlying
assets’, including how it plans to reduce these risks (e.g. through stipulating extra
variable lease payments in the event that the lessee uses the asset above certain
specified limits and the inclusion of residual value guarantees in the contract); and
- Significant changes in the carrying amount of the net investment in finance leases.
See IFRS 16.89 and .93-94
The following is a suggested layout that would satisfy the main presentation and disclosure
requirements for lessors involved in a finance lease:
Happy Limited

Profit before tax has been stated after taking into account the following
separately disclosable items:
x Profit or (loss) on sale of asset under a finance lease (if manufacturer/ dealer) xxx xxx
x Finance income on net investment in lease xxx xxx
x Income from variable lease payments that do not depend on an index or rate
Other lease payments xxx xxx
20X1 20X0
8. Net investment in finance lease C C
Carrying amount – beginning of year xxx xxx
Finance income xxx xxx
Lease payments received (xxx) (xxx)
Net investment of new leases commenced during current year xxx xxx
Lease modifications xxx xxx
Carrying amount – end of year xxx xxx
Chapter 17 865
Happy Limited
Gross Unearned Net
investment finance investment
9. Maturity analysis: future lease payments receivable
C C C
Future lease payments expected to be received (at
undiscounted amounts):
in 20X2 xxx
in 20X3 xxx
We must show expected cash inflows on a
in 20X4 xxx
per-annum basis for at least 5 years
in 20X5 xxx
in 20X6 xxx
after 20X6 (all lease pmts after 20X6 shown in total) xxx
Future lease payments xxx (xxx) xxx
Unguaranteed residual value xxx (xxx) xxx
Total (future lease payments & unguaranteed RV) xxx (xxx) xxx
10. Additional qualitative and quantitative information regarding finance leases
Include a description of the nature of the lessor’s leasing activities (operating and finance leases).
The risks associated with the rights retained in the underlying asset (e.g. items of property, plant and
equipment) that are held under finance leases are as follows…
The risk management strategy is as follows:… (e.g. incorporation of residual value guarantees in the
contracts etc)…
Examples involving disclosure of a finance lease from a lessor’s perspective

The disclosure of finance leases by lessors has already been shown in prior examples. Please see:
x Example 7 (part C): Finance lease - lessor is a manufacturer/ dealer
x Example 8 (part C): Finance lease - lessor is not a manufacturer/ dealer
x Example 9 (Part B): Finance lease - lessor is not a manufacturer/ dealer: advance payments
x Example 10 (Part B): Finance lease - lessor is a manufacturer/ dealer: advance payments and payment does
not coincide with reporting date.
3.8 Tax implications of a finance lease

Finance leases will generally have deferred tax implications From a tax
since most tax authorities do not differentiate between finance perspective:
leases and operating leases. Rather, most tax authorities treat x lessor is the deemed owner
all leases as operating leases for income tax purposes (In some - the asset has a tax base
cases, like in South Africa, the tax authorities recognise other - the lessor is allowed tax
types of leases, this was discussed in detail in chapter 16). deductions
x DT arises as the asset’s
This chapter will only deal with the instance where the tax authority CA = nil, but there is a TB!
does not recognise the substance of the finance lease (i.e. the ‘sale’)
but holds the view that the asset belongs to the lessor and not the lessee.
Beware of the S23A
From a tax perspective, the lessor’s taxable profit will limitations:
include the lease instalments it receives less an annual tax-
deduction based on the leased asset’s cost (e.g. an annual x Tax allowances on machinery/plant (s11
(e) & s12) are limited to taxable lease
capital allowance of 20% of the cost of the leased asset). income.
This creates a temporary difference because, for example:
x This limitation does not apply to building
x From an accounting perspective, the lessor immediately allowances (s13)
derecognises the asset’s entire cost at lease inception
(recognising a resultant expense), however from the tax perspective, the tax authorities still view
the lessor as the owner of the asset and thus the tax authorities continue granting the tax
deductions to the lessor (i.e. the tax authorities continue to gradually deduct the cost of the leased
asset from the lessor’s taxable profits) (e.g. S12C manufacturing allowances); and
866 Chapter 17
x the lessor then recognises the instalments as income using an effective interest rate table (i.e. using
the accrual basis to recognise interest income plus, if a manufacturer/ dealer, sales income) but the
tax authorities tax the instalments on a cash basis.
To complicate matters further, some tax authorities do not allow the tax deductions (e.g.
capital allowances) to exceed the taxable lease income in any one period. In South Africa, for
example, section 23A of the Income Tax Act limits certain tax deductions on the cost of the
asset being leased out by the lessor to the lessor’s taxable lease income.
See the section on transaction taxes (e.g. VAT) and its impact on a lessor in a finance lease.
Summary: Finance lease tax consequences (lessor)
Current tax Deferred tax

Profit before tax… x Finance lease receivable
+ lease payment – (VAT x lease pmt/ total lease pmts) (see later) - has a CA, but no TB
- tax allowance (consider S23A limitation) x Leased asset (e.g. machine)
- interest income (remove from profit; not taxed) - no CA, but has a TB
= Taxable profit
Example 11: Deferred tax on a finance lease with no s 23A limitation, VAT ignored
The facts from example 9 apply, repeated here for your convenience:
Pear Tree Limited is neither a dealer nor a manufacturer. Pear Tree Limited entered into an
agreement in which Pear Tree leased a machine to Giant Limited (cost C210 000 on 1 January 20X3).
The lease is a finance lease, the terms of which are as follows:
x guaranteed residual value: C10 000, payable on 31 December 20X3;
Assume further that the tax authorities:
x tax lease payments when received;
x allow the deduction of the cost of the asset over three years (capital allowance);
x the income tax rate is 30%.
This is the only transaction in the years ended 31 December 20X1, 20X2 and 20X3.
Required: Prepare the current tax and deferred tax journals for each of the years affected. Ignore VAT.
Solution 11: Deferred tax on a finance lease with no s 23A limitation, VAT ignored
Comment:
x This example is actually based on the same basic facts as given in example 9.
x The effective interest rate table for example 9 has been repeated here for your convenience.
x Please see example 9 for any other calculation and/ or for the journals.
W1: Finance income: Lease pmts & Receivable

Effective interest rate table 18.7927% unguaranteed RV balance
01 January X1 210 000
01 January X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 (250 000)
Chapter 17 867
W2: Carrying Tax Temporary Deferred

Deferred tax on the machine amount Base difference taxation
Opening balance 20X1 0 0 0 0
Purchase 210 000 210 000
Finance lease disposal (210 000) 0
Capital allowance 0 (70 000)
Closing balance 20X1 0 140 000 140 000 42 000 A
Closing balance 20X3 0 0 0 0
W3: Deferred tax on the Carrying Tax Temporary Deferred

finance lease receivable amount base difference taxation
New lease 210 000 0
Movement (W1) (55 569) 0
Closing balance (W1) 20X1 154 431 0 (154 431) (46 329) L
Movement (W1) (66 012) 0
Closing balance 20X2 88 419 0 (88 419) (26 526) L
Movement (W1) (88 419) 0
Closing balance (W1) 20X3 0 0 0 0
Finance lease
W4: Deferred tax summary Machine receivable Total
(W2) (W3)
Opening balance 20X1 0 0 0
Adjustment 20X1 (4 329) cr DT; dr TE
Closing balance 20X1 42 000 (46 329) (4 329) L
Adjustment 20X3 5 526 dr DT; cr TE
Closing balance 20X3 0 0 0
W5: Current tax summary 20X3 20X2 20X1 Total

C C C C
Profit before tax: finance income 1 581 13 988 24 431 40 000
Adjust for temporary differences
- less finance income (1 581) (13 988) (24 431) (40 000)
- add lease payment received 90 000 80 000 80 000 250 000
- less capital allowance (70 000) (70 000) (70 000) (210 000)
Taxable profit 20 000 10 000 10 000 40 000
Current income tax at 30% 6 000 3 000 3 000 12 000
Journals: 31/12/20X1 Debit Credit

Current tax charge (W5)
Deferred tax adjustment (W4)
31/12/20X2
868 Chapter 17

31/12/20X3
Example 12: Deferred tax on a finance lease: s 23A limitation, VAT ignored
The facts from example 9 apply, repeated here for your convenience, together with slightly
different tax-related information:
Pear Tree Limited is neither a dealer nor manufacturer. Pear Tree entered into an agreement in which it
leased a machine to Giant Limited (cost C210 000). The lease is a finance lease, the terms being:
x commencement date: 1 January 20X1 with the lease period being 3 years
x guaranteed residual value: C10 000, payable on 31 December 20X3
x tax lease payments when received;
x allow a capital allowance of the cost of the asset over two years;
x the tax authorities limit the capital allowance to the taxable lease income, where any excess that is
not allowed as a deduction is able to be deducted against future lease income (s 23A);
There are no temporary differences other than those evident from the information provided and there
are no non-deductible expenses and no exempt income.
Required: Prepare the current and deferred tax journals for each of the years affected. Ignore VAT.
Solution 12: Deferred tax on a finance lease with a s 23A limitation, VAT ignored
W1: Effective interest rate table Finance income: Lease pmts & Receivable
18.7927% Unguaranteed RV balance
01 January X1 210 000
01 January X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 250 000
W2: Deferred tax on the machine CA TB TD DT
Purchase 210 000 210 000
Finance lease disposal (210 000) 0
S23A limitation (W2.1) 25 000
S23A limitation (W2.1) 25 000
Capital allowance 0 0
S23A allowance (W2.1) (50 000)
Chapter 17 869
W2.1: s 23A: limitation of allowances to taxable rental income 20X1 20X2 20X3
Lease payment received 80 000 80 000 90 000
Less allowances (105 000) (130 000) (50 000)
- Capital allowance 105 000 105 000 0
- s 23A catch-up allowance b/f: X2: 25 000 + X1: 25 000 0 25 000 50 000
Capital allowances disallowed (s23A) (25 000) (50 000) 0
- s 23A limitation c/f 25 000 50 000 0
Comment: when doing a ‘lessor – finance lease’ question, it may be best to first do the s 23A check (W2.1) to
see whether or not the limitation applies.
W3: DT on the fin lease receivable CA TB TD DT

New lease (W1) 210 000 0
Movement (55 569) 0
Closing balance 20X1 154 431 0 (154 431) (46 329) Liability
Movement (66 012) 0
Closing balance (W1) 20X2 88 419 0 (88 419) (26 526) Liability
Movement (88 419) 0
Closing balance (W1) 20X3 0 0 0 0
W4: Deferred tax summary Machine (W2) Fin. lease receivable (W3) Total
Closing balance 20X1 39 000 (46 329) (7 329) Liability
Closing balance 20X2 15 000 (26 526) (11 526) Liability

Profit before tax: finance income 24 431 13 988 1 581 40 000
- less finance income (24 431) (13 988) (1 581) (40 000)
- add lease instalment received 80 000 80 000 90 000 250 000
- less capital allowance (105 000) (105 000) (0) (210 000)
- s 23A limitation 25 000 50 000 0
- s 23A catch-up allowance (0) (25 000) (50 000)
Taxable profit 0 0 40 000 40 000
Current income tax at 30% 0 0 12 000 12 000

There is no current tax charge and therefore no current tax journal (W4)
31/12/20X2
870 Chapter 17

Example 13: Deferred tax on a finance lease (manuf./ dealer):

s 23A limit, VAT ignored
The facts from example 7 apply, repeated here for your convenience, together with tax-
related information:
x Lemon Tree Limited deals in machinery, either selling for cash or under a finance lease.
x Lemon Tree Limited sold only one machine (cost C250 000) during 20X1.
x The machine was sold under a finance lease, but had a cash sales price of C320 000.
x This is the only transaction in the years ended 31 December 20X1 to 20X5.
x The terms of the lease are as follows:
commencement date: 1 January 20X1
lease period: 5 years
lease instalments: C100 000, annually in arrears, payable on 31 December of each year.
The market interest rate applicable is 16,9911%.
x charge tax on the lease instalments when they are received;
x allow the deduction of the following capital allowances:
- 50% once-off allowance in the year of acquisition
- 20% per year on the balance of the cost after deducting the 50% once-off allowance (including
the year of acquisition)
x limit the capital allowance to the taxable lease income: any excess that is not allowed as a
deduction may be deducted against future lease income (s 23A);
x levy income tax rate is 30%.
Required: Prepare the current tax and deferred tax journal entry for each year affected. Ignore VAT.
Solution 13: Def tax on a finance lease (manuf./ dealer) with a s 23A limit, VAT ignored
Comment:
This example is based on the same basic facts as given in example 7.
The effective interest rate table for example 7 has been repeated here for your convenience.
Please see example 7 for any other calculation and/ or for the journals.
W1: Effective interest rate table Finance income: Lease pmts & Receivable balance
16.9911% unguaranteed RV
1 Jan X1 320 000
31 Dec X1 54 372 (100 000) 274 372
31 Dec X2 46 618 (100 000) 220 990
31 Dec X3 37 549 (100 000) 158 539
31 Dec X4 26 938 (100 000) 85 477
31 Dec X5 14 523 (100 000) 0
180 000 (500 000)
W2: Current tax summary 20X1 20X2 20X3 20X4 20X5 Total
Sales income 320 000 320 000
Less cost of sale (250 000) (250 000)
Finance income earned 54 372 46 618 37 549 26 938 14 523 180 000
Profit before tax: 124 372 46 618 37 549 26 938 14 523 250 000
Calculation continued on the next page...
Chapter 17 871
W2: Current tax continued 20X1 20X2 20X3 20X4 20X5 Total
Carried forward from prior page:
Profit before tax: 124 372 46 618 37 549 26 938 14 523 250 000
- less profit on sale (70 000) 0 0 0 (0) (70 000)
- less finance income earned (54 372) (46 618) (37 549) (26 938) (14 523) (180 000)
- add lease instalment received 100 000 100 000 100 000 100 000 100 000 500 000
- less 50% once-off allowance (125 000) 0 0 0 0 (125 000)
- less 20% annual allowance (25 000) (25 000) (25 000) (25 000) (25 000) (125 000)
- add back s 23A limitation 50 000 0 0 0 0 50 000
- less s 23A catch-up allowance (0) (50 000) (0) (0) (0) (50 000)
Taxable profit 0 25 000 75 000 75 000 75 000 250 000
Current income tax at 30% 0 7 500 22 500 22 500 22 500 75 000
W3: DT on fin. lease receivable CA TB TD DT

New lease 320 000 0
Capital repaid (45 628) 0
Closing balance: 20X1 W1 274 372 0 (274 372) (82 311) L
Closing balance: 20X5 W1 0 0 0 0
W4: DT on the machine CA TB TD DT

Purchase 250 000 250 000
Finance lease sale (250 000) 0
50% tax allowance 0 (125 000)
0 125 000
s 23 limitation W2.1 0 50 000
Closing balance: 20X1 0 150 000 150 000 45 000 A
s 23A catch-up allowance W2.1 0 (50 000)
s 23 adjustment 0 0
s 23 adjustment 0 0
s 23 adjustment 0 0
W4.1: s 23A: limitation 20X1 20X2 20X3 20X4 20X5

Lease payment received 100 000 100 000 100 000 100 000 100 000
Less allowances: (150 000) (75 000) (25 000) (25 000) (25 000)
-Capital allowance 150 000 25 000 25 000 25 000 25 000
- s 23A catch-up allowance b/f 50 000 0 0 0
Capital allowances disallowed (s23A) (50 000) 0 0 0 0
- s 23A limitation c/f 50 000 0 0 0 0
872 Chapter 17
W5: Deferred tax summary Machine (W4) Receivable (W3) Total

Journals

Check:
Tax expense in 20X1 will be C37 311 (CT: 0 + DT: 37 311 = 30% x accounting profit: 124 372)
31/12/20X2
Check:
Tax expense in 20X2 will be C13 986 (CT: 7 500 + DT: 6 486 = 30% x accounting profit: 46 618)
31/12/20X3
Check:
Tax expense in 20X3 will be C11 265 (CT: 22 500 – DT: 11 235 = 30% x accounting profit: 37 549)
31/12/20X4
Check:
Tax expense in 20X4 will be C8 081 (CT: 22 500 – DT: 14 419= 30% x accounting profit: 26 938)
Chapter 17 873


Check:
Tax expense in 20X4 will be C4 357 (CT: 22 500 – DT: 18 143= 30% x accounting profit: 14 523)
4. Operating Leases (IFRS 16.81-97)
4.1 Recognition of an operating lease
An operating lease is a ‘pure lease’ since ownership of the asset is not transferred at any stage
during the lease. The lessor therefore keeps his asset in his statement of financial position
(and presents his asset according to its nature, as he would normally, e.g. as property, plant
and equipment), and recognises:
x the costs incurred on the lease as expenses over the period (e.g. depreciation on the
leased asset where the leased asset is a depreciable asset); and
x the lease payments as income over the lease period (normally on a straight-line basis).
4.2 Measurement of an operating lease

Operating leases:
The total lease income receivable should be recognised as
income evenly over the period of the lease. Measurement of x Accounting for OLs by lessors is
the income should be on the straight-line basis over the similar, in principle, to how leases
are accounted for by lessees
period of the lease (irrespective of the actual instalments x Recognise: lease income
receivable in each period). Only if there is a systematic x Measure:
basis that more accurately reflects the pattern in which the - straight line over lease term
asset is used, should a basis other than the straight-line basis - unless another systematic
be used. basis is more representative
of the usage of asset.
Costs (such as depreciation and impairment losses) are measured in terms of the relevant
standard (e.g. IAS 16 and IAS 36 respectively). The depreciation policy for depreciable
leased assets will be consistent with that used by the entity for similar assets.
Costs that are considered to be initial direct costs incurred in connection with the negotiating
and arranging the operating lease should be added to the cost of the leased asset and thereby
be expensed as the leased asset is expensed (e.g. through depreciation). However, these costs
are depreciated over the lease term – not over the useful life of the underlying asset.
Example 14: Operating lease – recognition and measurement

Banana Limited entered into an operating lease with Frond Limited on 1 January 20X1.
The lease was over a plant (which Banana Limited had bought on 1 January 20X1 for C300 000). The
terms of the lease is as follows:
x lease term: 3 years
x fixed lease instalments, payable as follows:
- 31 December 20X1: C100 000
- 31 December 20X2: C110 000
- 31 December 20X3: C150 000
x Frond Limited may purchase the leased asset at its market price on 31 December 20X3
x Unguaranteed residual value: C30 000.
874 Chapter 17
Frond Limited purchased the plant on 31 December 20X3 at its market price of C30 000.
Banana Limited depreciates its plant over three years on the straight-line basis.
Required:
Prepare the journal entries for each of the years affected. Ignore tax.
Solution 14: Operating lease – recognition and measurement

Comment:
As with operating lease expense in the lessee’s records, to determine the lease income in the lessor’s
records, we average the instalments over the period of the lease.

Bank (A) 300 000
Purchase of plant for C300 000
31/12/20X1
Depreciation – plant (P/L: E) (C300 000 – 30 000) / 3 years 90 000

Operating lease receivable (A) 20 000
Operating lease income (P/L: I) (100 000 + 110 000 + 150 000) / 3 years 120 000
Lease income earned (lease payments straight-lined over three years)
31/12/20X2
Depreciation of plant:

31/12/20X3
Depreciation of plant:

Plant: accumulated depreciation (-A) 90 000 x 3 years 270 000

Sale of plant at market value (also equal to residual value)
4.3 Tax implications of an operating lease
The tax consequences of operating leases are relatively simple to understand. The tax
authorities generally:
x charge tax on the lease instalments as they are received;
x allow a deduction of the cost of the leased asset over a period of time (e.g. an annual
capital allowance of 20% on the cost of the asset).
Chapter 17 875
The accounting treatment involves:

x recognising lease income evenly over the lease term (generally on the straight-line basis);
x recognising expenses (depreciation and impairments) evenly over the lease period
(although the rate of depreciation expense may differ from the rate of the capital
allowance granted by the tax authorities).
Deferred tax consequences may therefore arise if, for example:
x the taxable lease instalment received differs from the lease income recognised;
x the costs are allowed as a tax deduction (allowances) at a faster or slower rate than they
are expensed (depreciation and impairments);
x the initial direct costs are allowed as a tax deduction in full in the year in which they are
paid while being capitalised and recognised as expenses over the lease period from an
accounting profit perspective.
Summary: Operating leases (lessor perspective)
Recognition Measurement Taxation

x still recognise asset x lease income = straight line x current tax = lease income
x lease instalments = income basis (or systematic basis…) taxed on cash basis (when
x depreciate asset (incl. initial received)
x lease costs = expenses
x but recognise initial direct costs direct costs capitalised) x deferred tax =
as part of the cost of the x accruals or prepayment - on asset: depreciation vs
leased asset (recognised as adjustments arise if tax allowance
depreciation over the period, if instalment amount differs - on received in advance: DT
from amount recognised as asset; or
a depreciable asset)
income - on receivable: DT liability
Example 15: Operating lease – tax implications

The facts from example 14 (Banana and Frond) apply, with the following tax information:
x charge tax on the lease instalments that are received;
x allow the deduction of the cost of the leased asset over three years;
Required: Prepare Banana’s journals for each of the years 20X1, 20X2 and 20X3. Ignore VAT.
Solution 15: Operating lease – tax implications
W1: DT: plant CA TB TD DT

Purchase 300 000 300 000
Depreciation/ deduction (cost/ 3yr) (90 000) (100 000)
Closing balance 20X1 210 000 200 000 (10 000) (3 000) L
Closing balance 20X2 120 000 100 000 (20 000) (6 000) L
Carrying amount of asset sold
(300 000 – 90 000 x 3yrs) (30 000)
W2: DT: operating lease receivable CA TB TD DT

Movement 20 000 0
Movement 10 000 0
Movement (30 000) 0
876 Chapter 17
W3: Deferred tax summary Plant (W1) Op lease accrual (W2) Total
Closing balance 20X1 (3 000) (6 000) (9 000) L
Closing balance 20X2 (6 000) (9 000) (15 000) L
Closing balance 20X3 0 0 0 L

Operating lease income 120 000 120 000 120 000 360 000
Less depreciation (90 000) (90 000) (90 000) (270 000)
Add profit on sale of plant 0 0 0 0
- Proceeds on sale of plant 30 000 0 0 30 000
- Less carrying amount of plant sold (30 000) 0 0 (30 000)
Profit before tax 30 000 30 000 30 000 90 000
Adjust for temporary differences:
- less operating lease income (120 000) (120 000) (120 000) (360 000)
- add depreciation 90 000 90 000 90 000 270 000
- add lease instalment received 150 000 110 000 100 000 360 000
- less capital allowance (100 000) (100 000) (100 000) (300 000)
- add recoupment on sale
(proceeds: 30 000 – tax base: 0) 30 000 0 0 30 000
Taxable profit 80 000 10 000 0 90 000
Current income tax at 30% 24 000 3 000 0 27 000
Journals
No current tax journal because there is no current tax charge (W4)
Check: tax expense in 20X1: be C9 000 (CT: 0 + DT: 9 000 = 30% x accounting profit: 30 000)
31/12/20X2
Check: tax expense in 20X2: C9 000 (CT: 3 000 + DT: 6 000 = 30% x accounting profit: 30 000)
31/12/20X3
No current tax journal because there is no current tax charge (W4)
Check: tax expense in 20X3: C9 000 (CT: 24 000 – DT: 15 000 = 30% x accounting profit: 30 000)
Chapter 17 877
4.4 Disclosure of an operating lease (IFRS 16.89-92 and .95-97)

The disclosure requirements include:
x lease income, but we must separately present any income from variable lease payments
that do not vary in tandem with an index or a rate.
x a maturity analysis showing the undiscounted lease payments expected to be received
each year for at least 5 years, with lease payments expected to be received after 5 years to
be shown in total.
x additional qualitative and quantitative information about its leasing activities that would
enable users ‘to assess the effect that leases have on the financial position, financial
performance and cash flows of the lessor’, including, for example:
- ‘the nature of the lessor’s leasing activities’; and
- ‘how the lessor manages the risk associated with any rights it retains in underlying
assets’, including how it plans to reduce these risks (e.g. through stipulating extra
variable lease payments in the event that the lessee uses the asset above certain
specified limits and the inclusion of residual value guarantees in the contract).
x depending on the underlying asset that is being rented out under an operating lease, the
entity would have to provide the disclosures required by the relevant IFRS:
- IAS 16 Property, plant and equipment;
- IAS 38 Intangible assets;
- IAS 40 Investment property;
- IAS 41 Agriculture.
x if the underlying asset in the operating lease is an item of property, plant and equipment,
the disclosures required by IAS 16 Property, plant and equipment (see bullet point above)
must be shown separately by class of asset (e.g. vehicles, plant etc) as follows:
- those that are owned and used by the entity; and
- those that are owned and rented out by the entity under an operating lease.
x if the underlying asset in the operating lease was impaired (or had an impairment
reversed) during the year, then the entity must provide the disclosures required by:
- IAS 36 Impairment of assets. See IFRS 16.89; 90 (b) & .92 & .95-97
Happy Limited
Owned Owned Total
and used and leased
25 Property, plant and equipment C C C
Machinery
Net carrying amount – beginning of 20X0 xxx xxx xxx
Gross carrying amount xxx xxx xxx
Less accumulated depreciation and impairment losses (xxx) (xxx) (xxx)
…Detail of movements during 20X0 (shown here)… (xxx) xxx (xxx)
Net carrying amount – end of 20X0 xxx xxx xxx
Gross carrying amount xxx xxx xxx
Less accumulated depreciation and impairment losses (xxx) (xxx) (xxx)

disclosable items:
x Operating lease income from: xxx
Income from variable lease payment that do not depend on an index or rate xxx
Income from other lease payments xxx
878 Chapter 17
Happy Limited
Undiscounted
40. Maturity analysis of future lease payments receivable amounts
C
Future lease payments expected to be received (at undiscounted amounts): xxx
in 20X1 xxx
in 20X2 xxx
in 20X3 We must show expected cash inflows for at least 5 years xxx
in 20X4 xxx
in 20X5 xxx
after 20X5 (all lease payments after 20X5 shown in total) xxx
41. Additional qualitative and quantitative information regarding operating and finance leases
Include a description of the nature of the lessor’s leasing activities (operating and finance leases).
The risks associated with the rights retained in the underlying assets (e.g. items of property, plant and
equipment) that are held under operating leases are as follows…
The risk management strategy is as follows:… (e.g. incorporation of residual value guarantees in the
contracts etc)
Example 16: Operating lease – disclosure

The facts from example 14 and 15 apply.
Required: Prepare the disclosure for each of the years ended 31 December 20X1, 20X2 and 20X3.
Ignore any additional qualitative disclosures
Solution 16: Operating lease – disclosure

Comment: This is the same as example 14 and 15.
Please see example 15 for the tax workings. All other workings are in example 14.
Banana Limited
20X3 20X2 20X1
14. Plant – owned and leased under an operating lease C C C
Net carrying amount – 1 January 120 000 210 000 0
Gross carrying amount – 1 January 300 000 300 000 0
Less accumulated depreciation -1 January (180 000) (90 000) 0
x Purchase 0 0 300 000
x Depreciation (90 000) (90 000) (90 000)
x Sale (30 000) 0 0
Net carrying amount – 31 December 0 120 000 210 000
Gross carrying amount – 31 December 0 300 000 300 000
Less accumulated depreciation – 31 December 0 (180 000) (90 000)
15. Deferred tax liability

The deferred tax constitutes temporary differences from: 0 (15 000) (9 000)
x Plant 0 (6 000) (3 000)
x Operating lease receivable 0 (9 000) (6 000)
16. Maturity analysis of future lease payments receivable (undiscounted amounts)

Total future lease payments expected to be received: 0 150 000 260 000
x In 20X4 0 150 000 110 000
x In 20X5 0 0 150 000
x In 20X6 0 0 0
x In 20X7 0 0 0
x In 20X8 0 0 0
x After 20X8 0 0 0
Chapter 17 879
Banana Limited
20X3 20X2 20X1
C C C
9 000 9 000 9 000
x Current income tax – current year (Example 15 W4) 24 000 3 000 0
x Deferred income tax – current year (Example 15 W3) (15 000) 6 000 9 000
18. Profit before tax 20X3

C
Profit before tax has been stated after taking into account the following separately disclosable items:
x Depreciation 90 000
x Operating lease income from:
Income from variable lease payment that do not depend on an index or rate xxx
Income from other lease payments (120 000)
Banana Limited
20X3 20X2 20X1
Notes C C C
Non-current assets
Plant 14 0 120 000 210 000
Current assets
Operating lease receivable (20 000 + 10 000) 0 30 000 20 000
Deferred taxation: income tax 15 0 15 000 9 000
Current liabilities
Current tax payable: income tax 24 000 3 000 0
Banana Limited
20X3 20X2 20X1
Notes C C C
Taxation expense 19 9 000 9 000 9 000
Profit for the year 21 000 21 000 21 000
5. Lease involving both land and buildings (IFRS 16.B55-57)
5.1 Separate classification of the elements (IFRS 16.B55 and B56)
A lease of land and a lease of buildings would each be classified as Recognise lease
of land
operating or finance leases in the same way as leases of other assets.
separately from
However, if a lease agreement involves a property that combines land lease of buildings:
and buildings, IFRS 16 clarifies that classification of the lease of the
x Except if the land
property as either an operating or finance lease, must involve the element is immaterial
separate consideration and classification of the land element and the (then classify the
building element. This may result in a single lease agreement property as a single
involving land and buildings being recognised partly as an operating unit and use UL of
building as the UL of
lease and partly as a finance lease!
the property)
880 Chapter 17
Now, an interesting feature of land is that its economic life is normally deemed to be indefinite. The
fact that land normally has an indefinite economic life is an important consideration when
determining whether the lease of the land element should be classified as a finance lease or operating
lease. Thus, unless we expect legal title (legal ownership) to pass to the lessee at the end of the lease
term, we may conclude that the lessee could not possibly receive substantially all the risks and
rewards of ownership. As a result, we normally classify leases over land as operating leases (which
would require that the land remains recognised in the lessor’s accounting records).
However, it is not true to say that every lease of land where the legal title (ownership) does not
transfer from the lessor should automatically be accounted for by the lessor as an operating lease.
The ‘basis of conclusions’ within IFRS 16 explains a scenario that was debated where one could
lease land over a 999-year period. It explains that even if legal ownership does not pass to the lessee,
the lessor will have effectively handed over the risks and rewards of When
ownership. Substantiating this fact is that, from the lessor’s perspective, the classifying the
present value of the residual value of its land would be negligible even lease of land, an
after leasing land for just a few decades. Thus, it may be necessary to important consideration
classify a relatively long lease of land as a finance lease (which would is that it normally has
require the lessor to remove the land from its balance sheet as if it had been an indefinite economic
life
sold).
However, as always, it is important to examine the substance of the arrangement. Where
substantially all the risks and rewards have transferred, we must account for the lease as a finance
lease, even if this is inconsistent with the legal nature of the transaction.
Example 17: Lease of land and buildings
We enter into a 999-year lease (as a lessee) over a property constituting land and a building. The
building has a useful life of 80 years. Ownership of the property does not transfer to us at the end of the lease.
Required: Discuss the classification of the lease based purely on the information provided above.
Note that the classification of a lease combining land and buildings as either finance or operating
would not normally be restricted to the information above: all factors affecting the lease would need to
be considered (e.g. fair values versus present values of future lease payments etcetera).
Solution 17: Lease of land and buildings

x The building would be classified as a finance lease since the lease period more than covered a
major part of the economic life of the building (which was only 80 years), so thus the risks and
rewards of ownership were, in substance, transferred.
x The land would be classified as a finance lease because the long period of the lease (999-years)
means that a significant portion of the risks and rewards are transferred to the lessee and thus the
substance is that the lessor sold the land.
5.2 How to allocate the lease payments to the separate elements: land and buildings
(IFRS 16.B55 - B57)
When classifying a lease of a combination property (i.e. the property includes a land element
and a building element), the lease payments (as defined) plus any prepaid lease payments
(which are excluded from the definition of lease payments) will need to be allocated between
the two elements in proportion to the relative fair values of the leasehold interests in the land
and the building elements, measured at lease inception. See IFRS 16. B56
If the fair value of the leasehold interest in the land is immaterial, then we do not consider the
land element separately from the building element when classifying the lease. Instead, we
classify the property as ‘a single unit’. In this case, the useful life of the property must be
assumed to be the useful life of the building. See IFRS 16. B57
If we are not able to reliably allocate the lease payments, the entire lease is classified as:
x an operating lease, if it is clear that both the land element and the building element are
operating leases; or
x a finance lease. See IFRS 16. B56
Chapter 17 881
Example 18: Lease of land and buildings

Lessor Limited leased land and buildings to Lessee Limited, the detail of which follows:
x The lease commencement date is 1 January 20X3, and the lease term is for 20 years.
x The lease payments are C500 000 per annum, payable in arrears.
x At the inception of the lease, the fair value of the leasehold interest in the land is
C5 000 000 whilst the fair value of the leasehold interest in the building is C2 240 832.
x The building had been purchased for C3 000 000 and were being depreciated over its
total estimated useful life of 30 years to a nil residual value. At inception, the buildings
had a remaining useful life of 22 years.
x Land was purchased 10 years ago for C2 200 000 and is not depreciated.
x The interest rate implicit is given at 3,293512%.
x After a careful assessment of all facts and circumstances was done, each of the elements
was correctly classified as follows:
the lease over the land was classified as an operating lease, and
the lease over the building was classified as a finance lease.
Required: Prepare the journal entries for 20X3 and for 20X4 in the lessor’s accounting records.
Solution 18: Lease of land and buildings

Comment:
x The first step would be to classify each of the elements of the lease as either operating or finance
leases. However, we are told to assume that a careful assessment of all facts and circumstances was
done and that each of the elements has been correctly classified with land classified as an operating
lease and the building classified as a finance lease.
x However, by way of example, one of the factors we would have considered is the following:
The lease term is 20 years, which is a major portion of the building’s remaining useful life thus
suggesting that the lease is a finance lease.
The land has an indefinite useful life and thus the lease term of 22 years does not represent a
major portion of the asset’s life thus suggesting that the lease was an operating lease.
Step 1: Splitting the lease payment into operating and finance portions
Split instalments as follows: FV of the land/ building
x Lease payment
FV of the land + FV of the building
5 000 000
Land: x 500 000 = 345 264 (operating lease)
7 240 832
2 240 832
Buildings: x 500 000 = 154 736 (finance lease)
7 240 832
Step 2: Effective interest rate table: finance lease (building only)

Finance charges Finance lease Finance lease liability
3,293512 % instalment (pmt) outstanding at year end
A: C x 3,293512% B: Step 2 C: O/bal + A – B
01/01/20X3 2 240 832
31/12/20X3 73 802 (154 736) 2 159 898
31/12/20X4 71 137 (154 736) 2 076 299
31/12/20X5 68 383 (154 736) 1 989 946
... ...
853 888 (3 094 720)
Comment (regarding step 2):
x This effective interest rate table shows only the years relevant to the question.
x The total payments would be 154 736 x 20 years = 3 094 720
x Total interest over 20 years: 3 094 720 – original amt owed: 2 240 832 = 853 888
882 Chapter 17
Journals:

Finance lease receivable: gross investment (A) 154 736 x 20 yrs 3 094 720
Finance lease receivable: unearned finance income (-A) Step 2 or 853 888
GI: 3 094 720 – NI: 2 240 832
Building: acc depreciation (-A) (3 000 000 – 0)/30 x 8 800 000
Building: cost (A) Given 3 000 000
Profit on sale of building NI: 2 240 832 – CA: (3 000 000 40 832
– 800 000)
Lease over building element recognised as a finance lease
31/12/20X3
Finance lease receivable: unearned finance income (-A) Step 2 73 802
Finance income – lease (P/L: I) 73 802
Finance income earned on the lease over the building (finance lease)
Operating lease income (P/L: I) Step 1 345 264
Finance lease receivable: gross investment (A) Step 1 154 736
Payment of lease instalment (partly finance lease and partly operating lease):
apportioned based on fair values
31/12/20X4
Finance lease receivable: unearned finance income (-A) Step 2 71 137
Finance income – lease (P/L: I) 71 137
Finance income earned on the lease over the building (finance lease)
Operating lease income (P/L: I) Step 1 345 264
Finance lease receivable: gross investment (A) Step 1 154 736
Payment of lease instalment (partly finance lease and partly operating lease):
apportioned based on fair values
Comment: Operating lease income must be recognised on the straight-line basis (or other systematic
basis) over the lease term. However, the operating lease payments remained constant over this period.
5.3 Land and buildings that are investment properties (IAS 40.5)
Investment property comprises land and buildings that are held to earn rentals or for capital
appreciation or both. Thus, land that is leased to a third party under an operating lease (thus
earning rentals) would meet the definition of investment property. Land and buildings that are
leased under an operating lease must be classified as investment property and be recognised
and measured in terms of IAS 40 Investment property.
6. Change in classification: modifications versus changes in estimates (IFRS 16.66)
The classification of a lease is decided upon at the inception of the lease. The classification
should only be changed during the lease period if there is a Lease classifications may
lease modification. need to change if:
x there has been a contract
This means that if there is a change in estimate of the underlying modification – cancel old lease,
asset (e.g. change in the asset’s estimated economic life or treat modified contract as if it
residual value), the classification of the lease is not changed. For were a new lease; or
example, if the useful life is re-estimated to be shorter than the x a correction of error.
previous estimate, such that the lease term is now considered to Otherwise classifications should
be a substantial part of the economic life of the asset, where this never change (i.e. changes in
was previously not the case and thus where the lease had been estimates do not lead to a lease
classification changing).
classified as an operating lease, we would not subsequently
reclassify the lease as a finance lease.
Chapter 17 883
A modification is defined as ‘a change to the scope of the lease or the consideration for a
lease, that was not part of the original terms and conditions’. IFRS 16.App A
If there is a modification made to an operating lease, the original lease is considered cancelled
and the modified lease is considered to be a brand-new lease from the date the modification
becomes effective. Any adjustments are processed prospectively. Any lease payments
receivable or received in advance at effective date, will be treated as if they were lease
payments of the brand-new lease. See IFRS 16.87
A change made to a finance lease as a result of a modification will only be accounted for as as
separate lease if the following two criteria are met:
x ‘the modification increases the scope by adding the right to use one or more underlying
assets; and
x the consideration for the lease increases by an amount commensurate with the stand-
alone price for the increase in scope and any appropriate adjustments to that stand-alone
price to reflect the circumstances of the particular contract’. IFRS 16.79 (Extract)
If there is a modification made to a finance lease that is not accounted for as a separate lease
(because the two criteria mentioned above are not met), then the lessor:
x applies the requirements of IFRS 9 Financial instruments
x unless the finance lease would have been classified as an operating lease had the
modifications been in existence at inception of the original contract, in which case,
instead of applying IFRS 9, the lessor:
accounts for the modification as a new lease from the effective date of the
modification and
derecognises the balance in the ‘net investment in the finance lease’ account (credit)
and recognises it as the carrying amount of the underlying asset (debit). See IFRS 16.80
Worked example 1: Change in the contract terms and conditions

If an 8-year lease, originally classified as an operating lease, was altered at the beginning of
year 4 such that ownership now passes to the lessee at the end of year 8, the lease will be re-
classified as a finance lease from the beginning of year 4. No changes are made to the classification of
the lease as an operating lease in the preceding 3 years.
The approach above does not apply to normal renewals and to changes in estimates, for
example changes in estimates of the useful life or the residual value of the leased property.
Worked example 2: Change in the estimated useful life

An 8-year lease was originally classified as an operating lease on the basis that the
remaining useful life of the leased asset at commencement date was 20 years. At the
beginning of year 6, the remaining useful life of the asset was re-estimated to be 3 years. At this date,
the remaining lease term is also 3 years (this also means that at commencement date, the useful life
should have been considered to be 8 years instead of 20 years). Thus, the remaining lease term of 3yrs
is now a substantial portion of the asset’s useful life of 3 years (100%). Although it suggests that the
lease should have been classified as a finance lease at commencement date had we known the revised
estimated useful life of 8 years instead of using the original estimate of 20 years (total lease term = total
re-estimated useful life = 8 years), or that it should be classified as a finance lease at the date the useful
life is re-estimated (remaining lease term = remaining useful life = 3 years), no reclassification of the
lease may take place. The lease continues to be classified as an operating lease.
The only exception would be if, for example, an original useful life was incorrect and thus
that the subsequent change in the useful life is a correction rather than a change in estimate. In
this case, the classification of the lease would have been incorrect and we would thus need to
correct an error. If the error was material and occurred in the prior year, the correcting
adjustments would be made retrospectively, with prior years restated. See IAS8.41 - .49
884 Chapter 17
7. Transaction Taxes (e.g. VAT)
7.1 The effect of transaction taxes on a finance lease
The existence of a transaction tax (e.g. VAT) in a finance lease has certain accounting
implications. To understand these implications, one must know what tax legislation applies.
Output VAT is charged on initial In South Africa, the VAT Act requires that VAT
lease capitalisation: vendors calculate and charge VAT (i.e. output VAT)
x being the earlier of date of delivery or date on “instalment credit agreements”. A finance lease
of payment. satisfies the criteria as an “instalment credit
x It is recognised as a VAT payable agreement” and thus a lessor that is a VAT vendor
immediately. must charge VAT (i.e. output VAT) on a finance
lease. The VAT is charged and becomes payable to the tax authorities at the commencement date,
being the earlier of delivery, or payment (see chapter 16 for detailed discussion).
In other words, this output VAT is payable in total and upfront – it is not payable piecemeal
based on the lease payments over the lease term. Thus, this full VAT is included in the
receivables balance and credited to the VAT output account (VAT payable).
The amount is calculated by multiplying the VAT fraction by
the cash selling price (incl. VAT but excluding finance costs). Output VAT on initial
lease capitalisation:
This VAT that the lessor charges is not included in the x 15/115 x cash selling price incl.
VAT (excl. fin charges)
lessor’s taxable income and thus income tax is not payable on
the VAT included in the lease instalments received. As a result, lease instalments included in
taxable profit are adjusted to exclude the proportional VAT included therein (i.e. output
VAT). This proportional VAT is called “notional” output VAT.
The tax base of the finance lease receivable The effects of notional output VAT:
initially reflects the total VAT charged on the
lease, but as and when the lessee pays his x on current tax:
add instalment less notional VAT
instalments, a portion of the instalment is
notional VAT = this instalment/ total
recognised as a repayment of part of this original instalments x output VAT
total VAT payable. As mentioned above, the x on deferred tax:
portion of an instalment that is assumed to be a the tax base of lease receivable = total
repayment of VAT is called a “notional” VAT output VAT x outstanding instalments/ total
payment. These notional VAT payments reduce instalments (or total output VAT less
the notional VAT balance still owed by the lessee notional output VAT included in lease
(i.e. the tax base of the receivable is gradually instalments paid to date)
reduced by the notional VAT payments until the tax base of the receivable is eventually nil).
If the lessor is not a VAT vendor, then the lessor will not charge VAT and thus the input and
output VAT adjustments referred to above do not apply. The result is that the entire
instalments are included in taxable profits and the lease receivable (lease receivable) will be
nil.
As previously discussed, the VAT Act requires that VAT is charged on the lease, payable
immediately. We recognise this entire VAT on the initial capitalisation of the lease.
Example 19: Finance lease with transaction taxes (VAT)

A Limited sold only one machine during 20X5. This machine was bought on 1 January 20X5 and
had a cost price of C570 000 (including VAT).
This machine was then sold under a finance lease, on the same day.
This is the only transaction for the year ended 31 December 20X5.
A Limited is not a manufacturer/dealer in machines.
Chapter 17 885
x The terms of the lease are as follows:

- Inception of the lease: 1 January 20X5
- Lease period: 5 years
- Lease instalments: C150 000 (incl. VAT at 14%) payable annually in arrears on 31 December each year
- Market interest rate: 9,90505% p.a.
x The tax authorities:
- Apply Interpretation Note 47
- Allow the deduction of capital allowances over 5 years.
- Limit the capital allowance to the taxable lease income, where any excess that is not allowed as a
deduction is able to be deducted against future lease income (s 23A).
- Levy income tax at 30% on taxable profits and levy VAT at 14% on taxable supplies.
x A Limited is a VAT vendor.
Required: Prepare all the journals (including tax) for the year ended 31 December 20X5.
Solution 19: Finance lease with transaction taxes (VAT)

Comment:
Section 23A of the Income Tax Act does not apply as the instalments (C150 000) exceed the wear and tear
allowance (C570 000/5 = C114 000).
Debit Credit
1/1/20X5
Current tax receivable: VAT input (A) 70 000
Bank (A) 570 000
Purchase of machine
Finance lease receivable: gross investment (with VAT) (A 150 000 x 5 750 000
Finance lease receivable: unearned finance income (-A) 750 000 – 570 000 180 000
Current tax payable: VAT output (L) 500 000 x 14% 70 000
Machine: cost Given 500 000
Finance lease entered into
31/12/20X5
Finance lease receivable - gross investment (A) 150 000
Finance lease instalment received
Finance lease receivable - unearned finance income (-A) W2 56 459
Recognition of finance income
Income tax (E) W3 10 800
Current tax charge
Income tax (E) W4.3 6 138
Deferred tax adjustment
Workings:
Total future payments 750 000

Add guaranteed residual value (N/A) 0
Cost of asset 500 000
VAT output 70 000
886 Chapter 17
W2: Effective interest rate table Finance income @ 9.90505% Instalment Balance
1 Jan 20X5 570 000
31 Dec 20X5 56 469 (150 000) 476 459
31 Dec 20X6 47 194 (150 000) 373 653
31 Dec 20X7 37 011 (150 000) 260 664
31 Dec 20X8 25 819 (150 000) 136 483
31 Dec 20X9 13 518 (150 000) -
180 000 (750 000)
W3. Current tax calculation

Profit before tax Finance income is the only transaction (given) 56 459
Less finance income (56 459)
Less wear and tear 500 000 (excluding VAT)/ 5 years (100 000)
Add lease instalment received 150 000 – Notional VAT: 70 000 x (150 000/ 750 000) 136 000
W4. Deferred income tax CA TB TD DT

W4.1 Finance lease receivable
Opening balance 0 0 0 0
New lease 570 000 (a) 70 000 (d)
Movement (93 541) (b) (14 000) (e)
Closing balance 476 459 (c) 56 000 (f) (420 459) (126 138) L
Calculations supporting 4.1
CA = Gross investment – Unearned finance income TB = output VAT x (outstanding instalments/ total
(a) = 750 000 – 180 000 (W2/ jnls) instalments)
(b) = 56 459 – 150 000 (W2/ jnls) (d) = 70 000 output VAT x (750 000/ 750 000)
(c) = 750 000 – 180 000 – (150 000 – 56 459) (jnls/ W2) (e) = 70 000 output VAT x (150 000/ 750 000)
(f) = 70 000 output VAT x (750 000 – 150 000)/ 750 000
Note: The initial TB of the Lease receivable asset is calculated as the CA less amts taxable in future. On this initial recognition
date, the CA is 570 000, of which C500 000 will be taxed in future. Thus TB = 570 000 – 500 000 = 70 000
W4.2 Machine CA TB TD DT
Purchase (excluding VAT) 500 000 500 000
Lease disposal (500 000) 0
Wear and tear 0 (100 000)
Closing balance 0 400 000 400 000 120 000 A
W4.3 Summary of deferred tax Receivable Machine Total
(W4.1) (W4.2)
Opening balance of deferred tax 0 0 0
Movement (6 138) Cr DTL, Dr TE
Closing balance of deferred tax (126 138) 120 000 (6 138) L
7.2 The effect of transaction taxes on an operating lease

The existence of VAT in an operating lease is nowhere near as complex as in a finance lease.
The effect on the taxable profits calculation is what one might expect:
x add the operating lease income, excluding VAT;
x deduct the wear and tear, calculated on the cost of the asset, excluding VAT.
7.2.1 Input VAT, s 23C and Interpretation Note 47
When an input VAT deduction for the purchase of an asset is available for a lessor who is a
VAT vendor (i.e. when VAT paid on the purchase of an asset is reclaimable), the tax base will
exclude the amount of input VAT. Thus, the tax deductions or allowances on this asset will be
calculated on the cost of the asset excluding the VAT that is reclaimable.
Chapter 17 887
If the VAT was not reclaimable (e.g. the lessor is not a VAT vendor and thus when
purchasing an asset that included VAT, the lessor was not in a position to claim the VAT
back), then the cost of the asset for purposes of calculating an allowance includes the VAT.
Example 20: Operating lease with tax and VAT

A Limited entered into an operating lease (as a lessor) with B Limited over a machine
(original cost C1 140 000 incl. 14% VAT, purchased on 1 January 20X5). The lease terms include:
x Commencement date: 1 January 20X5 with the lease period being 3 years
x Fixed lease payments due as follows (incl. VAT):
- 31 December 20X5: C433 200
- 31 December 20X6: C182 400
- 31 December 20X7: C136 800
A Limited depreciates the machine over 4 years to a nil residual value.
The tax authorities allow the cost to be deducted over 5 years. Tax is levied at 30%.
A’s profit before tax for 20X5 (C400 000) has not been adjusted for the above lease transaction. There
are no temporary differences, no items of exempt income and no non-deductible expenses.
Assume that the tax authorities view this lease as a normal leasing agreement (i.e. not as a sale.
Required: Prepare the necessary journal entries for 20X5 in A Limited’s books.
Solution 20: Operating lease with tax and VAT

Comment: Notice how in W1 we average (smooth) the lease income net of VAT.
Machine: cost (A) 1 000 000

Current tax payable: VAT input (A) 140 000
Bank (A) 1 140 000
Purchase of machine
31/12/20X5
Depreciation: machine (E) (1 000 000 – 0) / 4yrs 250 000
Depreciation charge for the year
Bank (A) 433 200

Rent received in advance (L) Balancing 160 000
Current tax payable: VAT output (L) 433 200 x 14/114 53 200
Operating lease income (I) W1 220 000
Lease income received

Current tax charge

Deferred tax charge
W1: Operating lease income

20X5 – actual (net of VAT) Instalment:433 200 x 100/114 380 000
660 000
Annual average lease income (net of VAT) Total instalments excl VAT: 660 000/3yrs 220 000
888 Chapter 17
W2. Current tax calculation C
Profit before tax and before accounting for the lease 400 000
Add operating lease income W1 220 000
Less depreciation [(Cost excl VAT: 1 140 000 x 100 / 114) – 0] ÷ 4 yrs (250 000)
Less operating lease income See above (220 000)
Add depreciation See above 250 000
Add rental received net of VAT 433 200 x 100 / 114 (or W1) 380 000
Less wear and tear [(Cost excl VAT: 1 140 000 x 100 / 114) ÷ 5yrs (200 000)
W3. Deferred income tax
W3.1 Machine CA TB TD DT
Purchase 1 000 000 1 000 000
Depreciation / wear and tear (250 000) (200 000)
Closing balance 750 000 800 000 50 000 15 000 A
W3.2 Rent received in advance CA TB TD DT

Movement (160 000) 0
Closing balance (160 000) 0 160 000 48 000 A
W3.3 Summary of deferred tax Machine RRIA Total

(W3.1) (W3.2)
Opening balance of deferred tax 0 0 0
Movement 15 000 48 000 63 000 Dr DT, Cr TE
Closing balance of deferred tax 15 000 48 000 63 000 A
RRIA: = rent received in advance
Chapter 17 889
8. Summary
Lessors
Lease classification
x Finance lease if substantially all the lessor’s risks and rewards of ownership over
the underlying asset are transferred. For example, ask yourself if any of the
following are satisfied:
a) Does ownership transfer to the lessee by the end of the lease term?
b) Is there a purchase option that is reasonably certain, at inception date, of being
exercised by the lessee (e.g. is the exercise price a bargain?)
c) Is the lease term equal to a major part of the asset’s useful life?
d) Is the present value of the future lease payments equal to substantially all the
asset’s fair value (both measured at inception date)?
e) Is the leased asset specialised in nature such that only the lessee can use it
without major modification?
x Operating lease if substantially all the lessor’s risks and rewords of ownership over
See IFRS 16.61-63
the underlying asset do not transfer.
See IFRS 16.66
Assessed at inception and only reassessed if there is a modification.
Finance leases (lessor perspective)
If a manufacturer/ dealer: If not a manufacturer/ dealer:

x Derecognise asset & recognise a receivable x Derecognise asset & recognise a receivable
x Recognise two types of income: finance income x Recognise one type of income: finance income
and sales revenue x Recognise initial direct costs as part of cost of
x Recognise initial costs (legal fees) to acquire a lease receivable (built into implicit rate thus
finance lease as expense (when these are reduces finance income)
incurred by a manuf/ dealer, they are excl
from the def of ‘initial direct costs’)
Tax consequences (lessor perspective)
Current tax Deferred tax

Profit before tax… x Finance lease receivable
+ lease payment – (VAT x lease pmt/ total lease pmts) - has a CA, but no TB
- tax allowance (possibly limited by S23A) x Leased asset (e.g. plant or inventory)
- interest income (remove from profit; not taxed) - has no CA, but has a TB
…Taxable profit
Operating leases (lessor perspective)
Recognition Measurement Taxation

x still recognise asset x lease income = straight line x current tax = lease income
x lease instalment = income basis (or systematic basis…) taxed on cash basis (when
x depreciate asset (incl. initial received)
x lease costs = expenses
x but recognise initial direct costs direct costs capitalised) x deferred tax =
as part of the cost of the x receivable or prepayment - on asset: depreciation vs
leased asset (recognised as adjustments arise if tax allowance
depreciation over the period, if instalment amount differs - on received in advance: DT
from amount recognised as asset
a depreciable asset)
income - on receivable: DT liability
890 Chapter 17
Gripping GAAP Provisions, contingencies & events after the reporting period
Chapter 18
Provisions, Contingencies and

Events after the Reporting Period
Reference: IAS 37, IAS 10, IFRIC 21, IFRIC 1 (including any amendments to 1 December 2018)
CHAPTER SPLIT:
This chapter involves two standards IAS 37 (together with IFRIC 1, being a related interpretation) and
IAS 10. IAS 37 (and IFRIC 1) covers certain types of liabilities and assets, whereas IAS 10 deals with
events that occur after the reporting period but before the financial statements are authorised for issue.
The reason that they are combined into one chapter is that they are very much inter-related. However,
since the chapter is fairly long, it is split into these two separate parts as follows:
PARTS: Page
PART A: Provisions, Contingent Liabilities and Contingent Assets (IAS 37) 893
PART B: Events after the Reporting Period (IAS 10) 924
PART A:
Provisions, Contingent Liabilities and Contingent Assets
Contents: Page
A: 1 Introduction 893
A: 2 Scope 893
A: 3 Recognition: liabilities, provisions and contingent liabilities 894
3.1 Overview 894
3.2 Comparison: liabilities and provisions 894
3.3 Comparison: liabilities and contingent liabilities 894
3.4 Discussion of the liability definition 895
3.4.1 Present obligations 895
3.4.2 Past events 895
3.4.3 Obligating events 895
Example A1: Obligating events 896
Example A2: Obligating events 89
3.5 Discussion of the recognition criteria 897
3.5.1 Overview 897
3.5.2 Probable outflow of future economic benefits 897
3.5.3 Reliable estimate 897
Example A3: Reliable estimate 898
A: 4 Measurement: liabilities, provisions and contingent liabilities 899
4.1 Overview 899
4.2 Best estimates 900
Example A4: Best estimate using expected values 901
4.3 Risks and uncertainties 901
4.4 Future cash flows and discounting 901
Example A5: Discounting liabilities to present values and related journals 902
Example A6: Calculating present (discounted) values and related journals 903
4.5 Future events 904
Example A7: Future events 904
Chapter 18 891
Contents: Page
4.6 Gains on disposal of assets 905
Example A8: Gains on disposal of assets 905
4.7 Provisions and reimbursement assets 905
Example A9: Guarantees 906
Example A10: Reimbursements 907
4.8 Changes in provisions 907
4.8.1 Change in provisions and the cost model 908
Example A11: Changes in decommissioning liability: cost model 909
4.8.2 Change in provisions and the revaluation model 911
Example A12: Changes in decommissioning liability: revaluation
model 912
4.9 Changes in provisions through usage or derecognition 915
Example A13: Reduction in provisions 915
A: 5 Recognition and measurement: four interesting cases 916
5.1 Future operating losses 916
5.2 Contracts 916
Example A14: Onerous contracts 916
5.3 Restructuring provisions 917
Example A15: Restructuring costs 918
5.4 Levies 918
Example A16: Levies 918
A: 6 Recognition and measurement: contingent assets 919
6.1. Recognition of contingent assets 919
6.2. Measurement of contingent assets 919
A: 7 Disclosure: provisions, contingent liabilities and contingent assets 919
7.1. Disclosure of provisions 919
7.2. Disclosure of contingent liabilities 920
Example A17: Disclosure: decommissioning provision (change in estimate) 920
7.3. Disclosure of contingent assets 922
7.4. Exemptions from disclosure requirements 922
A: 8 Summary 922
PART B:
Events after the reporting period
Contents: Page
B: 1 Introduction 924
B: 2 Adjusting events after the reporting period 924
Example B1: Event after the reporting period 925
B: 3 Non-adjusting events after the reporting period 925
Example B2: Non-adjusting events after the reporting period 925
B: 4 Exceptions: no longer a going concern 926
Example B3: Events after the reporting period – various 926
B: 5 Disclosure: events after the reporting period 929
B: 6 Summary 929
892 Chapter 18
PART A:
Provisions, Contingent Liabilities and Contingent Assets
A: 1 Introduction
This chapter is separated into two parts: Part A and Part B. Part A explains IAS 37 and Part B
explains IAS 10 Events after the reporting period.
IAS 37 explains how to account for a:
x Provision, which is a liability that involves uncertainty in terms of either (or both) the
amount of the liability or the timing of its settlement;
x Contingent liability, of which there are two types: either it is only a possible obligation that has
not yet been confirmed (i.e. it is not a liability) or it is a liability that cannot yet be recognised;
x Contingent asset, which is a possible asset, the existence of which is still to be confirmed.
Before we begin, we consider what is excluded from the scope of IAS 37 (section A.2). After that
we will look at provisions and contingent liabilities, focusing first on recognition (section A.3) and
then on measurement (section A.4). A few interesting cases that involve both recognition and
measurement are then discussed (section A.5). Then we will look at contingent assets – these are
never recognised but may need to be disclosed, so we will focus on the measurement of any
contingent asset needing to be disclosed (section A.6). And we will end by looking at the detailed
disclosure requirements affecting all three: provisions, contingent liabilities and contingent assets
(section A.7).
Definitions and recognition criteria: IAS 37 versus 2018 Conceptual Framework:

A new Conceptual Framework was issued in 2018 (2018 CF) that replaces the prior Conceptual Framework
issued in 2010 (2010 CF). However, IAS 37 has not been updated for the new 2018 CF. As a result:
x IAS 37 uses the liability definition given in the prior 2010 CF. By contrast, the new 2018 CF defines a liability as a
present obligation of the entity to transfer an economic resource as a result of past events.
x Similarly, IAS 37 refers to the recognition criteria given in the prior 2010 CF. The new 2018 CF explains that an
item should only be recognised if it provides relevant information and would be a faithful representation of the
phenomena it purports to present .
On analysis, the IASB has concluded that, if we were to apply the new liability definition and recognition criteria, we
would generally but not necessarily reach the same conclusions as the conclusions reached when applying IAS 37.
However, the IASB has emphasized that we should continue to apply IAS 37 without adjustment (i.e. the new 2018 CF
does not override the requirements in the existing IFRSs).
A: 2 Scope (IAS 37.1 – .9)
IAS 37 shall be applied by all entities in accounting for provisions, contingent liabilities and
contingent assets, except:
x those resulting from executory contracts, unless the contract is onerous Note 1; and
x those covered by another standard. IAS 37.1
Note 1: Executory contracts and onerous contracts are discussed in section A: 5.2.
Some types of provisions, contingent liabilities and contingent assets are not covered by
IAS 37 but by other standards, for example:
x income taxes (see IAS 12 Income taxes);
x leases (see IFRS 16 Leases);
x employee benefits (see IAS 19 Employee Benefits);
x insurance contracts (see IFRS 4 Insurance Contracts); and
x revenue from contracts with customers (see IFRS 15 Revenue from contracts with
customers), excluding onerous contracts (i.e. a revenue contract that is or has become
onerous will be accounted for in terms of IAS 37). See IAS 37.5
Chapter 18 893
A: 3 Recognition: Liabilities, Provisions and Contingent Liabilities (IAS 37.14 – .30)
A: 3.1 Overview
There are significant differences between a ‘pure’ liability, a provision and a contingent
liability. These differences boil down to the extent to which they meet the liability definition
(per IAS 37) and the recognition criteria (per IAS 37) – if at all. If an item doesn’t meet both
the definition and the recognition criteria, then it won’t be recognised as a liability – although
it may still need to be disclosed. In the discussions below, you see which items are recognised
and which must be disclosed.
IAS 37 defines a liability, in terms of the prior 2010 CF, A liability is defined in
as a present obligation of the entity, that has arisen from IAS 37 (old 2010 CF) as:
a past event, and that we expect will result in a future x a present obligation
x of the entity
outflow of economic benefits (see pop-up). See IAS 37.10 x arising from past events
x the settlement of which is expected to
A fundamental part of this liability definition is that there result in an outflow from the entity of
must be an obligation and this obligation must be present. resources embodying economic benefits.
IAS 37.10
Deciding if there actually is an obligation at a specific point
in time can be difficult, and requires professional judgement. If we can’t be sure we have a present
obligation, then we know we are not dealing with a ‘pure’ liability or provision but we may be
dealing with a contingent liability.
IAS 37 refers to the recognition criteria that were given in the prior 2010 CF. In terms of
these recognition criteria, a liability may not be recognised unless:
x It is reliably measurable; and
x The outflow of benefits is probable. See IAS 37.14
In order to differentiate between a pure liability, a provision and a contingent liability, we
need to thoroughly understand every aspect of the definition and recognition criteria. These
will be explained below. Before we do this, however, let us compare the meanings of:
x the term ‘provision’ and the term ‘liability’, and then
x the term ‘contingent liability’ and the term ‘liability’.
A: 3.2 Comparison: liabilities and provisions
A provision is defined as:
A provision is a type of liability (i.e. in other words, all
provisions are liabilities, but not all liabilities are x a liability
IAS 37.10
x of uncertain timing / amount
provisions). A provision is a liability that involves
uncertainty in terms of either (or both):
x the amount of the outflows or Provisions
x the timing of the outflows. x Recognised (journalised) as a L
x Disclosed: separately to ‘pure’ Ls
If one does not know the amount of the outflows or when
they will occur, it means that the measurement of the liability is uncertain. Thus, a provision
is simply a liability that involves a significant degree of measurement uncertainty.
However, for a provision to be recognised, it must meet the liability definition and recognition
criteria (per IAS 37 and 2010 CF). This means that a provision may be recognised if, despite
the measurement uncertainty, we are confident that a reliable measure is possible.
Both provisions and liabilities are recognised in the statement of financial position but,
because of the level of uncertainty involved with provisions, they are disclosed separately.
A: 3.3 Comparison: liabilities and contingent liabilities (IAS 37.27 – .30)
Contingent liabilities are obligations that either: Contingent liabilities

x do not meet the liability definition (per IAS 37); or
x do not meet the recognition criteria (per IAS 37). x Recognised? No, no jnl is processed
x Disclosed? If considered useful
894 Chapter 18
Thus, there are two types of contingent liabilities:

A contingent liability is
x one is a liability (i.e. meets the liability definition) that defined as either:
may not be recognised because one or both of the
One where the recognition criteria are not
recognition criteria are not met (let’s call this type 1); met (type 1):
and x a present obligation
x the other is not a liability because it failed the x from past events
x that is not recognised because the
liability definition because there was only a possible
recognition criteria are not met:
obligation, (as opposed to a present obligation) (let’s - it is not probable that an outflow of
call this type 2). In this latter type, the existence of economic benefits will be needed to
the obligation will only be confirmed by the settle the obligation; or
occurrence of some future event/s that is not wholly - the amount of the obligation cannot
be measured sufficiently reliably.
within the control of the entity.
One where the liability definition is not
Since, by definition, a contingent liability either does not met (type 2):
meet the definition or the recognition criteria, they may x a possible obligation
x from past events;
not be recognised as liabilities.Although contingent x whose existence will be confirmed only
liabilities are not recognised, they must be disclosed in by the:
the notes to the financial statements (assuming it would - occurrence or non-occurrence
be useful information). - of one/more uncertain future events
- not wholly within the control of the
A: 3.4 Discussion of the liability definition entity (e.g. a negative court ruling.)
These two definitions have been reworded from IAS 37.10
A: 3.4.1 Present obligations (IAS 37.15 – .16)

For us to have a present obligation, we must have a past event that is also an obligating event.
In very rare instances, it may be difficult to determine if there is a present obligation or even
if there is a past event.
How to decide if we
In these instances, the entity must decide if it is: actually have an
x more likely that a present obligation did exist at year- obligation?
end, in which case a provision is recognised (i.e. A tip that may be helpful when deciding
greater than 50% chance); or whether an obligation exists, is to ask
yourself the following question: if the
x more likely that a present obligation did not exist at entity had to close down tomorrow,
year-end (i.e. less than 50% chance), in which case a would the obligation still exist?
contingent liability is disclosed (unless the possible If the answer to that is yes, then the
outflow of future economic benefits is remote, in entity has a present obligation as a
result of a past event.
which case it is ignored).
In making this decision, the entity uses its professional judgement, other expert opinions (e.g.
legal opinion) and events after the reporting period.
For example: A typical example of where an entity may be unsure of whether or not it has a
present obligation due to a past event, is a court case in progress at year-end where there is
currently no indication as to whether the deed that the entity is being accused of actually
occurred (i.e. whether there is a past event) and even if it did occur, whether or not the entity
will be required to pay a fine or other settlement (i.e. whether there is a resulting obligation).
A: 3.4.2 Past events (IAS 37.17 – .22) Past events are those:
x Events that
We need an event and it must have happened on or before x Occurred on/ before RD.
the reporting date (year-end) for it to be a past event.
An obligating event is
A: 3.4.3 Obligating events (IAS 37.17 – .22) defined as:
x an event that
For the past event to lead to an obligation, the event must be x creates an obligation (constructive or
an obligating event. An obligating event is a defined term (see legal)
x that the entity has no realistic
definition alongside) but is essentially an event that leaves the alternative to settling. IAS 37.10 reworded
entity with no realistic alternative but to settle the liability.
Chapter 18 895
There are two types of obligations possible: A legal obligation is

x a legal obligation, and defined as:
x a constructive obligation. x an obligation that derives from
x a contract (through its explicit or
A legal obligation (see definition in pop-up) refers to an implicit terms);
x legislation; or
obligation the settlement or which ‘can be enforced by law’. In
x other operation of law IAS 37.10
other words, we cannot legally avoid the outflows. See IAS 37.17
A constructive obligation is an obligation that the entity has created for itself through its own past
actions -explicitly (e.g. having drafted a policy or acted in a certain way) and where, importantly,
these past actions have somehow (directly/ indirectly) given other parties the idea that it will accept
or discharge certain responsibilities -implicitly.
A constructive obligation
For an obligation to exist, there must have been an event. This is defined as:
event (i.e. the obligating event) must both: x an obligation that derives from:
x an entity’s actions where
x exist independently of the entity’s future actions:
This is known as the ‘walk-away test’, i.e. if the entity x by an established pattern of past
practice, published policies
closed down its business today, would the obligation still (explicitly) or a sufficiently
exist? See IAS 37.19 specific current
x always involve another party (e.g.): statement(implicitly),
In other words, a decision must involve a third party, not x the entity has indicated to other
just the entity. However, this other party does not need to parties that it will accept certain
responsibilities; AND
be known i.e. it could be the public at large. See IAS 37.20
x as a result, the entity has created
Thus, a decision made at a board meeting would not lead to a a valid expectation on the part of
those other parties that it will
present obligation because: discharge those responsibilities.
x this event does not involve a third party; and IAS 37.10
x it is not separate from the entity’s future actions (its future

actions could be changed if the board later decides to change its mind).
IAS 37 has many great examples that explain the principles of recognition.
See IAS 37 Appendix C!
Example A1: Obligating events

Consider the following issues that were discussed during a directors meeting on
24 December 20X3:
A: A decision was made by the directors to pay a bonus to an employee.
B: A decision was made by the directors to purchase a new machine in 3 years time.
C: Legislation recently passed means that one of the plants has to be dismantled in a year’s time.
D: Future losses are expected from a branch in Botswana.
Required: Explain whether or not any of the above result in present obligations at 31 December 20X3.
Solution A1: Obligating events

A and B: The entity is neither legally nor constructively obligated to:
x pay the bonus (A); or
x purchase the asset (B).
Both these future payments may still be avoided by the future actions of the entity, and therefore do not
meet the definition of an obligating event. These decisions may currently still be revoked. Only if these
decisions are communicated to the relevant third parties in such a way that there is no realistic
alternative but to make these payments, would an obligation arise.
C: The fact that we own this plant is the past event that together with the new legislation means that
we now have unavoidable future dismantling costs. We thus have an obligating event at year-end.
D: The future losses expected from the branch in Botswana is not an obligation at year-end because
they are also avoidable (the branch could be sold or shut-down before any losses are incurred). The
expected losses may, however, indicate that certain assets may need to be tested for impairment (see
the chapter on ‘impairment of assets’ for more information in this regard). Provisions shall not be
recognised for future operating losses. IAS 37.63
896 Chapter 18
Example A2: Obligating events

Damij Limited owned a road tanker that overturned in December 20X3 during a bad rain
storm. The tanker spilled its contents, thus contaminating a local river. Damij has never
before contaminated a river. Damij has no legal obligation to clean the river, has no published policies
as to its views on the rehabilitation of the environment and has not made any public statement that it
will clean the river.
It intends to clean-up the river and has been able to calculate a reliable estimate of the cost thereof.
Required: Explain whether Damij should recognise a liability or a provision at 31 December 20X3.
Solution A2: Obligating events

The event is the accident, and since it happened before year-end, it is a past event. There is, however,
no present obligation since:
x there is no law that requires the company to rehabilitate the river, and
x there is no constructive obligation to rehabilitate the river since neither:
- a public statement has been made and nor
- is there an established pattern of past practice since this was its first such accident.
Although Damij intends to clean-up the river and even has a reliable estimate of the costs thereof, no
liability or provision should be recognised because an obligating event is one that results in the entity
having no realistic alternative but to settle the obligation: Damij can still change its intention.
A: 3.5 Discussion of the recognition criteria
A: 3.5.1 Overview (IAS 37.14)
Before a liability may be recognised, it needs to meet the liability definition and the
recognition criteria given in IAS 37 (these definition and recognition criteria are not the same
as those given in 2018 CF). The recognition criteria given in IAS 37 are the following:
x The outflow of economic benefits must be probable; and
x The amount of the obligation can be reliably estimated.
A: 3.5.2 Probable outflow of economic benefits (IAS 37.23 – 24)

In deciding whether a future outflow of economic benefits is probable, one must be sure that
the outflow is more likely to occur than not to occur, in which case a provision should be
recognised. If it is more likely that the outflow will not occur, then a contingent liability
should be disclosed (unless the possible outflow is remote).
A: 3.5.3 Reliable estimate (IAS 37.25 - .26)
It should be remembered that uncertainty and estimates are a normal part of the recognition
and measurement process. This means that, although a provision is a liability of uncertain
timing or amount, it does not mean that this liability cannot be reliably measured.
If the estimated amount of an obligation involves a normal degree of uncertainty, and it is
possible to make a reliable estimate thereof, it is recognised as a ‘pure’ liability.
Examples of a pure liability can be categorised into those that:
x do not involve uncertainty: a telephone payable recognised at year-end where the invoice
has been received; and
x do involve uncertainty: a financial liability that is measured at the present value of future
outflows: the present value is obviously based on an estimated discount rate where the
discount rate chosen is subject to measurement uncertainty.
A typical example of a provision is the estimated amount of damages payable pursuant to a
court case where the court has already ruled against the entity but has yet to establish an
amount. The level of uncertainty here could be extreme, and the measurement of the amount
will need to consider the probabilities for each possible outcome.
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If the estimated amount of an obligation involves a larger degree of uncertainty than normal,
but yet a reliable estimate is still possible, the liability is still recognised but is termed a
provision. Provisions should be disclosed separately from ‘pure’ liabilities and therefore it is
important to be able to differentiate a provision from a pure liability.
If an amount is so uncertain that the estimate is not reliable, then it is a contingent liability.
Contingent liabilities are not recognised at all since, by definition, either:
x one of the recognition criteria is not met (i.e. can’t reliably measure the amount); or
x the definition is not met, (i.e. a possible obligation rather than a present obligation exists).
A typical example of a contingent liability would be where the entity is being sued but:
x it is either not yet possible to estimate whether the courts will probably rule against the
entity (i.e. the outflow of future economic benefits is not yet probable) or
x it is not yet possible to estimate the amount that the courts will force the entity to pay (i.e.
a reliable estimate is not yet possible).
Contingent liabilities are disclosed in the notes to the financial statements unless the
possibility of the outflow of future economic benefits is considered to be remote.
Recognition of provisions and contingent liabilities flowchart
Example A3: Reliable estimate

A company sells goods with a refund policy – if the customer is not satisfied, the goods may
be returned for a full refund. Sales for the year came to C100 000.
Required: For each of the following scenarios, explain if there is a pure liability, provision or
contingent liability at year-end, or if the refund policy should be ignored:
a) At year-end, it is reliably estimated (based on past experience) that only 5% of sales will be
returned for a full refund.
b) At year-end, it is not possible to estimate the possible returns and related refunds.
Solution A3(a): Reliable estimate

Please note that in order to prove that the definition of a liability has been met, one needs to first
identify the event, assess whether this event occurred at or before year-end and then decide whether the
event leads to an obligation (either legal or constructive): if the event leads to an obligation but
occurred after year-end, it would not be a present obligation, which is a critical part of the definition.
x Liability definition: Is there an obligation?
Yes, the company has a refund policy attached to the sales whereby the company is obliged to
refund customers who are unhappy with their purchases. This obligation may either be:
- a legal obligation (i.e. written into the contract of sale) or
- a constructive obligation (i.e. through an established pattern of past practice of refunds).
x Liability definition: Does the obligation come from a past event?
Yes, since the sale of goods is the event and since it occurred before year-end, the event is a past event.
x Liability definition: Is there therefore a present obligation?
Yes, since there is a past event that lead to an obligation, we have a present obligation.
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x Liability definition: Is there expected to be an outflow of future economic benefits?

Yes, the refund policy means that if a customer is unhappy with his purchase, he may return it for a
cash refund, which represents an outflow of future economic benefits.
x Recognition criteria: Is the expected outflow of future economic benefits probable?
Yes, the refund policy represents a probable outflow of future economic benefits. There are
numerous sales transactions to which this refunds policy applies and, in the event that there are
numerous sales transactions to which a warranty is attached, it matters not that management may
estimate that only a few customers will demand a refund – the question is simply whether it is
probable that some outflow may be required in order to settle potential refunds – management’s
assessment of the extent of the refunds will be considered when measuring the liability.
x Recognition criteria: Is the probable outflow of future economic benefits reliably estimated?
Yes, past experience is available that suggests that it is probable that 5% of the sales will be refunded and
therefore the extent of the obligation can be reliably measured: C5 000 (5% x C100 000).
This is not a pure liability, however, since there is still more uncertainty than normal in predicting the
amount and timing of this outflow. Therefore, this liability is recognised and presented as a provision.
Comment: Note that it is the sale of goods that is the obligating event.
Solution A3(b): Reliable estimate

The answer to A3(b) is identical to that of A3(a) as far as the first 5 bullets above. The probable
outflow of future economic benefits is, however, not able to be reliably measured. Although the
definition of a liability is met, this recognition criteria (reliable measurement) is not met and therefore:
x no liability may be recognised in the financial statements, although
x a contingent liability must be disclosed in the notes to the financial statements.
A: 4 Measurement: Liabilities - Provisions and Contingent Liabilities (IAS 37.36 – .52 & .86)
A: 4.1 Overview
The same measurement principles are used whether we are measuring provisions or
contingent liabilities. The same logic would even apply to the measurement of ‘pure
liabilities’ although, since provisions and contingent liabilities involve more uncertainty, the
measurement thereof will involve the use of a higher degree of professional judgement.
Provisions should be measured at the ‘best estimate of the expenditure required to settle the
present obligation at the end of the reporting period’. See IAS 37.36
x The term ‘expenditure’ refers to the payment the entity would have to make.
x IAS 37 clarifies that the best estimate could include either ‘settling’ (paying) the obligation
directly or transferring the obligation to a third party (indirect settlement). In either case, the
entity would make a payment (either paying the person directly or paying the person indirectly
by paying a third party to take over the responsibility (transferring)).
x When we calculate the best estimate, it must reflect the expenditure required to settle the
obligation on a specific date, being ‘the end of the reporting period’ (i.e. the ‘reporting date’).
However, being able to settle an obligation (that may not yet even be due) on the actual reporting
date may actually be impossible or ridiculously expensive or both, and thus IAS 37 clarifies that this
best estimate should reflect the amount that the entity would ‘rationally pay’ to settle the obligation
or transfer it to a third party at the end of the reporting period. See IAS 37.37
Although a contingent liability is never recognised, it must be disclosed, unless the possibility
of an outflow is remote.
If we are to disclose it, we must try to estimate the amount thereof (although, remember that,
by definition, a reliable estimate of certain contingent liabilities may not actually be possible).
If a reliable estimate of a contingent liability is possible, we measure it in the same way that
we measure a provision. See IAS 37.86
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Provisions and contingent liabilities are measured at the best estimate of the expected amount of the
settlement (where the best estimate takes into account all the related risks and uncertainties).
The measurement would be calculated at the present value of the future cash flows, if the effects of
discounting to its present value are considered material.
Measurement:
The measurement should ignore:
The measurement of a
x future events unless there is ‘sufficient objective provision (or contingent
evidence that they will occur’; and liability) involves:
x gains made on the expected disposal of assets. x deciding the best estimate of the
amount needed to settle/ transfer
The measurement of the balance presented at year-end the obligation
can also be affected by: x after considering all related risks &
uncertainties
x changes to estimated provisions; and x calculating it at its present value, if
x reductions in provisions. the effects of discounting are
material.
Some of these aspects involved in measurement will now The following are ignored in the
be explained in more detail. measurement:
x Future events for which there is
A: 4.2 Best estimates (IAS 37.36 - .41) insufficient evidence.
x Gains on disposals of assets.
The best estimate of the amount of an obligation is the
amount that an entity would rationally pay to settle or transfer the liability at year-end. It is
often difficult for management to estimate the amount of the obligation where management
may have to base its estimate upon a combination of:
x management’s professional judgement;
x previous experience with similar transactions;
x independent expert advice, if available; and
x events after the reporting period. See IAS 37.38
The best estimate of an obligation can be calculated in a number of ways. IAS 37 suggests a
few methods, including the calculation of the:
x expected value;
x mid-point in the range;
x most likely outcome.
The expected value method is useful if prior experience suggests that there is a range of possible
outcomes where we are able to estimate the probability of each of these possible outcomes. We then
weight each of these possible outcomes based on their individual probabilities – this involves
multiplying each outcome by its individual probability and adding each of these products together,
the total of which is referred to as the ‘expected value’. The application of the expected value method
when calculating the best estimate is explained in example A4 below.
However, if there is a continuous range of possible outcomes, where each and any point in the range
is equally likely to be ‘the outcome’, then we would not bother trying to allocate a probability to
each and every possible outcome but would simply select the item in the middle of this
continuous range. In this case, the best estimate is thus simply the ‘mid-point’ in that range.
Another method of calculating the best estimate is the ‘most likely outcome’ method. This method is
ideal if there is a single obligation that must be measured with a few distinct possible outcomes.
For example: we may win a court case, in which case the costs will only be in the region of
C10 000, or we may lose the court case, in which case the costs will be around C1 000 000, or we
may reach an out-of-court settlement, in which case the costs will be around C500 000. Our view
may be that the most likely outcome is that we will win the court case. However, before simply
concluding that our provision should thus only be C10 000, we should consider the other possible
outcomes. If most of the other possible outcomes are higher (or most are lower) than the most likely
outcome, then the provision should be measured at an amount that is higher (or lower) than the most
likely amount. Thus, in our example, we would acknowledge that the other possible outcomes would
result in a significantly higher cost and thus the best estimate of the obligation is an amount higher
than the most likely amount.
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Example A4: Best estimate using expected values

An entity offers goods for sale with a 6-month warranty, where goods that are sold but
found to be faulty within 6 months after sale may be returned for a full refund. Not all goods
will be faulty and similarly, not all customers will bother to return faulty goods. The entity’s past
experience suggests that the following are the possible outcomes and the probability thereof:
Outcomes Probability Estimated cost
Goods will not be returned 70% 0
Goods will be returned 30% 100 000
100%
Required: Calculate the expected cost of the provision and journalise it.
Solution A4: Best estimate using expected values

The provision, measured at the best estimate, using the expected value of the future cost of fulfilling
the warranty obligation: Expected value = (70% x C0) + (30% x C100 000) = C30 000
Debit Credit
Warranty costs (P/L: E) 30 000
Provision for warranty costs (L) 30 000
Provision for warranty costs
A: 4.3 Risks and uncertainties (IAS 37.42 - .44)
When determining the best estimate of a provision, the risks and uncertainties surrounding the
events and circumstances must be taken into account. This may be done by using judgement,
or by the use of risk adjustments to either:
x the amounts of the provision; or
x the discount rate used (if the provision is present valued).
Care must be taken not to duplicate a risk adjustment thus overstating liabilities or
understating assets.
A: 4.4 Future cash flows and discounting (IAS 37.45 - .47)
The possibility that the settlement of an obligation may occur far into the future has an effect
on the value of the obligation in current day terms. The effect that the passage of time has on
the value of money is often referred to as the ‘time value of money’.
Imagine being asked whether you would prefer to

receive C100 today or C100 in 10 years’ time. For many Discount rate
reasons, (including the fact that you could utilise the The rate to be used is:
C100 immediately), you would choose to receive it
immediately. This is because you can buy more with x A pre-tax discount rate
x based on the current market
C100 today than you can with C100 in the future. In assessment of:
other words, today’s value (the present value) of a future - the time value of money and
See
cash flow is less than the actual (absolute/ future) - the risks specific to the liability.
IAS 37.47
amount of the cash flow. This is essentially the present
value effect or the effect of the time value of money.
Using a WACC rate as
If the difference between the actual amount of the future the discount rate is not
cash flow and its present value is material, then the appropriate!
liability should be measured at its present value. The WACC (Weighted average cost of
capital) is not an appropriate discount
rate as the WACC takes into account
The present value is calculated using a pre-tax discount the risk of the entity as a whole and not
rate based on the current market assessment of the time just the risk related to the provision.
value of money and the risks specific to the liability. The
discount rate must not include any risks which have already been adjusted for in the expected
future cash flows. See IAS 37.47
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As the period between now (the present) and the date of the payment (the future) gets shorter,
so the difference between the present value and the future value (actual amount) of the cash
flow gets smaller.
When you finally get to the day that the payment is due, the present value will equal the
actual amount due.
Thus, each year between the date that the provision is recognised and the date that the
provision is settled (paid), the present value of the future outflow must be recalculated.
Each year, as we get closer to the future payment date, the present value will increase until the
actual payment date is reached, when the provision (calculated as the present value) will
finally equal the actual value of the liability.
Unwinding the discount
The increase in the liability each year will be debited to The following journal is
finance charges and credited to the provision such that at processed each year to
each reporting date, the provision is measured at its present unwind the discount:
value. DR Finance charges (E)
CR Provision/Liability (L)
These finance charges are often called ‘notional finance
charges’ (meaning ‘make-believe finance charges’) and is really just the ‘unwinding of the discount’
process.
Example A5: Discounting liabilities to present values and the related journals
On 1 January 20X1, an event occurs that results in an obligation to pay C100 000 at
31 December 20X3. This is duly paid on 31 December 20X3. The present values of this
obligation have been calculated as follows:
x 1 January 20X1: C60 000
x 31 December 20X1: C70 000
x 31 December 20X2: C90 000
x 31 December 20X3: C100 000
Required:
Show the related journal entries for each of the three years.
Solution A5: Discounting liabilities to present values and the related journals
Expense/ Asset Given: PV of future amount 60 000
Liability 60 000
Initial recognition of the obligation: beginning of year 1
31/12/20X1
Finance charges (E) PV 31/12/X1: 70 000 – PV 1/1/X1: 60 000 10 000
Liability 10 000
Increase in liability as a result of time value of money
31/12/20X2
Liability 20 000
31/12/20X3
Liability 10 000
Liability Future cash flow now paid 100 000
Bank (A) 100 000
Payment of liability at the end of year 3
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Example A6: Calculating present (discounted) values and related journals

A factory plant is bought on 1 January 20X1:
x Cost: C450 000 cash, including costs of installation.
x The entity is obliged to decommission the plant after a period of 3 years.
x Future decommissioning costs are expected to be C399 300.
x The appropriate discount rate is expected to be 10%.
x The effect of discounting is considered to be material.
Depreciation is estimated on the plant using the straight-line method to a nil residual value
Required:
Prepare a present value table (amortisation table) showing the present value of the future costs on
1 January 20X1 and at the end of each related year, together with the annual movements and journal
entries to record the movements.
Solution A6: Calculating present (discounted) values and related journals

W1 Effective interest rate table:
Date Opening balance: Calculation of Finance Charge Closing balance:
Liability finance charges: Liability
01 Jan X1 300 000 (W2) 300 000 x 0.1 30 000 330 000
31 Dec X1 330 000 330 000 x 0.1 33 000 363 000
31 Dec X2 363 000 363 000 x 0.1 36 300 399 300
31 Dec X3 399 300
Total 99 300
W2 Present value *
PV = Cash outflow after 3 yrs: 399 300 x PVF after 3 years: 0.751 = 300 000 (see W3 for PVF calculation)
Or: Cash outflow after 3 years: 399 300 x (1/(1+0.1)3) = 300 000
Or: Present values can be calculated using a financial calculator instead, as follows:
FV= 399 300 n = 3 i = 10% Comp PV = 300 000
W3 Calculating discount factors manually *
Number of years until the cash settlement Calculation of discount factor Discount factor (rounded): 10%
0 years (i.e. it’s due) Actual = 1 1
1 year 1/ (1+10%) 0.909
2 years 0.909/ (1+10%) 0.826
3 years 0.826/ (1+10%) 0.751
Comments:
x As it gets closer to the date on which the C399 300 is to be paid, the discount factor increases.
x The gradual increase in the discount factor over the passage of time is referred to as the ‘unwinding of
discount’.
x The increase in the discount factor causes the liability to gradually increase from its original present
value of C300 000 to C399 300 on 31 December 20X3.
x The increase in the liability results in the recognition of finance charges each year.
x The present value of the liability of 300 000 (on date of initial recognition) less the actual future amount
payable of C399 300 equals C99 300, being the total finance charges expensed over 3 years.
x The finance charges are sometimes referred to as ‘notional’ finance charges.
x Remember the discount rate to be used must be a pre-tax discount rate.
Journals
Debit Credit
1 January 20X1
Bank (A) 450 000
Plant (decomm.): cost (A) PV of future amount (W1) 300 000
Decommissioning liability 300 000
Initial recognition of the decommissioning obligation
Chapter 18 903

Finance charges (P/L: E) PV 31/12/X1: 330 000 – PV 1/1/X1: 30 000
Decommissioning liability 300 000; OR 300 000 x 10% 30 000
Increase in liability as a result of unwinding of the discount
Depreciation: plant (P/L: E) (450 000 + 300 000 - 0) / 3 years 250 000
Plant: acc. depr (-A) 250 000
31 December 20X2
Finance charges (P/L: E) PV 31/12/X2: 363 000 – PV 31/12/X1: 33 000
Depreciation: plant (P/L: E) (450 000 + 300 000 - 0) / 3 years 250 000
31 December 20X3
Finance charges (P/L: E) PV 31/12/X3: 399 300 – PV 31/12/X2 36 300
Depreciation: plant (P/L: E) 250 000
Decommissioning liability Given 399 300
Bank (A) 399 300
Payment in respect of decommissioning
Comment:
x Please notice that a total of 849 300 is expensed over the 3 years:
849 300 = depreciation of 750 000 (250 000 for 3 years) + finance charges of 99 300
x This is the total cost of both using and decommissioning the asset:
849 300 = 450 000 (cost of asset excluding decommissioning cost) + 399 300 (decommissioning cost)
x Also note how the cost (PV) of decommissioning the plant is debited to the plant’s cost account IAS 16.16
A: 4.5 Future events (IAS 37.48 – .50)

When calculating the amount of the liability or provision, expected future events should be
considered if there is ‘sufficient objective evidence’ available suggesting that the future event
will occur. An example would be possible new legislation that is virtually certain to be
enacted that may lead to a provision for environmental restoration (clean-up).
Example A7: Future events
A company owns a number of nuclear plants.
x The company is presently obliged to dismantle one of these plants in 3 years’ time.
x The last nuclear plant dismantled by the company cost C1 000 000 to dismantle, but
the company expects to dismantle this nuclear plant, if using the same technology, at a
slightly reduced cost of C800 000 due to the increased experience.
x There is also a chance that completely new technology may be available at the time of
dismantling, which could lead to a further C200 000 cost saving
Required: Discuss the measurement of the provision.
Solution A7: Future events

A provision should reflect expected future events if there is sufficient objective evidence that these will occur.
x Since the company has had experience in dismantling plants, it is argued that the expected cost
savings due to this experience can be reasonably expected to occur.
x The cost savings expected as a result of the possible introduction of completely new technology,
being outside of the control of the company, should not be taken into account, unless of course the
company has sufficient objective evidence that this technology will be available.
Therefore, the provision should be measured at C800 000 (and not at C600 000).
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A: 4.6 Gains on disposal of assets (IAS 37.51 - .52)

When an obligation involves the sale of assets (e.g. we may have committed to restructure a
business, in which case obligations would exist for items such as retrenchment packages, but
there are assets that would probably also need to be sold), the expected asset disposals must
be seen as separate economic events. For this reason, gains on the expected disposal of assets
are not taken into account in measuring a provision, even if the expected disposal is closely
linked to the event giving rise to the provision. Instead, an entity recognises gains on expected
disposals of assets at the time specified by the standard dealing with the assets concerned.
Example A8: Gains on disposal of assets

New legislation means that Undoo Limited must dismantle its nuclear plant in a year’s time:
x The dismantling is estimated to cost C300 000.
x Undoo also expects to earn income from the sale of scrap metal of C100 000.
x The effects of discounting are expected to be immaterial.
Required: Process the required journal entry to raise the provision
Solution A8: Gains on disposal of assets

Debit Credit
Nuclear plant (dismantling): cost (A) 300 000
Provision for dismantling costs (L) 300 000
Expected costs of dismantling
Comment: The measurement of the provision is not reduced by the C100 000 expected income.
A: 4.7 Provisions and reimbursement assets (IAS 37.53 – .58)
An entity may have an obligation to one party and may be expecting to be reimbursed by
another party for all or part of the costs incurred in settling this obligation. The entity’s
obligation represents a liability and the entity’s expected reimbursement represents an asset.
Whilst the recognition of the liability (obligation) is based on the usual principles already
discussed in this chapter, any asset relating to an expected reimbursement (e.g. from a
manufacturer or other third party) should:
x only be recognised if it is virtually certain that the reimbursement will be received;
x be disclosed as a separate asset (i.e. the asset should not be set off against the liability); and
x be measured at an amount not exceeding the amount of the related provision. IAS 37.53 (reworded)
Please note that although the liability (obligation) and the asset (reimbursement) may not be set-off
against each other, the related expenses and income may be set-off against each other. The fact that
the asset and liability may not be set-off is because this would obscure the actual sequence of events
(e.g. the entity offers a guarantee, being a liability, and the entity receives a counter-guarantee, being
an asset) and would thus not result in fair presentation.
If reimbursement by the manufacturer is not virtually certain,
an asset may not be recognised, but a contingent asset may Reimbursement assets
be disclosed in the notes to the financial statements.
x A reimbursement asset is only
recognised if it is virtually certain
A typical example involves guarantees (or warranties). that the reimbursement will be
Let us look at a few examples. received See IAS 37.53
x The provision and related
In recognising a liability regarding a guarantee, we must reimbursement asset must be
look carefully at the detail of the agreement to assess its presented separately but their
substance. We look at these agreements to be sure we related expense & income may be
know who really has the obligation: presented on a net basis.
x Where the entity provides a guarantee (or warranty) to a customer, the entity has created an
obligation for itself and must recognise a liability. This guarantee could be a written
guarantee (i.e. a legal obligation) or could simply be due to past actions that created an
expectation that the entity will provide a guarantee (i.e. a constructive obligation).
Chapter 18 905
x If, however, the manufacturer (the supplier) of a product provides the guarantee to the
entity’s customer and the entity (the retailer) simply communicates this guarantee (or
warranty) to the customer, then it is the manufacturer, and not the entity (the retailer) that
has the obligation. The entity (the retailer) will therefore not recognise a liability since the
entity is simply acting as the conduit for a manufacturer.
x If the manufacturer and the entity (retailer) are jointly and severally obligated to the
customer, then the entity must recognise a provision for its share of the obligation and
must disclose a contingent liability to reflect the extent to which the entity is exposed, in
the event that the manufacturer defaults on its share of the obligation.
Where a provision is recognised reflecting a guarantee offered by the entity to its customer, we must
consider whether there is a possible reimbursement available to the entity. If the entity has received
a counter-guarantee (i.e. a reimbursement) from the supplier and it is virtually certain to be received,
we must assess to what extent the provision may be recovered.
For example:
x If an entity expects to incur costs of C100 to settle a guarantee and expects proceeds from
a counter-guarantee of only C70, the entity has a provision of C100 and an asset of C70.
x If an entity expects to incur costs of C100 to settle a guarantee and expects proceeds from
a counter-guarantee C110, the entity has a provision of C100 and an asset of C100 (the
measurement of the asset must be limited to the amount of the provision).
The guarantee and counter-guarantee are presented in the following diagram:

Diagram: Flow of guarantees
A guarantee is provided by the entity (e.g. retailer) to its customer and where the manufacturer offers
a counter-guarantee to the entity in case of any return:
x The customer returns goods to entity (retailer) under the guarantee (this is a L to the entity);
x The entity returns goods to manufacturer under the guarantee (this is an A to the entity)
Retailer (the entity):

Goods sold to: Goods sold to:
Guarantee offered
to customer = L
Manufacturer Customer
Guarantee Guarantee received Guarantee
offered to: from manufacturer = A offered to:
Example A9: Guarantees

A retailer company sells goods to its customers that are guaranteed.
Required:
State whether the retailer must raise a provision for the cost of meeting future guarantee obligations:
A. The retailer company provides the guarantee.
B. The manufacturer provides the guarantee. The retailer is not liable in any way.
C. The manufacturer provides the guarantee, but the retailer company provides a guarantee irrespective
of whether the manufacturer honours his guarantee.
D. The manufacturer and retailer company provide a joint guarantee, whereby they share the costs of
providing the guarantee: they jointly and severally accept responsibility for the guarantee.
E. The manufacturer and retailer company provide a joint guarantee, whereby they share the costs of
fulfilling the guarantee: the retailer is not liable for amounts that the manufacturer may fail to pay.
Solution A9: Guarantees

A. The retailer has the obligation and must therefore raise the provision.
B. The manufacturer has the obligation. The retailer has no obligation. No provision (i.e. no liability)
should be raised in the retailer’s books.
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C. The retailer must raise a provision for the full cost of the provision and must recognise a separate
reimbursement asset to the extent that it is virtually certain to receive the reimbursement.
D. The portion of the costs that the retailer is expected to pay is recognised as a provision, whereas
the portion of the costs that the manufacturer is expected to pay is disclosed as a contingent
liability in case the manufacturer does not honour his obligations. IAS 37.29
E. The portion of the costs the retailer is expected to pay is recognised as a provision. A contingent liability is
not recognised for the portion of the costs the manufacturer is expected to pay since the retailer has no
obligation to pay this amount in the event that the manufacturer does not honour his obligations.
Example A10: Reimbursements

A retailer company offers guarantees to its customers:
x It estimates that it will cost C100 000 to fulfil its obligation in respect of the guarantees.
x The supplier, however, offers a guarantee to the retailer company.
Required: Show all related journals and disclosure in the statement of financial position assuming that:
a) the entire C100 000 is virtually certain of being received from the supplier.
b) an amount of C120 000 is virtually certain of being received from the supplier.
Solution A10(a): Reimbursements

Debit Credit
Guarantee expense (P/L: E) 100 000
Provision for guarantees (L) 100 000
Provision for the cost of fulfilling guarantees
Guarantee reimbursement (A) 100 000
Guarantee reimbursement income (P/L: I) 100 000
Provision for guarantee reimbursements
Company name
Statement of financial position (extracts) 20X2
As at 31 December 20X2 C
ASSETS
Current assets
Guarantee reimbursements 100 000
Current liabilities
Provision for guarantees 100 000
Comment:
x The asset and liability should be separately disclosed and may not be set-off against each other (therefore both
asset and liability will appear in the statement of financial position); whereas
x The income and expense may be set-off against each other (as they both affect profit or loss). In this case, they would
cancel each other out (and would thus not appear in the statement of comprehensive income).
Solution A10(b): Reimbursements

The journals will be the same because the reimbursement asset is not allowed to be measured at an
amount exceeding the amount recognised as a provision.
A: 4.8 Changes in provisions (IAS 37.59 - .60 & IFRIC 1)

The measurement of a provision is estimated based on circumstances in existence at the time
of making the provision. As circumstances change, the amount of the provision must be
reassessed and increased or decreased as considered necessary.
There are a number of reasons that could necessitate a change being made to the estimated
measurement of a provision:
x the unwinding of the discount as one gets closer to the date of the future outflow (e.g.
getting closer to the date on which an asset has to be decommissioned);
x a change in the estimated future cash outflow (due to a change in the amount or timing);
x a change in the estimated current market discount rate; and/ or
x the future outflow is no longer probable.
Chapter 18 907
A payment that had been provided could also be made. This is a transaction rather than an
adjustment to the estimate and is thus discussed separately under section A: 4.9.
If the future outflow subsequently becomes no longer probable, then the provision would be
derecognised entirely (if the outflow is now only possible, then it would be disclosed as a
contingent liability, but if it is now only remotely possible, then it would be ignored entirely).
The unwinding of the discount is really just the natural increase in the measurement of a
present valued liability as one gets closer to the day on which the future outflow is expected
to occur (we could call this D-Day).
If you recall, if the effects of discounting are considered material, then the original
measurement of the provision would have been at the discounted amount (i.e. present value).
The unwinding of the discount thus reverses the original discounting (see example A6):
x The balance of the provision must be gradually increased as the present value increases so
that it finally equals the actual amount to be paid (the future amount).
x This increase in the provision is recognised directly in profit or loss as a finance cost.
Sometimes an obligation relates to dismantling, removing or restoring items of property, plant

and equipment (IAS 16). In these cases, IAS 16 requires that the initial recognition of the
provision (liability) is not recognised in profit or loss as an expense, but is capitalised to the
cost of the related asset instead. Thus, if this provision were to subsequently change, we would
need to decide if the change in the provision should be recognised in profit or loss or be
recognised as an adjustment to the related asset. If an adjustment to the provision is caused by:
x the unwinding of the discount, then the contra entry is always recognised in profit or loss as a
finance cost expense – these finance costs may never be subsequently capitalised to the asset;
x other factors, such as a change in the estimated future cash outflow or a change in the
estimated discount rate, then the contra entry will depend on whether the related asset
was measured under:
the cost model, or
the revaluation model.
A: 4.8.1 Change in provisions and the cost model (IFRIC 1.5)
The cost model measures the carrying amount of the asset at:
x cost
x less accumulated depreciation (decrease in carrying amount due to normal usage), and
x less accumulated impairment losses (the decrease in carrying amount due to damage).
If the provision requires an adjustment due to the unwinding of discount (i.e. the passage of
time), the contra entry is recognised as a finance cost expense in profit or loss: debit finance
cost expense and credit provision. This finance cost may never be subsequently capitalised.
(i.e. we are not allowed to subsequently credit the expense and debit the asset).
However, if the adjustment to the provision is due to some other reason (e.g. a change in the
estimated discount rate), then we must use the following logic instead. If the cost model is
used and an adjustment to the provision is needed (i.e. other than due to the unwinding of
discount), IFRIC 1 requires that the adjustment be processed as follows:
x An increase (credit) in the liability:
- is added (debited) to the cost of the related asset in the current period; but
- the entity shall consider whether this is an indication that the new carrying amount of
the asset may not be fully recoverable:
If it is such an indication, the entity must:
- test the asset for impairment (damage) by estimating its recoverable amount, and
- account for any impairment loss in accordance with IAS 36.
908 Chapter 18
x A decrease (debit) in the liability:

- is deducted (credited) from the cost of the related asset in the current period; but
- the amount deducted from the cost of the asset cannot exceed its carrying amount:
If a decrease in the liability does exceed the carrying amount of the asset, the excess:
- shall be recognised immediately in profit or loss. See IFRIC 1.5
The essence of IFRIC 1.5 and the cost model is as follows:

For an increase in the provision:
Dr Asset: cost (A)

Cr Provision (L)
However, because the cost of the asset is increasing purely due to the increase in the
provision, an impairment test (involving a calculation of the recoverable amount) must be
done to ensure that the new “inflated” carrying amount is fully recoverable.
If the recoverable amount is lower than the carrying amount, the carrying amount must be
decreased and recognised as an impairment loss in accordance with IAS 36.
For a decrease in the provision:
Dr Provision (L)
Cr Asset: cost (A) (limited to the asset’s carrying amount)
Cr Profit/Loss (excess of the decrease in provision over the asset’s carrying amount)
Example A11: Changes in decommissioning liability: cost model

Susan Limited acquired a plant for C1 000 000 on 1 January 20X5.
Depreciation is calculated using the straight-line method and a nil residual value.
Susan Limited has a legal obligation to dismantle the plant at the end of its 4-year useful life.
x The estimated future cost of dismantling is C40 000.
x The present value of the future dismantling costs is C27 321 (using a discount rate of 10%).
The company uses the cost model to account for property, plant and equipment.
Required: Ignoring tax, prepare the journal entries for the years ending 31 December 20X5 and 20X6
assuming:
a) The dismantling costs increased to C60 000 on 1 January 20X6.
b) The dismantling cost decreased to C30 000 on 1 January 20X6.
Solution A11(a): Increase in decommissioning liability: cost model

Workings:
W1: Effective interest rate table: estimate increases on 1 January 20X6
Date Discount Calculation of Finance Liability Calculation of finance charges: can be

factor liability balance charges balance calculated either way
(rounded): (present value) Liability balance x Movement in
10% 10% liability balance
01 Jan X5 0.683013 40 000 x 0.683013 27 321

31 Dec X5 0.751315 40 000 x 0.751315 2 732 30 053 27 321 x 10% 30 053 – 27 321
01 Jan X6 45 079 – 30 053 or
20 000/ 1.13 15 026
01 Jan X6 0.751315 60 000 x 0.751315 45 079
31 Dec X6 0.826446 60 000 x 0.826446 4 508 49 587 45 079 x 10% 49 587 – 45 079
31 Dec X7 0.909091 60 000 x 0.909091 4 958 54 545 49 587 x 10% 54 545 – 49 587
31 Dec X8 1 60 000 x 1 5 455 60 000 54 545 x 10% 60 000 – 54 545
Total 17 653
Chapter 18 909
Journals:
Plant: cost (A) 1 000 000 + 27 321 1 027 321
Provision: decommissioning costs (L) Given 27 321
Purchase of plant and provision is capitalised to the cost.
31 December 20X5
Depreciation: plant (P/L: E) (1 027 321 – 0) / 4yrs x 1yr 256 830
Depreciation for 20X5 year
Finance charge (P/L: E) W1 2 732
Provision: decommissioning costs (L) 2 732
Finance charge for 20X5
1 January 20X6
Plant: cost (A) * W1 15 026
Increase in decommissioning liability
31 December 20X6
Depreciation: plant (P/L: E) (1 027 321 – 256 830 +15 026 261 839
Plant: accumulated depreciation (-A) - 0) /3 remaining years x 1 yr 261 839
Depreciation for 20X6 year: (CA – RV) / remaining useful life
Finance charge for 20X6 based on the new estimate
* Comment: Because we are increasing the cost of the asset, we would also have to conduct an impairment test to
ensure this full amount is recoverable. See chapter 11.
Solution A11(b): Decrease in decommissioning liability: cost model

Workings:
W1: Effective interest rate table: estimate decreases on 1 January 20X6
Date Discount Calculation of Finance Liability Calculation of finance charges: can be
factor liability balance charges balance calculated either way
(rounded): (present value) Liability balance Movement in
10% x 10% liability balance
01 Jan X5 0.683013 40 000 x 0.683013 27 321
31 Dec X5 0.751315 40 000 x 0.751315 2 732 30 053 27 321 x 10% 30 053 – 27 321
01 Jan X6 22 539 – 30 053 or
(7 514)
10 000/ 1.13
01 Jan X6 0.751315 30 000 x 0.751315 22 539
31 Dec X6 0.826446 30 000 x 0.826446 2 254 24 793 22 539 x 10% 24 793 – 22 539
31 Dec X7 0.909091 30 000 x 0.909091 2 480 27 273 24 793 x 10% 27 273 – 24 793
31 Dec X8 1 30 000 x 1 2 727 30 000 27 273 x 10% 30 000 – 27 273
Total 10 193
Journals:
Plant: cost (A) 1 000 000 + 27 321 1 027 321
Provision: decommissioning costs (L) Given 27 321
Purchase of plant
910 Chapter 18

Depreciation: plant (P/L: E) (1 027 321 – 0) / 4yrs x 1yr 256 830
1 January 20X6
Provision: decommissioning costs (L) W1 7 514
Plant: cost (A) * 7 514
Decrease in decommissioning liability
31 December 20X6
Depreciation: plant (P/L: E) (1 027 321 – 256 830 – 7 514 – 0) 254 326
Plant: accumulated depreciation (-A) / 3 remaining years x 1 year 254 326
Depreciation for 20X6 year: (CA – RV) / remaining useful life
Finance charge for 20X6 based on the new estimate
* Comment:
If our plant’s carrying amount had, for whatever reason, been lower than the decrease that needed to be
credited to the asset, the excess would be recognised immediately in profit or loss.
For example, had the plant’s carrying amount dropped to C7 000 on 1 January 20X6 (e.g. through an
impairment in the prior year), then
x only C7 000 of the decrease could be credited to the plant and
x C514 would have had to be recognised in profit or loss.
A: 4.8.2 Change in provisions and the revaluation model (IFRIC 1.6)
The revaluation model measures the carrying amount of an asset at:

x fair value
x less subsequent accumulated depreciation (decrease in value due to normal usage), and
x less accumulated impairment losses (decrease in value due to damage).
When the provision relating to an asset requires Important

adjustment due to unwinding of the discount (i.e. due to A change (increase or
the passage of time), the contra entry is recognised as a decrease) in the liability may be an
finance cost expense in profit or loss: indication that the asset may have to be
debit finance cost expense and credit provision. revalued in order to ensure that its CA
does not differ materially from its fair
This finance cost expensed in profit or loss may never be value. Any such revaluation shall be
subsequently capitalised to the asset. taken into account in determining the
amounts to be recognised in P/L or OCI
However, if the provision requires adjustment due to under IFRIC 1.IFRIC 1.6(c) slightly reworded
some other reason (e.g. a change in the estimated
discount rate), then we use the following logic instead. So before processing the adjustments
to the provision in accordance with
If the revaluation model is used for the asset and an IFRIC 1, revalue the asset if necessary
adjustment to its related provision is needed, and it has and then use the updated balances in
nothing to do with the unwinding of discount, IFRIC 1 revaluation surplus account to do the
requires that the adjustment be processed as follows: relevant adjustments.
x An increase in the provision – credit the provision and process the debits as follows:
- First debit the revaluation surplus account (i.e. other comprehensive income), if there
is one for this asset, until this balance is zero;
- Then debit any excess to a revaluation expense account (i.e. in profit or loss).
Chapter 18 911
x A decrease in the provision – debit the provision and process the credits as follows:
- First credit a revaluation income account (i.e. in profit or loss) if the decrease reverses
a previous revaluation expense on the asset (since this revaluation expense would
have been recognised in profit or loss);
- Then credit any excess to the revaluation surplus account (i.e. other comprehensive
income). But, if the ‘decrease in the liability exceeds the carrying amount that would have
been recognised had the asset been carried under the cost model (i.e. the historical carrying
amount), the excess shall be recognised immediately in profit or loss’.
For example: An asset with a historical carrying amount (HCA) of C200 000 (depreciated
cost), was previously revalued, with the balance in the revaluation surplus currently
C300 000. Its related dismantling provision decreases by C250 000. We cannot credit the
revaluation surplus account (OCI) with C250 000, because the amount of the decrease
exceeds the asset’s HCA of C200 000. Thus, only C200 000 is credited to revaluation
surplus (OCI), and the excess of C50 000 is credited to a revaluation income account in P/L.
The essence of IFRIC 1.6 and the revaluation model is as follows:

First, revalue the asset to its latest fair value. Interestingly, we could be given this fair value in a variety of ways.
This is important to understand since, when revaluing our asset, we must use a fair value that reflects just the
asset. For example, if the fair value was determined on a discounted cash flow basis, it could have been
calculated gross or net of the related provision (some valuations calculate fair value net of the provision on the
basis that a purchaser would have to assume the obligation, for example, to dismantle the asset at some stage in
the future). However, since we account for this obligation as a separate provision, the fair value that we use to
revalue the asset must relate only to the asset (i.e. we revalue it to a gross fair value). Thus, if we are given a net
fair value, we must add back the present value of the provision. For example: if the fair value of an asset has
been calculated to be C900 000, net of a dismantling provision with a present value of C100 000, the fair value
of the asset to be used for its revaluation is the gross fair value of C1 000 000 (net FV: C900 000 + PV of the
provision: C100 000).
Then we remeasure the provision. Any adjustments needed (that are not due to the unwinding of the
discount) are accounted for as follows:
For an increase in the provision:
Dr Revaluation surplus (OCI) (limited to the RS balance available for this asset)
Dr Revaluation expense (P/L) (excess over RS or if RS does not exist)
Cr Provision (L)
For a decrease in the provision:
Dr Provision (L)
Cr Revaluation surplus (OCI) (limited to historical carrying amount)
Cr Revaluation income (P/L) (excess over historical carrying amount)
Example A12: Changes in dismantling liability: revaluation model

Nabilah Limited acquired a plant for C1 000 000 on 1 January 20X5.
Depreciation is calculated using the straight-line method and a nil residual value.
Nabilah Limited has a legal obligation to dismantle the plant at the end of its 4-year useful life.
x The estimated future cost of dismantling is C750 000.
x The present value thereof, at acquisition date, is C512 260 (using a discount rate of 10%).
Nabilah uses the revaluation model to account for property, plant and equipment and accounts for
revaluations on the ‘net method’. Any resultant revaluation surplus is transferred to retained earnings
on disposal of the asset.
The plant was revalued on 31 December 20X5 when its ‘net’ fair value (i.e. after deducting the present
value of the dismantling provision of C563 486) was C1 200 000.
Required: Ignoring tax, prepare journals for the years ending 31 December 20X5 and 20X6 assuming
that the gross fair value of the asset remained unchanged but that:
a) the future dismantling costs increased to C900 000 on 31 December 20X6;
b) The future dismantling cost decreased to C300 000 on 31 December 20X6.
912 Chapter 18
Solution A12(a): Increase in dismantling liability: revaluation model

W1: Effective interest rate table: estimate increases on 31 December 20X6
Date Discount Calculation of Finance Liability Calculation of finance charges: can

factor liability balance charges balance be calculated either way
(rounded): (present value) Liability Movement in
10% balance x 10% liability balance
01 Jan X5 0.683 013 750 000 x 0.683 013 512 260
31 Dec X5 0.751 315 750 000 x 0.751 315 51 226 563 486 512 260 x 10% 563 486 – 512 260
31 Dec X6 0.826 446 750 000 x 0.826 446 56 349 619 835 563 486 x 10% 619 835 – 563 486
31 Dec X6 743 802 – 619 835;
or: 150 000/ 1.12 123 967
31 Dec X6 0.826 446 900 000 x 0.826 446 743 802
31 Dec X7 0.909 091 900 000 x 0.909 091 74 380 818 182 743 802 x 10% 818 182 - 743 802
31 Dec X8 1 900 000 x 1 81 818 900 000 818 182 x 10% 900 000 – 818 182
Total 263 773
Journals
Plant: cost (A) 1 000 000 + 512 260 1 512 260
Provision: dismantling costs (L) Given 512 260
Purchase of plant and provision is capitalised to the cost
31 December 20X5
Depreciation: plant (P/L: E) (1 512 260 – 0) / 4 yrs x 1 yr 378 065
Finance charge (P/L: E) W1 or O/bal: 512 260 x 10% 51 226
Provision: dismantling costs (L) 51 226
NRVM: set-off of accumulated depreciation before revaluation
Plant: cost (A) FV (1 200 000 + 563 486 (W1)) – 629 291
Revaluation surplus (Eq: OCI) CA: (1 512 260 – 378 065) 629 291
Revaluation to fair value (the gross FV of 1 763 486)
31 December 20X6
Depreciation: plant (P/L: E) FV: (1 200 000 + 563 846 – 0) / 587 829
Plant: accumulated depreciation (-A) 3 years remaining x 1 year 587 829
Finance charge (P/L: E) W1; Or 56 349
Provision: dismantling costs (L) O/bal (512 260 + 51 226) x 10% 56 349
Revaluation surplus (Eq: OCI) Incr in prov: 123 967 limited to 123 967
Provision: dismantling costs (L) RS balance: 629 291 Note 1 123 967
Remeasurement of the dismantling provision (increasing the provision)
due to an increase in expected future outflows of C150 000 (900k – 750k)
Note 1:
x The balance in the revaluation surplus was C629 291 and was thus not a limiting factor.
x If we had, for example, previously revalued upwards by only C100 000 (instead of C629 291), then C100 000
of the increase in the provision would have been debited to the revaluation surplus account (OCI) and the
excess of C23 967 would have been debited to an expense (P/L).
Chapter 18 913
Solution A12(b): Decrease in dismantling liability: revaluation model

Workings:
W1: Effective interest rate table: estimate decreases on 31 December 20X6
Date Discount factor Calculation of Finance Liability Calculation of finance charges: can
(rounded): liability balance charges balance be calculated either way
10% (present value) Liability Movement in
balance x 10% liability balance
01 Jan X5 0.683 013 750 000 x 0.683 013 512 260

31 Dec X5 0.751 315 750 000 x 0.751 315 51 226 563 486 512 260 x 10% 563 486 – 512 260
31 Dec X6 0.826 446 750 000 x 0.826 446 56 349 619 835 563 486 x 10% 619 835 – 563 486
247 934 – 619 835
or: 450 000/ 1.12 (371 901)
31 Dec X6 0.826 446 300 000 x 0.826 446 247 934
31 Dec X7 0.909 091 24 793
300 000 x 0.909 091 272 727
247 934 x 10% 272 727 – 247 934
31 Dec X8 1 300 000 x 1 27 273 300 000
272 727 x 10% 300 000 – 272 727
Total 159 641
W2: Historical carrying amount (depreciated cost) C
Cost 1 January 20X5 1 000 000 + 512 260 1 512 260
Less accumulated depreciation 31 December 20X6 (1 512 260 – 0) / 4 yrs x 2 yrs (756 130)
Historical carrying amount 31 December 20X6 756 130
Journals:
Plant: cost (A) 1 512 260
Bank 1 000 000
Purchase of plant
31 December 20X5
Depreciation: plant (E) (1 512 260 – 0) / 4 yrs x 1 yr 378 065
Plant: accum. depreciation (-A) 378 065
Finance charge (P/L: E) W1 or O/bal: 512 260 x 10% 51 226
Plant: cost (A) FV (1 200 000 + 563 486 (W1)) – 629 291
Revaluation surplus (Eq: OCI) CA: (1 512 260 – 378 065) 629 291
Revaluation of plant to fair value (the gross FV of 1 763 486)
31 December 20X6
Depreciation: plant (P/L: E) (1 200 000 + 563 486 – 0) / 3 587 829
Plant: Accum. depreciation (-A) years remaining x 1 year 587 829
Finance charge (P/L: E) W1; Or 56 349
Provision: dismantling costs (L) O/bal (512 260 + 51 226) x 10% 56 349
Provision: dismantling costs (L) Decr in prov: 371 901 (see W1) is 371 901
Revaluation surplus (Eq: OCI) credited to the RS to the extent
that it does not exceed the HCA of
756 130 (W2)* 371 901
Decrease in dismantling liability
914 Chapter 18
* If the amount of the decrease in the provision exceeded the asset’s historical carrying amount (C756 130), any
excess would be recognised immediately as income in profit or loss (P/L).
However, the decrease in the liability was only C371 901 and thus was not limited by the historical carrying
amount and is thus recognised as a credit to the revaluation surplus, in other comprehensive income (OCI).
If the HCA had been C300 000, then of the C371 901 reduction in the provision,
only C300 000 would be credited to revaluation surplus (OCI) and
the remaining C71 901 would be credited to income (P/L).
A: 4.9 Changes in provisions through usage or derecognition (IAS 37.61 - .62)

A provision is made for future costs. When these costs are eventually incurred or paid for, the
provision is reduced. A provision may only be used (reduced) for the purpose for which it was
originally created. If expenditures were to be set off against a provision that was recognised
for a different purpose, this would conceal the impact of two different events. In other words,
we should only debit (reduce) the provision with the payment of a cost if we are sure that this
cost had originally been included in the provision account. If expenditures that were provided
for in a provision are no longer expected to be incurred, that provision must be derecognised
(i.e. it cannot be used for any other purpose/expenditure).
Example A13: Reduction in provisions

A company recognised a provision of C350 000 in respect of a court case, which was
estimated at 31 December 20X5 as follows:
x Amount to be paid to lawyer A: C250 000
x Amount to be paid to lawyer B: C100 000.
During 20X6, the company attended a number of court hearings and on a few occasions received
parking fines whilst inside the court house.
The following are all the court-related payments made (all payments were made on 31 August 20X6):
x Lawyer A: C270 000
x Lawyer B: C70 000
x Parking fines: C10 000
The case was thrown out of court on 30 November and no further payments were required.
Required: Show the journal entries in both 20X5 and 20X6.
Solution A13: Reduction in provisions

Legal expenses (P/L: E) 250 000 + 100 000 350 000
Provision for legal expenses (L) 350 000
Provision for expected lawyers’ fees
31 August 20X6
Legal expenses (P/L: E) 20 000
Bank (A) 270 000
Payment to Lawyer A: only C250 000 had been raised as a provision
and thus the C20 000 must be expensed (not debited to the provision)
31 August 20X6
Bank (A) 70 000
Payment to Lawyer B
Parking fines (P/L: E) 10 000
Bank (A) 10 000
Payment of parking fines
30 November 20X6
Provision for legal expenses (L) 350 000 – 250 000 – 70 000 30 000
Legal expenses (P/L: I) 30 000
De-recognition of the balance on the provision for legal fees
Chapter 18 915
Comment:
x Payment of parking fines – although the fines occurred at the time of the court case, these fines had not
originally been provided for and therefore may not be debited to the provision.
x When we know that payments that have been provided for will not occur, the balance in the provision must be
derecognised. When the case was thrown out of court, it becomes clear that no further legal fees will be
incurred. This therefore means that the extra fee of C30 000 provided for in respect of lawyer B will not be
incurred and this balance must therefore be derecognised (C100 000 – C70 000).
A: 5 Recognition and Measurement: Four Interesting Cases
A: 5.1 Future operating losses (IAS 37.63 - .65)

Future operating losses
A future operating loss does not meet the definition of a A provision may never be
liability, since there is no obligation to incur the future loss recognised for future operating losses
(remember that a liability exists independently of the entity’s as it is avoidable. No present obligation
exists to incur the loss.
future actions and therefore, if there is any future action that
may avoid the obligation, there is no liability). Thus, an expected future operating loss may not be
recognised as a provision. An expected future loss may, however, be considered as an indication
that some or all of the entity’s assets may be impaired (see chapter 11).
A: 5.2 Contracts (IAS 37.3 & .66 - .69)

An onerous contract is
There are two kinds of contracts referred to in IAS 37: defined as:
x Executory contracts, and x a contract where:
x Onerous contracts. - the unavoidable costs of
meeting the obligations (terms)
Executory contracts are simply contracts still being of the contract
executed – in other words, either: - exceed the economic
x ‘neither party has performed any of its obligations or benefits expected to be
received from the contract
x both parties have partially performed their IAS 37.10 reworded
obligations to an equal extent.’ IAS 37.3
Costs that have been contractually committed to by an entity but not yet incurred should not
be recognised as a liability since these are considered to be future costs (there is no past event
and thus no present obligation exists).
The only time that costs in respect of a contract should be provided for is when the executory
contract is an onerous contract. Therefore, a provision may only be recognised if the contract
is an onerous contract as defined in IAS 37.
Measuring an onerous
An onerous contract is one where the unavoidable costs contract provision.
to fulfil the terms of the contract are greater than the The provision must be
benefits that will be derived from it (i.e. the contract will measured at the lower of the:
make a loss). In this case, a provision must be recognised x costs of fulfilling the contract, and;
for the unavoidable costs, measured at the ‘least net cost x any compensation/ penalties arising
of exiting’, this being the lower of: from failure to fulfil the contract
x the cost of fulfilling the contract; and See IAS 37.68
x the compensation or penalties that would be incurred if the contract were to be cancelled.
See IAS 37.68
Example A14: Onerous contract

Silliun Limited entered into a contract to perform certain services.
x The total contract price is C80 000.
x The estimated costs of fulfilling these contractual obligations have been recently re-
assessed to be C140 000. No work has yet been done.
x A penalty of C30 000 is payable if the contract is to be cancelled.
Required: Process the required journal entry.
916 Chapter 18
Solution A14: Onerous contract

Debit Credit
Contract cost (P/L: E) 30 000
Provision for onerous contract (L) 30 000
Provision recognised at the minimum cost related to the onerous
contract
Comment: The onerous contract is measured at the lower of the net cost to cancel: C30 000 (cost/penalty to
cancel prior to completion) or C60 000 (being the net cost to complete: C140 000 – C80 000).
A: 5.3 Restructuring provisions (IAS 37.70 - .83)

Restructuring occurs when, for example, a line of business is sold (e.g. a company producing
shoes and clothes sells its shoe-manufacturing factory) or there is a change in the management
structure (see the definition of ‘restructuring’ in the pop-up below).
An entity that is involved in or planning a restructuring will be expecting to incur a variety of
costs, for example, retrenchment packages will probably need to be paid out and in the case of
the sale of a factory, there may be costs incurred in the removal of certain machinery.
However, before recognising a provision for the expected costs of restructuring, the same
basic definition and recognition criteria for a provision would need to be met. In this regard,
IAS 37 provides further criteria to assist in determining whether the basic definition and
recognition criteria have been met.
These further criteria for recognising a constructive obligation to restructure are as follows:
x there must be a detailed formal plan that identifies at least all the following:
the business or part of a business concerned;
the principal locations affected;
the location, function and approximate number of employees who will be
compensated for terminating their services;
the expenditure that will be undertaken; and
when the plan will be implemented.
x the entity must have raised valid expectations in those affected before the end of the
reporting period that it will carry out restructuring, by either having:
started to implement the plan; or

announced its main features to those affected by it. IAS 37.72 (reworded slightly)
Costs of restructuring a business entity should be provided for (i.e. should be recognised as a
provision) on condition that the costs provided for are only those costs that are directly
associated with the restructuring, being:
x those that are necessary; AND
x not related to the ongoing activities of the entity (i.e. future operating costs are not part of
the provision, for example: retraining and relocation costs for continuing staff, investment
in new systems, marketing, etc.). See IAS 37.80
Where a restructuring is to be achieved by selling an

operation, no obligation arises until there is a binding Restructuring is defined as:
sale agreement. x A programme that is planned and
controlled by management, and
x materially changes either:
The logic behind this is that the entity is able to reconsider
- the scope of a business
the restructuring if a buyer on suitable terms cannot be found undertaken by an entity; or
(e.g. it may have to abandon the idea of restructuring entirely - the manner in which that business
– and if it can do that, there is clearly no obligation yet). is conducted IAS 37.10
However, if only part of the restructuring involves a sale of an operation, it is possible for a
constructive obligation to arise for the ‘non-sale part’ (the other aspects of the restructuring
that do not involve a sale of an operation) before a binding sale agreement exists, in which
case a restructuring provision would have to be recognised. See IAS 37.78-.79
Chapter 18 917
Example A15: Restructuring costs

A few days before year-end, Dropout Limited decided to close its shoe factory within 6
months of year-end:
x A few days before year-end, Dropout announced its intention.
x There is a detailed formal plan that lists, amongst other things, the expected costs of
closure:
retrenchment packages: C1 000 000
retraining the staff members who will be relocated to other factories: C500 000
loss on sale of factory assets: C100 000.
Required:
Process the required journal entry.
Solution A15: Restructuring costs

Debit Credit
Restructuring costs (P/L: E) 1 000 000
Provision for restructuring costs (L) 1 000 000
Provision for restructuring costs
Note:
The cost of retraining staff is a future operating cost and must therefore not be provided for, as it is avoidable. The
loss on sale of assets simply indicates a possible need to impair the assets at year-end. See IAS 37.81(a)
A: 5.4 Levies (IFRIC 21)
A levy is defined as ‘an outflow of resources embodying economic benefits that are imposed
by governments on entities in accordance with legislation, other than:
x those outflows of resources that are within the scope of other standards (such as income
taxes, which are covered by IAS 12); and
x fines or other penalties that are imposed for breaches of the legislation’. IFRIC 21.4
Over and above the items excluded from this definition, IFRIC 21 also states that it does not
apply to liabilities arising from emission trading schemes. See IFRIC 21.6
IFRIC 21 on Levies does
IFRIC 21 gives guidance on the accounting treatment not apply to:
and recognition principles for the liability to pay a levy if
that levy is within the scope of IAS 37. x Outflows within the scope of other
x The obligating event that gives rise to the standards (e.g. income taxes),
recognition of a liability to pay a levy is the activity x Fines or penalties, and
x Liabilities arising from emissions
that triggers the payment of the levy, as identified by
trading schemes. See IFRIC 21.4 & .6
legislation. IFRIC 21.8 (reworded slightly)
x The liability to pay a levy is recognised progressively, if the obligating event occurs over
a period of time. IFRIC 21.11
x If an obligation to pay a levy is triggered by reaching a minimum activity threshold, the
corresponding liability will be recognised when that threshold is reached. See IFRIC 21.12
Example A16: Levies

Dash Limited is required to pay a levy to the government for operating in its sector.
x The levy is determined with reference to the amount of revenue generated.
x The financial year end of the company is 31 December 20X1;
x Dash starts generating revenue in 20X1 from 2 January 20X1.
Required: Discuss when the liability to pay the levy should be recognised if:
A. The levy is triggered as Dash Limited generates revenue in 20X1.
B. The levy is triggered once Dash Limited reaches revenue of C30 million.
C. The levy is triggered as soon as Dash Limited generates revenue in 20X1; however, the levy is
calculated based on 2% of the 20X0 revenue.
918 Chapter 18
Solution A16: Levies

A. The liability is recognised progressively as the entity generates revenue in 20X1. If Dash Limited
prepares interim financial statements during 20X1 the liability will be recognised in these interim
financial statements based on the revenue to date for 20X1.
B. The liability will be recognised on the date that Dash Limited’s revenue reaches C30 million.
C. The liability will only be recognised in 20X1 as soon as revenue is generated in 20X1. The
generation of revenue in 20X0 is necessary but not sufficient to create a present obligation. The
activity that triggers the payment of the levy is the generation of revenue in 20X1 (and not 20X0).
Thus, the liability will be recognised on 2 January 20X1, and measured at 2% of the 20X0 revenue.
A: 6 Recognition and Measurement: Contingent Assets (IAS 37.31 - .35)
A: 6.1 Recognition of contingent assets A contingent asset is

defined as:
Contingent assets are not recognised. This is because
they are defined as possible assets (see pop-up), which x a possible asset
x that arises from past events and
means we are not yet sure they exist. Recognising a x whose existence will be confirmed
contingent asset could result in recognising income that only by the:
might never materialise. Whether or not these assets occurrence or non-occurrence of
exist will only be known in the future, and is dependent one or more uncertain future events
on future events over which the entity has no control. not wholly within the control of
the entity IAS 37.10
E.g. a possible positive court ruling.
If the inflow of economic benefits from a ‘contingent asset’:
x is possible or remote, the contingent asset is ignored (based on the concept of prudence)
x is probable, a contingent asset would be disclosed; and
x is virtually certain, the asset is no longer considered to be a ‘contingent’ asset but a normal asset
and is recognised (unless a reliable estimate is not possible).
A: 6.2 Measurement of contingent assets (IAS 37.89 and IAS 37.36 - .52)
Although contingent assets are not recognised, they may Accounting for contingent
need to be disclosed (if the inflow of economic benefits is assets:
probable), in which case its value will need to be measured. x Inflow possible or remote:
Ignore
We measure contingent assets in the same way we x Inflow probable:
measure provisions and contingent liabilities: Disclose
x it must be measured at the best estimate of the expected x Inflow virtually certain:
benefits to be received, as at the reporting date; Recognise (i.e. journalise) a ‘pure’ asset
x it must include any risks and uncertainties associated (no longer a contingent asset)
with the contingent asset;
x if the effect of discounting is material, then it should be measured at its present value (using a
pre-tax discount rate that reflects market conditions and factors specific to the liability); and
x future events that may affect the amount to be received is only included where there is ‘sufficient
objective evidence’ of their occurrence. See IAS 37.89
A: 7 Disclosure: Provisions, Contingent Liabilities and Contingent Assets

(IAS 37.84 - .92)
A: 7.1 Disclosure of provisions (IAS 37.84 - .85)
Provisions should be disclosed as a separate line item in the statement of financial position.
For each class of provision, disclose the following in the notes to the financial statements:
x a brief description of the nature of the obligation;
x the expected timing of the outflows;
x the uncertainties relating to either or both the amount and timing of the outflows;
Chapter 18 919
x major assumptions made concerning future events (e.g. future interest rates; the
assumption that a future law will be enacted with the result that a related provision was
raised; future changes in prices and other costs);
x the expected amount of any reimbursements including the amount of the reimbursement
asset recognised (if recognised at all);
x a reconciliation between the opening and closing carrying amounts of the provision (for
the current period only) indicating each movement separately:
additional provisions made, including increases to existing provisions;
increases in a provision based on increasing present values caused by the normal
passage of time and from any changes to the estimated discount rate;
amounts used during the year (debited against the provision); and
unused amounts reversed during the year.
comparative information is not required in the notes.
Since provisions are estimates, a change in a provision must be accounted for as a change in
estimate in terms of IAS 8 Accounting policies, changes in accounting estimates and errors.
The disclosure requirements for a change in accounting estimate (per IAS 8.39) are as follows:
x the nature and amount of the change in estimate, showing:
- the effect on the current period; and
- the effect on future periods.
A: 7.2 Disclosure of contingent liabilities (IAS 37.86)
Where a contingent liability is to be disclosed, the following information should be provided
(per class of contingent liability):
x a brief description of the nature of the contingent liability;
x an estimate of its financial effect;
x the uncertainties relating to the amount or timing of the outflows; and
x the possibility of any reimbursement.
Example A17: Disclosure: decommissioning provision (change in estimate)
The following information relates to an item of plant:
x Cash purchase price (1 January 20X1) : C450 000
x Future decommissioning (the outflow expected on : C399 300
31 December 20X3, as assessed on 1 January 20X1)
x Discount rate : 10%
x Depreciation straight-line to nil residual values : 3 years
On 1 January 20X2, it was established that, due to unforeseen price increases, the expected future cost
of decommissioning will be C665 500.
Note: The future costs have not been discounted.
Required: Disclose the above in the financial statements for the year ended 31 December 20X2.
Solution A17: Disclosure: decommissioning provision (change in estimate)
W 1. Effective interest rate table
Date Discount Calculation of Finance Liability Calculation of finance charges: can
factor liability balance charges balance be calculated either way
(rounded): (present value) Liability balance x Movement in
10% 10% liability balance
1 Jan X1 0.751315 399 300 x 0.751315 300 000
31 Dec X1 0.826446 399 300 x 0.826446 30 000 330 000 300 000 x 10% 330 000 – 300 000
1 Jan X2 550 000 – 330 000 or
266 200/ 1.12 220 000
1 Jan X2 0.826446 665 500 x 0.826446 550 000
31 Dec X2 0.909091 665 500 x 0.909091 55 000 605 000 550 000 x 10% 605 000 – 550 000
31 Dec X3 1 665 500 x 1 60 500 665 500 605 000 x 10% 665 500 – 605 000
Total 145 500 30 000 + 55 000 + 60 500
920 Chapter 18
W 2. Change in estimated finance costs Was Is Difference Adjustments

(a) (b) (b) – (a)
Initial liability (300 000)
Finance costs: 31/12/20X1 (30 000)
Carrying amount: 31/12/20X1 (330 000) (330 000)
Adjustment (see W1) (220 000) (220 000) Extra liability
(550 000)
Finance costs: 20X2 (33 000) (55 000) (22 000) Extra expense
Carrying amount: 31/12/20X2 (363 000) (605 000) (242 000)
Finance costs: future (36 300) (60 500) (24 200) Extra expense
Carrying amount: future (399 300) (665 500) (266 200) Total change
W 3. Change in estimated depreciation Was Is Difference Adjustments

(a) (b) (b) – (a)
Cost (450 000 + 300 000) 750 000
Depreciation 20X1 750 000 / 3 yrs (250 000)
Adjustment (see W1) 220 000 220 000 Extra asset
Remaining useful life (years) 2 years 2 years
Depreciation: 20X2 (250 000) (360 000) (110 000) Extra expense
Depreciation: future (250 000) (360 000) (110 000) Extra expense
Carrying amount: final 0 0 0 Total change
Company name
Statement of financial position (extracts) Note 20X2 20X1
ASSETS
Non-current assets
Property, plant and equipment 7 360 000 500 000
Provision for decommissioning 6 605 000 330 000
Company name
6. Provision for decommissioning
Opening carrying amount 330 000 0
Provision for decommissioning raised 0 300 000
Increase in provision – increased future cost 220 000
Increase in present value – unwinding of discount: 55 000 30 000
finance charges (per note 8)
Closing carrying amount 605 000 330 000
The plant is expected to be decommissioned on 31/12/20X3 and is expected to result in cash outflows of
C665 500 (20X1: C399 300). The amount of the outflow is uncertain due to changing prices. The timing of
the outflow is uncertain due to the changing asset usage, which may result in a longer or shorter useful life.
Major assumptions include the 10% interest rate and the 3-year useful remaining unchanged.
Net carrying amount: 1 January 500 000 0
Gross carrying amount: 1 January 750 000 0
Accumulated depreciation: 1 January (250 000) 0
Acquisition (450 000 + 300 000) 0 750 000
Depreciation (per profit before tax note) (360 000) (250 000)
Increase in present value of future decommissioning costs W1 220 000 0
Net carrying amount: 31 December 360 000 500 000
Gross carrying amount: 31 December 970 000 750 000
Accumulated depreciation: 31 December (610 000) (250 000)
Chapter 18 921

Profit before tax is stated after accounting for the following disclosable (income)/ expense items:
Finance charges W1 55 000 30 000
Depreciation W3 360 000 250 000
9. Change in estimate
The expected cash outflow on 31 December 20X3 in respect of the decommissioning of plant was
changed. The effect of the change is as follows: increase/(decrease)
x Current year profits (before tax) (W2: 22 000 + W3: 110 000) (132 000)
x Future profits (before tax) (W2: 24 200 + W3: 110 000) (134 200)
A: 7.3 Disclosure of contingent assets (IAS 37.89 - .90)

Where a contingent asset is to be disclosed, the following information should be provided:
x a brief description of the nature of the contingent asset; and
x where practicable, an estimate of its financial effect.
A: 7.4 Exemptions from disclosure requirements (IAS 37.91 – 92)

There are two instances where the above disclosure of provisions, contingent liabilities and
contingent assets are not required:
x where disclosure thereof is not practicable, in which case this fact should be stated; and
x where the information required would be seriously prejudicial to the entity in a dispute
with a third party. If this is the case, then simply disclose the general nature of the dispute
together with the fact that full disclosure has not been made and the reason for this.
Part A: Summary
Liabilities
Liabilities Provisions Contingent Liability Contingent Liability

– type 1 – type 2
x Present obligation of x Liability of uncertain x Present obligation x Possible obligation
the entity x timing (not sure when x from past events x from past events
x from past events outflows will occur), OR x the settlement of which is x the existence of which
x the settlement of x amount (not sure how expected to cause an is to be confirmed
which is expected to much) outflow of economic x by the occurrence or
result in an outflow of benefits non-occurrence of
economic benefits x but where the liability may uncertain future event/s
See IAS 37.10
not be recognised since x that are not wholly
This is not the same the recognition criteria within the control of the
liability definition per are not met: entity
the 2018 CF - the amount is not
reliably measured &/or
- the future outflow of
economic benefits is not
probable
Contingent asset
x Possible asset arising from past events
x The existence of which will be confirmed by the occurrence/ non-occurrence
x of uncertain future events not wholly within the entity’s control. See IAS 37.10
e.g. the entity is a claimant in a court case where the outcome is uncertain
If this ‘inflow possibility’ is/ becomes:
virtually certain / certain: probable: possible or remote:

Recognise as a ‘pure’ asset Disclose as a contingent asset Ignore
(it is not a contingent asset)
922 Chapter 18
Recognition flowchart: provisions and contingent liabilities
Liability
Present Possible Future obligation:

No No
obligation? obligation? Ignore
Yes Yes
Probable Possible
No No Remote: Ignore
outflow? outflow?
Yes Yes
Disclose as a
Reliable
No contingent
estimate?
liability
Yes but
high degree of
Yes uncertainty
Recognise a Recognise a provision

liability (liability)
Note: IAS 37 defines an outcome as being probable if it is ‘more likely than not’ to occur. This applies only to this
standard and is not always appropriate for other standards. The term ‘possible’ referred to in the flowchart above
refers to both ‘as likely to occur as not to occur’ (i.e. an equal possibility) and ‘less likely to occur than not to occur’.
Recognition/ disclosure flowchart: assets
Asset
Inflow certain Inflow

Inflow
or virtually No No possible/
probable?
certain? remote?
Yes Yes Yes
Disclose as a
Reliable
contingent Ignore
estimate?
asset
Yes
Recognise (pure
asset – not
contingent)
Chapter 18 923
PART B:
Events After the Reporting Period
B: 1 Introduction
Although one might assume that events that occur after the current year-end should not be
taken into account in the current year’s financial statements, this is not always the case!
There is generally a fairly significant time delay between our financial year-end and the date
on which our financial statements are ready to be authorised for issue. During this time,
certain things (events) may happen which we need to consider carefully in terms of our users’
needs. Some of the events that happen during this period could influence our users’ decisions
and thus we need to consider whether this information should somehow be included in our
financial statements or not. The events need not be unfavourable to be included – they could
be favourable as well!
There are two types of events after the reporting period: Events after the reporting
x adjusting; and period are defined as events
x non-adjusting. that:
x are favourable or unfavourable
The period between the end of the reporting period (the x occur between the:
year-end) and the date on which the financial statements - end of the reporting period and
are authorised for issue is often called the post-reporting - date when the f/statements are
authorised for issue. IAS 10.3
date period.
Assume that an entity has a December year-end and that the financial statements for 20X1
were completed and ready for authorisation on 25 March 20X2. In this case, the period
1 January 20X2 to 25 March 20X2, is the ‘post-reporting date period’, and events taking place
during this period need to be carefully analysed in terms of this standard into one of two
categories: adjusting events and non-adjusting events.
B: 2 Adjusting Events after the Reporting Period (IAS 10.8 - .9)
When considering whether or not to make adjustments for Adjusting events after the
an event that occurred after our reporting date but before reporting period are
the financial statements are authorised for issue, (i.e. defined as events that:
referred to as an ‘event after the reporting date’ or ‘post- x provide evidence of
reporting period event’) we simply need to ask ourselves x conditions that existed at the end of
if the event is one that gives more information about a the reporting period IAS 10.3
condition that existed at year-end.
If the event does give us information about a condition that existed at year-end, then we must
adjust the financial statements that we are about to issue. In other words, we will actually
need to post journal entries to account for the event in the current year financial statements.
The essence here is that the condition must already have been in existence at year-end. For
example, many estimates are made at year-end (e.g. impairment losses, legal and settlement
costs) where these estimates are made based on the circumstances prevailing at the time that
the estimate is made. If new information is discovered during the post-reporting date period
that gives a better indication of the true circumstances at year-end, then these estimates would
need to be changed accordingly.
Please remember that the event need not be unfavourable to be an adjusting event; for
example, a debtor that was put into provisional liquidation at year-end may reverse the
liquidation procedure during the post-reporting date period, in which case it may be
considered appropriate to exclude the value of his account from the estimated allowance for
credit losses and thus increase the value of the receivables balance at year-end.
924 Chapter 18
Example B1: Event after the reporting period

A debtor, who owed Newyear Limited C100 000 at 31 December 20X2, had their factory
destroyed in a fire and as a result, filed for insolvency. The following info is relevant:
x A letter from the debtor’s lawyers was received in February 20X3, in which it was
stated that they will probably pay 30% of the balance,
x The financial statements are not yet authorised for issue.
x The fire occurred during December 20X2.
Required: Explain whether or not the above event should be adjusted for in the financial statements of
Newyear Limited as at 31 December 20X2. If it is an adjusting event, provide the journal entries.
Solution B1: Event after the reporting period

The event that caused the debtor to go insolvent was the fire, which happened in December 20X2,
being before year-end. This is therefore an adjusting event.
The adjustment would be as follows:
20X2 Debit Credit
Impairment loss (E) 70 000
Receivable: allowance for credit loss (-A) 70 000
Impairing the receivable balance due to credit risk: 100 000 x 70%
Comment: Disclosure of this may also be necessary if the amount is considered to be material.
B: 3 Non-Adjusting Events after the Reporting Period (IAS 10.10 – .13)
As already mentioned, when we decide whether or not to Non-adjusting events

adjust for an event that occurred after the reporting date after the reporting period
but before the financial statements are authorised for are defined as events that:
issue, (i.e. referred to as an ‘event after the reporting date’ x are indicative of
or ‘post-reporting period event’) we simply need to ask x conditions that arose after the
ourselves if the event gives more information about a: reporting period. IAS 10.3
x condition that existed at reporting date; or about a
x condition that arose after reporting date.
If the event gives us information about a condition that only developed after year-end, then
this event obviously has no connection with the current financial statements that are being
finalised, and thus no adjustments should be made to these current financial statements.
However, if the event is material (i.e. useful to our users) we should disclose information
about this event in the notes.
Example B2: Non-adjusting events after the reporting period

A debtor that owed Newyear Limited C100 000 at 31 December 20X2 (year-end) had their
factory destroyed in a fire.
x As a result, this debtor filed for insolvency and will probably pay 30% of the balance
owing. A letter from the debtor’s lawyers to this effect was received by Newyear
Limited in February 20X3.
x The financial statements are not yet authorised for issue.
x The fire occurred during January 20X3.
Required: Explain whether the above event should be adjusted for or not in the financial statements of
Newyear Limited as at 31 December 20X2. If it is an adjusting event, provide the journal entries.
Solution B2: Non-adjusting events after the reporting period

The event that caused the debtor to go insolvent was the fire, which happened in January 20X3, being
after year-end. Thus this is a non-adjusting event.
Disclosure of this may be necessary if the amount is material. You will need to use professional
judgement to decide if disclosure is necessary.
Chapter 18 925
A typical example of an event after the reporting period is a dividend distribution that is
declared after the reporting date but before the financial statements are authorised for issue.
If a dividend distribution relating to the period under review is declared during this post-
reporting period, this dividend would not be recognised (adjusted for) as a dividend
distribution in the statement of changes in equity in the current period under review.
x This is because the obligation only arises on the date that the dividend is declared (being
the obligating event).
x Since the dividend was declared after the reporting date, the obligating event cannot be
considered to be a past event.
x Since the obligating event was not a past event, it means that the obligation could not
have existed on reporting date. In other words, there is no present obligation at reporting
date.
Thus, the dividend declaration represents a condition that arose after reporting date. These
dividends declared must not be journalised, but must be disclosed in the notes to the financial
statements instead (in accordance with IAS 1 Presentation of financial statements).
B: 4 Exceptions: No Longer a Going Concern (IAS 10.14 - .16)
IAS 1, which deals with the presentation of financial Going concern

statements, requires that management make an annual
formal assessment of the ability of the entity to continue If the going concern
as a going concern. When assessing the going concern of assumption is no longer appropriate, the
entire financial statements will need to
the entity, management needs to consider events that have
be revised even if these conditions were
occurred right up until the date the financial statements not in existence at year end.
have been authorised for issue! Thus, if it is believed that
the going concern assumption is no longer appropriate, then the financial statements will need
to be completely revised, whether or not the condition was in existence at year-end!
Example B3: Events after the reporting period – various

Finito Limited is currently in the process of finalising their financial statements for the year
ended 31 December 20X2.
The following events occurred / information became available between 1 January 20X3 and
28 February 20X3 (the date the financial statements were authorised for issue):
A. A debtor that owed Finito C110 000 at year-end was in financial difficulties at year-end and, as a
result, Finito processed an impairment loss adjustment of C30 000 against this account. In January
20X3, the debtor’s lawyers announced that it would be paying 40% of all debts.
B. A debtor that owed Finito C150 000 at year-end had their factory destroyed in a labour strike in
December 20X2. As a result, this debtor has filed for insolvency and will probably pay 60% of the
balance owing. Finito was unaware of this debtor’s financial difficulties at 31 December 20X2.
C. Inventory carried at C100 000 at year-end was sold for C80 000 in January 20X3. It had been
damaged in a flood during June 20X2.
D. Current tax expense of C30 000 had been incorrectly debited to revenue in 20X2.
E. Finito had decided in a directors meeting held on 28 December 20X2 to close down a branch in the
Canary Islands. This decision was announced to the affected suppliers and employees via a
newspaper article published on 15 January 20X3.
F. A court case was in progress at 31 December 20X2 in which Finito was the defendant against
claims of radiation from cell phones purchased by a group of customers during 20X2. No
provision was recognised at year-end because Finito disputed the claims made.
The court ruled against Finito on 20 February 20X3 but has not yet indicated the amount to be paid
to the claimant in damages although Finito’s lawyers have now estimated that an amount of
C200 000 will be payable.
There was no inventory of the radioactive cell phones on hand at year-end.
926 Chapter 18
G. A customer lodged a claim against Finito in February 20X3 for food poisoning experienced in
January 20X3. After investigation, Finito found that all cans of berries produced in December 20X2
were poisoned. The claim is for C100 000. The carrying amount of canned berries at
31 December 20X2 is C80 000. Legal opinion is that Finito may be sued for anything up to
C1 000 000 in damages from other customers although a reliable estimate is not possible.
H. Finito declared a dividend on 20 February 20X3 of C30 000.
Required: None of the above events has yet been considered. Explain whether the above events should
be adjusted for or not when finalising the financial statements for the year ended 31 December 20X2. If
the event is an adjusting event, provide the relevant journal entries.
Solution B3: Events after the reporting period – various

A. An adjusting event: the event that caused the debtor to go insolvent occurred before year-end: the
lawyer’s announcement simply provided information regarding conditions in existence at year-end.
20X2 Debit Credit
Receivables: allowance for credit losses (-A) 36 000
Further impairment of receivables: 110 000 x 60% – 30 000
B. An adjusting event: the event that caused the debtor to go insolvent was the strike, which happened
before year-end.
20X2 Debit Credit
Receivables: allowance for credit losses (-A) 60 000
Impairment of receivables: 150 000 x (100% - 60%)
C. An adjusting event: the event that caused the inventory to be sold at a loss occurred before year-
end (the post-reporting period event simply gives more information about the net realisable value
at year-end).
20X2 Debit Credit
Inventory write-down (E) 20 000
Write-down of inventory to net realisable value: 100 000 – 80 000
D. The discovery of this error during the post-reporting date period is an adjusting event since it gives
us more information about a condition that existed at year-end.
20X2 Debit Credit
Revenue (I) 30 000
Correction of error
E. Non-adjusting event: A liability is based on either a legal obligation or present obligation. There is
no legal obligation at year-end to close the factory and there is no constructive obligation at year-
end since the announcement was only made after year-end. The announcement is therefore a non-
adjusting event. If the decision-making ability of the users may be affected by this information,
details of the decision should be disclosed.
F. A liability (present obligation) is based on either a legal obligation or constructive obligation.
There is no evidence to suggest that a constructive obligation existed at year-end and therefore the
situation appears to be based purely on whether a legal obligation existed at year-end.
At year-end, alleged radiation had already taken place (the past event) but Finito was disputing the
related legal claims, and therefore it was not clear whether a present obligation existed. Therefore:
x no provision would have been recognised at year-end since it was considered more likely that
no obligation existed at year-end. See IAS 37.16(b)
x a contingent liability would have been disclosed instead, unless the outflow of economic
benefits was considered to be remote. See IAS 37.16(b)
Chapter 18 927
Solution B3: Continued...

Since the sales of the allegedly radioactive cell phones were made before year-end, we have a past
event that leads to a possible legal obligation at year-end. Where it is not clear that an obligation
exists at year-end, events that occur during the post reporting period must be considered and may
result in us having to deem that an obligation existed at year-end. See IAS 37.15
The court ruling during the post-reporting date period is therefore an adjusting event.
Since the court ruled against Finito, a legal obligation is deemed to exist at year-end. A liability
should therefore be recognised.
The exact amount owed is not available, but an estimate is available: the liability should therefore
be classified as a provision
Since the estimate was made by a team of experts, the estimate is assumed to be reliable: the
definition and recognition criteria are met and therefore the following journal should be processed:
20X2 Debit Credit

Legal costs and damages (E) 200 000
Provision for legal costs and damages (L) 200 000
Provision for legal costs and damages
If the estimate is not considered to be reliable, then a contingent liability would need to be
disclosed in the notes instead.
Please note: Had the court ruling not occurred during the post-reporting period, there would have
been no journal entry to recognise a liability (remember that contingent liabilities are not
recognised) although Finito Limited would have disclosed a contingent liability note instead.
G. The inventory:
Information arising in the post-reporting period that brought to the attention the fact that inventory
at 31 December 20X2 was poisoned, requires an adjustment to the carrying amount thereof (i.e. an
adjusting event) since it is representative of conditions in existence at year-end.
The inventory of poisoned cans on hand at year-end must be written-off:
20X2 Debit Credit
Inventory write-down (E) 80 000
Write-down of inventory to net realisable value:
The claim:
The event that caused the claim was poisoning that occurred in January 20X3, being after year-
end. No provision is raised for this claim since the event that lead to it was poisoning that
occurred after year-end. Any information relating to this claim is therefore a non-adjusting event.
Claims in the post-reporting period due to poisoning that occurred after year-end would therefore
normally be non-adjusting events, but if they are so significant that they could result in Finito
having a going concern problem, then the entire financial statements would need to be adjusted to
reflect this fact (i.e. use liquidation values).
The possible future claims:
Since it is clear, however, that all inventory on hand at year-end was also poisoned, it is evidence
to suggest that there were other instances of poisoning that took place before year-end.
Poisoning that occurred before year-end would lead to an obligation at year-end. The fact that
claims had not yet been received does not alter the fact that an obligation exists (Finito will either
have a constructive obligation through past practice to reimburse customers for poisoning or legal
claims will be lodged against the company which the company will not be able to defend).
928 Chapter 18
Solution B3: Continued...

Whether or not Finito expects claims to be made in connection with poisoning that occurred
before year-end is simply taken into account in the measurement of the liability (using the theory
of probability and expected values): the liability exists.
Although Finito’s lawyers have estimated that Finito may expect claims of up to C1 000 000, this
was not considered to be a reliable estimate.
Since no reliable estimate is possible, the recognition criteria are not met and therefore a provision
may not be recognised. A contingent liability note would be included instead.
H. Non-adjusting event: Since the declaration was announced after year-end, there is no past event
and no obligation at year-end and the declaration is therefore a non-adjusting event. Details of the
dividend declaration must, however, be disclosed (IAS 1) See IAS 10.13.
B: 5 Disclosure: Events after the Reporting Period (IAS 10.17 - .22)
The following information should be disclosed:

x the date that the financial statements were authorised for issue;
x the person or persons who authorised the issue of the financial statements;
x the fact that the financial statements may be amended after issue, if this is the case;
x each material category of non-adjusting event after the end of the reporting period:
the nature of the event; and
the estimated financial effect or a statement that such an estimate is not possible.
Part B: Summary
Events after the reporting period
Events that occur after year-end,

but before the financial statements are
authorised for issue
Adjusting events Non-adjusting events Exceptions

Events that give more Events that give more Where the going concern
information about conditions information about ability of the entity becomes
that were already in conditions that only arose no longer feasible, the
existence at year-end after year-end financial statements need to
be completely revised,
Disclosure may be whether or not this condition
necessary was in existence at year-end
x Make adjustments x No adjustments x Make adjustments

x No extra disclosure x Disclosure may be x Disclosure is necessary
necessary
Chapter 18 929
Gripping GAAP Employee benefits
Chapter 19
Employee Benefits
Reference: IAS 19; IFRIC 14 (updated for any amendments to 1 December 2018
Contents: Page
1. Introduction 931
2. Short-term employee benefits 932
2.1 Overview of short-term benefits 932
2.2 Short-term paid absences 933
2.2.1 Leave taken in the year it was earned 934
2.2.2 Unused leave 934
2.2.2.1 Non-accumulating leave 934
Example 1: Short-term paid leave: non-accumulating: single employee 934
Example 2: Short-term paid leave: non-accumulating: group of employees 935
2.2.2.2 Accumulating leave 935
Example 3: Short-term paid leave: accumulating: vesting vs non-vesting 936
Example 4: Short-term paid leave: accumulating, vesting and non-vesting 937
2.3 Profit sharing and bonus plans 939
Example 5: Bonuses – recognising the bonus payable 939
Example 6: Bonuses – paying the bonus 940
Example 7: Profit sharing as a bonus 940
3. Post-employment benefits 941
3.1 Overview of post-employment benefits 941
3.2 Defined contribution plans 942
Example 8: Defined contribution plans 943
3.3 Defined benefit plans 944
4. Other long-term benefits 946
5. Termination benefits 946
6. Disclosure 948
6.1 Short-term employee benefits 948
6.2 Post-employment benefits 948
6.2.1 Defined contribution plans 948
6.2.2 Defined benefit plans 948
6.3 Other long-term employee benefits 948
6.4 Termination benefits 948
7. Summary 949
930 Chapter 19
1 Introduction
Why do we work? Apart from philosophical reasons (that are unfortunately beyond the scope
of this book), we generally work for rewards.
In the mid 1890’s a Russian scientist, by the name of Ivan Pavlov, began investigating the
gastric function of dogs. He very importantly noticed that dogs tend to salivate before food
was delivered to their mouths. He called this a ‘psychic secretion’. He became so interested
in this phenomenon that his research, which began as a scientific study of the chemistry of
their saliva, mutated into a psychological study and led to the establishment of what is
commonly referred to as ‘conditional reflexes’ or ‘Pavlovian response’.
The answer to ‘why do we work’ lies in this Pavlovian theory of conditional reflexes: we
work since we expect to receive a benefit – a bit like the dog salivating in expectation of food!
The term ‘employee’ includes all categories: full-time, part-time, permanent, casual,
temporary, management, directors and even their spouses or dependants where the benefits
are paid to them.
The benefit we, as employees, expect to receive may be summarised into four categories:
x benefits in the short-term (benefits payable to us while employed and shortly after we
provide the service, e.g. a salary payable within 12 months);
x benefits in the long-term (benefits payable to us while employed but where the benefits
may become payable long after we provide the service, e.g. a long-service award);
x benefits post-employment (i.e. after we have retired from employment e.g. a pension); and
x termination benefits (those that would be receivable if our employment were to be
terminated before normal retirement age (e.g. a retrenchment package).
The definitions of these four categories of employee benefits are as follows:

Employee benefits:
The different types
Short-term Other long-term Post-employment Termination

benefits benefits benefits benefits
EBs that are: All EBs other than: EBs that are: EBs that are payable as a
x expected to be x short-term; x payable after the result of either the:
settled wholly x post-employment; or completion of x entity’s decision to
before 12m after employment terminate employment
x termination benefits
the end of the See IAS 19.8 x other than: before normal
period retirement date; or
short-term employee
x in which the benefits x the employee’s
employees render decision to accept an
termination benefits
the related service offer of benefits in
See IAS 19.8
x other than: exchange for
termination benefits termination of
See IAS 19.8 employment See IAS 19.8
Employee benefits include settlements made to both past and present employees. Benefits
given to an employee’s spouse, children or others in exchange for services provided by that
employee would be considered to be a benefit given to that employee.
Employee benefits apply to any type of settlement, with the exception of IFRS 2: Share based
payments. Thus, employee benefits only include settlements an entity makes in the form of:
x cash (e.g. cash salary);
x goods (e.g. free products); or
x services (e.g. free medical check-ups).
Chapter 19 931
Post-employment benefits are usually provided under either:

Employee benefits are
x defined contribution plans; or
defined as:
x defined benefit plans.
x All forms of consideration
IAS 19 requires a lot of disclosure for defined benefit plans x Given by an entity
whereas little or no disclosure is required for other types of x in exchange for:
employee benefits. There are, however, disclosure service rendered by employees or
requirements that emanate from other standards such as: the termination of employment.
IAS 19.8 (reworded)
x IAS 1 Presentation of Financial Statements:

- requiring disclosure of the employee benefit expense;
x IAS 24 Related Party Disclosures:
- requiring disclosure of each type of benefit provided to key management personnel;
x IAS 37 Provisions, Contingent Liabilities and Contingent Assets:
- which may require a contingent liability to be disclosed upon termination of employee services.
In addition to the other standards that require disclosure relating to employee benefit/s, other
related disclosure may also be required due to the requirements of the Companies Act, the
JSE Listing Requirements and King IV (see principle 14 regarding remuneration reports).
2 Short-Term Employee Benefits (IAS 19.9 – 19.25)
2.1 Overview of short-term benefits

Short-term employee benefits are benefits that are expected to be settled wholly before twelve
months after the end of the reporting period in which the employees provided the service. See IAS 19.8
The following is an overview of the 4 categories of short-term benefits:
Short-term benefits
Wages, salaries and Paid leave Profit sharing and/or Non-monetary benefits
Note 1
social security (e.g. annual/sick bonuses
contributions leave) (e.g. a car, medical care,
(e.g. medical aid) housing & free/subsidised
goods/services)
Note 1: For current employees only (e.g. excluding non-monetary benefit given to a past employee)
Short-term benefits are recognised when the employee renders the service (this is the accrual
concept). This means that:
x an expense is recognised (debit); and
x bank is reduced (credit) to the extent that it is paid, or a liability is recognised (credit) to
the extent that any amount due has not been paid.
In the case of non-monetary assets, items such as ‘free or cheap’ housing, lunches, weekends
(etc) are straight-forward (debit employee benefit, credit bank). But the free use of a car has
caused some debate. The car is a depreciable asset, which thus involves depreciation and
other related costs such as maintenance. It is submitted that these costs be recorded in the
usual manner and then a portion of all these car-related expenses be transferred to employee
benefit expense. Note that IAS 1 requires that depreciation be separately presented.
Measurement of the short-term employee benefit is relatively simple because:
x no actuarial assumptions are required to measure either the obligation or the cost; and
x no discounting is applied to short-term employee benefit obligations (simply because, by
definition, the time between receiving the service and the payment of the benefit is short).
IAS 19 does not require any disclosure of a short-term benefit although other standards may
require certain limited disclosure. This is covered in the section on disclosure (section 6).
932 Chapter 19
The accrual approach is evident in the following journals, shown below.
Step 1: The employee benefit is raised as a liability when incurred: Debit Credit
Employee benefit expense xxx

Account payable (e.g. wages payable) (L) xxx
Recognising short-term employee benefits incurred (e.g. wages)
Step 2: When the benefit is paid, the journal entry is: Debit Credit

Bank xxx
Payment of short-term employee benefit (e.g. wages)
Step 3: If the expense has been underpaid, there will be a credit balance on the account
payable. But if the expense has been overpaid, there will be a debit balance on the account
payable. If an overpayment cannot be recovered from the employee (e.g. the employee is not
obligated to return the cash, or a future payment to the employee may not be reduced by the
overpayment) then the overpayment (which will be reflected as a debit balance in, for
example, the wages payable account) is expensed:
Debit Credit
Over-payment of short-term employee benefit (e.g. wages) expensed
It is also possible that another standard allows or requires that the employee cost be
capitalised instead of expensed. This may happen if, for example, an employee is used on the
construction of another asset such as inventory. In this case, the benefits payable to this
employee (or group of employees) will be capitalised to inventory (IAS 2) instead of
expensed (see Step 1 above).
Debit Credit
Inventory (or other asset) xxx
A portion of the short-term employee benefit expense relating to
inventory manufacture is included in the cost of inventories
Whereas we are all probably capable of processing the journals for wages (or salaries
etcetera), the following other types of short-term benefits warrant a bit more attention:
x short-term paid absences;
x profit sharing and bonuses.
2.2 Short-term paid absences (IAS 19.13 – 19.18)
Short-term paid absences can
either be: See IAS 19.14
Short-term paid absences are also referred to as
short-term paid leave. The term effectively refers to x accumulating; or
x non-accumulating
a type of leave entitlement where an employer
This affects whether a liability is recognised.
continues to pay his employee during certain
periods in which the employee takes leave (i.e. is Accumulating leave can either be:
x vesting; or
absent) from work. For example, an employer may x non-vesting. See IAS 19.15
offer its employees 10 days annual leave per year. This affects the measurement of the liability.
Short-term paid absences are categorised as either:

x accumulating paid absences, which can be carried forward and used in a future period; or
x non-accumulating paid absences, which are forfeited if unused at period end.
Accumulating paid absences can be either:

x vesting, which means it may be converted into cash if unused; or
x non-vesting, which means it may not be converted into cash if unused.
Chapter 19 933
If the leave is vesting leave, the possibility that an employee may resign, for example, before
having taken all his accumulative leave will not reduce the amount of the obligation (liability)
that should be recognised. This is because all untaken leave on the date that the employee is
no longer employed by the entity would then have to be paid to the employee in cash. Thus,
the measurement of the liability for leave is simply based on all the accumulative leave
currently owed to the employee.
If the leave is non-vesting, however, any leave that was owed to an employee but which the
employee had not yet taken by the time that he/she was no longer employed by the entity will
be forfeited. Thus, if the leave is non-vesting, the probability that the employee may resign,
for example, before taking his leave must be taken into consideration when measuring the
leave-pay liability. In other words, if accumulative leave owed to an employee is non-vesting
leave, the leave-pay liability would be lower than if the leave owed to that employee had been
vesting leave.
In summary, a liability to pay the employee for unused leave may need to be recognised: the
decision on whether to recognise this leave-pay liability depends on whether the leave is non-
accumulating (there is no obligation and thus no liability is recognised) or accumulating
(there is an obligation and thus a liability is recognised). If the leave is accumulating leave,
our next step is to measure the amount of the liability to be recognised, which involves
considering whether it is vesting or non-vesting.
The concept of leave is explained in more detail below.
2.2.1 Leave taken in the year it was earned
When an employee takes leave from work, the cost of this employee’s short-term absence is
recognised as part of his salary expense (no separate adjustment is required). For example, if
you were to take paid annual leave, your salary would be paid to you while you were on
holiday: there would be no extra amount owing to you and thus the leave that you have taken
is simply absorbed into the usual salary expense journal (i.e. there is no extra journal entry).
2.2.2 Unused leave
If leave was earned by an employee during the year but was not taken by the employee, a
distinction will need to be made between whether the leave was:
x non-accumulating: where unused leave cannot be carried forward (i.e. it falls away if not
used in the current period); or
x accumulating: where unused leave can be carried forward to another period.
2.2.2.1 Non-accumulating leave (IAS 19.13 - .14 & .18)

The cost of giving employees short-term paid leave that is non-accumulating is simply recognised
when the leave is taken. In other words, we recognise the salary expense as usual despite the
employee not being at work. We do not recognise a liability for any non-accumulating leave that
may be currently owed to an employee. The reason for not recognising a liability for non-
accumulating leave is that, if an employee fails to take all the non-accumulating leave that he earned
during the year, his unused leave would simply be forfeited (i.e. the employee would simply lose his
rights to take that leave and would not be entitled to receive a cash payment in lieu thereof). Thus,
since the entity has no obligation to let the employee take this unused leave in future years or to pay
him out, the definition of a liability is not met and thus a leave-pay liability is not recognised.
Example 1: Short-term paid leave: non-accumulating: single employee
Mitch Limited has one employee. His name is Guy.
x Guy is owed 22 days leave per year.
x Guy is paid C90 000 per year.
x The year is 365 days and Guy is expected to work 5 days a week.
x Guy took 8 days leave in 20X1. Guy’s leave is non-accumulating.
Required: Show all journals and calculate any leave pay liability at the 31 December 20X1 year-end.
934 Chapter 19
Solution 1: Short-term paid leave: non-accumulating leave: single employee

No leave pay liability is recognised at 31 December 20X1 for the 14 days that Guy did not take (of the
22 days leave that was offered to Guy, 8 days were used and thus 14 days remained unused). This is
because the leave is non-accumulating, which means that Mitch Limited is not obliged to give him this
leave (i.e. Guy simply forfeits/loses whatever leave that he does not take in a year).
The following journal relating to Guy’s salary would be processed as 12 individual journals over the
year (90 000 / 12 = 7 500 per month).
Debit Credit
Employee benefit expense (E) Total salary processed over the year 90 000
Salaries payable (L) 90 000
Salary owed to Guy for 20X1 (includes leave taken)
Comment: When leave is non-accumulating, it means that any leave that is not taken at year-end simply falls away
and thus the entity has no obligation to provide the employee with this leave. Since there is no obligation, there
can be no liability (since the definition of a liability is not met) and thus a leave-pay liability is not recognised.
Example 2: Short-term paid leave: non-accumulating: group of employees

Lee Limited operates a five-day working week. At Lee Limited’s financial year ended 31
December 20X4 (a year with 365 days):
x there were 50 similarly paid employees
x each earning an average annual salary of C50 000
x and earning 20 days annual leave per year of service.
The leave entitlement of 20 days is non-accumulating and has remained the same for years
and will remain the same for years to come. Similarly, the salary of C50 000 has remained
unchanged for years and no significant changes are expected in the next few years.
The following are the actual average leave statistics to date:
x end of prior year 20X3: an average of 10 days was used, all earned in 20X3
x end of current year 20X4: an average of 12 days was used, all earned in 20X4
The estimated future leave statistics for the year ended 31 December 20X5:
x an average of 14 days will be taken, all earned in 20X5
Required: Calculate the leave pay liability for Lee Limited’s financial year ended 31 December 20X4
assuming that the annual leave does not accumulate. Ignore public holidays.
Solution 2: Short-term paid leave: non-accumulating: group of employees

Comment: This example is similar to example 1, with the difference being that the measurement of the leave-pay liability in
this example involves a group of employees whereas the measurement in example 1 involved an individual employee.
Leave that is taken is simply recognised as part of the salary of C50 000 (which would have been
debited to salaries and credited to bank over the year).
The employees lost an average of 10 days each in 20X3 (20 – 10 days) and 8 days in 20X4 (20 – 12
days taken). Non-accumulating means that the entity is not obliged to allow the employee to take any
of the unused leave in the future and thus the leave that was not taken at the end of the period is
forfeited. Since the entity has no obligation, the definition of a liability is not met, and thus we do not
recognise a leave-pay liability at 31 December 20X4 to account for the leave that was not taken.
2.2.2.2 Accumulating leave (IAS 19.13 - .16)

Whereas non-accumulating leave is effectively recognised when the leave is taken (with no
liability recognised for any leave that the employee might have earned but not taken),
accumulating leave is recognised as an obligation when the employee renders the service that
increases their entitlement to leave. See IAS 19.13
If an employee fails to take all the leave that was owing to him and this leave is accumulating
leave, the unused leave will continue to be owed to the employee. Since the entity has an
obligation to allow the employee to take the unused leave in future years, a liability for
unused leave must be recognised. This liability is recognised when the employee has
rendered the service that entitles him to that leave.
Chapter 19 935
The measurement of this leave-pay liability depends on how many days are owing multiplied
by what his average salary per day is expected to be when he takes this leave. The reason for
using the future salary per day is because the entity will effectively be losing this future value
on the days that the employee eventually does stay away from work.
The measurement of the leave-pay liability for accumulating leave is also affected by whether the leave is:
x vesting: unused leave can be taken in the future or can be exchanged for cash when
leaving the entity; or
x non-vesting: unused leave can be taken in the future but cannot be exchanged for cash.
If the leave is accumulating but non-vesting and the employee leaves (e.g. resigns or retires)
before taking all of his accumulative leave, the entity would not need to pay the employee out
for the unused leave. This possibility needs to be considered when measuring this leave-pay
liability (i.e. a liability for unused accumulating leave that is non-vesting would possibly be
measured at a lower amount than if the leave was vesting).
Example 3: Short-term paid leave: accumulating: vesting versus non-vesting
Mark Limited has one employee. His name is Scott.
x Scott is paid C365 000 per year, but this is expected to increase by 10% in 20X2.
x The year is 365 days and Scott is expected to work 5 days a week.
x Scott is owed 30 days leave per year.
x Scott took 20 days leave in 20X1. Scott’s leave is accumulating.
Mark Limited’s financial year-end is 31 December 20X1.
Required: Calculate the leave pay liability at 31 December 20X1, if any, and show all journals assuming:
A. the leave is accumulating and vesting (i.e. Scott is entitled to convert his unused leave into cash):
experience suggests that Scott will only take 90% of his unused leave balance before he finally
either resigns or retires from Mark Limited;
B. the leave is accumulating and non-vesting (i.e. Scott may not convert unused leave into cash):
experience suggests that Scott will only take 90% of his unused leave balance before he finally
either resigns or retires from Mark Limited;
C. the leave is accumulating for a limited period and non-vesting: it accumulates for one year only
after which unused leave will be forfeited: experience suggests that Scott will take 3 days leave in
20X2 from his 20X1 leave entitlement carried forward.
Solution 3: Short-term paid leave: accumulating: vesting versus non-vesting

The leave-pay liability is based on the expected daily cost of employing Scott.
The cost per day is calculated as:
x Average salary per day: (C365 000 x 110%) / 365 days = C1 100
x Effective cost per day: C1 100 x 7/ 5 = C1 540 (since he not required to work every day but rather
5 days out of every 7 days, the effective cost per day is a little higher)
Or: (C365 000 x 110%) / (365 / 7 x 5) = C1 540
Ex 3A Ex 3B Ex 3C
Debit/ Debit/ Debit/
(Credit) (Credit) (Credit)
Employee benefit expense (E) Total salary for the year 365 000 365 000 365 000
Salaries payable (L) (365 000) (365 000) (365 000)
Salary owed to Scott for 20X1 (includes leave taken) NOTE 1
Employee benefit expense (E) A: W1; B: W2; C: W3 15 400 13 860 4 620
Leave-pay liability (L) (15 400) (13 860) (4 620)
Leave still owing to Scott at 31 December 20X1
Note 1: The salary journal would, in reality, be processed as 12 individual journals over the year
(365 000 / 12 = 30 416)
W1: (30 – 20 days) x 100% x C1 540 per day = 15 400
The average cost per day is multiplied by the total number of outstanding days since Scott
will either take this leave or be paid out for it. In other words, the fact that he will probably
only use 90% of his leave is irrelevant since he would then be paid for the remaining 10%.
Thus, the entity must recognise the liability based on 100% of the leave owing.
936 Chapter 19
W2: (30 – 20 days) x 90% x C1 540 per day = 13 860

The average cost per day is multiplied by the total number of outstanding days that Scott
will probably take as leave (since the leave is non-vesting, the 10% leave that will probably
remain unused when he either retires or resigns will not be paid out and will thus be lost).
W3: 3 days x C1 540 per day = 4 620
The average cost per day is multiplied by the total number of outstanding days that Scott
will probably take as leave (since the leave is non-vesting leave, the leave that will probably
not have been taken by the end of 20X2 will not be paid out in cash and will thus be lost).
Comment:
x The measurement of the liability is based on the expected cost when the leave is expected to be
taken – since the leave is expected to be taken in 20X2, the expected salary in 20X2 is used.
x The principle applied in A, deals with vesting leave: since the leave is vesting, the liability is
measured based on the total unused leave, irrespective of how many days the company is expecting
Scott to be able to take – this is because the company is obliged to pay Scott for any unused leave.
x The principle applied in B and C is the same: since the leave is non-vesting, the liability recognised
is measured only on the leave that the company is expecting Scott to take.
In practice, there are many more employees than just one employee. It is normally impractical
to estimate the amount of the leave pay obligation relating to each employee and this is
therefore estimated on an average basis. When measuring the leave-pay liability on an
average basis, we will need to:
x identify the number of employees within a certain salary/ leave bracket;
x calculate the average salary per employee within this salary bracket;
x calculate the average employee salary per day; and then
x estimate the average days leave that the entity owes each employee at year-end (either in
days or in cash).
The leave-pay liability will therefore be:

x the estimated average days leave owing per employee,
x multiplied by the average employee salary cost per day.
Example 4: Short-term paid leave: accumulating, vesting and non-vesting

Lee Limited operates a five-day working week. At Lee Limited’s financial year ended
31 December 20X4 (a year with 365 days):
x there were 50 similarly paid employees
x each earning an average annual salary of C50 000 and
x each earning 20 days annual leave per year of service.
The leave entitlement of 20 days has remained the same for years and will remain the same
for years to come. Similarly, the salary of C50 000 has remained unchanged for years and
no significant changes are expected in the next few years.
The following are the actual average leave statistics per employee:
x end of prior year 20X3: an average of 10 days of the 20X3 leave were unused
x end of current year 20X4: an average of 12 days was used, coming from, on average:
- the 20X3 leave entitlement: 4 days
- the 20X4 leave entitlement: 8 days.
The estimated future leave statistics per employee for the year ended 31 December 20X5:
x an average of 14 days will be taken and on average this is expected to come from:
- 20X3: 0 days (The 20X3 leave days cannot be taken in 20X5 as they expired at the
end of 20X4)
- 20X4: 5 days
- 20X5: 9 days
Ignore public holidays.
Required: Calculate the leave-pay liability for Lee Limited’s financial year ended 31 December 20X4 if:
A. annual leave is carried forward and available for use in the next financial year (i.e. accumulating)
and is paid out in cash at the end of the next financial year if not used (i.e. vested).
B. annual leave is carried forward to the next financial year (i.e. accumulating) but simply expires if
not used by the end of the next financial year end (i.e. non-vesting).
Chapter 19 937
Solution 4A and B: Short-term paid leave

Comment:
x This example involves a calculation for a group of employees rather than for just one employee.
x No leave relates to 20X3 as all this leave was either paid out or expired at the end of 20X4.
The average rate per actual day is:
C50 000 / 365 = C136.99 per actual day
But, only 5 out of 7 days are worked, therefore, the effective rate per working day is actually higher:
C136.99 x 7 / 5 days = C191.78 per working day
Or: C50 000 / (365 / 7 x 5) = C191.78 per working day
Solution 4A: Short-term paid leave – accumulating and vesting

Total liability to be recognised at 31 December 20X4:
= 20X3 leave: C0 + 20X4 leave: C115 068 + 20X5 leave: C0 = C115 068
Explanation and calculations:
x 20X3 unused leave: No obligation; (C191.78 x 0 days x 50 employees = 0)
There were 10 days still due to the employee at 31 December 20X3 (given) for which a liability
would have been recognised at 31 December 20X3:
x 4 of these days were then taken in 20X4 and
x the remaining 6 days from 20X3 would then have been paid out on 31 December 20X4.
However, no liability is recognised at 31 December 20X4 in respect of 20X3 leave because
unused leave will have been used or paid out in full by 31 December 20X4. Thus, there is no
further obligation regarding this leave.
x 20X4 unused leave: Obligation for 12 days leave; (C191.78 x 12 days x 50 employees = C115 068)
There were 12 days still due to the employee at 31 December 20X4 (20 days – 8 days used from
the 20X4 entitlement): the entity is obliged to either allow the employees to take this leave in
20X5 or to pay the employees out for any unused leave on 31 December 20X5.
x 20X5 expected unused leave: No obligation; (C191.78 x 0 days x 50 employees = 0)
Since the 20X5 leave has not yet been earned by the employees (the services in 20X5 have not yet
been provided by the employees), there is no past event that obligates the entity to provide any of
the 20X5 leave. If there is no past event, there can be no obligation at 31 December 20X4.
Solution 4B: Short-term paid leave – accumulating and non-vesting

Total liability to be recognised at 31 December 20X4:
20X3 leave: C0 + 20X4 leave: C47 945 + 20X5 leave: C0 = C47 945
Explanation and calculations:
x 20X3 unused leave: No obligation; (C191.78 x 0 x 50 = 0)
There were 10 days still due to the employee at end of 20X3:
x 4 of these days were taken in 20X4 and
x the remaining 6 days from 20X3 would have been forfeited at the end of 20X4.
No liability is recognised at 31 Dec 20X4 in respect of 20X3 leave since unused leave will have been
used or forfeited by 31 Dec 20X4. Thus, there is no further obligation regarding this leave.
x 20X4 unused leave: Obligation for 5 days leave - (C191.78 x 5 days x 50 employees = C47 945)
The employee is owed 20 days leave per year. Of the 20 days owed to the employee in 20X4, 8 days
were taken as leave in 20X4 (note: another 4 days were also taken, but these came out of the 20X3
leave entitlement). This means that at 31 December 20X4, the entity owes the employee another 12
days. Since the employee has already rendered the service that entitles him to this leave, a past event
has occurred and there is therefore an obligation at 31 December 20X4. A liability must therefore be
recognised at 31 December 20X4 for unused leave.
Because the leave is non-vesting, however, any leave that is not used will not be paid out in cash. As
a result, the liability must be measured based on the number of 20X4 days that the employee will
probably take in 20X5: only 5 days – not the full 12 days (we are therefore expecting that the
employees will forfeit an average of 7 days of their 20X4 leave: 20 – 8 – 5 days = 7 days).
938 Chapter 19
Compare this to part A where the liability was based on the full 12 days since the terms of part A’s
leave entitlement was that the employee would be paid out for every day that he does not take.
Although the entity will not be paying the employee out in cash, the cost to the entity is still C191.78
per day since the entity will effectively lose this value on the days that the employee stays at home.
The liability to be recognised = C191.78 x 5 days (20X4 unused leave expected to be used in 20X5)
x 50 employees = C47 945
x 20X5 expected unused leave: No obligation - (C191.78 x 0 days x 50 employees = 0)
The 20X5 leave entitlement of 20 days of which 9 days will probably be taken in 20X5 is ignored
since the employee has not yet provided the 20X5 services that would entitle him to the 20X5 leave.
Since there is no past event (services rendered) there is no present obligation. No liability is therefore
recognised for any of the 20X5 leave entitlement.
2.3 Profit sharing and bonus plans (IAS 19.19 – 19.25)
Profit sharing or bonuses given to employees as a reward for services rendered are also
considered to be employee benefits. If these are payable within 12 months of the year-end in
which the employee provided the services, these would be considered to be short-term
employee benefits (otherwise they would be other long-term employee benefits).
Recognition of these benefits should only occur when:

x there is a present obligation at year end (i.e. settlement cannot realistically be avoided);
x resulting from a past event (the provision of the agreed upon services); and
x the obligation can be reliably estimated. See IAS 19.19
The obligation can be either be a legal obligation or constructive obligation. For instance:
x a legal obligation would arise if the employment contract detailed the profit-sharing or
bonus arrangement, and if all conditions of service were met;
x a constructive obligation could arise if the entity created an obligation for itself through,
for instance, a past practice of paying bonuses (or sharing in profits). Therefore, even
though the employment contract may be silent on such profit-sharing or bonuses (in
which case there would be no legal obligation), it is possible for the entity to create a
constructive obligation through its past practices, policies, actions or public
announcements etc.
In accordance with IAS 19.22, a reliable estimate can

Bonus schemes that are
only be made if the: either:
x the formal terms of the plan contain a formula for
determining the amount of the benefit; x Settled in the entity’s own shares; or
x entity calculates these payments before authorising x based on, or determined in relation to
the entity’s share price
the financial statements for issue; or x are not within the scope of IAS 19,
x past practice gives clear evidence of the amount of but IFRS 2.
the entity’s constructive obligation.
A characteristic of profit sharing and bonuses are that they often accrue over a period of time,
and may end up being only partially earned or even forfeited if an employee resigns before
the payment date. This characteristic will impact on the measurement of the liability: the
probability that the employee/s may leave before they become entitled to the benefit must be
factored into the calculation.
Example 5: Bonuses – recognising the bonus payable

During 20X2, Luke Limited created an obligation to pay a bonus of C120 000 to each
employee:
x There were 6 employees at 1 January 20X2, and
x 2 more employees were hired on 1 April 20X2 (i.e. 8 employees at
31 December 20X2).
x It was expected that 3 employees would resign during 20X3.
Chapter 19 939
Required: Measure the liability to be recognised in the financial statements of Luke Limited for the
year ended 31 December 20X2 and show the journal if the terms of the agreement are such that:
A. the bonus accrues to those employees still employed at year-end (31 December 20X2);
B. the bonus accrues proportionately based on the number of months worked during 20X2;
C. the 20X2 bonus accrues only if the employee is still employed at 31 December 20X3.
Solution 5: Bonuses – recognising the bonus payable

Comment: this example highlights the importance of understanding the exact terms of the obligation.
A slight alteration of the terms can have a significant outcome on the amount of the liability.
Liability balance at year-end: Calculation C
Part A: 120 000 x 8 employees 960 000
Part B: 120 000 x 6 employees x 12 / 12 + 120 000 x 2 employees x 9 / 12 900 000
Part C: 120 000 x (8 – 3 employees) 600 000
Ex 5A Ex 5B Ex 5C
31 December 20X2 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Employee benefit expense (E) 960 000 900 000 600 000
Bonuses payable (L) (960 000) (900 000) (600 000)
Bonuses provided for
Example 6: Bonuses – paying the bonus

Assume the same information as that in the previous example together with the following
additional information:
x The C120 000 bonus accrued to each of those employees who were still employed on
31 December 20X3 (i.e. example 5C).
x No employees resigned during 20X3 and the bonus was paid on 31 December 20X3.
Required: Show the journals to be processed by Luke Limited for the year ended 31 December 20X3.
Solution 6: Bonuses – paying the bonus

Comment: this example emphasises that, when recognising and measuring the bonus, the initial
obligation to pay the bonus and the payment of the bonus, are separate economic events.
Employee benefit expense (E) 8 x 120 000 – 600 000 360 000
Bonuses payable (L) 360 000
Increase in 20X2 bonus payable
Bonuses payable (L) 8 x 120 000; OR 960 000
Bank (A) 600 000 + 360 000 960 000
Payment of 20X2 bonuses at 31 December 20X3
Example 7: Profit sharing as a bonus

John Limited has 5 directors at 31 December 20X2 with whom it has employment contracts
that provide for a 20% share each of the 10% of the profits that exceed a pre-determined
target – which is set at the end of each year for the next year’s profit sharing calculation.
x At 31 December 20X1 it was decided that the target profit for 20X2 was C1 000 000.
The actual profit achieved in 20X2 was C1 200 000.
x The targeted profit for 20X3, set on 31 December 20X2, is C1 400 000. Before the
20X2 financial statements were authorised for issue it looked probable that this profit
target will also be achieved.
Each of the directors still employed on 31 March of the year after the target is achieved is
entitled to their 20% of the total 10% profit share.
Required: Journalise the liability in the financial statements at 31 December 20X2 assuming:
A. John expects that no directors will resign before 31 March 20X3.
B. John expects that one director will resign before 31 March 20X3.
C. John pays the bonus to all of its employees, (i.e. not just 20% of the 10% excess to each of its
directors), who are still employed by the end of the next year. It is estimated that 10% of the
employees will leave during the next 12 months.
940 Chapter 19
Solution 7: Profit sharing as a bonus

Ex 7A Ex 7B Ex 7C
31 December 20X2 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Employee benefit expense (E) 20 000 16 000 18 000

Bonuses payable (L) (20 000) (16 000) (18 000)
Recognising a liability for bonus based on profit-sharing
W1 (A): 10% x (1 200 000 – 1 000 000) x 5/5 = 20 000
The entire 10% profit share is expected to be paid since no directors are expected to resign
before 31/3/20X3
W2 (B): 10% x (1 200 000 – 1 000 000) x 4/5
Only 4/5 (80%) of the 10% profit share is expected to be paid since 1 director is expected
to resign before 31/3/20X3, leaving only 4 out of the original 5 directors employed.
W3 (C): 10% x (1 200 000 – 1 000 000) x 90%
Only 90% of the 10% profit share is expected to be paid since only 90% of current
employees are still expected to be employed on 31/3/20X3. The bonus that relates to the
10% of employees that left is not redistributed to the remaining employees as it was earned
by the 10% that had left, and not the remaining 90%.
Comment: Did you notice that no liability is recognised for the expected profit share related to the 20X3 targeted
profit (in part A, B or C)? This is because, even though it seems probable that the target will be met, the profit
share depends on the actual and final achievement of the profit – this has not yet happened and therefore there is no
past event and therefore there is no present obligation at 31 December 20X2.
3 Post-Employment Benefits (IAS 19.26 – 19.152)
3.1 Overview of post-employment benefits

If the employee remains employed by the entity until normal retirement age (i.e. does not
terminate his employment before this date) he may be entitled to further benefits. Since these
benefits would accrue while he was no longer employed, they would be referred to as ‘post-
employment’ benefits. Examples of these benefits: pensions, medical and life insurance.
It is important to note that it is the services that he provided whilst employed that entitle him
to these benefits after employment. Therefore, the services that he provided whilst employed
are considered to be the past event for which the entity has an obligation.
Since the obligation arises (accrues) during the employee’s work-life, the journal recognising
the obligation and related cost must be processed as and when the services are provided:
Debit Credit
Employee benefit expense (E) xxx
Post-employment benefits (L) xxx
Post-employment benefit obligation arising during the current year
As mentioned in the introduction to this chapter, post-employment benefits are either:

x defined contribution plans; or
x defined benefit plans.
The classification will affect the measurement of the obligation. If the plan is a defined
contribution plan, the entity’s obligation ‘is limited to the amount that it agrees to contribute
to the fund’. In the case of a defined benefit plan, the obligation is a lot harder to measure
since the benefit is usually based on many unknown factors, such as the salary of the
employee on the date he retires, and the number of years of service he provided to the entity.
The classification of the plan as either a defined contribution plan or a defined benefit plan
depends on whether the entity has an obligation (legal or constructive) to fund any possible
short-fall that the plan might experience.
Chapter 19 941
In the case of a defined benefit plan, it is the entity who bears the risk for any possible shortfall,
whereas in the case of a defined contribution plan, it is the employee who bears the risk.
These risks are categorised as:

x the actuarial risk, which is the risk that the benefits are less than expected; and
x the investment risk, which is the risk that the assets invested will be insufficient to fund
the expected benefits. See IAS 19.28.
Classifying a post-employment benefit plan as either a defined contribution plan or a defined benefit
plan can be complicated in practice. This is because the entity might have entered into an agreement
that commits it to not only making certain contributions towards a post-employment plan, but also
opening itself up to an obligation to fund a certain level of the benefits. In such cases, the
classification must be based on the concept of substance over form. In this regard, if the agreement
(which could be legal or constructive) results in the entity:
x having an obligation to make contributions to a plan, then it is a defined contribution plan.
x having an obligation to pay benefits to the ex-employee, then it is a defined benefit plan.
Defined contribution plans are easier to recognise, measure and require almost no disclosure
whereas defined benefit plans are more complex to measure and thus require lots of disclosure.
The post-employment plan may be a simple single employer plan or may be a:

x multi-employer plan: explained in IAS 19.32-37;
x group administration plan: explained in IAS 19.38;
x common control shared-risk plan: explained in IAS 19.40-42;
x state plan: explained in IAS 19.43-45; or an
x insured benefit plan: explained in IAS 19.46-49.
The classification of such plans as defined contribution plans or defined benefit plans,
although not complicated, is not covered further in this chapter. Instead, this chapter focuses
on single-employer plans only.
3.2 Defined contribution plans (DCP) (IAS 19.50 – 19.54)
The term ‘defined contribution plan’ is defined in IAS 19
Defined contribution plans
(please see the definition alongside). Essentially, these
are defined as:
plans are post-employment benefit plans in which the
x post-employment benefit plans
entity (and possibly also the employee) agrees to make
x under which an entity
contributions to a separate entity (fund). On resignation pays fixed contributions into a
or retirement, the contributions together with any gains separate entity (a fund), and
(or less any losses) are paid to the employee. will have no legal or constructive
obligation to pay further
What is important is that defined contribution plans limit contributions if the fund does not
hold sufficient assets to pay all
the entity’s obligation: the entity is only obliged to pay employee benefits relating to
the contributions in terms of the agreed plan (these are employee service in the current and
paid to a separate entity that runs the plan). The entity is prior periods. See IAS 19.8
not responsible for any possible shortfall that may arise in the plan and, conversely, has no
claim to any gain that may arise.
Defined contribution
Thus, the economic substance of a defined contribution
plans:
plan is that:
x the entity’s obligation is limited to the agreed upon x involve payments to a separate entity
contributions; and (a fund, usually independently
x the employee carries the risk (e.g. the risk that the administered);
benefits will be less than expected). x limit the entity’s obligation to
contributions payable; and
x burden the employee with the risks.
The amounts recognised in the entity’s accounting
records are simply the contribution paid/ payable by the employer to the defined contribution
fund. This contribution is expensed.
942 Chapter 19
The journal is as follows:

Debit Credit
Employee benefit expense (E) xxx
Contributions payable (L) xxx
Post-employment benefit: defined contributions provided for
As already explained (see section 3.1), the post-employment benefit expense and related
liability is recognised as and when the employee provides the services.
The measurement of the liability to be recognised is really easy since:
x no actuarial assumptions are needed; and
x it is normally undiscounted (although we will need to discount contributions if they are
payable after 12 months from the end of the period in which the employee provides the
service, where it would be discounted using a rate determined by reference to market
yields at the end of the reporting period on high quality corporate bonds).
Example 8: Defined contribution plans

Matthew Limited’s annual salary expense for 20X4 is as follows:
x gross salary of C4 000 000, of which:
x C1 200 000 is employees’ tax, which was withheld (payable to the tax authorities)
x 7% was withheld, payable, on behalf of the employee, to a defined contribution plan
x the balance thereof was payable to the employees;
x company contributions to the defined contribution plan: 10% of gross salaries.
Required:
Show the journals and the profit before tax note for Matthew’s financial year ended 31 December
20X4. Show the journals on an annual basis (i.e. these are normally processed monthly).
Solution 8: Defined contribution plans

Employee benefit expense (E) Given 4 000 000
Current tax payable: employees tax (L) Given 1 200 000
Defined contributions payable (L) 4 000 000 x 7% 280 000
Employees payable (L): net salary Balance (paid to the employee) 2 520 000
Gross salaries for the year: payable to tax authorities, DCP & employees
Employee benefit expense (E) 4 000 000 x 10% 400 000
Defined contributions payable (L) 400 000
Matthew’s (the employer’s) contribution to the defined contribution plan
Matthew Limited
20X4 20X3
Profit before tax is stated after taking into account the following disclosable expenses/ (income):
x Employee benefit expenses 4 000 000 + 400 000 4 400 000 xxx
Included in employee benefit expenses are the following:
x Defined contribution plan costs Employer contribution only 400 000 xxx
Comment:
x Both the employer and the employees contributed to the plan: the employees contributed C280 000 over the
year whereas the employer contributed C400 000.
x Both the employees’ and the employer’s contributions (280 000 + 400 000, respectively) are included in the
total employee benefit expense (this expense is disclosable in terms of IAS 1).
x The entity’s cost relating to the defined contribution plan (DCP) must be disclosed (IAS 19.53), being the
400 000. The 280 000 contribution is a cost relating to the DCP that was incurred directly by the employees
(who effectively paid 280 000 out of their salaries of 4 000 000) and not directly by Matthew Ltd.
Chapter 19 943
3.3 Defined benefit plans (DBP) (IAS 19.26 & .55 - .152)
Where an entity guarantees (promises) that it will pay certain Defined benefit plans are
specific benefits to its employees after employment, we have defined as:
a ‘defined benefit plan’ (e.g. a pension fund). This is quite
x Post-employment benefit plans
different to an entity that simply commits to paying x Other than defined contribution plans.
contributions to an external fund, where it is then the IAS 19.8
responsibility of the external fund to pay the benefits to the

employee after employment (i.e. a ‘defined contribution
plan’ See section 3.2). Defined benefit plans:
x the entity has the obligation to pay

Thus, when an entity offers a ‘defined benefit plan’, it opens agreed-upon benefits, & thus
itself up to an obligation that is potentially much bigger than x the entity bears the risks.
simply the payment of future contributions to a fund, where
the fund would be responsible for paying the benefits (e.g. entities offering defined benefits often
promise pension payments that will be a percentage of the
employee’s last salary, where this last salary may be far The plan obligation balance
greater than originally expected). is measured as the:
x present value of the
In the case of defined benefit plans, the entity is required x future expected outflows based on
x actuarial assumptions at year-end.
to set aside assets so that it will be able to settle the
obligation in the future.
Plan assets must: See IAS 19.8
Defined benefit plans expose the entity to risks:
actuarial risk (the risk that the promised ‘benefits will be x be held in a fund that is a separate
legal entity, or
less than expected’) and investment risk (the risk that the x be a qualifying insurance policy issued
assets that have been set aside ‘will be insufficient to by an insurer that is not a related
meet expected benefits’). See IAS 19.26-30 party; and
x not be used for anything other than
paying/ funding employee benefits.
Obviously, due to the greater risks involved in a ‘defined
benefit plan’, far more disclosure is required than when disclosing a ‘defined contribution
plan’.
The plan asset balance is
When recognising a ‘defined benefit plan’ we recognise measured at its:
both the: x FV at year-end. See IAS 19.57
x plan obligation (i.e. the benefits that it has promised
to its employees); and
x plan assets (i.e. those assets that are set aside in order to settle the obligation).
The plan obligation is measured at the present value of the future expected outflows and the
plan assets are measured at their fair value (where this
fair value reflects the present value of the economic Defined benefit costs: See
IAS 19.120
benefits expected from the assets). Ideally these assets
match or exceed the obligation. x are the costs of offering a DBP
x include service costs, interest costs
The contra entries processed when accounting for the plan and remeasurement adjustments
obligation and plan assets are collectively referred to as the
defined benefit costs. They include interest costs, service costs and remeasurement adjustments.
x The interest costs and service costs will be included in the total employee benefit expense
for the period (i.e. together with the other costs associated with employees, such as
salaries) and are generally recognised in profit or loss (unless they are included in the cost
of another asset).
x The remeasurement adjustments (i.e. when remeasuring the obligation to its year-end
present value and the assets to their year-end fair values) are never recognised in profit or
loss. Instead, these are recognised in other comprehensive income (unless these are
included in the cost of another asset). See IAS 19.120
944 Chapter 19
When presenting a defined benefit plan in the statement of financial position, the plan obligation
account and the plan asset account are set-off against each other and presented as either a:
x ‘net defined benefit plan asset’; or
x ‘net defined benefit plan liability’. Deficit or surplus
With regard to the above-mentioned presentation, if at reporting Plan asset

Less plan obligation
xxx
(xxx)
date, we find that the balance in our plan obligation account is Surplus/(deficit) xxx
bigger than the balance in our plan asset account, we say our
plan has a deficit (we owe more than we own and are thus ‘in trouble’, having a net liability
position). A deficit would be presented as a ‘net defined benefit plan liability’ in the statement
of financial position. The amount of the deficit will equal the amount presented as the ‘net
defined benefit plan liability’.
On the other hand, if we find that the balance on our plan asset account is bigger than the
obligation, we say that our plan has a surplus (we own
Presentation of deficits &
more than we owe and are thus ‘in a healthy position’, surpluses
having a net asset position). Having a surplus means that
we will present a ‘net defined benefit asset’. However, if x A deficit is presented in the SOFP
as a ‘net DBP liability’
we have a surplus, the amount of the surplus does not x A surplus is presented in the SOFP
always equal the amount presented as the ‘net defined as a ‘net DBP asset’, but must first
benefit plan asset’. This is because, whenever we have a be limited to the asset ceiling (if
surplus, we must first check that it does not exceed the the ceiling is lower).
amount referred to as the ‘asset ceiling’. In other words, the ‘net defined benefit plan asset’
must be measured at the lower of the surplus and the asset ceiling. See IAS 19.64
This ceiling represents a formal calculation of the present value of certain available future
economic benefits that the entity expects from the plan assets. If the amount of the surplus
exceeds the amount of the asset ceiling, the amount presented as the ‘net defined benefit
asset’ must be limited to the lower ‘asset ceiling’ amount. In other words, if the surplus
exceeds the asset ceiling, the amount presented as the ‘net defined benefit asset’ will not equal
the surplus but will equal the asset ceiling instead. This will require the use of an ‘asset
ceiling adjustment account’. This is explained in the journal below.
Interrelationship between the surplus/deficit, asset ceiling and the net DBP asset/
liability to be presented
Scenario A: We have a surplus of C100 (caused by the assets exceeding the obligation by C100). This needs
to be checked to the asset ceiling, which is then found to be C80. Thus, an asset ceiling adjustment account is
created to ensure the ‘net DBP asset’ presented in the SOFP is measured at the lower amount of C80.
Scenario B shows a deficit caused by the obligation exceeding the assets by C70. There is no surplus and
thus no need to check the asset ceiling and thus no need for an asset ceiling adjustment account. The net DBP
liability presented in the SOFP simply equals the deficit.
C C
Plan assets Fair value 800 800
Less: Plan obligation Present value of future obligation (700) (870)
Surplus/ (Deficit) 100 (70)
Asset ceiling adj account To limit a surplus to an asset ceiling of C80 see IAS 19.64 (20) N/A
Net DBP asset/ (liability) 80 (70)
The following journal will need to be processed in the case of Scenario A

Debit Credit
Remeasurement adjustment (E: OCI) 20
DBP: asset ceiling (-A) 20
Recognising an asset ceiling account (an asset measurement account)
in order to reduce a surplus on the DBP to the amount of the ceiling
For further information on defined benefit plans, please see IAS 19 Employee benefits.
Chapter 19 945
4 Other Long-Term Benefits (IAS 19.153 – 19.158)
Whereas short-term benefits are due before twelve months after the end of the period during
which the employee rendered the service, long-term benefits are due after twelve months after
the end of the period during which the employee rendered the service. Examples of ‘other
long-term benefits’ include: long-term disability benefits, long-term paid absences (e.g. long-
service leave), deferred remuneration and profit-sharing or bonuses that are not payable
within 12 months of reporting date. See IAS 19.153
‘Other long-term employee benefits’ are recognised and measured in the same way as we
recognise ‘defined benefit plans’ (a post-employment benefit) with the exception that all
adjustments are recognised in profit or loss (unless these are included in the cost of another
asset). In other words, re-measurements of ‘other long-term benefits’ are not recognised in
other comprehensive income. The reason we recognise these remeasurements directly in profit
or loss is that, whereas remeasurement adjustments affecting ‘post-employment benefits:
defined benefit plans’ are prone to a high degree of uncertainty, this same high level of
uncertainty does not apply in the case of ‘other long-term employee benefits’. See IAS 19.154-155
Although ‘other long-term employment benefits’ are An important observation!

Remeasurements:
recognised and measured in the same way as ‘post-
employment benefits: defined benefit plans’, IAS 19 x that relate to ‘post-employment
benefits’ are recognised in OCI;
stipulates many disclosure requirements for ‘post-
x that relate to ‘other long-term
employment benefits: defined benefit plans’ whereas benefits’ are recognised in P/L.
IAS 19 does not stipulate any disclosure requirements for
‘other long-term employment benefits’. Please note, however, that although IAS 19 does not
require disclosures, IAS 1 and IAS 24 do require certain disclosures (see section 6). Since
there is no need to separately disclose adjustments such as interest costs, service costs and
remeasurement adjustments in the case of ‘other long-term benefits’, the contra entries when
adjusting our obligation account, plan asset accounts (if any) and asset ceiling adjustment
account (if any) can all be made to a single ‘employee benefit expense account’ (this is not
the case when we account for ‘post-employment benefits: defined benefit plans’).
Another important difference between ‘other long-term employment benefits’ and ‘post-
employment benefits’ is that the former refers to a benefit that both accrues and is given to an
employee during his employment whereas the latter is a benefit that, although it accrues to an
employee during his employment, it is given to the employee after his employment.
The net asset or liability relating to ‘other long-term employee benefits’ that would be
included in the statement of financial position is the difference between the present value of
the obligation and the fair value of the assets (if any). If the difference between the obligation
and the assets results in a surplus, this surplus would have to be limited to the asset ceiling. It
must be noted, however, that it is fairly unusual (but not impossible) for plan assets to be set
aside to cover an obligation to provide ‘other long-term benefits’ such as long-service leave.
C
Obligation account Present value of future obligation (xxx)
Plan asset account (if any) Fair value of the related assets xxx
(Deficit)/ surplus xxx
Asset ceiling adjustment account (xxx)
(Net liability)/ asset of the ‘other long-term employee benefits’ xxx
5 Termination Benefits (IAS 19.159 – 19.171)
Whereas all other benefits are earned by the employee for services provided to the employer,
termination benefits are those that arise due to a termination of a service (i.e. the past event is
the termination rather than the employee services provided).
Termination benefits are those that are not conditional upon future services. Instead, they
relate purely to the termination of employment.
946 Chapter 19
Termination benefits are benefits payable as a result of either:

Termination benefits are
x the entity’s decision to terminate the employment; or the only employee benefits
x the employee’s decision to accept an entity’s offer of that:
termination. See IAS 19.8 (slightly reworded) x do not arise from a service provided
by the employee, but rather,
For example: an entity decides to terminate an employment x arise from termination of services
(i.e. termination of employment).
contract and offers to pay the employee C10 000 on
termination plus a further C40 000 if the employee agrees to work for a further 6 months:
x C40 000 relates to future services and thus does not relate to the termination of
employment: it is not a termination benefit but a short-term benefit for services rendered.
x C10 000 is a termination benefit since it relates to the termination of services.
Be careful! If the benefit payable on termination does not relate to either a forced termination or an
offer of a voluntary termination, the benefit is a post-employment benefit and not a termination
benefit. Thus, if an employee requests early termination (i.e. is not offered or forced into an early
termination), this is a post-employment benefit and not a termination benefit. See IAS 19.160
The termination benefits are recognised as an expense and related liability at the earlier of:
x when the entity can no longer withdraw the offer of those benefits, and
x when the entity recognises the related restructuring costs in terms of IAS 37 Provisions,
contingent liabilities and contingent assets and where this restructuring involves the payment of
termination benefits. See IAS 19.165 (slightly reworded)
If the termination benefit is payable due to an employee’s decision to accept an offer of termination,
the date on which the entity can no longer withdraw an offer of termination is the earlier of:
x the date when a restriction (e.g. legal, regulatory or contractual) on the entity’s ability to
withdraw the offer takes effect (e.g. if labour law does not allow an entity to withdraw an offer
of termination, then the date would be the day on which the offer is made); or
x the date when the employee accepts the offer. See IAS 19.166
If the termination benefit is payable as a result of an employer’s decision to terminate an employee’s
employment, the date on which the entity can no longer withdraw the offer is:
x the date on which the entity has communicated the plan of termination to the affected employees;
x this plan identifies the number of employees whose employment will be terminated, their job
classification/ function, their locations and the expected completion date;
x it is unlikely that significant changes to this plan will be made; and
x this plan gives sufficient detail such that employees are able to determine the type and amount of
benefit that they will receive upon termination. IAS 19.167 (slightly reworded)
Since termination benefits do not provide the entity with future economic benefits, they are recognised as
an expense. If they are not paid at the same time, a liability will be recognised.
The measurement of the termination benefits depends on the following:
x if the benefits are entirely payable within 12 months after reporting date (i.e. payable in the short-term),
they are measured like ‘short-term benefits’ and thus would not be discounted to present values;
x if the benefits are not entirely payable within 12 months after reporting date (i.e. they are payable in
the long-term) they are measured like ‘other long-term employee benefits’ and thus would be
discounted to present values;
x if the benefits are enhancements of existing post-employment benefits, then they will be measured
like ‘post-employment benefits’. See IAS 19.169
When the termination benefit is an offer of benefits that is made to encourage termination, the measurement
of the benefits will be based on the number of employees who will probably accept the offer:
x If we can estimate this number of employees who will accept this offer, we must measure
the liability using this number of employees.
x If we cannot estimate the number of employees who may accept the offer, we won’t
recognise a liability (since we cannot measure it) but will disclose a contingent liability.
Chapter 19 947
For example: if we offered each of our 100 employees a C1 000 retrenchment package, and:
x we estimate that 20 of these employees will accept the package, we must recognise a
liability and expense equal to C20 000 (C1 000 x 20 employees); or
x we are unable to estimate the number of employees who may accept the offer, we would
simply disclose in the contingent liability note the fact that we have offered employees a
redundancy package together with as many details as we possibly can.
6 Disclosure
6.1 Short-term employee benefits (IAS 19.25)

The disclosure required for short-term employee benefits is as follows:
x IAS 19: no specific disclosure requirements
x IAS 24: disclose the short-term employee benefits relating to key management personnel
x IAS 1: disclose the employee benefit expense, if material.
6.2 Post-employment benefits
6.2.1 Defined contribution plans (IAS 19.53 – 19.54)
The disclosure required for defined contribution plans is as follows:

x IAS 19: disclose the amount of the defined contribution plan expense that is included in the
employee benefit expense
x IAS 24: disclose defined contribution plans relating to key management personnel.
6.2.2 Defined benefit plans (IAS 19.135 – 19.152)

The disclosure requirements relating to defined benefit plans are dictated not only by IAS 19, but
also IAS 37, IAS 24 and IAS 1:
x IAS 37 may require the entity to disclose information about contingent liabilities arising from
the plan. See IAS 19.152
x IAS 24 may require the entity to disclose information about related party transactions involving the
plan and also to disclose the post-employment benefits owed to key management personnel. See IAS 19.151
x IAS 1 requires the employee benefit expense to be disclosed. See IAS 1.102 & 104
x IAS 19 requires copious disclosures for a defined benefit plan. See IAS 19.135-150
6.3 Other long-term employee benefits (IAS 19.158)
The disclosure required for other long-term employee benefits is as follows:
x IAS 19: no disclosure requirements
x IAS 24: disclose the other long-term employee benefits relating to key management personnel
x IAS 1: disclose the employee benefit expense, if material.
6.4 Termination benefits (IAS 19.171)
The disclosure required for termination benefits is as follows:

x IAS 19: no disclosure requirements
x IAS 24: disclose the termination benefits relating to key management personnel
x IAS 1: disclose the employee benefit expense, if material
x IAS 37: a contingent liability for an offer of termination benefits where there is uncertainty about
how many employees will accept the offer (unless the possibility of the outflow is remote).
The disclosure requirements relating to employee benefits are dictated by a variety of standards:
x IAS 1 Presentation of financial statements
x IAS 19 Employee benefits
x IAS 24 Related party disclosures
x IAS 37 Provisions, contingent liabilities and contingent assets
948 Chapter 19
7. Summary
Employee benefits
Defined in IAS 19 as: All forms of consideration given by an entity in
exchange for services rendered by the employees or for the termination of
their services.
Short-term Post-employment Other long-term Termination

benefits benefits benefits benefits
Defined in IAS 19 as: Defined in IAS 19 as: Defined in IAS 19 as: Defined in IAS 19 as:
All EB's* that are All EBs * that are All EBs other than: Those that are payable
x expected to be x payable after the x short-term employee as a result of either the:
settled in full before completion of benefits x entity’s decision to
12 months employment x termination benefits terminate employment
x after the end of the x post-employment before normal
period in which the benefits retirement date; or
employee renders the *Other than: x employee’s decision to
service x termination benefits accept benefits
x short-term employee offered in exchange
*Other than: benefits for termination of
x termination benefits employment
Other long-term employee benefit: Termination benefit:

(e.g. long-service benefits) (e.g. retrenchment package)
Recognise: Recognise:
As and when the employee provides the services At the earlier of the date on which the entity:
x can no longer withdraw its offer of
x recognises the restructuring costs in terms
of IAS 37 and where these costs include
Measurement: Measurement:
Statement of financial position: Balance Statement of financial position:
Net asset/ liability for Other LT EBs: Liability (or credit bank):
x Plan obligation: PV of benefit promised (Credit) x amount of the benefit
x Plan assets: FV of separate plan assets Debit
x Surplus/ (deficit) Dr/ (Cr)
x Asset ceiling adjustment: if applicable (Cr)
Net asset/ (liability) Dr/ (Cr)
The measurement of the net asset/ liability involve The measurements are subject to:
recognising: x discounting only if the termination is
x interest (due to discounting) payable more than 12 months after the end
x service costs (current and past) of the reporting period
x remeasurements of the:
- Asset: return on plan asset (if any)
- Obligation: actuarial gains and losses
- Asset Ceiling Adjustment Account (if any)
Interest, service costs and remeasurement
adjustments are all recognised in P/L (part of the
employee benefit expense), unless these defined
benefit costs are included in the cost of another asset
(This is not the case when accounting for DBPs, where
remeasurement adjustments are recognised in OCI)
Statement of comprehensive income: Statement of comprehensive income:

P/L: employee benefit expense: P/L: employee benefit expense:
x includes all movements in the net asset/ liability x includes the amount of the benefit
Chapter 19 949
Short-term benefits
Wages, salaries and Short-term Profit sharing and/ or Use of non-monetary

social security compensated absences bonuses benefits (e.g. a
contributions (e.g. (paid sick/annual company car)
medical aid) leave)
Short-term profit sharing and bonuses

(i.e. those due within 12 months of year-end)
Recognise when:
x entity has an obligation,
x the settlement of which cannot be reasonably avoided, and
x a reliable estimate is possible
Measurement:
Measure using:
x Formula stipulated in the plan (or contract);
x The entity determined amount; or
x Past practice where this gives a clear indication of amount of the
obligation
x Factor into the calculation the probability that the employee may
leave without receiving his profit share/ bonus.
Short-term compensated absences

(i.e. paid leave)
Accumulating: unused leave Non-accumulating: unused leave
Recognise when: Recognise when:

Employee renders the service Employee is absent
Measure at: Measure at:
Vesting Non-vesting N/A: No journal entry

Expected cost of: Expected cost of: No liability or expense is recognised because the
all accumulated unused the accumulated employee simply loses his unused leave at year-end:
leave unused leave that will there is no obligation to either allow the employee
probably be used in to take this leave in the future or to pay the
the future employee out for unused leave
Annual salary / working Annual salary /

days x number of working days x number
employees x days: (all of employees x days:
days owed at year-end) (only the days c/f that
the entity expects the
employee to take)
Note: the number of actual working days can either be given (i.e. 260-day working year) or, if not explicitly
given, then a reasonable calculation may be 365 x 5 / 7 days.
950 Chapter 19
Post-employment benefits
Defined contribution Defined benefit

(e.g. a provident fund) (e.g. a pension fund)
Economic substance Economic substance

x Obligation: limited to agreed-upon contributions x Obligation: provide certain benefits to the employee
x Risks: belong to the employee x Risks: belong to the employer
Variations
x Single employer plans
x Multi-employer plans
x Group administration plans
x Common control shared risk plans
x State plans
x Insured benefit plans
Post-employment benefit: Post-employment benefit:

Defined contribution plans Defined benefit plans
(i.e. obligations limited to contributions) (i.e. obligations = benefit promised)
Recognise: Recognise:
As & when the employee provides the services As & when the employee provides the services
Measurement: Measurement:
The amount of the contributions: Statement of financial position: Balance
x no actuarial assumptions needed Net DBP asset or liability:
x undiscounted normally (but will need to discount if the x Plan obligation: PV of benefit promised (Credit)
contributions become payable after 12 months from x Plan assets: FV of separate plan assets Debit
the end of the period in which the employee provides x Surplus/ (deficit) Dr/ (Cr)
the service) x Asset ceiling adjustment (if there was a (Cr)
surplus)
Net DBP asset/ (liability) Dr/ (Cr)
The measurement of the net DBP asset/ liability involved

recognising:
x interest (due to discounting)
x service costs (current and past)
x remeasurements of the:
- asset: return on plan asset (excl interest)
- obligation: actuarial gains and losses
- asset ceiling adjustment account
Interest and service costs are recognised in P/L (part of the

employee benefit expense) whereas remeasurements are
included in OCI (unless these defined benefit costs are
included in the cost of another asset)
Statement of comprehensive income:

P/L: Employee benefit expense:
x includes the DBP costs: interest and service costs
OCI: Items that may never be reclassified to P/L
x includes remeasurements of the DBP
Chapter 19 951
Gripping GAAP Foreign currency transactions
Chapter 20
Foreign Currency Transactions
Reference: IAS 21, IFRS 7 and IFRS 9 (all including any amendments to 1 December 2017)
Contents: Page
1. Introduction 953
2. Foreign currency transactions 953
2.1 Overview 953
2.2 Monetary and non-monetary items 954
2.3 How exchange rates are quoted 954
Example 1: Exchange rates 954
2.4 Dates 954
2.4.1 Determining the transaction date 955
2.4.2 Determining the settlement date 955
2.4.3 Determining the reporting date (if applicable) 956
Example 2: Dates: transaction, settlement and reporting dates 956
2.5 Initial recognition and measurement: monetary and non-monetary items 956
2.6 Subsequent measurement: monetary items 957
2.6.1 Overview 957
2.6.2 Translation at the end of the reporting period: monetary items 957
2.6.3 Translation at settlement date: monetary items 957
2.7 Exchange differences: monetary items 957
2.7.1 Overview 957
Example 3: Exchange differences – monetary item: debtor 957
2.7.2 Import and export transactions 958
2.7.2.1 Transaction and settlement on same day (cash transaction) 958
Example 4: Import transaction: settled on same day (cash transaction) 958
Example 5: Export transaction: settled on same day (cash transaction) 959
2.7.2.2 Settlement deferred (credit transactions) 959
2.7.2.2.1 Settlement of a credit transaction before year-end 959
Example 6: Import: credit transaction settled before year-end 959
Example 7: Export: credit transaction settled before year-end 960
2.7.2.2.2 Settlement of a credit transaction after year-end 961
Example 8: Import: credit transaction settled after year-end 961
Example 9: Export: credit transaction settled after year-end 961
Example 10: Import: credit transaction: another example 962
2.7.3 Foreign loans 964
Example 11: Foreign loan received 965
Example 12: Foreign loan granted 966
2.8 Subsequent measurement: non-monetary items 967
Example 13: Non-monetary item: measurement of plant purchased from foreign supplier 968
Example 14: Non-monetary item: measurement of inventory owned by foreign branch 969
Example 15: Non-monetary item: measurement of plant owned by foreign branch 970
2.9 Exchange differences: non-monetary items 971
Example 16: Revaluation of PPE owned by a foreign branch 971
3. Presentation and Functional Currencies 972
3.1 General 972
3.2 Determining the functional currency 972
3.3 Accounting for a change in functional currency 972
3.4 Using a presentation currency other than the functional currency 973
3.4.1 Explanation of the foreign currency translation reserve 973
Example 17: Foreign currency translation reserve 973
4. Presentation and Disclosure 974
5. Summary 975
952 Chapter 20
1. Introduction
IAS 21 The effects of changes in foreign exchange rates IAS 21 does not apply to:
explains how an entity accounts for transactions that involve x foreign currency derivatives
foreign currency, how to account for foreign operations and or balances (e.g. from hedge
accounting) that fall within
how to translate a set of financial statements into a foreign IFRS 9 Financial instruments; and
presentation currency. See IAS 21.3 x presentation of cash flows related to
foreign currency transactions or the
This section is not difficult and simply requires that you translation of cash flows of a foreign
operation. See IAS 21.4 - .5 & .7
understand that currencies are being traded every day, and
thus the value of a foreign currency today is not the same as it will be tomorrow, or was yesterday. If
we happen to have a transaction that involves a foreign currency, the changing value of the foreign
currency may need to be taken into consideration in our accounting records.
Transactions that businesses frequently enter into with foreign entities may be denominated in foreign
currencies (e.g. an invoice that is in dollars, is referred to as ‘denominated in dollars’). Since financial
statements are prepared in one currency only, any foreign currency amounts must be converted into
the primary currency used by the entity (functional currency). This conversion may involve
converting certain items at the exchange rate ruling on the
date of the conversion (spot exchange rate). To complicate Foreign currency is
defined as:
matters, there is often a considerable time lag between the
date that a foreign debtor or creditor is created and the date x a currency
upon which that debtor pays or creditor is paid. As explained x other than IAS the functional currency of
21.8
the entity.
above, currencies are being traded daily and thus the spot
exchange rate used to measure a foreign debtor or creditor on Functional currency is
initial recognition of the transaction will no doubt be defined as:
different to the spot rate on the date the debtor pays or the x the currency
creditor is paid. This difference is an exchange difference. x of the primary economic environment
Additionally, an entity may present their financial statements x in which the entity operates. IAS 21.8
in one or more currencies that could be different from the
functional currency (presentation currency). The conversion from a functional currency to a
presentation currency will also result in exchange differences that the entity will have to account for.
The rest of this chapter is dedicated to:
x Foreign currency transactions
x Presentation and functional currencies
x Presentation and disclosure issues.
2. Foreign Currency Transactions
2.1 Overview
A foreign currency
In this section, we will look at how a transaction that is transaction is defined as:
denominated in a foreign currency impacts both the initial x a transaction that:
recognition and measurement of that transaction and also its - is denominated; or
subsequent measurement. In this regard, a distinction must - requires settlement
also be made between monetary items (e.g. cash) and non- x in a foreign currency. IAS 21.20 extract
monetary items (e.g. plant), because whether an item is
monetary or non-monetary will affect how we account for the item’s subsequent measurement and
related exchange differences (section 2.2).
An exchange difference is
To be able to account for foreign currency transactions, we defined as the:
must understand how exchange rates are quoted x difference resulting from
(section 2.3), be aware of the various transactions that could x translating a given number of units of
one currency
be denominated in a foreign currency and the dates on which
x into another currency
we will need to convert our various foreign currency
x at different exchange rates. IAS 21.8
denominated amounts (section 2.4). The important dates
include transaction dates, settlement dates and reporting dates.
Chapter 20 953
2.2 Monetary and non-monetary items (IAS 21.8 & .16)
The core feature of a monetary item is the right to Monetary items are
receive (or obligation to deliver) a fixed or determinable defined as:
number of units of currency. Examples include: x units of currency held, and
x cash; x assets to be received, and
x accounts receivable; x liabilities to be paid
x accounts payable; and x in a fixed or determinable number of
x provisions to be settled in cash. units of currency. IAS 21.8 (slightly reworded)
A non-monetary item is not defined but it is described in IAS 21 as being an item is that it
involves neither a right to receive, nor an obligation to deliver, a fixed or determinable
number of units of currency. Non-monetary items include:
x property, plant and equipment;
x intangible assets; Exchange rate is defined
x inventories; and as:
x prepaid expenses. See IAS 21.16 x the ratio of exchange
IAS 21.8
x for two currencies.
2.3 How exchange rates are quoted
An exchange rate is the price of one currency in another currency. For example, if we have
two currencies, a local currency (LC) and a foreign currency (FC), we could quote the
exchange rate directly as, for example, FC1: LC4. This effectively means that to purchase
1 unit of FC, we would have to pay 4 units of LC.
It is also possible to quote the same exchange rate indirectly as LC1: FC0.25. This effectively
means that 1 unit of LC would purchase 0.25 units of the FC.
Global market forces determine currency exchange rates.

If you ask a bank or other currency dealer to buy or sell a Spot exchange rate is
defined as:
particular currency, you will be quoted an exchange rate
that is valid for that particular day only (i.e. immediate x the exchange rate
delivery). This exchange rate is called a ‘spot rate’. x for immediate delivery. IAS 21.8
Example 1: Exchange rates

You are quoted a spot exchange rate on 1 March 20X1 of: $2: £1
Required:
A. If we had £1 000 to exchange (i.e. sell), how many $ would we receive (i.e. buy) from the currency dealer?
B. If we had $1 000 to exchange (i.e. sell), how many £ would we receive (i.e. buy) from the currency dealer?
C. Restate the exchange rate in the format $1: £?
Solution 1: Exchange rates

A: £1 000 / £1 x $2 = $2 000
B: $1 000 / $2 x £1 = £500
C: £1 / 2 = £0.5 therefore, the exchange rate would be $1: £0.5
2.4 Dates
Dates involved with foreign currency transactions are very important because exchange rates differ
from day to day. The following dates are significant when recording a foreign currency transaction:
x transaction date – this is when we recognise the transaction (e.g. when we recognise the
money borrowed/ lent or when we recognise the purchase/ sale of an item);
x settlement date – this is when cash changes hands in settlement of the transaction (e.g. the
creditor is paid or payment is received from the debtor); and
x reporting date – this normally refers to the financial year-end of the local entity (or could
refer to any other date upon which financial information is to be reported).
954 Chapter 20
The transaction date is the date on which the transaction qualifies for recognition in terms of
the relevant IFRS (e.g. if our foreign currency transaction involved the purchase of plant, we
would determine the recognition date in terms of IAS 16 Property, plant and equipment). It
can happen that the date we place an order is also the date on which the transaction qualifies
for recognition (i.e. order date = transaction date). However, generally the process of placing
an order does not yet qualify for recognition of a transaction, in which case, the order date
occurs before the transaction date. Since we are not normally interested in events before
transaction date, the order date is normally irrelevant. However, sometimes events before
transaction date are important: for example, when hedging a foreign currency transaction (see
IFRS 9 Financial instruments & chapter 21).
2.4.1 Determining the transaction date (IAS 21.22)
Transation date is defined
as:
The first important date in a foreign currency transaction is
the transaction date. This is the date on which the transaction the date on which the transaction first
will be recognised, and must be established with reference to qualifies forIASrecognition
21.22 (extract)
in accordance
with IFRSs.
the IFRS that is relevant to the type of transaction in
question. Many aspects must be considered when determining the date on which a transaction should
be recognised (i.e. depending on the type of transaction, there are specific definitions and recognition
criteria that must be met). As part of this process, we often need to consider ‘when the risks and
rewards of ownership transfer from the one entity to the other entity’. In the case of the purchase of
an asset, for example, after all relevant definitions and recognition criteria have been considered, the
transaction date is often found to be the same date on which the risks and rewards of ownership
transferred from the seller to the buyer.
For regular import or export transactions, establishing the date that risks and rewards are
transferred is complicated by the fact that goods sent to or ordered from other countries
usually spend a considerable amount of time in transit (e.g. on a ship at sea).
The exact wording of the terms used in shipping documentation must always be investigated
first before determining the transaction date as it can often be confusing and can vary
considerably. The general principle is that risks and rewards transfer to the buyer when the
seller has completed their primary duties. In order to assist one in determining when the risks
and rewards have transferred, the International Chamber of Commerce produced a list of
trading terms, called the International Chamber of Commerce Terms of Trade (commonly
referred to as “Incoterms”). The following are some of the common terms used:
x Free on Board (F.O.B.) – The risks and rewards transfer when goods are loaded onto the
ship at the port of shipment.
x Carriage, Insurance and Freight (C.I.F.) – The seller arranges and pays for the carriage and
insurance of shipping the goods so one might think the risks and rewards remain with the seller
until the goods reach the destination port. However, the buyer is the beneficiary of the insurance
with the seller having completed their primary duties from the date that the goods are loaded
onto the ship, with carriage and insurance paid for. Therefore, risks and rewards transfer when
the goods are ‘delivered over the ship’s rail’ (i.e. loaded onto the ship) at the port of shipment.
x Delivery at terminal (D.A.T.) – The risks and rewards transfer when goods are offloaded
at the named destination terminal.
x Delivered Duty Paid (D.D.P.) – The risks and rewards transfer when goods have arrived
at the named destination port or other place and the import clearances have been obtained.
2.4.2 Determining the settlement date Settlement date is:

the date on which payment
Next, the settlement date must be determined, which is changes hands.
the date on which payment changes hands. For example:
x a foreign creditor is fully or partially paid; or
x full or partial payment is received from a foreign debtor.
The settlement date is generally not difficult to establish.
Chapter 20 955
2.4.3 Determining the reporting date (if applicable)

Reporting date is:
It is possible for a foreign currency transaction to spread the financial year-end of the
over more than one reporting period. In other words, at local entity (or any other date
least one reporting date (e.g. financial year-end) occurs upon which the financial
between transaction date and settlement date. Every time information is to be reported).
that a reporting date falls between the transaction and settlement date, there will be a foreign
currency monetary item (e.g. a creditor balance) that will need to be translated into the local
currency. Thus, the reporting date is often referred to as the translation date.
Example 2: Dates: transaction, settlement and reporting dates

Home Limited purchased bicycles from Far Away Limited, a bicycle manufacturer in
Iceland:
13 January 20X4: Home faxed an order for 1 000 yellow bicycles to Far Away.
16 January 20X4: Home received a faxed confirmation from Far Away informing them that the order had
been accepted.
25 January 20X4: Far Away finished manufacturing the 1 000 bicycles and packed them for delivery.
1 February 20X4: The bicycles were delivered to a harbour in Iceland and were loaded onto a ship.
4 February 20X4: The ship set sail.
31 March 20X4: Due to bad weather, the ship only arrived at the port in Home’s country on 31 March.
The bicycles were offloaded and released from customs on the same day.
5 April 20X4: The bicycles finally arrived in Home Limited’s warehouse.
30 April 20X4: Home paid Far Away.
28 February Home's financial year-end.
Required:
A. State the transaction, reporting and settlement dates assuming the bicycles were shipped F.O.B.
B. State the transaction, reporting and settlement dates assuming the bicycles were shipped D.A.T.
Solution 2: Dates: transaction, settlement and reporting dates

Comment:
Please bear in mind that the events before the transaction date have no influence on the foreign currency
transaction unless the transaction has been hedged (see chapter 22).
A.
x The transaction date is 1 February 20X4: in terms of an F.O.B. transaction, the risks of ownership
of the bicycles pass to Home Limited on the date the bicycles are loaded at the originating port.
x The reporting date is 28 February 20X4 since this is Home Limited’s year-end: on this date, the foreign
currency monetary item (foreign creditor) still exists (the transaction date has occurred and settlement
has not yet happened) and thus it will need to be converted from foreign currency into local currency.
x The settlement date is 30 April 20X4, the date on which Home Limited pays the foreign creditor.
B.
x The transaction date is 31 March 20X4: in terms of a D.A.T. transaction, the risks of ownership
pass to Home Limited on the date that the bicycles are off loaded at the destination port.
x The reporting dates are 28 February 20X4 and 28 February 20X5: no translation is required on
either of these reporting dates, however, since no foreign currency monetary item (foreign creditor)
existed (at 28 February 20X4 the transaction date had not yet occurred and the foreign transaction
had already been settled by 28 February 20X5).
x The settlement date is 30 April 20X4 being the date when the foreign creditor was paid.
2.5 Initial recognition and measurement: monetary and non-monetary items
The foreign currency transaction is: Spot exchange rate is
x initially recognised on transaction date. defined as the:
x initially measured by: x exchange rate
multiplying the foreign currency amount x for immediate delivery. IAS 21.8
by the spot exchange rate (between foreign

currency and functional currency)
on transaction date See IAS 21.21.
956 Chapter 20
Thus, we measure both the monetary and non-monetary items at the spot exchange rate. It is
permissible to use an average exchange rate for the past week or month, as long as it
approximates the spot exchange rate.
2.6 Subsequent measurement: monetary items (IAS 21.23)
2.6.1 Overview Monetary items must be
translated:
Monetary items are essentially cash or cash equivalents x at the end of each reporting period,
(currency) and amounts of currency receivable (e.g. x at the closing rate. See IAS 21.23 (a)
debtors) or amounts of currency payable (e.g. creditors).
As the exchange rate changes (and most fluctuate on an hourly basis!), the measurement of
amounts owing to or receivable from a foreign entity changes. For example, an exchange rate
of FC1: LC4 in January can change to an exchange rate of FC1: LC7 in February and
strengthen back to FC1: LC6 in March. Due to this, a foreign debtor or creditor will owe
different amounts depending on which date the balance is measured.
Monetary items (e.g. receivable balances) are translated to the latest exchange rates:
x on each subsequent reporting date; and
x on settlement date.
2.6.2 Translation at the end of the reporting period: monetary items
If a monetary item is not settled by the end of the reporting Closing rate is defined as
period, and if there is a difference between the spot rate on the:
transaction date and the spot rate on reporting date, then an x spot exchange rate
exchange difference will arise. This is because the item x at reporting date. IAS 21.8 slightly reworded
(originally measured at the spot rate on transaction date) must be restated at the closing rate.
2.6.3 Translation at settlement date: monetary items
The amount paid or received is based on the spot rate on settlement date. If the spot rate on
transaction / reporting date (whichever is applicable) is different to the spot rate on settlement
date, an exchange difference will arise.
2.7 Exchange differences: monetary items (IAS 21.28)
Exchange differences on
2.7.1 Overview monetary items: are
generally recognised in P/L (in
The translation of monetary items will almost always certain cases, they are
recognised in OCI). See IAS 21.28
result in exchange differences: gains or losses (unless
there has been no change in the exchange rate since transaction date).
Any exchange difference on monetary items is:
x ‘recognised in profit or loss in the period in which they arise’; however
x if the exchange difference relates to the consolidation of a foreign operation, the exchange
gain or loss is recognised in other comprehensive income in the consolidated financial
statements. See IAS 21.28 & .32
Consolidations are not covered in this book and thus all exchange gains or losses will be
recognised in profit or loss.
Example 3: Exchange differences – monetary item: debtor
A sale transaction on 31 January led to the recognition of a foreign debtor, of FC2 000.
The local currency is denominated as LC and the foreign currency is denominated as FC.
The exchange rates of FC: LC are as follows:
31 January: FC1: LC4
28 February: FC1: LC7
31 March: FC1: LC6
Chapter 20 957
Required:
A. Calculate the foreign debtor balance in local currency at the end of January, February and March.
B. Calculate the exchange differences arising over those 3 months and in total.
C. Show how the debtor and exchange differences would be journalised in the entity’s books on
31 January, 28 February and 31 March. Ignore the journal required for the cost of the sale.
Solution 3: Exchange differences – monetary item: debtor

A. On 31 January the foreign debtor balance would be FC2 000 x LC4 = LC8 000.
On 28 February the foreign debtor balance would be FC2 000 x LC7 = LC14 000.
On 31 March the foreign debtor balance would be FC2 000 x LC6 = LC12 000.
B. An exchange gain arises between 31 January - 28 February: LC14 000-LC8 000 = LC6 000
An exchange loss arises between 28 February - 31 March: LC12 000-LC14 000 = LC2 000
Thus, a net exchange gain arises between 31 January - 31 March: LC12 000-LC8 000 = LC4 000
All these gains or losses are recognised in profit or loss in the respective financial years.
C. Journals: Debit Credit

31 January
Foreign debtor (A) 8 000
Sales (I) 8 000
Sold goods to foreign customer
28 February
Foreign exchange gain (I) 6 000
Translating foreign debtor
31 March
Foreign exchange loss (E) 2 000
Translating foreign debtor
Comment: Notice that the amount of sales income is unaffected by changes in the exchange rates.
It should now be clear that fluctuating currency exchange rates will have an effect on all
monetary items that are denominated in a foreign currency, including but not limited to:
x receivables arising from sales to a foreign customer (export) on credit;
x payables arising from purchases from a foreign supplier (import) on credit;
x loans made to a foreign borrower; and
x loans raised from a foreign lender.
Exchange differences that arise on the translation of monetary items are recognised in profit or loss
(as a foreign exchange gain or loss). Although the basic principles apply to import, export and loan
transactions, loan transactions have an added complexity, being the interest accrual. Let us therefore
first look at the journals involving exports and imports and then at loan transactions.
2.7.2 Import and export transactions
2.7.2.1 Transaction and settlement on the same day (cash transaction)
If the date on which the transaction is journalised (transaction date) is the same date on which
cash changes hands in settlement of the transaction (settlement date), then there would
obviously be no exchange differences to account for.
Example 4: Import transaction - settled on same day (cash transaction)
On 5 March 20X1 (transaction date), a company in Botswana (in which the local / functional
currency is the Pula: P) purchased inventory for £100 from a company in the United
Kingdom (the local / functional currency is the Pound: £). The purchase price was paid on
this same day, when the spot rate was P3: £1.
Required: Show the journal entry/ies in the books of the company in Botswana.
958 Chapter 20
Solution 4: Import transaction - settled on same day (cash transaction)

Comment: No exchange difference arises since there is no balance payable needing translation.
Debit Credit
5 March 20X1
Inventory (A) £100 x 3 300
Bank (A) 300
Example 5: Export transaction - settled on same day (cash transaction)

A company in the United Kingdom sold inventory for P1 200 to a company in Botswana on
17 May 20X5, the transaction date.
The sale proceeds were received on the same day when the spot rate was P4: £1.
The cost of the inventory to the UK company was £150.
The local currency (functional currency) in Botswana is the Pula (P).
The local currency (functional currency) in the United Kingdom is the Pound (£).
Required: Show the journal entries in the books of the company in the United Kingdom.
Solution 5: Export transaction - settled on same day (cash transaction)
17 May 20X5 Debit Credit

Bank (A) P1200 / 4 = £300 300
Sales (I) 300
Sale of inventory for cash
Cost of sales (E) Given as £150 150
Inventory (A) 150
Recording cost of the inventory sold
2.7.2.2 Settlement deferred (credit transactions)

Exchange differences arise when the settlement date occurs after transaction date.
x The non-monetary item e.g. asset acquired, expense incurred or sale earned (the initial
transaction) is recorded at the spot rate on transaction date. Non-monetary items are
unaffected by movements in the exchange rates, thus no exchange differences will occur.
x The monetary item, being the amount payable or receivable, is affected by the movement
in the exchange rate after transaction date. The monetary item is translated at the spot
rates on reporting dates and payment dates and any increase or decrease in the monetary
item is recognised in profit or loss as either a foreign exchange gain or loss.
2.7.2.2.1 Settlement of a credit transaction before year-end
When the transaction date and settlement date occur in the same reporting period:
x record the initial transaction at spot rate on transaction date;
x convert the outstanding monetary item balance (i.e. payable or receivable) from the spot
rate on transaction date to the spot rate on settlement date; and
x record the payment (made or received).
Example 6: Import - credit transaction settled before year-end
A company in Botswana purchased inventory for £100 from a company in the United
Kingdom on 5 March 20X1, the transaction date. The purchase price was paid on 5 April
20X1.
Date Spot rates (Pula: Pound)
5 March 20X1 P3: £1
5 April 20X1 P4: £1
Required: Show the journal/s for the company in Botswana for the year ended 30 April 20X1.
Chapter 20 959
Solution 6: Import - credit transaction settled before year-end

Comment:
x The £ became more valuable/costly (i.e. £1 cost P3 on transaction date but cost P4 on settlement date), and
thus the Botswana company made a loss of P100 by not paying for the inventory on transaction date.
x The cost of the inventory, however, remains unaffected since inventory is a non-monetary item!
5 March 20X1 Debit Credit
Inventory (A) £100 x 3 = P300 300
Foreign creditor (L) 300
Purchase of inventory on credit
5 April 20X1
Foreign exchange loss (E) (£100 x 4) - 300 = P100 100
Translation of creditor to spot rate on settlement date
Foreign creditor (L) £100 x 4 = P400 400
Bank (A) 400
Payment of creditor at spot rate on settlement date
Example 7: Export - credit transaction settled before year-end

A company in the United Kingdom sold inventory for P1 200 to a company in Botswana
on 17 May 20X5, the transaction date. The inventory was paid for on 13 June 20X5.
The inventory cost the UK company £150.
The year-end of the company in the United Kingdom is 30 September .
Relevant exchange rates are:
Date Spot rates (Pound: Pula)
17 May 20X5 £1: P4
13 June 20X5 £1: P3
Required:
Show the journal entries in the books of the company in the United Kingdom.
Solution 7: Export - credit transaction settled before year-end

Comment:
x The P became more valuable (i.e. £1 bought P4 on transaction date but £1 bought only P3 on
settlement date), the UK company made a gain of £100.
x The sales income, however, remains unaffected by the changes in the exchange rates: this is
because sales are non-monetary (only monetary items – payables or receivables – are affected!).
Foreign debtor (A) P1 200 / 4 = £300 300
Sales (I) 300
Sale of inventory
Cost of sales (E) Given (cost of £150) 150
Inventory (A) 150
Recording cost of sale of inventory
13 June 20X5
Foreign debtor (A) (P1 200 / 3) – 300 = £100 100
Foreign exchange gain (I) 100
Translating debtor at settlement date
Bank (A) P1 200 / 3 = £400 400
Foreign debtor (A) 400
Amount received from foreign debtor
960 Chapter 20
2.7.2.2.2 Settlement of a credit transaction after year-end

When the transaction date and the settlement date occur in two different reporting periods:
x record the initial transaction at spot rate on transaction date;
x translate the outstanding monetary item balances (payable or receivable):
- to the spot rate on translation date (year-end); and then again
- to the spot rate on settlement date;
x record the payment (made or received).
Example 8: Import - credit transaction settled after year-end
A company in Botswana purchased inventory for £100 from a company in the United
Kingdom on 5 March 20X1, the transaction date. The purchase price was paid on
5 April 20X1. The year end of the company in Botswana is 31 March.
Date Spot rates (Pound: Pula)
5 March 20X1 £1: P3
31 March 20X1 £1: P3.70
5 April 20X1 £1: P4
Required:
Show the journal entry/ies in the books of the company in Botswana.
Solution 8: Import - credit transaction settled after year-end

Comment:
x The £ became more expensive (£1 cost P3 on transaction date but cost P4 on settlement date), and
so the Botswana company made a loss of P100 by not paying for the inventory on transaction date.
x This loss is recognised partially in the year ended 31 March 20X1 (P70) and partially in the year
ended 31 March 20X2 (P30), because the P depreciated against the £ in each respective period.
x Notice how the cost of inventory remains unaffected by the changes in the exchange rate. This is
because inventory is a non-monetary item and is thus translated at the spot rate on transaction date.
5 March 20X1 Debit Credit
Inventory (A) £100 x 3 = P300 300
Purchase of inventory on credit
31 March 20X1
Foreign exchange loss (E) (£100 x 3.7) – 300 = P70 70
Translation of creditor to spot rate at year-end
5 April 20X1
Foreign exchange loss (E) (£100 x 4) – (£100 x 3,7) = P30 30
Translation of creditor to spot rate on settlement date
Foreign creditor (L) £100 x 4 = P400 400
Bank (A) 400
Payment of creditor at spot rate on settlement date
Example 9: Export - credit transaction settled after year-end

A company in the United Kingdom sold inventory for P1 200 to a company in Botswana on
17 May 20X5, the transaction date. The sale proceeds were received on 13 June 20X5.
x The cost of the inventory to the UK company was £150.
x The UK company has a 31 May financial year-end.
x Relevant exchange rates are:
Spot rates
Date (Pound: Pula)
17 May 20X5 £1: P4
31 May 20X5 £1: P3.4
13 June 20X5 £1: P3
Required: Show the journal entries in the books of the company in the United Kingdom.
Chapter 20 961
Solution 9: Export - credit transaction settled after year-end

Comment: Notice how the sales figure of 300 remains unaffected by changes in the exchange rate. This is
because sales is a non-monetary item (you may want to read the definition of monetary items).

Foreign debtor (A) P1200 / 4 = £300 300
Sales (I) 300
Sale of inventory
Cost of sales (E) Cost = £150 (given) 150
Inventory (A) 150
Recording the cost of the inventory sold
31 May 20X5
Foreign debtor (A) P1200 / £3.4 = £353 – 300 = £53 53
Translating the foreign debtor at year-end
13 June 20X5
Foreign debtor (A) P1200 / £3 = 400 – (300 + 53) = £47 47
Translating foreign debtor at settlement date
Bank (A) P1200 / £3 = £400 400
Foreign debtor (A) 400
Proceeds received from foreign debtor at spot rate on settlement date
Example 10: Import – credit transaction – another example

A company in the United Kingdom ordered inventory to the value of $900 from an
American company on 16 January 20X1. The transaction date is 5 February 20X1.
The year-end is 31 March 20X1.
The relevant exchange rates are as follows:
Spot rates
Date (Pound: dollar)
16 January 20X1 £1: $2.2
5 February 20X1 £1: $2.5
31 March 20X1 £1: $2.25
5 April 20X1 £1: $3.0
Required:
Show all journal entries and show the balances in the trial balance of the UK company as at
31 March 20X1 assuming in the following 3 scenarios that the UK entity paid the American entity on:
A. 5 February 20X1 (on transaction date).
B. 31 March 20X1 (at year-end).
C. 5 April 20X1 (after year-end).
Solution 10A: Import – credit transaction – payment before year-end
Journals:
Debit Credit
5 February 20X1
Inventory (A) $900 / £2.5 360
Bank (A) 360
Purchase of inventory: exchange rate £1: $2.5
Trial balance as at 31 March 20X1 (extracts)

Debit Credit
Inventory 360
Creditor 0
962 Chapter 20
Solution 10B: Import – credit transaction – payment at year-end

Journals:
Inventory (A) $900 / £2.5 360
31 March 20X1
Foreign exchange loss (E) $900 / 2.25 – 360 40
Translation of foreign creditor at settlement date
Foreign creditor (L) $900 / 2.25 = 400 400
Bank (A) 400
Trial Balance
As at 31 March 20X1 (extracts)
Debit Credit
Inventory 360
Foreign creditor 0
Foreign exchange loss (P/L) 40
Solution 10C: Import – credit transaction – payment after year-end

Journals:
Inventory (A) $900 / £2.5 360
31 March 20X1
Foreign exchange loss (E) $900 / 2.25 – 360 40
Translation of foreign creditor at year-end
5 April 20X1
Foreign creditor (L) $900/ 3 – (360 + 40) 100
Translation of the foreign creditor at settlement date
Foreign creditor (L) $900/ 3 300
Bank (A) 300
Trial Balance
As at 31 March 20X1 (extracts)
Debit Credit
Inventory 360
Foreign creditor 400
Foreign exchange loss (P/L) 40
Comment on A, B and C:
There is no exchange gain or loss when the amount is paid on transaction date (part A). Contrast this with:
2.9 part B where the foreign exchange loss recognised to payment date is 40; and
2.10 part C where a foreign exchange loss of 40 is recognised in 20X1 and a foreign exchange gain of 100
is recognised in 20X2 (i.e. a net foreign exchange gain of 100 – 40 = 60 on this transaction).
In all 3 scenarios, the inventory remains at £360 because inventory is a non-monetary item.
In all 3 scenarios, no entry is made on 16 January 20X1 (the order date), because control of the
inventory had not been acquired and no obligation had yet been incurred.
Chapter 20 963
2.7.3 Foreign loans Accounting for foreign

loans:
The third possible type of transaction involves loans, where
we are either granting a loan to a foreign entity or receiving x Recognise loan capital at SR on TD
a loan from a foreign lender, but specifically where the loan x Recognise pmts at SR on SD
amount is denominated in a foreign currency. x Recognise interest at average rates
over the period the interest accrued
x Remeasure the loan balance using the
As with all other foreign currency transactions, the receipt (or SR on RD and recognise any
payment) of the initial loan capital, in the foreign currency, difference as a foreign exchange gain
would be translated into the local currency using the spot rate or loss.
on transaction date. For example, if we receive a loan of FC10 000, and the spot rate on transaction
date is LC12: FC1, then we recognise an initial loan liability of LC120 000 (FC10 000 x LC12).
The next thing to consider is interest. Interest incurred (or earned) on foreign currency loans raised
(or given) must first be calculated in terms of foreign currency and based on the outstanding
foreign currency amount (e.g. if our loan of FC10 000 accrues interest at 10% pa, the interest
incurred for a year would be FC1 000). Once we have calculated the interest incurred (or earned) in
the foreign currency, we then translate it into the local currency based on the spot rate on the date
that the interest was incurred (or earned). However, for practical purposes, IAS 21 allows us to use
the average rate for the period that the interest was earned (or incurred), unless the exchange rates
fluctuate significantly during the period. So, using our example, if the average spot rate over the
year that the interest of FC1 000 was incurred was LC14: FC1, then we would recognise interest
expense of LC14 000 (thus increasing our loan liability by LC14 000). See IAS 21.22
Similarly, as with all payments (or receipts) made in foreign currency, we do the translation into the local
currency using the spot rate on payment date. Thus, if we pay FC2 000 to our lender a day before
reporting date, when the spot rate was LC15: FC1, we recognise a payment of LC30 000 (FC2 000 x LC15).
Similarly, as with all other monetary items, a loan balance (whether this is a liability or asset) is first
calculated in the foreign currency. Using our example thus far, this balance would be FC9 000
(FC10 000 capital + FC1 000 interest payable - FC2 000 paid). This foreign currency denominated
balance is then translated at the spot rate on reporting date (i.e. at the closing rate). Thus, using our
example so far and assuming the exchange rate on reporting date was LC16: FC1, our loan liability
balance should be measured at LC144 000 (FC9 000 x LC16).
Now, of course, we have been using a variety of exchange rates to account for different aspects of
our loan (e.g. the spot rate on date of receipt of the loan, the average rate used to account for the
interest incurred, the spot rate on date of repayment of the loan capital and the spot rate on reporting
date) and thus our loan liability balance is currently reflecting LC104 000 (LC120 000 capital +
LC14 000 interest payable – LC30 000 paid). The fact that this balance should reflect the
remeasured carrying amount of LC144 000 (the foreign currency balance of FC9 000 translated at
the closing rate of LC16: FC1) means that our current loan liability balance is understated by
LC40 000 (RLC44 000 – LC104 000). This difference is obviously because we have used constantly
changing exchange rates to translate the foreign currency amounts. Thus, when we increase our
liability balance by LC40 000 (so as to reflect LC144 000 instead of LC104 000), we debit the
foreign exchange loss expense account, as an exchange difference (of LC40 000) has arisen.
Thus, in summary, if, for example, we are the borrower in a loan transaction and we receive a loan
amount that is denominated in a foreign currency:
x the receipt of the loan is journalised at an amount that is translated at the spot exchange rate on
transaction date;
x each loan repayment is journalised at an amount that is translated at the spot exchange rate on
settlement date;
x the interest incurred is journalised at an amount that is translated at the average rate over the
accrual period (or spot rates if the exchange rates fluctuate significantly during this period); and
x the loan balance at reporting date is adjusted so that it reflects the foreign currency balance
translated at the closing rate (spot rate on reporting date), which requires us to journalise a
foreign exchange difference.
This is best explained by way of an example:
964 Chapter 20
Example 11: Foreign loan received

On 1 January 20X4 (transaction date), Brix ’n Stones Limited, a South African brick
making entity, raised a long-term loan from Gill Bates of the Cayman Islands.
The terms of the loan were as follows:
x Gill transfers EUR100 000 into Brix ’n Stones Limited’s bank account on 1 January 20X4.
x The interest rate on the loan was 7,931% p.a.
x Brix ‘n Stones is required to make repayments on the loan of EUR25 000 annually in arrears,
with the first payment falling due on 31 December 20X4.
Brix ’n Stones Limited has the ZAR (South African Rand) as its functional currency.
The currency used in the Cayman Islands is the EUR (Euro).
Brix ‘n Stones Limited has a 31 December financial year-end.
Relevant exchange rates are:
Date Spot rates Average rates
1 January 20X4 EUR1: ZAR8.00
31 December 20X4 EUR1: ZAR8.50
31 December 20X5 EUR1: ZAR7.50
20X4 EUR1: ZAR8.20
20X5 EUR1: ZAR7.70
Required:
Show the journal entries required to record the above loan transaction in Brix ’n Stones Limited’s
accounting records for the years ended 31 December 20X4 and 31 December 20X5.
Solution 11: Foreign loan received

Comment: Notice how:
x the loan is translated at the spot rate on transaction date (TD);
x the interest is translated at the average exchange rate for the year;
x the payments made are translated at the spot rate on settlement date (SD); and
x the foreign exchange gain or loss is calculated as the difference between the closing balance
translated at the closing rate and the carrying amount in Rands to date.
Debit Credit
1 January 20X4
Bank (A) EUR100 000 x R8 (spot rate on TD) 800 000
Long-term loan (L) 800 000
Proceeds received on the foreign loan raised from Cayman Islands
31 December 20X4
Finance cost (E) EUR 7 931 (W1) x R8.20 (Av rate) 65 034
Interest expense on the foreign loan (converted at average rate)
Long-term loan (L) EUR 25 000 x R8.50 (spot rate) 212 500
Bank (A) 212 500
Payment of instalment on loan (at spot rate on pmt date)
Foreign exchange loss (E) EUR: 82 931 (W1) x R8.5 (spot rate) – CA 52 380
Long-term loan (L) so far:(R800 000 + R65 034 – R212 500) 52 380
Translating foreign loan at year end (at spot rate at year-end)
31 December 20X5
Finance cost (E) EUR 6 577 (W1) x R7.70 (Av rate) 50 643
Interest expense raised on loan (converted at average rate)
Long-term loan (L) EUR 25 000 x R7.5 (spot rate) 187 500
Bank (A) 187 500
Payment of instalment on loan: (at spot rate on pmt date)
Long-term loan (L) EUR 64 508 (W1) x R7.5 (spot rate) – CA 84 247
Foreign exchange gain (I) so far *: (R800 000 + R65 034 – R212 500 84 247
+R52 380 + R50 643 – R187 500)
Translating foreign loan at year end (at spot rate at year-end)
* Alternative calculation: CA so far = EUR 82 931 (W1) x R8.5 (spot rate end prior year) + R50 643 – R187 500
Chapter 20 965
Working 1: Effective interest rate table in foreign currency: Euros

Date Interest Payments Balance
(7,931%) (in Euros)
100 000
20X4 7 931 (25 000) 82 931
20X5 6 577 (25 000) 64 508
20X6 5 116 (25 000) 44 624
20X7 3 539 (25 000) 23 163
20X8 1 837 (25 000) 0
25 000 (125 000)
Example 12: Foreign loan granted

On 1 January 20X5 (transaction date), Incredible Limited (a South African company:
functional currency of Rands: ZAR), granted a loan to Amazing Limited (registered in the
USA: functional currency of Dollars: $).
The loan was for $10 000 and Amazing Limited is required to make 4 annual payments in arrears of
$3 000, commencing 31 December 20X5. Interest is levied at 7,714% per annum.
Date Spot rates Average rates
1 January 20X5 $1: ZAR7.00
31 December 20X5 $1: ZAR7.50
31 December 20X6 $1: ZAR6.00
20X5 $1: ZAR7.30
20X6 $1: ZAR6.70
Required: Show the journals to record the above loan in Incredible Limited’s accounting records for
the years ended 31 December 20X5 and 31 December 20X6.
Solution 12: Foreign loan granted

Comment: If the loan made to Amazing was repayable in Rands instead of Dollars, Incredible would not
have been exposed to foreign currency risks and this would therefore not be a foreign currency transaction.
The fact that Amazing has a functional currency other than the Rand would then have been irrelevant.

Foreign loan (A) $10 000 x R7(spot rate on TD) 70 000
Bank (A) 70 000
Loan granted to Amazing Limited
31 December 20X5
Foreign loan (A) $771 (W1) x R7.30 (Av rate) 5 628
Interest income converted at average rates
Bank (A) $3 000 x R7.50 (spot rate at YE) 22 500
Foreign loan (A) 22 500
Receipt of first instalment on the loan
Foreign loan (A) $7 771 (W1) x R7.5 (spot rate at YE) – CA 5 155
Foreign exchange gain (I) so far: (R70 000 + R5 628 – R22 500) 5 155
Translating loan at year-end
31 December 20X6
Foreign loan (A) $600 (W1) x R6.70 (Av rate) 4 020
Interest income converted at average rates
Bank (A) $3 000 x R6 (SR on SD) 18 000
Foreign loan (A) 18 000
Receipt of second instalment on the loan
Foreign exchange loss (E) $5 371(W1) x R6 (spot rate at YE) 12 077
Foreign loan (A) – CA so far*: (R70 000 + R5 628 – R22 500 12 077
+ R5 155 + R4 020 – R18 000)
Translating loan at year-end
*: Alternative calculation: CA so far = ($7 771 (W1) x R7.50 (spot rate end prior year) + R4 020 – R18 000
966 Chapter 20
Working 1: Effective interest rate table in foreign currency: Dollars

Date Interest Payments Balance
(7,714%) (in Dollars)
10 000
20X5 771 (3 000) 7 771
20X6 600 (3 000) 5 371
20X7 414 (3 000) 2 785
20X8 215 (3 000) 0
2 000 (12 000)
2.8 Subsequent measurement: non-monetary items (IAS 21.23 - .26)
Foreign currency can affect non-monetary items (e.g. plant and expenses prepaid) in two
basic ways:
x Local currency denominated non-monetary items: Non-monetary items is an
A non-monetary item, the purchase of which had item:
been denominated in a foreign currency, would have x that does not have a right to receive/
been converted into the local currency at the spot an obligation to deliver
x a fixed or determinable number of
rate on transaction date, at which point we can say it units of currency. IAS 21.16 (slightly reworded)
is now denominated in the local currency (called the
functional currency). Since this item is now already accounted for in the local currency,
there is no need to translate it into the local currency at a later date. See IAS 21.21
x Foreign currency denominated non-monetary items:
The local entity may have a foreign branch or foreign operation (the latter would require
consolidation into the books of the entity).
If this is the case, any non-monetary items owned by the foreign branch or foreign
operation would obviously be accounted for in the books of the foreign branch or
operation using the currency in which it operates (i.e. using its own functional currency).
From the perspective of the local entity, however, these non-monetary items are
denominated in a foreign currency. When the local entity presents the assets of the foreign
branch or consolidates the foreign operation, these foreign currency denominated non-
monetary items will obviously need to be converted into the local entity’s local currency
(i.e. into the local entity’s functional currency). See IAS 21.23 (b) & (c)
Non-monetary items that are denominated in a foreign currency are either:

x measured at historical cost, and translated using the exchange rate on transaction date; or
x measured at a value other than historical cost (e.g. fair value or recoverable amount), and
translated using the exchange rate when the fair value (or other amount, for example a
recoverable amount) was determined. See IAS 21.23(b) and (c)
What spot rate to use
The subsequent measurement of non-monetary items that when translating a foreign
are denominated in local currency is simply done in currency NMI:
terms of the relevant IFRS. These items are not affected If you’re translating a:
x CA based on historic cost,
by subsequent changes in exchange rates. x use the spot rate on original
transaction date.
For example, where the purchase of an item of plant is See IAS 21.23 (b) & .25 (a)
denominated in a foreign currency, this is converted into If you’re translating:

the local currency on transaction date and the plant is x CA that represents FV, a NRV or a RA
x use the spot rate on the date this
then measured in terms of IAS 16 Property, plant and value was determined (e.g. closing
equipment without any subsequent translations. rate).
See IAS 21.23 (c) & .25 (b)
The subsequent measurement of non-monetary items that

are denominated in foreign currency, whilst measured in terms of the relevant IFRS, may be
affected by a change in an exchange rate. This occurs when the measurement of the item
depends on the comparison of two or more amounts.
Chapter 20 967
Typical examples include:

x investment properties measured under the fair value model, where measurement involves
a comparison of the previous fair value with the fair value at year-end (translated at the
spot rate at reporting date);
x property, plant and equipment measured using the revaluation model, where measurement
involves determining the fair value (translated at the spot rate at reporting date)
x property, plant and equipment, where the measurement at year-end involves a comparison
of the carrying amount with the recoverable amount in terms of IAS 36 Impairment of
assets (translated at the spot rate at reporting date); and
x inventory, where the measurement at year-end involves a comparison of the cost with the
net realisable value (translated at the spot rate at reporting date).
The reason that an exchange rate can affect such items is because:
x the cost or carrying amount is translated at the spot rate on transaction date; and
x the net realisable value or recoverable amount, for example, is translated at the spot rate
on, for example, reporting date.
Example 13: Non-monetary item: measurement of plant purchased from

foreign supplier
On 1 January 20X1 (transaction date), a South African company bought plant from an
American company for $100 000. The South African company settled the debt on 31 March 20X1.
Date Spot rates: (Rand: Dollar)
1 January 20X1 R6.0: $1
31 March 20X1 R6.3: $1
31 December 20X1 R6.5: $1
31 December 20X2 R6.2: $1
The plant is depreciated to a nil residual value over 5 years using the straight-line method.
The recoverable amount was calculated on 31 December 20X2: R320 000.
Required:
Show all the SA entity’s journals for the years ended 31 December 20X1 and 20X2.
Solution 13: Non-monetary item: measurement of plant purchased from foreign supplier
Comment:
x Notice how the measurement of the non-monetary asset (plant) is not affected by the changes in
the exchange rates. This is because it is a local-currency-denominated item. However, had the
recoverable amount been determined in a foreign currency it could have resulted in an impairment
loss measured in one of the currencies, foreign or local, see example 15.
x This example also deals with a monetary item (foreign creditor), which is affected by the exchange
rates. This is because the monetary item is denominated in a foreign currency.
Plant: cost (A) $100 000 x R6 600 000
Foreign creditor (L) 600 000
Purchased plant from a foreign supplier (translated at spot rate)
31 March 20X1
Foreign exchange loss (E) $100 000 x R6.30 – R600 000 30 000
Translating foreign creditor on settlement date (at latest spot rate)
Foreign creditor (L) $100 000 x R6.30 630 000
Bank (A) 630 000
31 December 20X1
Depreciation: plant (E) (R600 000 – 0) / 5 years 120 000
968 Chapter 20

Depreciation: plant (E) (R600 000 – 0) / 5 years 120 000
Impairment loss (E) CA: 600 000 –120 000 –120 000 40 000
Plant: acc imp loss (-A) – Recoverable amount: 320 000 40 000
Impairment of plant
Example 14: Non-monetary item:

Measurement of inventory owned by a foreign branch
A South African company (local currency: Rand: R) has a branch in Britain (local
currency: Pound: £). On 1 January 20X1 (transaction date), the British branch bought
inventory from a British supplier for £100 000 in cash:
Date Spot rates (Rand: Pound)

1 January 20X1 R10: £1
31 December 20X1 R12: £1
The inventory is still in stock. Its net realisable value is estimated to be £90 000 at 31 December 20X1.
Required: Show all journal entries for the year ended 31 December 20X1:
A. in the books of the British branch (the foreign branch); and
B. in the books of the South African entity (the local entity).
Solution 14: Non-monetary item:

Measurement of inventory owned by a foreign branch
Comment on 14A: Notice how, in the foreign branch’s books, the inventory is written down because the net
realisable value in Pounds is less than the carrying amount in Pounds.
Comment on 14B: The British branch recognises a write-down whereas the South African branch does not.
x There is no write-down of inventory in the SA entity’s books because the net realisable value is measured
using the spot rate on the date at which the net realisable value is calculated (R12: £1) yet the cost is measured
using the lower spot rate on transaction date (R10: £1). See W1.2 (Rand).
x The fact that the British branch recognises a write-down whereas the South African branch does not is
purely as a result of the difference in the exchange rates!
Sol 14A Sol 14B
Journals Pounds (£) Rands (R)
Debit/(Credit) Debit/ (Credit)
1 January 20X1
Inventory (A) 14A: Given: £100 000 100 000 1 000 000
Bank (A) 14B: £100 000 x R10 (100 000) (1 000 000)
14A: Purchased inventory from a local supplier (British); or
14B: Purchased inventory from a foreign supplier (translated at spot rate)
31 December 20X1
Inventory write-down (E) 14A: £100 000 – £90 000: See W1 10 000 N/A
Inventory (A) 14B: No write-down applicable: See W1 (10 000) N/A
14A only: Inventory written down to lower of cost or net realisable value
W1: Calculation of possible write-down W1.1 W1.2

Pounds (£) Rand (R)
Cost: 31/12/20X1 Pounds: £100 000 100 000 1 000 000
Rands: £100 000 x R10
Net realisable value: 31/12/20X1 Pounds: £90 000 90 000 1 080 000
Rands: £90 000 x R12
Write-down: 31/12/20X1 10 000 N/A
(1) (2)
(1) NRV is less than CA, therefore a write-down is needed
(2) NRV is greater than CA, therefore no write-down is processed
Chapter 20 969
Example 15: Non-monetary item:

Measurement of plant owned by foreign branch
A South African company (local currency: Rand: R) has a branch in United States (local
currency: Dollar: $). On 1 January 20X1 (transaction date), the branch in United States
bought a plant for $100 000 in cash.
Date Spot rates: (Rand: Dollar)
1 January 20X1 R12.0: $1
31 December 20X1 R10.7: $1
31 December 20X2 R10.0: $1
The recoverable amount was calculated on 31 December 20X2: $70 000.
Required: Show all journal entries for the years ended 31 December 20X1 and 31 December 20X2:
A. in the books of the United States branch (the foreign branch); and
B. in the books of the South African entity (the local entity).
Solution 15: Non-monetary item: Measurement of plant owned by foreign branch
Comment on 15A: Notice how:

x In the foreign branch’s books, the asset is not considered to be impaired, since the recoverable amount in
Dollars ($70 000) is greater than the carrying amount in Dollars ($100 000 – 20 000 – 20 000).
x There are obviously no exchange differences in this example since the purchase in Dollars is
recorded in Dollars in the books of the United States branch.
Comment on 15B: Notice how:
x The South African entity reflects an impairment loss on the plant despite the fact that, in Dollar
terms, the plant is not impaired! This is because of the change in the exchange rate.
- the recoverable amount in the SA entity’s books is measured using the spot rate on the date at
which the recoverable amount is calculated (R10: $1); whereas
- the cost and accumulated depreciation is measured using the spot rate on transaction date (R12: $1).
x It is thus the change in exchange rate that causes a South African impairment loss despite the fact
that the British branch does not recognise an impairment loss!
Sol 15A Sol 15B
Journals Dollars ($) Rands (R)
Debit/ (Credit) Debit/ (Credit)
1 January 20X1
Plant: cost (A) 15A: Given: $100 000 100 000 1 200 000
Bank (A) 15B: $100 000 x R12 (100 000) (1 200 000)
Purchased plant
31 December 20X1
Depreciation: plant (E) 15A: ($100 000 – 0) / 5 yrs 20 000 240 000
Plant: acc depr (-A) 15B: (1 200 000 – 0) / 5 yrs (20 000) (240 000)
31 December 20X2
Depreciation: plant (E) 15A: ($100 000 – 0) / 5 yrs 20 000 240 000
Plant: acc depr (-A) 15B: (1 200 000 – 0) / 5 yrs (20 000) (240 000)
Impairment loss (E) 15A: N/A: see W1 N/A 20 000
Plant: acc imp loss (-A) 15B: see W1 N/A (20 000)
15B only: Impairment of plant (CA measured at spot rate on
transaction date; RA measured at spot rate at year-end)
W1: Calculation of possible impairment Dollars Rands
Carrying amount: 31/12/20X2 15A: $100 000 x 3 / 5 yrs 60 000 720 000
15B: $100 000 x 3 / 5 yrs xR12
Recoverable amount: 31/12/20X2 15A: Given: $70 000 70 000 700 000
15B: $70 000 x R10
Impairment: 31/12/20X2 N/A 20 000
970 Chapter 20
2.9 Exchange differences: non-monetary items (IAS 21.–23 -26 & .30 - .31)
As mentioned in section 2.8, the subsequent measurement of foreign currency denominated

non-monetary items may be affected by a change in an exchange rate. This happens when the
asset is measured at an amount that is not based on historic cost (e.g. property, plant and
equipment measured at fair value under IAS 16’s revaluation model or investment property
measured at fair value under IAS 40’s fair value model).
Please also note that when a gain or loss on a foreign-currency denominated non-monetary item:
x is recognised in other comprehensive income, any exchange component of that gain or
loss shall also be recognised in other comprehensive income. For example: IAS 16
requires gains and losses arising on a revaluation of property, plant and equipment to be
recognised in other comprehensive income. Thus, any exchange difference arising from
the remeasurement will also be recognised in other comprehensive income. IAS 21.30
x is recognised in profit or loss, any exchange component of that gain or loss shall be recognised
in profit or loss. For example: IAS 40 requires fair value adjustments on investment property
carried under the fair value model to be recognised in profit or loss, thus, any exchange
differences arising from remeasurement will be recognised in profit or loss.
Example 16: Revaluation of PPE owned by a foreign branch
A South African company (local currency: Rand: R) has a branch in the United States
(local currency: Dollar: $). On 1 January 20X1, the branch in United States bought a plant
for $100 000 cash.
Date Spot rates

1 January 20X1 R12.00: $1
31 December 20X1 R10.70: $1
31 December 20X2 R10.00: $1
The plant was revalued on 31 December 20X2 to $110 000 using the net method.
Required:
Show all journals for the years ended 31 December 20X1 and 20X2 (Ignore tax effects):
A. In the general journal of the US branch; and
B. In the general journal of the SA entity.
Solution 16: Revaluation of PPE owned by a foreign branch

Comment:
x A: Notice that there is obviously no exchange difference in this example since the purchase in
dollars is recorded in dollars in the books of the United States branch.
x B: Notice how the difference between the exchange rate on date of purchase (R12: $1) and the
exchange rate on date of revaluation (R10: $1) gets absorbed into the revaluation surplus (OCI).
Ex 16A Ex 16B
$ R
Plant: cost (A) A: Given as $100 000 100 000 1 200 000
Bank (A) B: $100 000 x R12 (100 000) (1 200 000)
Purchase of plant
31 December 20X1
Depreciation: plant (E) A: ($100 000 – 0)/5yr x 1 20 000 240 000
Plant: acc depreciation (-A) B: R1 200 000 / 5yr x 1 (20 000) (240 000)
31 December 20X2
Depreciation: plant (E) A: ($100 000 – 0)/5yr x 1 20 000 240 000
Plant: acc depreciation (-A) B:: R1 200 000 / 5yr x 1 (20 000) (240 000)
Chapter 20 971
Ex 16A: $ Ex 16B: R
Plant: accum. depreciation (-A) A: $20 000 x 2 years 40 000 480 000
Plant: cost (A) B: R240 000 x 2 years (40 000) (480 000)
Plant: cost (A) A: W1 50 000 380 000
Revaluation surplus (OCI) B: W1 (50 000) (380 000)
Revaluation of plant to fair value of $110 000
W1: Calculation of revaluation surplus on 31 December 20X2 Dollars Rands
Carrying amount: 31/12/X2 A: Cost: $100 000 – AD: 40 000 60 000 720 000
B: Cost: R1 200 000 – AD: R480 000
Fair value: 31/12/X2 A: Given: $110 000 110 000 1 100 000
B: $110 000 x R10 (SR at year end)
Revaluation surplus: 31/12/X2 50 000 380 000
3. Presentation and Functional Currencies (IAS 21.8 – .14)
3.1 General
IAS 21 allows an entity to present its financial statements in whichever currency it chooses to, which
is then known as the presentation currency. However, IAS 21 requires that an entity’s transactions
and balances be measured in that entity’s functional currency. Thus, it is important that entities know
how to correctly establish their functional currencies. An entity’s functional and presentation
currency is often the same currency, but where it is not the same, a translation reserve will arise.
3.2 Determining the functional currency (IAS 21.9 – 12)
Functional currency is
An entity determines its functional currency (a defined term, defined as:
see pop-up alongside) based on a number of factors as x the currency of the
outlined below. There is no free choice in deciding on its x primary economic environment
functional currency. It must be based on the primary x in which the entity operates. IAS 21.8
economic environment in which the entity operates, which is
usually taken to be the environment in which it primarily generates and expends cash.
In determining its functional currency, an entity must consider:
x The currency that influences its selling prices (this is often the currency in which prices for its
goods and services are denominated and settled).
x The country whose competitive forces and regulations mainly determine its selling prices, and
the currency of that country.
x The currency that influences its costs (this is often the currency in which such costs are
denominated and settled).
x The currency in which the entity obtains most of its financing (i.e. where financing includes the
issuing of both debt and equity instruments).
x The currency in which the entity usually invests amounts received from its operating activities.
See IAS 21.9 &.10
As these factors usually do not change often, once a functional currency is determined it is not
changed unless an entity’s circumstances have changed so significantly that the above factors
would result in a different functional currency being more appropriate. See IAS 21.13
3.3 Accounting for a change in functional currency (IAS 21.35 - .37)
An entity may not change its functional currency unless there is a change in the underlying
transactions and conditions that result in changes to the factors discussed in section 3.2 above.
For example: a change in the currency that influences the sales price of goods and services
could very well lead to a change in an entity’s functional currency (substance over form).
Should there be a change in functional currency, it must be accounted for prospectively from
the date of change of functional currency See IAS 21.35.
972 Chapter 20
Accounting for such a change is relatively simple. All items are translated into the new
functional currency using the spot exchange rate available at the date of change. For non-
monetary items, the new translated amount shall now be considered to be their historical cost.
3.4 Using a presentation currency other than the functional currency (IAS 21.38 - .41)
An entity may choose to present its financial statements
in any currency of its choice (presentation currency). If Presentation currency is
defined as:
an entity chooses to disclose financial statements in a
currency other than its functional currency, it will have x the currency in which the
to translate all of its items from the functional to the x financial statements are presented.
IAS 21.8
presentation currency at year end.
The following procedure (often referred to as the closing rate method) is used to translate an
entity’s trial balance into a presentation currency that is different to its functional currency:
x all assets and liabilities (including comparative amounts) shall be translated into the
presentation currency using the closing rate available at the reporting date;
x all incomes and expenses shall be translated at the If functional currency ≠
spot rate available at the dates of the various presentation currency,
translate:
transactions (for practical purposes, it is often
acceptable to use the average rate for the x assets & liabilities @ spot rate at
reporting date (e.g. YE)
presentation period, provided the currency did not
x income & expenses @ spot rate on
fluctuate too much); and transaction date (or at average SR).
x all resulting exchange differences are recognised in other
comprehensive income (the account in which these exchange differences are accumulated is
often referred to as the foreign currency translation reserve, being an equity account). See IAS 21.39
3.4.1 Explanation of the foreign currency translation reserve (IAS 21.41)
Exchange differences arise upon translation because:
x assets and liabilities are translated at one rate, while movements in those assets and
liabilities (represented by incomes and expenses) are translated at a different rate; and
x opening balances of net assets are translated at a rate different to the previous closing rate.
As these exchange rate differences have no effect on future cash flows from operations (i.e. they are just
book entries), they are not recognised in profit or loss, but rather in other comprehensive income (equity).
Example 17: Foreign currency translation reserve
StickyFingers Limited, a sweet manufacturer in NeverNever Land, has a functional currency of
Chocca’s (C). It decided to present its financial statements in the currency of Faraway, (a nearby
island), as most of its shareholders reside on this island. Faraways currency is the Flipper (F). The following
exchange rates are available:
Dates Exchange Rates
20X5 1chocca: 6.5 flippers (Average rate)
31 December 20X5 1chocca: 7 flippers (Spot rate)
Trial balance of Sticky-Fingers Ltd at 31 December 20X5 Debit Credit
Accounts payable 294 600
Accounts receivable 155 000
Bank 300 000
Land & buildings 944 300
Property, plant & equipment 600 000
Investments – at fair value 120 000
Ordinary share capital 403 300
General reserve 680 900
Long-term loan 810 500
Sales 1 509 500
Operating expenses 407 000
Taxation 439 300
3 698 800 3 698 800
Required: Translate this trial balance into the presentation currency.
Chapter 20 973
Solution 17: Foreign currency translation reserve

Comment: This example shows how to use the closing rate method. It is used when the functional
currency and the presentation currency are different.
Account Working Debit Credit

Accounts payable 294 600 x 7 2 062 200
Accounts receivable 155 000 x 7 1 085 000
Bank 300 000 x 7 2 100 000
Land & buildings 944 300 x 7 6 610 100
Property, plant & equipment 600 000 x 7 4 200 000
Investments – at fair value 120 000 x 7 840 000
Ordinary share capital 403 300 x 7 2 823 100
General reserve 680 900 x 7 4 766 300
Long-term loan 810 500 x 7 5 673 500
Sales 1 509 500 x 6.5 9 811 750
Cost of sales 733 200 x 6.5 4 765 800
Operating expenses 407 000 x 6.5 2 645 500
Taxation 439 300 x 6.5 2 855 450
Foreign currency translation reserve* Balancing figure 35 000
25 136 850 25 136 850
* This reserve appears in three places in the financial statements; it is presented:
x in the statement of comprehensive income as other comprehensive income (the movement therein),
x as a column in the statement of changes in equity (the balances and movement therein), and
x as part of the total issued capital and reserves in the statement of financial position (the balances).
If the foreign currency translation reserve relates to the consolidation of a foreign operation
and if this foreign operation is subsequently disposed of, the reserve would be:
x reclassified from other comprehensive income (where the exchange differences are
accumulated as a separate component of equity) to profit or loss, and
x disclosed as a reclassification adjustment. See IAS 21.48
4. Presentation and Disclosure (IAS 21.51 - .57)
The following disclosures are required by IAS 21:

x the amount of the exchange differences recognised in profit and loss except for those
arising on financial instruments measured at fair value through profit or loss (see IFRS 9);
x the net exchange difference recognised in other comprehensive income and accumulated
in a separate component of equity, reconciling the amount of such exchange differences at
the beginning and end of the period.
x if there is a change in the functional currency, state this fact and the reason for the change
in functional currency.
x where the presentation currency differs from the functional currency:
- state the functional currency and the reason for using a different presentation
currency;
- it shall describe the financial statements as complying with the IFRSs only if they
comply with all the requirements of each applicable IFRS including the method
required for translating functional currency items to presentation currency amounts.
x when an entity displays its financial statements or other financial information in a
currency that is different from either its functional currency or its presentation currency
and the IFRS requirements (referred to in the above bullet) are not all met, it shall:
- clearly identify the information as supplementary information to distinguish it from
the information that complies with IFRSs;
- disclose the currency in which the supplementary information is displayed; and
- disclose the entity’s functional currency and the method of translation used to
determine the supplementary information.
974 Chapter 20
5 Summary
Foreign currency transactions
Functional currency Foreign currency Presentation currency

This is the currency This is a currency x This is the currency we
x used in the primary x other than present our financial
economic environment; & x the functional currency statements in
x that we must use in our own x The presentation currency
records (i.e. all may be any currency
transactions/ balances must x Functional currency is
be measured in the translated into
functional currency) presentation currency
Exchange rates
Variety of formats:
x How much LC is required to buy 1 unit of FC = LCxxx: FC1; (direct) or
x How much FC can be bought for 1 unit of LC = LC1: FCxxx (indirect)
Effects of changes in foreign exchange rates
Foreign currency transactions Translation of financial statements
Dates Currencies
Dates: Currencies:
x Transaction date (TD) x The functional currency is used in our
x Translation (reporting) date (RD) own records
x Settlement (payment) date (SD) x Presentation currency is the currency we
use to present our F/S’s
Initial Subsequent
Spot rate on TD MI: If functional currency differs from
Spot rate on: presentation currency; translate:
RD or SD x Asset and liabilities:
@ spot rate at year-end
x Income and expenses:
@ spot rate on transaction date
(otherwise an average spot rate)
NMI:
Historic cost:
x SR on TD
Fair value:
x SR on FV date
Interest on loan:
x Average SR
Exchange difference recognised in Exchange difference recognised in

x Profit or loss: for all monetary items Other comprehensive income:
x OCI: for some adjustments to non- foreign currency translation reserve
monetary items (e.g. RS on PPE)
Abbreviations:
MI: monetary item SR: spot rate RD: reporting date
NMI: non-monetary item TD: transaction date SD: settlement date
LC: local currency FC: foreign currency
Chapter 20 975
Gripping GAAP Financial instruments – general principles
Chapter 21
Financial Instruments – General Principles
Main References: IFRS 9, IAS 32, IFRIC 19, IFRS 7, IFRS 13 & IAS 1 (updated to 1 December 2018)
Contents: Page
1. Introduction 979
1.1 A bit of history 979
1.2 Overview of the main financial instrument standards: IFRS 9, IAS 32 and IFRS 7 979
1.3 Scope of IFRS 9 979
2. Financial Instruments 980
3. Financial Assets 980
3.1 Financial assets: identification 980
Example 1: Financial assets 981
Example 2: Financial assets versus financial instruments 981
3.2 Financial assets: recognition 982
3.3 Financial assets: classification 982
3.3.1 Overview of the different classifications 982
3.3.2 Overview of the classification process 982
3.3.3 Classification: financial assets at amortised cost 983
3.3.4 Classification: financial assets at fair value through OCI – debt instruments 983
3.3.5 Classification: financial assets at fair value through profit or loss 983
3.3.6 Classification: financial assets at fair value through OCI – equity investments 984
3.3.7 Classification process – a diagrammatic summary 985
3.3.8 The contractual cash flows criteria 986
Example 3: Classifying financial assets – considering the cash flows 986
3.3.9 The business model criteria 987
Example 4: Classifying financial assets – considering the business model 988
3.4 Financial assets: measurement overview 989
3.5 Financial assets: initial measurement 989
3.5.1 Initial measurement: fair value and transaction costs 989
3.5.2 Initial measurement: fair value and day-one gains or losses 990
3.6 Financial assets: subsequent measurement 991
3.6.1 Overview 991
3.6.2 Subsequent measurement: Financial assets at amortised cost 992
Example 5: Calculating the effective interest rate using a calculator 993
Example 6: Financial assets at amortised cost 993
3.6.2.2 If the financial asset is credit-impaired 995
3.6.2.3 If the financial asset is renegotiated or modified 996
Example 7: Financial assets at amortised cost – with modification 996
3.6.3 Subsequent measurement: Financial assets at FVOCI – debt instruments 997
Example 8: Debentures at fair value through other comprehensive income 998
Example 9: Financial assets at FVOCI-debt (foreign currency treatment) 999
3.6.4 Subsequent measurement: Financial assets at FVOCI – equity instruments 1000
Example 10: Financial assets at fair value through OCI – equity 1001
3.6.5 Subsequent measurement: Financial assets at fair value through profit or loss 1002
Example 11: Financial assets at fair value through profit or loss 1002
976 Chapter 21
Contents continued ... Page

4. Impairment of financial assets 1003
4.1 Overview 1003
4.2 Explanation of the principles behind recognising a loss allowance 1005
4.3 Expected credit loss model – the general approach 1006
4.3.1 Assessment of credit risk on initial recognition date 1006
4.3.2 Re-assessing the credit risk at reporting date 1006
4.3.2.1 Overview 1006
4.3.2.2 Lifetime expected credit losses 1007
4.3.2.3 Assessing the credit risk 1007
4.3.2.4 The effect of the credit risk assessment at subsequent reporting dates 1007
4.4 Measurement of expected credit losses 1008
Example 12: Loss allowances – comparison of the three stages 1009
Example 13: Loss allowances – effect of an increase in credit risk 1010
Example 14: Loss allowances – significant increase in credit risk 1011
4.5 Expected credit loss model – the simplified approach 1014
Example 15: Expected credit losses – simplified approach – trade receivable 1014
Example 16: Expected credit loss measurement – simplified approach – measurement of the
expected credit losses using a provision matrix 1015
5. Financial assets: derecognition 1016
5.1 Overview 1016
5.2 A transfer of a financial asset that qualifies for derecognition 1017
Example 17: Derecognition of financial assets (equity) – FVOCI & FVPL 1017
Example 18: Derecognition of financial assets (debt) – amortised cost 1018
5.3 A transfer of a financial asset that does not qualify for derecognition 1019
Example 19: Financial asset that does not qualify for derecognition 1020
5.4 A transfer of a financial asset involving continuing involvement 1020
6. Financial liabilities 1021
6.1 Financial liabilities – identification 1021
Example 20: Financial liabilities 1021
6.2 Financial liabilities – recognition 1021
6.3 Financial liabilities – classification 1022
6.3.1 General classification 1022
6.3.1.1 Overview 1022
6.3.1.2 Held for trading 1022
6.3.1.3 Designated as FVPL 1022
6.3.2 Exceptions to the general classifications 1023
6.4 Financial liabilities – measurement overview 1023
6.5 Financial liabilities – initial measurement 1023
6.6 Financial liabilities – subsequent measurement 1024
6.6.1 Overview 1024
6.6.2 Financial liabilities at amortised cost – subsequent measurement 1024
Example 21: Financial liabilities at amortised cost 1024
6.6.3 Financial liabilities at fair value through profit or loss – subsequent measurement 1025
Example 22: Financial liability at FVPL – no change in credit risk 1026
Example 23: Financial liability at FVPL – with a change in credit risk 1027
6.6.4 Financial liabilities general classification exceptions: subsequent measurement 1027
6.6.4.1 Financial liabilities due to a derecognition prohibition 1028
6.6.4.2 Financial liabilities due to continuing involvement 1028
6.6.4.3 Financial liabilities that are financial guarantee contracts 1028
6.6.4.4 Financial liabilities: loan commitments at below-market interest rates 1028
6.7 Financial liabilities: derecognition 1028
6.7.1 Overview 1028
6.7.2 Extinguishment results in the derecognition of the liability 1029
Example 24: Financial liability extinguishment 1029
Chapter 21 977

6.7.3 Extinguishment results in derecognition of the liability and recognition of another liability 1029
Example 25: Financial liability: modification lead to extinguishment 1029
6.7.4 Extinguishments using equity instruments after renegotiating terms 1030
Worked example: Debt for equity swaps 1031
7. Reclassifications of financial instruments 1031
7.1 Reclassifications overview 1031
Example 26: Reclassification date 1031
7.2 Reclassifying from amortised cost to fair value through P/L 1032
Example 27: Reclassification of a financial asset from AC to FVPL 1032
7.3 Reclassifying from fair value through P/L to amortised cost 1034
Example 28: Reclassification of a financial asset: FVPL to AC 1034
7.4 Reclassifying from amortised cost to fair value through OCI 1035
Example 29: Reclassification of a financial asset from AC to FVOCI 1036
7.5 Reclassifying from fair value through OCI to amortised cost 1038
Example 30: Reclassification of a financial asset from FVOCI to AC 1038
7.6 Reclassifying from fair value through OCI to fair value through P/L 1040
7.7 Reclassifying from fair value through profit or loss to fair value through OCI 1040
8. Compound Financial Instruments 1040
8.1 Overview 1040
Example 31: Compound financial instruments: initial recognition & measurement 1042
8.2 Compound financial instruments consisting of convertible instruments 1043
Example 32: Convertible debentures – theory 1044
Example 33: Convertible debentures – calculations 1044
Example 34: Compulsorily convertible debentures 1045
8.3 Compound financial instruments consisting of non-convertible preference shares 1047
8.3.1 Overview 1047
8.3.2 Preference shares: dividends 1047
8.3.3 Preference shares: redemptions 1047
Example 35: Non-redeemable preference shares – discretionary dividends 1050
Example 36: Non-redeemable preference shares – mandatory dividends 1050
Example 37: Non-redeemable pref shares: mandatory & discretionary dividends 1051
Example 38: Redeemable preference shares – discretionary dividends 1052
9. Settlement in Entity’s Own Equity Instruments 1053
Example 39 Settlement in entity’s own equity instruments 1053
10. Interest, dividends, gains and losses 1054
11. Derivatives 1055
11.1 Overview 1055
11.2 Options 1055
11.3 Swaps 1056
Example 40: Swaps 1056
11.4 Futures and forwards 1056
11.5 Embedded derivatives 1056
Example 41: Hybrid instruments 1057
Offsetting of Financial Assets and Liabilities 1058
Deferred tax consequences of financial instruments 1058
13.1 Overview 1058
13.2 Financial assets and liabilities subsequently measured at amortised 1059
13.3 Financial assets subsequently measured at fair value 1059
Example 42: Deferred tax consequences of financial assets 1059
14. Financial risks 1060
14.1 Overview 1060
14.2 Market Risk 1060
14.2.1 Interest rate risk 1061
14.2.2 Currency risk 1061
14.2.3 Price risk 1061
14.3 Credit risk 1061
14.4 Liquidity risk 1061
15. Disclosure 1061
16. Summary 1065
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1. Introduction
1.1 A bit of history
IFRS 9 Financial instruments is mandatorily effective for financial periods commencing after
1 January 2018. IFRS 9 replaces IAS 39 Financial Instruments: Recognition and Measurement,
a complex standard and a source of heated debate. The storm over problematic aspects of IAS
39 reached a peak during the 2008 global financial crisis, with some arguing that the effect of
these problems, particularly the incurred credit loss model, had been a significant reason for the
extent of the financial crisis. Under pressure, the IASB published several critical amendments
to IAS 39 during late 2008 and 2009. It then proceeded to produce a completely new standard,
IFRS 9 Financial instruments.
1.2 Overview of the main financial instrument standards: IFRS 9, IAS 32 and IFRS 7
Apart from IFRS 9, there are two other standards that also deal with financial instruments:
IAS 32 Financial instruments: presentation and IFRS 7 Financial instruments: disclosures.
IFRS 9 essentially deals with the:

x Classification and measurement of financial instruments
x Impairment of financial assets
x Hedge accounting.
Hedge accounting is explained in chapter 22.
IAS 32 provides some essential definitions and clarification that assist in identifying whether
an item is a financial instrument, whether it should be presented as a financial asset, financial
liability or equity instrument and whether a financial asset and financial liability may be offset
against each other in the financial statements. It also deals with how to present compound
financial instruments (i.e. where an instrument is partly equity and partly liability). These issues
are explained in this chapter as well as in chapter 23 on 'share capital'.
IFRS 7 explains the disclosures requirements, which will assist users to assess the:
x financial instrument's 'significance' in relation to an entity's 'financial position and
performance'; and
x 'nature and extent of risks' to which the financial instruments have exposed the entity, as
well as how the entity is managing these risks.
1.3 Scope of IFRS 9
IFRS 9 applies to most financial instruments, although the following are excluded from its scope:
x interests in subsidiaries, associates and joint ventures unless the relevant standard
(IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial Statements and
IAS 28 Investments in Associates and Joint Ventures) require or permit the entity to apply IFRS 9.
x rights and obligations to which IFRS 16 Leases applies. Note 1 & 2
x employers’ rights and obligation to which IAS 19 Employee Benefits applies.
x equity instruments which have been issued by an entity.
x a forward contract to buy shares resulting in a business combination in terms of IFRS 3.
x financial instruments in the scope of IFRS 2 Share-based Payment except for those contracts to
buy or sell a non-financial item which can be settled net in cash or another financial instrument,
provided the contract is not held for the delivery/receipt of the non-financial item. See IFRS 9.2.1-.7
Note 1: IFRS 16: Lease receivables are subject to the impairments and derecognition requirements of IFRS 9.
Note 2: IFRS 16: Lease liabilities are subject to the derecognition requirements of IFRS 9.
Chapter 21 979
2. Financial Instruments (IAS 32.11)
A financial instrument is defined as:

any contract that gives rise to:
a financial asset AND a financial liability or equity instrument

of one entity of another entity. IAS 32.11
(Section 3) (Section 5)
A financial instrument is an item, born from a contract, which will be recognised as a financial
asset by one entity and recognised as either a financial liability or equity instrument by another
entity. This means that a financial instrument involves matching, where one entity has a
financial asset (e.g. the right to receive cash) and another entity has a financial liability or equity
instrument (e.g. the obligation to pay cash).
If we look at the financial instrument definition (see above), we see that an item can only be a financial
instrument if it arises from a contract. This contract can even be a verbal contract, but whatever its
form, there must be a contract. Interestingly, this means that an item could qualify as a financial asset,
but, if it does not involve a contract, it would fail to qualify as a financial instrument (e.g. cash in your
pocket is a financial asset but it is not a financial instrument). See example 2.
You will find that a statement of financial position includes many financial instruments,
including common items such as cash, trade receivables and trade payables as well as the more
complex items such as derivatives.
3. Financial Assets (IFRS 9.4.1.1 – 4.1.5)
3.1 Financial assets: identification (IAS 32.11)

A financial asset is defined as
For an item to be identified as a financial asset, it must
meet the definition of a financial asset (see pop-up xx cash, an equity instrument of another
alongside). The definition states that the term ‘financial entity
asset’ would include any asset that is: x a contractual right to:
- receive cash or another financial
a) Cash – this is because cash is at the root of all our
asset from another entity; or
transactions – it is 'the medium of exchange' and the - exchange financial assets or financial
'basis on which all transactions are measured and liabilities with another entity under
recognised'. See IAS 32.AG3 conditions that are potentially
favourable to the entity; or
Interestingly, cash invested in a bank account would x certain contracts to be settled in the
also meet part (c) of the financial asset definition, since entity's own equity instruments.
a cash deposit in the bank gives the entity a contractual IAS 32.11 (summarised)
right to receive the cash back from the bank.

b) Equity instruments of another entity. For example, a purchase of ordinary shares in another
entity would be a financial asset to the purchaser of these shares (i.e. the issuer of the shares
would recognise the shares as equity instruments).
c) Contractual rights that give the entity the right:
- to receive cash or any other financial asset from another entity. For example, accounts
receivable represents a financial asset because it gives the entity the contractual right
to receive payment in cash. Please note, however, that it is possible that this right to
receive payment may involve a payment in something other than cash. If payment is
to be received by way of government bonds, for example, this right would still be a
financial asset because bonds are a financial asset. However, if payment was to be made
by way of cattle, a non-financial asset, then the right would not be a financial asset
because the entity does not in essence have a contractual right to receive cash or any
other financial asset. For this reason, a prepaid expense is not a financial asset.
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- To exchange financial assets or liabilities under conditions that will be potentially

favourable to the entity. For example, an option to buy shares in another entity at C3 per
share when the market price is C8 per share is a financial asset because the conditions
appear to be potentially favourable. Essentially, a contractual right to exchange
financial instruments will be recognised as a financial asset if the right will ultimately
lead to the receipt of cash or an equity instrument. See IAS 32.AG7
d) a contract that will or may be settled in the entity’s own equity instruments and is:
- a non-derivative for which the entity is or may be obliged to receive a variable number
of the entity’s own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity’s own equity instruments
(see section 8). Simply put, a derivative is a financial instrument whose value depends
on the value of another variable, such as exchange rates – see section 10 of this chapter
for additional detail. IAS 32.11 & IFRS 9 App A
In both situations described above (d), the substance of the transaction is that the entity is
using its equity instruments as 'currency'.
.
Example 1: Financial assets
Discuss whether any of the following are financial assets:
a. Cash on hand (i.e. petty cash)
b. Gold held in the bank safety deposit box
c. Inventory
d. Trade accounts receivable
e. Prepaid electricity
f. A right to receive as many of the entity’s own equity instruments as equals the
value of C100
g. A right to receive as many of the entity’s own equity instruments as equals the
market value of 100 barrels of crude oil.
Solution 1: Financial assets See IAS 32.AG10&11
a. Cash is a financial asset in terms of the definition IAS 32.11(a). Furthermore, cash derives its
value from what the cash paper represents rather than the paper itself.
b. Gold is not a financial asset since it does not meet the definition of a financial asset: it is not cash,
not an equity instrument, and not a contractual right to receive cash or a contract that will be settled
in the entity's own equity instruments. Although gold was previously used as currency (cash), it
now derives its value from its usefulness in, for example, dentistry, jewellery and industry.
c. Inventory is not a financial asset because, although it creates the possibility of receiving cash or
other financial assets, it does not represent a present right to receive cash or another financial asset.
d. Trade accounts receivable is a financial asset because it represents a contractual right to receive a
payment of cash from the debtor/s.
e. Prepaid electricity is not a financial asset because it does not represent a right to receive cash or
other financial assets, but rather represents a right to receive services.
f. A right to receive as many of the entity’s own equity instruments as equals C100 is a financial
asset. This is because the right is a non-derivative that will be settled by the exchange of a variable
amount of the entity’s own equity instruments (part (d) (i) of the definition).
g. A right to receive as many of the entity’s own equity instruments as equals the market value of 100
barrels of crude oil is a financial asset. This is because it is a derivative (the value of the right is
dependent on the market value of crude oil) and it will be settled by the exchange of a variable
amount of equity instruments (part (d) (ii) of the definition). Adapted from IAS 32.21 & AG27
Example 2: Financial assets versus financial instruments
Briefly explain whether 'petty cash on hand' and an 'instant access cash deposit at the bank'
would meet the definitions of financial assets and financial instruments.
Solution 2: Financial assets versus financial instruments

Petty cash (often called a cash float) would meet the definition of a financial asset (IAS 32.11(a)) but
it would not meet the definition of a financial instrument because no contract exists.
A cash deposit in a bank account would meet the definition of a financial asset (IAS 32.11(c)). It
would also meet the definition of a financial instrument because the entity (the depositor) has a
contractual right to obtain cash from the bank or to draw a cheque against the balance. See IAS32.AG3
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3.2 Financial assets: recognition (IFRS 9.3.1.1)

Financial assets are initially recognised when, and only when, the entity becomes party to the
contractual provisions of the instrument.
3.3 Financial assets: classification (IFRS 9.4.1.1 – 4.1.5)
3.3.1 Overview of the different classifications
Financial assets are essentially classified based on the two basic measurement models of amortised
cost and fair value. However, there are actually four formal classifications due to the three possible
accounting treatment of the gains or losses under the fair value model:
x amortised cost (AC)
x fair value through profit or loss (FVPL)
x fair value through other comprehensive income for debt instruments (FVOCI-debt)
x fair value through other comprehensive income for equity instruments (FVOCI-equity)
How to actually measure fair value and amortised cost is explained in section 3.4.
3.3.2 Overview of the classification process
Other than cash, financial assets are essentially comprised of investments in debt instruments,
investments in equity instruments, and derivatives. Each one of these assets is classified by assessing:
x Its contractual cash flow characteristics (step 1 – the CCF test); and
x The business model within which that financial asset is managed (step 2 – the BM test).
Step 1 - the CCF test: The contractual cash flows test involves assessing whether the asset's
contractual terms will lead to the entity receiving:
x cash flows on specified dates
x that are solely payments of:
- principal, and
- interest on the principal (SPPI). See IFRS 9.4.1.2b
Investments in equity instruments (e.g. ordinary shares) fail this test since they do not offer
contractual cash flows at all, whereas investments in debt instruments (e.g. bonds) would generally
pass the test. The assessment of cash flow characteristics is explained in more detail in section 3.3.8.
Step 2 - the BM test: The business model test involves assessing the business model relevant to the asset
to determine the objectives applied in managing that asset. These objectives may be:
x to hold the asset with the principal aim being to sell the asset (hold to sell);
x to collect the contractual cash flows (hold to collect); or
x to collect the contractual cash flows and to sell the asset (hold to collect and sell).
The assessment of the business model is explained in more detail in section 3.3.9.
Essentially, the process is as follows:

x If a financial asset does not meet the CCF test (i.e. does not offer contractual cash flows on specified
dates that are solely payments of principal and interest), the asset is classified at fair value through profit
or loss (FVPL), unless it is an investment in an equity instrument that is not held for trading, in which
case the entity can elect to classify it at fair value through other comprehensive income (FVOCI-debt)
instead (although this designation can only happen on initial recognition and is irrevocable).
x If the asset does meet the CCF test, our next step is to consider the objective of the business model
that will be used to manage the asset. If the objective of the relevant business model is to:
- simply collect these contractual cash flows, the asset is classified at amortised cost (AC);
- collect the contractual cash flows and also to sell the asset, then the asset is classified at fair
value through other comprehensive income (FVOCI-debt);
- sell the asset, then the asset is classified at fair value through profit or loss (FVPL).
If classification at AC or FVOCI would cause an accounting mismatch (see section 3.3.5), the asset
may be designated at FVPL instead (although this designation can only happen on initial
recognition and is irrevocable).
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3.3.3 Classification: Financial assets at amortised cost (IFRS 9.4.1.2)
A financial asset shall be classified as amortised cost (AC) if Financial assets classified
both the following conditions are met: at AC:
x The contractual cash flows: the contractual terms of the asset This classification only applies to
investments in debt instruments:
must give rise to cash flows on specified dates and these cash x CCF = specified dates & SPPI; &
flows must be solely payments of principal and interest on the x BM = held to collect CCF.
See IFRS 9.4.1.2
principal amount outstanding (i.e. SPPI); &
Note: if classifying at AC leads to
x The business model: the objective of the business model relevant an accounting mismatch, it may be
classified at FVPL instead.
to this asset must be to collect contractual cash flows (i.e. no See IFRS 9.4.1.5
intention to trade in the instruments). See IFRS 9.4.1.2
However, a financial asset that should be classified at AC (on the basis that it meets both these
conditions), may be designated as fair value through profit or loss (FVPL) instead, if classifying at
AC would cause an accounting mismatch. See section 3.3.5.
3.3.4 Classification: Financial assets at fair value through other comprehensive income
– debt instruments (IFRS 9.4.1.2A)
Financial assets classified
A financial asset shall be classified as fair value through other at FVOCI – debt:
comprehensive income (FVOCI) if both the following conditions This classification only applies to
are met (which means by implication that the asset will be an investments in debt instruments:
x CCF = specified dates & SPPI; &
investment in some kind of debt instrument e.g. a loan asset): x BM = held to collect CCF and sell.
See IFRS 9.4.1.2A
x The contractual cash flows (CCF): the contractual terms of Note: if classifying at FVOCI leads
the financial asset must give rise on specified dates to cash to an accounting mismatch, it may
flows that are solely payments of principal and interest on be classified at FVPL instead.
See IFRS 9.4.1.5
the principal amount outstanding (i.e. SPPI); and
x The business model (BM): the objective of the business model relevant to this asset must be to both collect
contractual cash flows and sell the asset. See IFRS 9.4.1.2A
However, a financial asset that meets both these requirements, and should thus be classified at FVOCI,
may be designated as fair value through profit or loss (FVPL) instead if the FVOCI classification
would cause an accounting mismatch. See section 3.3.5. See IFRS 9.4.1.5
Please note that since this classification requires that the asset has contractual cash flows, the AC and
FVOCI classifications would include only debt instruments (i.e. these classifications would not include
equity or derivative instruments because these do not offer contractual cash flows). There is a further
classification of FVOCI that deals exclusively with equity instruments that the entity has elected to classify
at FVOCI (see section 3.3.6). The FVOCI classification that deals only with debt instruments is accounted
for differently to the FVOCI classification that deals with equity instruments. For this reason, we will refer
to the one classification as FVOCI-debt and the other as FVOCI-equity.
The measurement of this classification (FVOCI-debt) is explained in section 3.6.3.
3.3.5 Classification: Financial assets at fair value through profit or loss (IFRS 9.4.1.4 – 4.1.5)
The fair value through profit or loss (FVPL) classification is essentially a 'catch-all' classification for
financial assets that do not qualify for classification as either amortised cost (AC) or fair value through
other comprehensive income (FVOCI). However, financial assets that do meet one of these other
classifications (i.e. AC or FVOCI) may be designated as fair value through profit or loss (FVPL)
instead if the other classification would have caused an 'accounting mismatch'.
Example of an accounting mismatch: A financial asset is bought to offset the risks in a particular
financial liability, and the entity does not apply hedge accounting. The liability is measured at fair
value, but the asset is to be measured at amortised cost. This situation would mean that the gains and
losses on the asset and liability would be recognised in different periods and on different bases. To
avoid this, one is able to choose to designate the asset to be measured FVPL instead of amortised cost.
Chapter 21 983
This designation as FVPL due to there being an accounting mismatch may only be made on initial
recognition and is irrevocable (i.e. management may not change its mind). See IFRS 9.4.1.5
In summary, a financial asset shall be classified as fair value through profit or loss (FVPL) if:
x it does not meet the criteria for classification at amortised cost Financial assets classified
(AC) and does not meet the criteria for classification as fair at FVPL:
value through other comprehensive income (FVOCI-debt), i.e.: x This classification applies to any
FA that does not meet the
- the contractual terms do not lead to cash flows on requirements to be classified as
specified dates that are solely payments of principal and AC or FVOCI See IFRS 9.4.1.4
interest on principal (i.e. the SPPI test fails); and/or x FAs that are designated as FVPL
so as to avoid an accounting
- the business model is neither to 'hold to collect ' nor to mismatch. See IFRS 9.4.1.5
'hold to collect and sell' (i.e. the objective of the business Note: some equity investments that
model is to 'hold to sell') (i.e. the BM test fails); or meet these requirements may be
designated as FVOCI-equity instead.
x the entity chooses to designate the asset as FVPL because See IFRS 9.4.1.4
another classification would have caused an accounting mismatch. See IFRS 9.4.1.4 -5
A financial asset that is an equity investment would fail the SPPI test and thus automatically meet
the FVPL classification but may be classified as FVOCI-equity instead under certain
circumstances. See section 3.3.6.
The measurement of this classification is explained in section 3.6.5.
3.3.6 Classification: Financial assets at fair value through other comprehensive income
– equity investments (IFRS 9.4.1.2 & IFRS 9.4.1.2A & IFRS 9.4.1.4 & IFRS 9.5.7.5)
Financial assets classified
The classification of certain equity instruments at fair value at FVOCI – equity:
through other comprehensive income (FVOCI-equity) is
This classification is one that may be
regarded as a fourth classification because the measurement elected if the FA is an:
thereof differs from the measurement of the classification of x investment in equity instruments that is
fair value through other comprehensive income (FVOCI- x not held for trading &
x not contingent consideration in an
debt) that was described in section 3.3.4 IFRS 3 business combination
This election is
The FVOCI-debt classification described in section 3.3.4 only x only possible on initial recognition
involves investments in debt instruments and is a mandatory x irrevocable. See IFRS 9.4.1.4 and IFRS 9.5.7.5
classification (i.e. if the requirements are met, the debt instrument Reclassification to P/L: prohibited.
must be classified at FVOCI). In contrast, the FVOCI-equity See IFRS 9.5.7.5 & B5.7.1
classification described in this section involves only investments

in equity instruments and is purely an elective classification.
An entity may elect to classify a financial asset as fair value through other comprehensive income
for equity instruments (FVOCI - equity) if it:
x is an investment in an equity instrument
x that is:
not held for trading; and
is not 'contingent consideration recognised by an acquirer in a business combination to
which IFRS 3 applies'). See IFRS 9.5.7.5
In other words, if a financial asset is an investment in an equity instrument that is held for trading,
the entity may not elect to classify it at 'FVOCI-equity' (i.e. it will have to be classified at FVPL).
The reason why this elective classification was introduced was because investments in equity instruments
(e.g. ordinary listed shares) would otherwise always be classified as fair value through profit or loss
(FVPL). This means that as the relevant share price rises and falls, fair value gains or losses would be
recognised in 'profit or loss'. However, if an entity has no intention to trade in its equity investments, it
would generally prefer to present the related fair value gains or losses in 'other comprehensive income'
to avoid its 'profit or loss' from being needlessly affected.
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In this case, the entity may thus prefer to classify its equity instrument as fair value through other
comprehensive income (FVOCI-equity) instead. However, a factor that should be considered
before electing to classify an equity instrument at FVOCI-equity is that, if and when the equity
instrument is eventually sold, the fair value gains or losses previously recognised in 'other
comprehensive income' may never be reclassified to 'profit or loss’. See IFRS 9.B5.7.1
This election to classify the equity investment at FVOCI-equity may only be made on initial
recognition and is irrevocable (i.e. management may not change its mind). See IFRS 9.4.1.4
The election is made on an 'instrument-by-instrument' basis. However, judgement is needed in

deciding whether one will have to classify all shares within an investee in the same way or whether
it is possible to classify some of the shares in an investee as FVOCI-equity and some as FVPL.
For your interest: In trying to answer whether an investment in an investee can be classified partly
as FVOCI-equity and partly as FVPL, the IASB attempted to split equity investments into two classes,
one being ‘strategic investments’ (long-term) and the other ‘non-strategic investments’ (short-term),
where gains or losses relating to strategic investments could be recognised in other comprehensive income.
However, the IASB was unable to decide what the definition of a ‘strategic investment’ would be and thus, by
the IASB’s own admission, there is still some mystery regarding which instruments would qualify. See IFRS 9.BC5.25(c)
The measurement of this classification (FVOCI-equity) is explained in section 3.6.4.
3.3.7 Classification process – a diagrammatic summary
This classification process can be summarised as follows:
Step 1: CCF Test (contractual cash flows)

Do the contractual terms of the FA give rise, No Is it a derivative? Yes
x on specified dates, No
x to cash flows that are SPPI …i.e. solely payments of: Is it an investment in an No
x principal and equity instrument?
x interest on the principal amount outstanding?
Yes Yes
Step 2: Business model (BM) Test Is it held for trading? Yes
No
Elect to classify at FVOCI? No
Is the BM 'held to Is the BM 'held to Yes
collect'? collect and sell'?
FV through P/ L
FV through OCI
i.e. is the objective to i.e. is the objective to
collect only the:
(equity instrument)
collect both the:
x contractual cash
x contractual cash
flows (i.e. the entity
flows; and
does not intend
dealing in the x cash flows from selling
instruments) the asset No (Neither BM applies)
Yes Yes
Would classification at amortised cost / FV through OCI

cause an accounting mismatch and, if so, do you wish to
designate as FV through P/L instead? Yes
No No
Amortised cost FV through OCI

(debt instrument) (debt instrument)
Let us now look in more detail at the issues surrounding the contractual cash flows and then
the business model and its characteristics.
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3.3.8 The contractual cash flows criteria (IFRS 9.4.1.3 & B4.1.7-B4.1.19)
All financial instruments, by definition, involve a contract of some form or another (whether in
writing or not). Depending on the contract, the cash flows will be stipulated to some degree or
another. Bank loan agreements normally stipulate all the cash flows, such as the loan amount
granted (i.e. the principal amount to be repaid), the rate of interest that will be charged as well
as the dates on which payments will need to be made. In contrast, investments in equity
instruments, such as ordinary shares, may involve a prospectus stipulating the price per share
that the investor would have to pay but the future cash flows, such as dividends, would be
unspecified and dependent on an uncertain future. The cash flows that are stipulated in the
contract are referred to as 'contractual cash flows'.
For a financial asset to be classified at amortised cost or fair value through other comprehensive
income (debt instruments only), the contractual cash flows must be set to occur on specific dates
and must relate solely to payments of the ‘principal sum’ and ‘interest on this principal’ (SPPI).
The term 'principal' refers to 'the fair value of the financial asset at initial recognition'. The term
'interest' includes a return that compensates the holder for the time value of money and credit risk
and possibly also other lending risks (e.g. liquidity risk) and costs (e.g. administration costs) as
well as a profit margin.
Essentially, contractual cash flows are solely payments of principal and interest (SPPI) if they 'are
consistent with a basic lending arrangement'. Thus, if the contract stipulates cash flows that are
linked, for example, to equity or commodity prices, it will have introduced factors that are not
normal in a basic lending arrangement and thus the contractual cash flows cannot be said to be
solely payments of principal and interest. See IFRS 9.4.1.3 & IFRS 9.B4.1.7A
Example 3: Classifying financial assets – considering the cash flows

(Adapted from illustrative example – IFRS 9 B4.1.13 and .14)
Determine whether the contractual cash flow (CCF) characteristics of Calm Limited's
financial assets (A – E) would be considered to be solely payments of principal and interest
on the principal amount outstanding (SPPI):
a) A is a loan asset with a stated maturity date and interest charged at a rate equal to LIBOR + 3% to
cover credit risk, but where interest is capped at a maximum rate of 12%.
b) B is an investment in a loan collateralised by a building. The loan amount is repayable after 5 years
and interest, payable monthly, will be charged at rates based on the debtor's credit rating.
c) C is an investment in a bond, convertible (at the option of the holder) into a fixed number of the
issuer’s ordinary shares.
d) D is an investment in a bond with a stated maturity date and an interest rate linked to an unleveraged
inflation index.
e) E is an investment in a bond where the contract stipulates a stated maturity date, interest charged at
market interest rates and that payment is linked to the performance of the debtor: interest will be
deferred in the event that the debtor is in financial difficulty and no interest will be charged on the
deferred interest during the period of deferral.
Solution 3: Classifying financial instruments - considering the cash flows

a) The CCF = SPPI: The loan has a maturity date suggesting that the principal is repayable. The fact
that interest on the principal is charged at a variable interest rate that may be capped does not detract
from the fact that the interest rate is designed to compensate the issuer for the time value of money
and the credit risk relating to the debtor, both of which meet the description of 'interest' for purposes
of the SPPI test. Capping the interest rate simply means that a variable interest rate may, in essence,
be converted into a fixed interest rate.
b) The CCF = SPPI: The interest charged is based on the risk of default of the debtor and thus the
interest would compensate the issuer not only for the time value of money but also for the credit risk
faced, both of which are considered to be 'interest'. The fact that the loan is collateralised does not
affect the assessment of whether the contractual cash flows are SPPI.
c) The CCF ≠ SPPI: The payments received will not be solely principal and interest on the principal
because the principal is not guaranteed to be repaid in cash…it could come back as shares instead,
in which case the holder would be exposed to the value of the ordinary shares.
986 Chapter 21
d) The CCF = SPPI: The loan has a maturity date suggesting that the principal is repayable. As for the
interest rate being linked to the inflation rate, inflation is what causes the time value of money to
deteriorate. Payment of interest linked to inflation thus simply 'resets the time value of money to a
current level', with the result that the interest rate 'reflects real interest'. Thus the interest payments
relate to time value and credit risk – and are thus considered to be 'interest'.
e) The CCF ≠ SPPI: Although the bond involves repayment of principal and interest, as a result of the
contractual terms, interest charges may have to be deferred and since no interest is charged on the
deferred interest, the cash payments are not considered to be related to the time value of money,
which is one of the basic requirements of a basic lending arrangement. Since the payments are not
consistent with a basic lending arrangement, the contractual cash flows are not solely payments of
principal and interest. Note: if the requirement to defer interest and not charge interest on the
deferred interest had been a legal requirement rather than a contractual term, then the contractual
cash flows would have been solely payments of principal and interest (i.e. CCF = SPPI).
3.3.9 The business model criteria (IFRS 9.B4.1.1-B4.1.6)

The business model essentially considers the intention of the entity in holding the financial asset/s,
that is whether the financial asset is being held in order to collect the contractual cash flows (hold
to collect) or whether it is being held to realise the gains in changes in the fair value through sale
thereof (hold to sell) – or whether the intention is a mixture of the two (hold to collect and sell).
It is the responsibility of key management personnel (as defined in IAS 24 Related Party
Disclosures) to determine the business model. Determining the business model requires judgement
and an assessment of 'all relevant evidence that is available at the date of assessment'. The business
model used to manage the financial asset/s is considered to be a matter of fact rather than a mere
assertion. In other words, it requires observing the actual activities undertaken by the entity in
achieving its stated objectives. See IFRS 9.B4.1.2B
The business model is neither decided on an 'entity basis' nor on an 'instrument-by-instrument
basis', but somewhere in between:
x The business model is not decided on an entity basis: In other words, an entity may have more
than one business model, having for example, one business model for one group of assets
(portfolio of investments) and another business model for another group of assets.
x The business model is not decided on an instrument-by-instrument basis: In other words, the
business model is assessed rather on the basis of portfolios (collective groups of financial
investments) and how these portfolios are managed together to achieve a particular business
objective. See IFRS 9.B4.1.1 – B4.1.3
Interestingly, although the business model’s objective may be to hold financial assets in order to collect
contractual cash flows, the entity need not actually hold all of those instruments until maturity. For
example, it can happen that the business model is to collect the contractual cash flows but the entity is
forced to sell the asset because it needs cash – referred to as a 'stress-case scenario'. In such a case, the
business model remains 'hold to collect'. Realising cash flows in a manner that differs from the expectations
when the business model was assessed does not result in a correction of error in terms of IAS 8, but could
result in a reclassification – see section 6 of this chapter on reclassifications.
This assessment is not performed on the basis of scenarios that the entity does not reasonably expect
to occur. However, if sales of assets from this portfolio of investments are found to be 'more than
infrequent' or 'more than insignificant in value', the entity must reconsider if the objective to collect
contractual cash flows is still relevant. IFRS 9.B4.1.2, B4.1.3 & .B4.1.3B
In a 'hold to collect' business model, assets are managed in a way that enables the collection of the
contractual cash flows over the life of the asset. However, if one of these assets is sold due to a
sudden liquidity problem, it does not necessarily mean that the 'hold to collect' model was incorrect.
Such a sale may have been purely incidental to the main objective of collecting cash flows.
Judgement is obviously necessary to assess the true situation but as a general rule, the sale of assets
within this business model would generally be 'infrequent'. See IFRS 9.B4.1.2C
Chapter 21 987
In a 'hold to collect and sell' business model, both the collection of contractual cash flows and the
sale of the asset are integral to the objective. An example of an objective under this business model
would be for the assets to not only generate contractual cash flows but to also be kept at a level for
purposes of maintaining a given liquidity. Thus, in this model, the number of assets sold would
normally be 'more than infrequent'. See IFRS 9.B4.1.4A
The 'hold to sell' business model means that decisions regarding the assets will be based on their fair
values. This model is normally evidenced by active buying and selling and thus the sale of assets
would typically be considered 'frequent'. However, the fact that contractual cash flows are received
while the entity holds the asset does not detract from the model being 'hold to sell' because if the
assets are being managed and evaluated based on their fair values, the receipt of contractual cash
flows are considered incidental – not integral – to the business mode's objective. See IFRS 9.B4.1.5
Example 4: Classifying financial assets – considering the business model
(Adapted from illustrative example – IFRS 9 B4.1.4)
Determine whether the following business models are aimed at collecting contractual cash
flows, selling the asset, or a combination:
a) The entity has bought an investment in order to collect contractual cash flows but has indicated that it
would certainly sell the asset if it needed the cash or if the asset no longer met the credit criteria
documented in the entity’s investment policy.
b) The entity bought a portfolio of debtors. These debtors are charged interest on their outstanding balances.
Some of these debtors will not pay and many debtors need to be phoned to encourage payment. On
certain occasions the entity found it necessary to enter into interest rate swaps (swapping the variable
rate with a fixed rate).
c) Entity A lends money to clients and then sells these loan assets to Entity B, being an entity that focuses
on collecting the cash flows. Entity A owns Entity B.
d) Entity A has budgeted for capital expenditure in a few years. Excess cash is invested in short and long-
term investments. When the opportunity arises, investments are sold to reinvest in investments with a
higher return. Portfolio managers are remunerated on the return of the portfolio. See IFRS 9.4.1.4C, eg 5
Solution 4: Classifying financial assets – considering the business model

a) BM = hold to collect. The fact that the business would act with common sense in a situation of illiquidity
does not detract from the basic objective of holding the asset in order to collect contractual cash flows.
Irrespective of their value and frequency, sales of financial assets due to an increase in credit risk do not
contradict this basic objective. This is because the credit quality of the financial assets is integral to the
entity’s ability to collect contractual cash flows. See IFRS 9.B4.1.3A
Note: Sales to manage credit concentration risk of a portfolio without an increase in the asset’s credit
risk may still meet the BM test, provided that sales are infrequent (even if significant in value), or
insignificant in value (even if such sales occur frequently). If this is not the case, the entity will need to
reconsider whether the BM is consistent with collecting contractual cash flows. See IFRS 9.B4.1.3B
b) BM = hold to collect. The fact that some debtors may lead to bad debts and that the entity enters into
derivatives to protect its interest cash flows does not detract from the fact that the entity’s business model
relating to these debtors is simply to collect the principal and interest. There is no evidence that the
entity bought the portfolio in order to make a profit from the sale thereof.
c) Entity A's BM = hold to sell. Entity A’s business model involves trading the assets rather than collecting
the contractual cash flows. Thus, the loan assets must be measured at fair value through profit or loss in
Entity A's separate financial statements.
Entity B's BM = hold to collect. Entity B’s business model involves collecting the contractual cash flows,
thus the loan assets must be measured at amortised cost * in Entity B's separate financial statements.
The group's BM = hold to collect. For the purposes of the group financial statements, the loans are issued
with the objective of ultimately collecting the contractual cash flows and thus the loan assets must be
measured at amortised cost * in the group's consolidated financial statements.
* The loan assets would be measured at amortised cost assuming the cash flows related solely to payments
of principal and interest.
d) BM = hold to collect and sell. The objective of the BM is to maximise the return of the portfolio. Holding
the portfolio to collect contractual cash flows and selling financial assets to maximise the yield of the
portfolio are both integral to achieving this objective.
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3.4 Financial assets: measurement overview (IFRS 9.5)

The measurement of financial assets can be split into initial measurement and subsequent measurement.
x Initial measurement:
Financial assets are initially measured at ‘fair value’, although, depending on their classification, some
are adjusted for transaction costs.
However, a trade receivable (i.e. a receivable arising from revenue) may need to be measured at its
‘transaction price’ (see chapter 4 and IFRS 15). See section 3.5.1.
A day-one gain or loss arises if the fair value does not equal the transaction price.
It is either recognised in profit or loss, or as part of the asset’s carrying amount, depending on the
reliability of the fair value measurement. See section 3.5.2.
The financial asset's subsequent measurement depends on its classification.
There are four potential classifications: one involves measurement at amortised cost (AC), one
classification involves a combination of measurement at amortised cost and fair value (FVOCI-debt)
and two classifications involve measurement at fair value (FVPL and FVOCI-equity). See section 3.6.
Impairment losses must also be recognised on financial assets subsequently measured at AC and
FVOCI-debt. IFRS 9 uses the ‘expected credit loss’ model to account for impairment of these assets.
This impairment reflects the credit losses that are expected on the asset. The model is thus a forward-
looking model that requires us to recognise a credit loss before a ‘credit event’ occurs. A loss
allowance is recognised, and is measured at each reporting date to reflect the latest estimate of the
expected credit losses, based on updated information regarding the asset’s credit risk. The application
of this model (i.e. how to journalise the loss allowance) is described in section 3.6. A more detailed
explanation, including how to measure the loss allowance, is given in section 4.
Fair value is defined as: Amortised cost of a financial asset or liability is

x The price that would be defined as:
- received to sell an asset or x The amount at which the FA/FL is measured at initial
- paid to transfer a liability recognition minus the principal repayments
x in an orderly transaction between x Less/add: cumulative amortisation using the effective
market participants interest rate method to account for the difference
x at measurement date. IFRS 13.9 between the initial amount and maturity amount.
For financial assets: the amortised cost is also adjusted
for any loss allowance. IFRS 9 App A (reworded)
3.5 Financial assets: initial measurement (IFRS 9.5.1)

3.5.1 Initial measurement: fair value and transaction costs
Initial measurement of financial assets (and, in fact, all financial instruments) is at:
x fair value, and
x may involve the adjustment for transaction costs (added in the case of financial assets).
There are exceptions, where we may not necessarily use fair value for the initial measurement:
x Trade receivables that do not have a significant financing component (or where there is one, but
IFRS 15 allows us to ignore it because the financing involves less than one year) are always measured
at the transaction price as defined by IFRS 15 Revenue from contracts with customers. See IFRS 9.5.1.3
x If there is a day-one gain or loss that is deferred, we will effectively be measuring the asset at
transaction price. See section 3.5.2
Whether or not to adjust a financial asset's fair value for transaction costs depends on the asset
classification. This is summarised below. See IFRS 9.5.1.1
Classification Initial measurement:
Fair value through profit or loss Fair value *
Fair value through other comprehensive income (debt or equity) Fair value + transaction costs
Amortised cost Fair value + transaction costs
* in the case of FVPL, any transaction costs would be expensed
Chapter 21 989
Transaction costs relating to a financial asset are the incremental costs (defined as being costs ‘that
would not have been incurred’ if the financial instrument had not been ‘acquired, issued or disposed
of’) that are directly attributable to the acquisition or disposal of the asset.
Transaction costs:
Transaction costs are
x include payments made, for example, to: defined as:
- agents or brokers in respect of their commissions/ fees; x incremental costs that are
- regulatory agencies and securities exchanges for levies; or x directly attributable to the acquisition,
- government bodies in respect of transfer taxes and duties. issue or disposal of a FA/FL.
An incremental cost is one that:
x exclude costs such as: x would not have been incurred
- internal administration or holding costs, e.g. the monthly fee x if the entity had not acquired, issued or
charged for servicing loans; disposed of the fin instrument. IFRS 9 App A
- debt premiums; or
- financing costs. See IFRS 9.B5.4.8
3.5.2 Initial measurement: fair value and day-one gains or losses
The fair value at which all financial assets (except trade receivables that do not have a significant
financing component) are initially measured, is determined in terms of IFRS 13 Fair value
measurement. The financial asset's fair value at initial recognition is normally equal to its
transaction price, and in fact, the transaction price is often considered to be a good indicator of
its fair value. However, it is possible that the fair value (the amount we use to initially measure
the financial asset) does not equal the transaction price (the amount we actually paid for this asset).
If the fair value and the transaction price differ, the amount by which they differ is referred to as
a day-one gain or loss. This difference is either immediately accounted for in profit or loss or
deferred depending on how reliable the determination of fair value is:
x If the fair value was considered to have been reliably measured (i.e. level 1 or 2 inputs), the
difference is recognised immediately in profit or loss. This occurs if the fair value was either:
- determined as a quoted price in an active market, referred to as a level 1 input; or
- determined by using a valuation technique that was based on observable inputs, referred
to as level 2 inputs.
Example: We pay C120 for an asset with a FV of C100, measured using observable inputs: credit
bank: C120, debit financial asset: C100 and debit day-one loss expense: C20.
x If the fair value measurement was considered to be less reliable (i.e. level 3 inputs), the difference is
deferred (delayed).
This occurs if the fair value was determined using a valuation technique that used unobservable
inputs, referred to as level 3 inputs. In this case, the asset is measured at fair value but the recognition
in profit or loss of the difference is deferred. We defer it by recognising the difference as an
adjustment to the asset's carrying amount instead. The result is that the asset's carrying amount will
reflect its transaction price (TP) (FV ± Day-one gain/loss = TP).
The deferred gain/ loss may be reversed out of the asset's carrying amount and recognised in profit
or loss after initial recognition, but only to the extent it arises from a change in a factor (including
time) market participants would consider when pricing the asset. See IFRS 9.B5.1.2A
Example: We pay C120 for an asset with a FV of C100, measured based on unobservable inputs: credit
bank: C120, debit: ‘financial asset’: C100 (FV) and debit: ‘financial asset deferred day-one loss’: C20.
The net effect is that the ‘financial asset’ is measured at its transaction price of C120 (FV 100 + deferred
loss C20). This deferred loss may or may not be expensed in the future (by crediting the ‘financial asset
deferred loss’ and debiting the ‘day-one loss expense’).
Fair value: Measured using Level 1 or Level 2 inputs. Measured using Level 3 inputs
Accounting: x FA = measured at FV x FA = measured at TP (FV + deferred loss / - deferred gain)
x Day-one gain/ loss = recognised in P/L x Day-one gain/ loss = deferred (i.e. recognised as an
adjustment to the carrying amount of the FA)
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3.6 Financial assets: subsequent measurement (IFRS 9.5.2 - .3)
3.6.1 Overview
Subsequent measurement of financial assets differs significantly depending on the classification of
the asset. The following outlines the measurement of each of the four classifications (ignoring
financial assets that are used in hedging relationships: hedging is explained in chapter 22).
x Assets classified at amortised cost will be presented at amortised cost. This classification involves
measurement using the effective interest rate method. This requires two accounts, the asset measured
at its gross carrying amount, (measured using the effective interest rate method) and its loss
allowance (measured at expected credit losses), which are set-off against each other:
Gross carrying amount (measured using the effective interest rate method): This account has a
Initial fair value, including transaction costs, debit balance
Plus interest income (at the effective interest rate)
Less repayments
Less: Loss allowance for expected credit losses This account has a
x Measured at expected credit losses debit balance
Net carrying amount (Amortised cost)
x Assets that are equity instruments classified at fair value through other comprehensive income
(FVOCI – equity) will be presented at fair value, and all fair value adjustments are recognised in
other comprehensive income. There is no loss allowance. The gains or losses recognised in other
comprehensive income may never be reclassified to profit or loss.
x Assets that are debt instruments classified at fair value through other comprehensive income (FVOCI
– debt) will be presented at fair value. However, the asset is first measured, as if it were an amortised
cost asset, using the effective interest rate method, and then it’s carrying amount (gross carrying
amount) is revalued to fair value. This classification involves a loss allowance. The gains or losses
recognised in other comprehensive income will be reclassified to profit or loss, but only when the
asset is eventually derecognised.
x Assets that are classified at fair value through profit or loss (FVPL) will be presented at fair value.
The fair value adjustment will be recognised in profit or loss. There is no loss allowance.
Thus, the different classifications affect the asset in many ways:

x It affects the measurement of the asset
x It determines whether or not the asset will require the recognition of a loss allowance
x It determines whether any of the gains or losses should be recognised in other comprehensive income
x It determines whether any gains or losses that may need to be recognised in other
comprehensive income will ever be reclassified to profit or loss.
The treatment of foreign currency gains or losses will also differ depending on the classification, although this
has nothing to do with the requirements of IFRS 9, but rather the requirements of IAS 21 Foreign currency
transactions. This is explained in the grey box below.
The treatment of foreign currency gains or losses is also affected by the classification!
When reading the following sections on how to measure the 4 different classifications, you might also
notice that foreign currency gains or losses are sometimes recognised in P/L and sometimes in OCI.
IAS 21 Foreign currency transactions requires foreign exchange gains or losses on monetary items to
be recognised in P/L.
Thus, since a debt instrument is a monetary item & an equity instrument is a non-monetary item, foreign
exchange gains or losses would, for example, be recognised:
x in P/L under the FVOCI classification for debt instruments; but
x in OCI under the FVOCI classification for equity instruments. See IFRS 9.B5.7.2-3
The requirement to recognise a loss allowance applies to assets classified at amortised cost (AC) and debt
instruments classified at fair value through other comprehensive income (FVOCI-debt). It also applies to
lease receivables, trade receivables and contract assets (arising from IFRS 15 Revenue from customer
contracts), loan commitments and certain financial guarantee contracts. See IFRS 9.5.5.1
Chapter 21 991
How to journalise a loss allowance is shown within the section on subsequent measurement at amortised
cost (see section 3.6.2) and the section on subsequent measurement of debt instruments at fair value
through other comprehensive income (see section 3.6.3). However, these journals apply equally to all
financial assets to which a loss allowance applies (e.g. it also applies to lease receivables, trade receivables,
contract assets). A more detailed explanation of the impairment of financial assets and how to measure the
expected credit losses is included in section 4.
3.6.2 Subsequent measurement: Financial assets at amortised cost (IFRS 9.4.1.2; 9.5.4)
3.6.2.1 Overview
Amortised cost FAs are
measured as follows:
Financial assets classified at amortised cost are initially
x Initially at FV plus transaction costs.
measured at fair value (plus any transaction costs). They are x Subsequently measured using the
then subsequently measured at ‘amortised cost’ (i.e. using the effective interest method.
effective interest rate method). x Tested for impairment
x All gains or losses recognised in P/L.
This effective interest rate method requires that we measure the asset and the related interest
income through a process that involves applying the effective interest rate (EIR) to the gross
carrying amount (GCA).
The effective interest rate is the rate that exactly discounts the The effective interest
future cash flows throughout the life of the financial asset, to method is defined as
the gross carrying amount of the asset (i.e. its present value). x the method that is used in the
- calculation of the amortised cost of
Please note: when calculating this effective interest rate, a FA (or FL) and the
we must take into account all the cash flows that are - allocation & recognition of the
interest revenue (expense) in P/L
expected to arise from the terms of the contract (i.e. the over the period. See IFRS 9 App A (Reworded)
contractual cash flows) and must ignore the fact that we
may expect, as a result of the asset’s credit risk, that some
The effective interest rate
of these contractual cash flows may not be received (i.e. is defined as
we ignore expected credit losses). Section 4 explains how
x the rate that exactly discounts
to measure the expected credit losses. x estimated future cash flows through
the expected life of the financial asset
Thus, the effective interest rate method recognises the x to the asset’s gross carrying amount.
difference between the future contractual cash flows and the These cash flows are the contractual
cash flows, not adjusted for expected
present value thereof as interest income over the life of the credit losses. See IFRS 9 App A (Reworded)
asset. The ‘present value’ at any one point in time is referred

to as the ‘gross carrying amount’ at that point in time).
We measure this interest income by multiplying the opening

gross carrying amount (GCA) by the effective interest rate The gross carrying amount
(EIR): is defined as:
Interest income = GCA x EIR x the amortised cost of a FA, but
x before adjusting for any loss
allowance.
The asset's closing gross carrying amount is then calculated by See IFRS 9 App A (reworded)
adding this effective interest income to the opening gross

carrying amount and subtracting any cash receipts
Asset’s closing GCA =
Opening GCA + Interest income – Cash receipts
The journals to account for the above interest income and cash flows would be as follows:
Debit Financial asset (gross carrying amount)
Credit Income (P/L: I)
Income earned on financial asset (interest at the effective interest rate)
Debit Bank
Credit Financial asset (gross carrying amount)
Receipt of cashflow from financial asset (e.g. interest at the coupon rate on a bond)
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The ‘amortised cost’ classification also requires the application of IFRS 9’s impairment requirements:
the expected credit loss model. This ‘expected credit loss model’ involves recognising a loss allowance
and a related impairment loss (or reversal) as follows:
Debit Impairment loss (E: P/L)
Credit Financial asset: Loss allowance (-A).
The loss allowance is an ‘asset measurement account’ (i.e. a ‘negative asset’)
The loss allowance must be measured at each reporting date to reflect the ‘expected credit losses’.
How to measure this loss allowance is explained in more detail in section 4.
Assets classified at amortised cost (AC) must obviously be presented at amortised cost. The ‘amortised
cost’ is the gross carrying amount (i.e. the balance per your effective interest rate table), net of the loss
allowance: See IFRS 9.5.2.2
Asset’s closing carrying amount at ‘amortised cost’ (AC) = Net carrying amount (NCA) =
Gross carrying amount (GCA) – Loss allowance (LA)
Under amortised cost, all gains and losses are recognised in profit or loss. This includes the interest
income on the asset as well as the impairment loss (or gain) arising from the loss allowance. See IFRS 9.5.7.2
Please note that if a financial asset that is classified at amortised cost is either already credit-impaired on
initial recognition, or became credit-impaired after initial recognition, then we do not use the same effective
interest rate method described above (i.e. the effective interest rate method would not involve recognising
interest income measured at the effective interest rate multiplied by the gross carrying amount). Credit
impaired assets are explained in section 3.6.2.2.
Sometimes the terms relating to an asset are renegotiated or modified. Modifications are explained
in section 3.6.2.3.
How to calculate the effective interest rate using a financial calculator:

The EIR is sometimes given in questions, but may be calculated using a financial calculator. The
following are the buttons to press if using a financial calculator (e.g. a Sharp EL-733A):
PV = Cash flow on purchase/ issue (after adjusting for transaction costs if applicable)
FV = Future cash flow on redemption/ conversion
n = number of annuity payments/ receipts during the discounting period until maturity
PMT = Actual amounts received or paid during the period to maturity (based on coupon rate)
Comp = i (the effective interest rate)
Example 5: Calculating the effective interest rate using a calculator

We buy debentures with a face value of C100 000 at a discount of 3%. The coupon rate is
12% p.a., payable bi-annually. They are redeemable at a premium of 7% after 5 years.
Required: Calculate the effective interest rate using a calculator.
Solution 5: Calculating the effective interest rate using a calculator

PV = -97 000 (100 000 x (100% - 3%)) (cash flow is negative because it is an outflow for us)
FV = 107 000 (100 000 x (100% + 7%)) (cash flow is positive because it is an inflow for us)
n = 10 (5 years x 2 payments per year)
PMT = 6 000 (100 000 x 12% x ½) (actual amount received every 6 months)
Comp i = 6,934054179% per half year or 13,86810836% p.a.
Example 6: Financial assets at amortised cost

Eternity Ltd purchased 10% redeemable debentures for C200 000 on 1 January 20X5.
Transaction costs incurred were 1% of the cost.
The debentures are redeemable at C250 000 on 31 December 20X7.
Eternity intends to hold them to collect contractual cash flows (i.e. classifies them at amortised cost).
The fair value on 31 December 20X5 was C260 000 and C280 000 on 31 December 20X6.
The asset was not considered to be credit-impaired at any stage.
Chapter 21 993
x The relevant expected credit losses, for use in measuring the loss allowance, were as follows:
01 January 20X5: C7 000
31 December 20X5: C10 000
31 December 20X6: C12 000.
Required:
Prepare the journals for the year ended 31 December 20X5 and 20X6.
Solution 6: Financial assets at amortised cost

W1: Effective interest rate table:
Effective interest rate calculation, using a financial calculator:
PV: -202 000 FV: 250 000 PMT: 20 000 N: 3 Comp i:? Answer: i = 16,6386%
Date Opening balance Effective interest Receipts Closing balance
@16,6386%
A B C D
20X5 0
Note 1
202 000
Note 2 Note 3
202 000 33 610 (20 000) 215 610
20X6 215 610 35 874 (20 000) 231 484
20X7 231 484 38 516 (20 000) 250 000
Note 4
(250 000) 0
Note 5
108 000 (310 000)
Notes:
1) Measurement at initial recognition = Cost: C200 000 + Transaction costs: (C200 000 x 1%) = 202 000
2) Effective interest = Opening balance (GCA) x EIR: 16,6386%
3) Receipt of interest based on coupon interest = C200 000 x 10% = C20 000
4) Receipt of redemption amount = C250 000 (given)
5) Notice how the difference between the total amount originally paid (C202 000) and the total of the
amounts received (C310 000) is recognised in profit or loss as effective interest income of C108 000.
Journals:
Debit/
1 January 20X5 (Credit)
FA: Debentures at AC (A) Fair value 200 000+ 202 000
Bank Transaction costs (200 000 x 1%) (202 000)
Purchase of debentures at amortised cost (thus add transaction costs)
Impairment loss (E: P/L) Given 7 000
FA: Debentures: Loss allowance (-A) (7 000)
Recognising a loss allowance, measured at the appropriate ECL (given)
31 December 20X5
Bank Face value: 200 000 x Coupon rate: 10% 20 000
Interest income (I: P/L) Per EIRT (33 610)
FA: Debentures at AC (A) Balancing 13 610
Interest earned on debentures and cash received (EIR method)
Impairment loss (E: P/L) ECL at reporting date: 10 000 – 3 000
FA: Debentures: Loss allowance (-A) Bal in this account: 7 000 (3 000)
Remeasuring the loss allowance to reflect the latest ECLs at reporting date
31 December 20X6
Bank FV: 200 000 x Coupon rate: 10% 20 000
Interest income (I: P/L) Per EIRT (35 874)
Interest earned on debentures and cash received (EIR method)
Impairment loss (E: P/L) ECL at reporting date: 12 000 – 2 000
FA: Debentures at AC (A) Bal in this account: 10 000 (2 000)
Remeasuring the loss allowance to reflect the latest ECLs at reporting date
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Comments:
x No journal is processed for the increase in fair value at the end of 20X5 since the debentures are measured
at amortised cost and not at fair value. The closing fair values are thus ignored in the solution.
x Interest actually received is based on the coupon rate applied to the face value.
x Interest earned is based on the effective interest rate applied to the asset's gross carrying amount (which
included transaction costs).
x The asset’s net carrying amount, at amortised cost, would be presented as:
1 January 20X5: GCA: 202 000 (Given) – Loss allowance: 7 000 = 195 000
31 December 20X5: GCA: 215 610 (W1) – Loss allowance: 10 000 = 205 610
31 December 20X6: GCA: 231 484 (W1) – Loss allowance: 12 000 = 219 484
3.6.2.2 If the financial asset is credit-impaired (IFRS 9.5.4.1-2)

The measurement of the financial asset and its related interest income differs slightly from the
calculation described above if the asset is credit impaired:
If the financial asset becomes credit-impaired on initial recognition:

If the financial asset becomes credit-impaired after initial recognition, the effective interest rate
method would involve calculating the effective interest rate (i.e. the ‘normal’ effective interest rate
described in section 3.6.2.1), but when calculating the effective interest income on this asset, this rate
is applied to the amortised cost of the asset (not to the gross carrying amount):
Interest income = Amortised cost x EIR.
If in a subsequent period, the asset's credit risk subsequently improves with the result that the asset is
no longer considered to be credit-impaired (e.g. if there is an improvement in the borrower’s credit
rating), then we would revert to measuring the asset’s carrying amount and related interest income by
applying the effective interest rate to the gross carrying amount:
Interest income = Gross carrying amount x EIR
In other words, we would apply the original effective interest rate to the gross carrying amount
at the start of the period in which the asset is no longer considered to be credit impaired. See
section 4.2 for more detail. See IFRS 9.5.4.1-2
If the financial asset was already credit-impaired on initial recognition:

If the financial asset was already credit-impaired on
The credit-adjusted
initial recognition, the effective interest rate method will effective interest rate of a
involve calculating a ‘credit-adjusted effective interest FA is defined as
rate’ (instead of the ‘normal’ effective interest rate
described in section 3.6.2.1). x estimated future cash flows through
the expected life of the financial asset
Furthermore, when calculating the effective interest x to the asset’s amortised cost.
income on this asset, the credit-adjusted effective These cash flows are the contractual
interest rate will be applied to the amortised cost of the cash flows adjusted for the expected
asset, (instead of to the gross carrying amount): credit losses. See IFRS 9 App A (Reworded extract)
Interest income = Amortised cost x Credit-adjusted EIR.

When we calculate this credit-adjusted effective interest rate we include:
x all contractual cash flows arising from the financial asset (i.e. based on the terms of the contract),
x but these are adjusted for the lifetime expected credit losses (i.e. we adjust the contractual cash flows
downwards to reflect the lifetime expected credit losses). See definition in IFRS A: defined term ‘credit-adjusted EIR
Please note, this differs from the calculation of the ‘normal’ effective interest rate which:
x involved discounting the future cash flows to the financial asset’s gross carrying amount, and
x included all contractual cash flows arising from the financial asset, but where these were not
adjusted for expected credit losses. (See section 3.6.2.1)
Chapter 21 995
If the asset was credit-impaired on initial recognition, the asset and its interest income will always be
measured using a credit-adjusted effective interest rate applied to the amortised cost, even if the credit
risk subsequently improves.
Since the lifetime expected credit losses that existed on initial recognition date, are already built
into the credit-adjusted effective interest rate, the loss allowance on this asset is measured at the
changes to the lifetime expected credit losses since initial recognition date (i.e. it is not measured
at the amount of the lifetime expected credit losses at reporting date, but at the increase or decrease
in the lifetime expected credit losses since initial recognition date).
3.6.2.3 If the financial asset is renegotiated or modified (IFRS 9.5.4.3)

Sometimes the terms relating to an asset are renegotiated or modified. Depending on the extent
of the modification, this can lead to the asset being derecognised and a new asset recognised.
The derecognition of a financial asset is explained in section 3.7. However, if the renegotiation
or modification does not lead to the derecognition of the asset, the entity would need to:
x calculate the asset's revised gross carrying amount: this is done by calculating the present value of
the revised future contractual cash flows, discounted using the original effective interest rate; and
x recognise a modification gain or loss in profit or loss, based on the difference between the current
carrying amount and the revised gross carrying amount.
Example 7: Financial assets at amortised cost – with modification

Use the same example above (example 6: Eternity). Now assume that, on 3 January 20X6,
the issuer of the debentures successfully renegotiated the terms of the debentures.
Instead of the debentures being redeemable at C250 000 on 31 December 20X7, they would now be
redeemable at C300 000 on 31 December 20X8. Interest on the debentures would remain payable at 10%.
The issuer paid all costs related to the negotiation of terms (i.e. Eternity did not incur any further transaction
costs). The debentures have never been considered to be credit-impaired.
Required: Prepare the journals for the year ended 31 December 20X6. Ignore the loss allowances.
Solution 7: Financial assets at amortised cost – with modification

Date Opening balance Effective interest Receipts Closing
@16,6386% balance
A B C D
20X5 0
202 000
202 000 33 610 (20 000) 215 610
20X6 215 610
Note 2
17 900
Note 1 Note 3
233 510 38 853 (20 000) 252 363
20X7 252 363 41 990 (20 000) 274 352
20X8 274 352 45 647 (20 000) 299 999
Rounding error
(300 000) (1)
Note 4
160 100 (380 000)
Notes:
1) Revised gross carrying amount (using a financial calculator): C233 510, calculated as follows:
FV: -300 000 PMT: -20 000 N: 3 i = 16,6386% Comp PV = C233 510
2) Modification gain or loss: C17 900, calculated as follows:
Revised GCA (calc 1): C233 510 – Previous GCA (per EIRT): C215 610 = C17 900
3) Effective interest income, (using the original EIR!) calculated on the revised GCA:
Revised GCA x original EIR; e.g. 20X6 interest = 233 510 x 16,6386% = C38 853
4) Notice how the difference between the total amount originally paid (C202 000) and the total of the
amounts received (C380 000) is C178 000 and that this will be recognised in profit or loss as follows:
Interest income of C160 100 + Modification gain of C17 900 = C178 000.
996 Chapter 21
Journals:
FA: Debentures at AC (A) EIRT above 17 900
Modification gain (I: P/L) 17 900
Remeasurement of financial asset to its revised GCA after modification
31 December 20X6
Bank Face value: 200 000 x Coupon rate: 10% 20 000
Interest income (I: P/L) Per EIRT 38 853
Interest earned on debentures
3.6.3 Subsequent measurement: Financial assets at fair value through other comprehensive
income – debt instruments (IFRS 9.5.7 & 9.5.7.10-11 & 9.B5.7.1A)
If the financial asset is a debt instrument classified at fair value through other comprehensive
income (FVOCI-debt), the asset is presented in the statement of financial position at an amount
reflecting its fair value. All fair value adjustments are recognised in other comprehensive
income (OCI). However, the objective of this classification is to provide users with information
on both a fair value basis and on an amortised cost basis. Thus, before we measure the asset to
fair value, we first measure it using the effective interest rate method. Thus, the effect of the
debt instrument on profit or loss should be the same as if it had been classified and measured at
amortised cost. See IFRS 9.BC5.119 & IFRS 9.5.7.11 & IFRS 9.B5.7.1A
FVOCI – debt instruments
Debt instruments that are classified as fair value through are measured as follows:
other comprehensive income (FVOCI-debt) are also subject x Initially at FV plus transaction costs.
to the impairment requirements of IFRS 9. These x Subsequently measured:
requirements involve recognising a loss allowance to reflect - 1st step: using the EIR method; &
the expected credit losses relevant to the asset, remeasured - 2nd step: at FV.
at each reporting date. x Tested for impairment
x Gains or losses due to:
The recognition and measurement of the loss allowance - Changes in FV: recognised in OCI
(reclassify to P/L on derecognition),
follow the same basic impairment principles in IFRS 9 - Anything else: recognised in P/L.
that are applied to assets classified at amortised cost (see
sections 3.6.2.1-2). However, when accounting for a loss allowance for assets classified
FVOCI-debt instruments there is one significant difference: the loss allowance will be
recognised in ‘other comprehensive income’ and not as an ‘asset measurement account’ as was
the case for assets classified at amortised cost. In other words, the carrying amount of a financial
asset classified at FVOCI-debt will not be presented net of the loss allowance. The reason for
this is that the asset is measured at its fair value, which already reflects the credit risk specific
to the asset. However, although the loss allowance is recognised in other comprehensive
income, the related loss allowance adjustments (impairment losses/ reversals) are recognised in
profit or loss See IFRS 9.5.2.2
The measurement of the loss allowance is explained in more detail in section 4.
Thus, the steps to follow are as follows:

Step 1: Measure the asset as if it were classified at amortised cost, and in so doing, recognises
interest income, as well as foreign exchange gains or losses and present them all in
profit or loss.
Step 2: Recognise the loss allowance to reflect the expected credit losses. Remember that this loss
allowance is recognised in other comprehensive income (not an asset measurement account).
Although the loss allowance is recognised in other comprehensive income, the related loss
allowance adjustments (impairment losses/ reversals) are recognised in profit or loss.
Step 3: The entity then remeasures the asset to its fair value at reporting date and recognises
the related fair value adjustment in other comprehensive income. These cumulative fair
value gains or losses recognised in other comprehensive income will eventually be
reclassified to profit or loss, but only upon derecognition. See IFRS 9.5.7.10
Chapter 21 997
Example 8: Debentures at fair value through other comprehensive income

This example uses the same information given in example 6 (Eternity), with the exception
that we are now classifying the asset at fair value through other comprehensive income
(FVOCI – debt), not at amortised cost (AC).
The details are repeated here for your convenience:
x Eternity Ltd purchased 10% redeemable debentures for C200 000 on 1 January 20X5.
x Transaction costs incurred were 1% of the cost.
x The debentures are redeemable at C250 000 on 31 December 20X7.
x The fair value on 31 December 20X5 was C260 000 and C280 000 on 31 December 20X6.
x The asset was not considered to be credit-impaired at any stage.
x The relevant expected credit losses, for use in measuring the loss allowance, were:
01 January 20X5: C7 000
31 December 20X5: C10 000
31 December 20X6: C12 000.
Required:
Prepare the journals for the year ended 31 December 20X5 and 31 December 20X6
Solution 8: Debentures at fair value through other comprehensive income

x The EIR table is the same as the EIR table in the solution to example 6 (Eternity).
x The effective interest rate = 16,6386%, calculated using a financial calculator as follows:
PV: 202 000 FV: -250 000 PMT: -20 000 N: 3 Comp i:? Answer: i = 16,6386%
20X5 20X6
1 January Dr/ (Cr) Dr/ (Cr)
FA: Debentures at FVOCI (A) Fair value 200 000 + 202 000 N/A
Bank Transaction costs (200 000 x 1%) (202 000) N/A
Purchase of debentures at FVOCI (thus add transaction costs)
Impairment loss (E: P/L) Given 7 000 N/A
FA: Debentures: Loss allowance (OCI) (7 000) N/A
Recognising a loss allowance, measured at the appropriate ECL (given)
Since the FA was measured at FVOCI-debt, this loss allowance is recognised
in OCI and is NOT a ‘negative asset’ measurement account
31 December
Bank Face value: 200 000 x Coupon rate: 10% 20 000 20 000
Interest income (I: P/L) Per EIR Table (see Example 6: W1) (33 610) (35 874)
FA: Debentures at FVOCI (A) Balancing 13 610 15 874
Recognising interest earned on debentures, measured using EIR method
(as if the asset was classified at amortised cost!), and cash received
Impairment loss (E: P/L) 20X5: ECL at reporting date: 10 000 – o/b: 7 000 3 000 2 000
20X6: ECL at reporting date: 12 000 – o/b: 10 000
FA: Debentures: Loss allowance (OCI) (3 000) (2 000)
Remeasuring the loss allowance to reflect the ECLs at each reporting date
FA: Debentures at FVOCI (A) 20X5: FV 260 000 – Bal in this a/c: 215 610 Calc 1 44 390 4 126
20X6: FV 280 000 – Bal in this a/c: 275 874 Calc 2
Fair value gain (I: OCI) Balancing (44 390) (4 126)
Remeasuring debentures to FV at reporting date, with FV adjustment
recognised in OCI (because classified at FVOCI-debt)
Calculations: Balance in the FA account just before the FV adjustment can be calculated using journals or Ex 6 W1:
1) 20X5: Using journals = o/bal 0 + 202 000 + 13 610 = 215 610; or
Using Ex 6 W1 = 215 610
2) 20X6: Using journals = o/bal 260 000 + 15 874 = 275 874; or
Using Ex 6 W1 =: 231 484 + FV adj: 44 390
= 275 874
998 Chapter 21
Example 9: Financial assets at FVOCI-debt (foreign currency treatment)

J&M is South African retail company that holds an investment in 10% debentures that are
denominated in US dollars ($).
The investment in debentures is managed with the objective of maximising the return on the portfolio
(i.e. they are classified as FVOCI because holding the debentures to collect contractual cash flows and
selling the debentures are both important to achieving this objective).
J&M purchased these debentures for $200 000 on 1 January 20X5. The debentures are compulsorily
redeemable at $250 000 on 31 December 20X6. Coupon payments (at 10% of cost) are made in arrears
on 31 December each year.
The fair value on 31 December 20X5 was $240 000.
The asset was not considered to be credit-impaired at any stage. Ignore any loss allowance.
Exchange rates (Rand: Dollar) were as follows:
Date 20X5 20X6
1 January R10.0: $1 R10.3 $1
31 December R10.3: $1 R13.3: $1
Average exchange rate R10.2: $1 R11.5: $1
Required: Prepare the journals for the year ended 31 December 20X5 and 20X6.
Solution 9: Financial assets at FVOCI-debt (foreign currency treatment)

Effective interest rate calculation using a financial calculator (calculated in $):
PV: -200 000 FV: +250 000 PMT: 20 000 N: 2 Comp i: ? Answer: i = 21,29703%
Date Amortisation in Exchange rate Amortisation in
$ (Rx: $1) R
1 January 20X5 200 000 10.0 Note 1 2 000 000
Interest income: 20X5 42 594 200 000 x 21.2970% 10.2 Note 2 434 459
Receipt: 31/12/20X5 (20 000) 200 000 x 10% 10.3 Note 3 (206 000)
Balancing: forex gain/(loss) - 64 259
31 December 20X5 222 594 10.3 Note 1 2 292 719
Interest income: 20X6 47 406 222 594 x 21.2970% 11.5 Note 2 545 168
Receipt: 31/12/20X6 (20 000) 13.3 Note 3 (266 000)
Balancing: forex gain/(loss) - 753 113
31 December 20X6 250 000 13.3 Note 1 3 325 000
Notes:
1) Foreign currency monetary items are translated using the closing rate on transaction date and at the end of
each reporting period. See IAS 21.23
2) The interest expense is earned evenly over the year and thus it is translated using the average exchange rate.
3) Foreign currency transactions are translated at the spot exchange rate at the date of the transaction.
20X5 20X6
1 January Dr/(Cr) Dr/(Cr)
FA: Debentures at FVOCI (A) EIRT above 2 000 000 -
Bank (A) (2 000 000) -
Purchase of debentures
31 December
FA: Debentures at FVOCI (A) Balancing 228 459 279 169
Bank (A) EIRT above 206 000 266 000
Interest income (I: P/L) EIRT above (434 459) (545 169)
Interest earned & interest received on debentures
FA: Debentures at FVOCI (A) EIRT above 64 259 753 113
Forex gain (I: P/L) (64 259) (753 113)
Foreign exchange gain on debentures
FA: Debentures at FVOCI (A) 20X5: FV: $240 000 x 10.3 – GCA: 179 281 -
Fair value gain (I: OCI) 2 292 719 (179 281) -
20X6: FV = GCA, thus no FV adj.
Fair value gain on debentures at FVOCI
Bank $250 000 x 13.3 3 325 000
FA: Debentures at FVOCI (A) (3 325 000)
Redemption of debentures
Chapter 21 999
Comment:
This calculation can be confusing if performed in the incorrect sequence. As a rule of thumb, financial assets
subsequently measured at FVOCI-debt should be translated and measured by applying the following steps:
1. Calculate the EIR in the foreign currency.
2. Prepare the effective interest table in the foreign currency.
3. Translation difference: Translate the effective interest table into the functional currency of the entity, using
the relevant exchange rates (spot or average as the case may be). Restate the GCA at the spot rate at year-end.
The balancing amount should be reflected in profit or loss as foreign exchange gain or loss. See IAS 21.28
4. Fair value adjustment: Translate the fair value into the local currency at the spot rate at year-end. The FV less
the GCA (both in the functional currency) results in a cumulative gain or loss which should be recognised in
other comprehensive income. In subsequent periods the gain or loss to be recognised is determined by
deducting the cumulative gain/loss from the prior period from the cumulative gain/loss in the current period.
3.6.4 Subsequent measurement: Financial assets at fair value through other comprehensive
income – equity instruments (IFRS 9.5.7.5-6 & IFRS 9.B5.7.1-2)
Investments in equity instruments that are held for

FVOCI – equity instruments
trading must always be classified at ‘fair value through are measured as follows:-
profit or loss’ (FVPL). However, if the investment in
x Initially at FV plus transaction costs.
equity instruments is not held for trading, the entity can,
x Subsequently measured at FV
under certain circumstances, elect to classify it at either
x Not tested for impairment
fair value through profit or loss (FVPL) or at ‘fair value
x Gains or losses: all recognised in OCI
through other comprehensive income’ instead (FVOCI- (may never be reclassified to P/L)
equity). This election may only occur on initial recognition x Dividend income: recognised in P/L
and is an irrevocable election (see section 3.3.6).
The subsequent measurement of an investment in equity instruments at 'FVOCI-equity' involves

measuring the asset to fair value at each subsequent reporting date and recognising the related fair value
gains or losses in other comprehensive income (OCI).
Dividend income is
Gains or losses recognised in OCI may never be reclassified recognised when:
to profit or loss (P/L). See IFRS 9.B.5.7.1 x The entity's right to receive payment
has been established;
If the equity instrument declares a dividend, we will only x It is probable that the economic benefits
associated with the dividend will flow to
recognise the dividend as having been earned once three the entity; and
criteria are met (see pop-up above). x The amount of the dividend can be
measured reliably. IFRS 9.5.7.1A
Dividends that are earned are recognised in ‘profit or loss’ (P/L), unless it is a ‘part recovery’ of the cost
of the investment. In other words, if the dividend is received in cash, the entry could either be:
x Debit bank; Credit dividend income (P/L); or
x Debit bank; Credit financial asset (A), if it is part recovery of the cost of the asset. See IFRS 9.B5.7.1
However, if the dividend is not received immediately (i.e. the dividend has been declared, but we have
not received the cash), the usual approach is to include it in the carrying amount of the financial asset:
debit financial asset and credit income earned. However, IFRS 9 is silent on this issue and thus one could
debit a separate ‘receivable’, if preferred (e.g. debit receivable; credit dividend income). When the cash
flow occurs, we will reduce the carrying amount of the asset and recognise the receipt of cash.
x Earn the dividend: Debit financial asset; Credit dividend income
x Receive the dividend: Debit bank, Credit financial asset.
Please note that the FVOCI-debt classification and the FVOCI-equity classification have some
significant differences (these are listed below):
x Assets at FVOCI-debt are first measured at amortised cost before being measured to fair value
x There are no impairment tests required for an equity instrument at FVOCI. This is because
impairment testing focuses on credit risk, and whilst credit risk exists on debt instruments,
it does not exist in the case of equity investments (because there are no contractual cash
flows on which the counterparty may default).
1000 Chapter 21
x The treatment of foreign exchange gains or losses will differ. This is due to the requirements
of IAS 21 The effects of changes in foreign exchange rates and is explained as follows:
- An investment in an equity instrument is a non-monetary asset (because it does not meet the
definition of a monetary item: it is not an asset that will be received in a fixed or determinable
number of currency units).
This is important because IAS 21 requires that, in the case of non-monetary assets, a foreign
exchange gain or loss must be recognised in the same component as the related fair value gain
or loss (i.e. in P/L or OCI).
Thus, since investments in equity instruments are measured at fair value with the fair value
gains or losses recognised in OCI, any related froeign exchange difference must also be
recognised in OCI.
- By contrast, an investment in a debt instrument meets the definition of a monetary item, and
thus, in terms of IAS 21, all foreign exchange differences are simply recognised in P/L.
See IAS 21.30
See chapter 20 for more detail.
x Dividends earned on equity instruments at FVOCI (i.e. FVOCI-equity) are recognised as dividend
income (unless they represent a partial recovery of the cost of the asset), whereas dividends earned
on debt instruments at FVOCI (FVOCI-debt) are recognised as interest income under the effective
interest rate method.
Example 10: Financial assets at fair value through OCI – equity

Stubborn Limited purchased 1 000 ordinary shares of Help-us Limited on
1 January 20X8. Each share cost C100. Broker fees cost C8 000.
x On initial recognition the management of Stubborn Limited determined that the equity
investment qualified as a ‘strategic equity investment’ and elected to present the fair
value changes in other comprehensive income.
x Help-us declared dividends of C1 per share on 15 December 20X8 (the three criteria for
recognition as dividend income were met on this date). The dividend has not yet been received.
x At 31 December 20X8 the investment had a fair value of C120 000.
x On 5 January 20X9, the dividend was received
Required:
Prepare the journal entries for the year ended 31 December 20X8 and 20X9.
Solution 10: Financial assets at fair value through OCI - equity

FA: Shares at FVOCI (A) 1 000 shares x C100 100 000
Bank 100 000
Investment in financial asset
FA: Shares at FVOCI (A) 8 000
Bank 8 000
Brokers fees capitalised because the FA is classified as FV through OCI
15 December 20X8
FA: Shares at FVOCI (A) 1 000 shares x C1 1 000
Dividend income (I: P/L) 1 000
Dividend income earned
31 December 20X8
FA: Shares at FVOCI (A) FV at reporting date: 120 000 – Bal in 11 000
Fair value gain (I: OCI) this a/c: (100 000 + 8 000 + 1 000) 11 000
Remeasuring equity to FV at reporting date, with FV adjustment
recognised in OCI (because classified at FVOCI-equity)
5 January 20X9
Bank (A) 1 000 shares x C1 1 000
FA: Shares at FVOCI (A) 1 000
Dividend received
Chapter 21 1001
3.6.5 Subsequent measurement: Financial assets at fair value through profit or loss
The classification of fair value through profit or loss (FVPL) includes the entire spectrum of
financial assets: investments in equity, debt, and all derivatives. Compare this with the
classification of:
x FVOCI-debt, which only applies to debt instruments,
x FVOCI-equity, which only applies to investments in equity instruments, &
x Amortised cost, which only applies to debt instruments.
The measurement of financial assets classified at FVPL is

FVPL financial assets are
quite simple: they are initially measured at fair value (with measured as follows:-
transaction costs expensed) and are then subsequently
x Initially at FV (transaction costs are
remeasured at each reporting date to their latest fair expensed).
values. The resultant fair value adjustment (fair value gain x Subsequently measured at FV
or loss) is recognised in profit or loss. See IFRS 9.5.7.1 x Not tested for impairment
x Gains or losses: all recognised in P/L
A financial asset may generate cash flows (e.g. an Dividend income (if any): recognised
in P/L
investment in debentures would generate interest and an
investment in shares may generate dividends). IFRS 9
does not stipulate how to account for these, but the If the FV drops below
convention is to first accrue for the cash flows, when zero…
appropriate: debit financial asset and credit income
If the FV of a fin asset classified at
(interest income or dividend income). FVPL drops below zero, the financial
Then, if and when the cash is received, we would debit asset switches to being:
bank and credit the financial asset. This is the approach x identified as a financial liability and
x measured as a financial liability!
used in this text. Other alternative approaches are See IFRS 9.B5.2.1
possible. For example, we could simply recognise the
cash flow if and when it occurs (debit bank and credit financial asset). The approach used will
affect the amount of the fair value adjustment, but the effect on profit or loss will be the same.
However, it is important to remember that, if the financial asset is an investment in an equity

instrument that generates dividends, these dividends would be recognised in profit or loss only if and
when certain criteria are met (see the pop-up under section 3.6.4 for the 3 criteria that must be met
before dividend income may be recognised).
Foreign exchange gains/ losses are recognised in profit or loss whether the financial asset is a
monetary (e.g. loan receivable) or non-monetary (e.g. equity) item. See IAS 21.28 & .30 & IFRS 9B5.7.2
This FVPL classification is not subject to any impairment requirements. Impairment tests focus
on the credit risk relating to the asset's contractual cash flows. Thus, the impairment test would
not apply to an investment in equity instruments classified at FVPL (because there are no related
contractual cash flows). But the point is that the impairment test does not apply to any asset
classified at FVPL – even to assets that do have contractual cash flows, such as loan assets.
The reason for this is that financial assets at FVPL are measured at fair value, which already
reflects credit risk and since the fair value adjustments are recognised in profit or loss, the
effects of credit risk will have automatically been recognised in profit or loss. See IFRS 9.5.2.2
Example 11: Financial assets at fair value through profit or loss

Grime Limited purchased 25 000 shares at a total cost of C25 000 on 1 November 20X5.
Initial directly attributable transactions costs amounted to C 2 500.
At 30 December 20X5, a dividend of C1 000 was declared, on which date all criteria for recognition as
dividend income were met.
At the year-end (31 December 20X5) the fair value of the shares was C55 000.Grime Limited purchased
these shares with the intention to sell in the short term (i.e. shares are held for trading).
Required:
Show the necessary journal entries to record the change in fair value.
1002 Chapter 21
Solution 11: Financial assets at fair value through profit or loss

Comment:
x Since the shares were held for trading, the investment is classified as fair value through profit or loss.
x If no dividend income had been earned, the fair value gain would have been C30 000.
1 November 20X5 Debit Credit

FA: Shares at FVPL (A) Given 25 000
Bank 25 000
Purchase of shares – classified as ‘fair value through profit or loss’
Transaction costs (E) 2 500
Bank 2 500
Payment of transaction costs expensed because FA is classified at FVPL
30 December 20X5
FA: Shares at FVPL (A) Dividend earned 1 000
Dividend income (I: P/L) 1 000
Dividend income earned
31 December 20X5
FA: Shares at FVPL (A) FV at RD: 55 000 – 29 000
Fair value gain (I: P/L) Bal in this account: (25 000 + 1 000) 29 000
Re-measurement of shares (FVPL) to FV at year-end (recog in P/L)
4. Impairment of Financial Assets (IFRS 9.5.2.2 and IFRS 9.5.5)
4.1 Overview A loss allowance is defined

as the:
A big change brought about by IFRS 9 is the introduction of allowance for expected credit losses
the ‘expected credit loss model’ (the ECL model). This on financial assets measured at
model requires that, in the case of certain financial assets, we amortised cost, lease receivables &
contract assets;
recognise a loss allowance. This loss allowance reflects the
accumulated impairment amount for
credit losses that are expected on an asset due to credit risk financial assets measured at FV
(i.e. the loss allowance reflects ‘expected credit losses’). The through OCI; and the
model is thus a forward-looking model that requires us to provision for expected credit losses
recognise a credit loss before a ‘credit event’ occurs. on loan commitments and guarantee
IFRS 9 Appendix A (slightly reworded)
contracts.
This ECL model has been designed specifically for financial assets that involve ‘contractual cash flows’
and that are managed in a business model that regards the 'collection’ thereof as being an ‘integral
activity’. The premise is that, since the collection of the contractual cash flows is considered to be an
integral activity, information about the effects of an asset’s credit risk on the extent to which an entity
expects to receive these cash flows will be useful to users of financial statements.
The ECL model will thus apply to the following classifications, where, by definition, the 'collection of
contractual cash flows' is integral to the entity’s business model:
x The ‘amortised cost’ classification (AC); and
x The ‘fair value through other comprehensive income - debt’ classification (FVOCI-debt), being a
classification that includes only financial assets that involve debt instruments.
The ECL model is not used for the following classifications:

x The ‘fair value through other comprehensive income – equity’ classification (FVOCI-equity):
This does not involve the recognition of a loss allowance because it refers only to investments in
equity, and the very nature of equity instruments means that there are no contractual cash flows.
x The ‘fair value through profit or loss’ classification (FVPL):
This classification does not involve a loss allowance, because the financial asset is measured at fair
value, where fair value automatically reflects any credit risks (the higher the risk, the lower the fair
value), and the related fair value adjustments are recognised in profit or loss. Since these adjustments
are recognised in profit or loss, it means that the effects of any changes to the asset’s credit risk are
already reflected in profit or loss. Thus, if we recognised a loss allowance, with the related loss
allowance adjustments in profit or loss, the effects of the credit risk on profit or loss would be double-
counted (i.e. once as a fair value adjustment and once as an impairment adjustment).
Chapter 21 1003
As mentioned earlier, the ‘FVOCI’-debt’ classification does involve the recognition of a loss allowance.
Notice that this is despite the fact that the financial asset will be measured at fair value, where fair value
already reflects the effects of credit risk. The reason for this is, when we use this classification, the related
fair value adjustments are recognised in other comprehensive income (OCI).
x The ‘problem’ with this is that IFRS 9 states that the effects of any change to the asset’s
credit risk must be recognised in profit or loss (P/L).
x So, to fix this problem, we need to process a journal that:
- will reflect the asset’s changing credit risk within profit or loss (i.e. debit impairment
loss or credit impairment reversal), and then,
- in order to avoid double-counting the negative effects of credit risk on the asset’s
carrying amount (because it is already measured at fair value), this journal must
recognise the related ‘loss allowance’ in other comprehensive income (OCI).
x In other words, in the case of a financial asset classified at FVOCI-debt, the loss allowance
will not be a ‘measurement account’ that reduces the financial asset’s carrying amount and,
because the impact on ‘profit or loss’ of a financial asset classified at FVOCI-debt must be
the same as if it was classified at AC instead, we recognise the loss allowance adjustment
in profit or loss.
Thus, the impact of the principles explained above, is that the ECL model results in the following journals:
x Amortised cost classification (AC):
The ECL model requires that a loss allowance be recognised for financial assets classified at
amortised cost. This loss allowance is an ‘asset measurement account’ (with a credit balance)
that effectively reduces the carrying amount of the financial asset. When recognising this loss
allowance account, the contra-entry is an impairment loss adjustment (an expense), recognised in
profit or loss. The journal would be as follows:
Debit Credit
Impairment loss (P/L: E) xxx
Financial asset: loss allowance (-A) xxx
Recognising the loss allowance on a FA at amortised cost
x Fair value through other comprehensive income – debt instruments (FVOCI-debt):
The ECL model requires that a loss allowance be recognised for financial assets that are
investments in debt instruments classified at fair value through other comprehensive income
(FVOCI-debt). However, as explained above, although the impairment loss is recognised
in profit or loss, the related loss allowance account is not recognised as an ‘asset
measurement account’ (i.e. it does not reduce the carrying amount of the financial asset).
Instead, the loss allowance is recognised as 'other comprehensive income' (i.e. part of
equity). The journal would thus be as follows:
Debit Credit
Impairment loss (P/L: E) Note 2 xxx
Loss allowance on financial asset (OCI) Note 1 xxx
Recognising the loss allowance on a FA at FVOCI
Notes:
1) Remember, the fact that the loss allowance is recognised in OCI, (instead of as an ‘asset
measurement account’ that reduces the asset’s carrying amount), does not result in the asset
being overstated. This is because assets in this classification are measured at fair value, where
fair value automatically reflects the market’s reaction to the asset’s credit risk.
2) Remember that IFRS 9 requires that the effects of credit risk of an asset at ‘FVOCI-debt’ must
be measured and reflected in profit or loss (P/L) as if it were an asset at ‘amortised cost’ (AC),
instead. Thus, the adjustment to the loss allowance must be recognised as an impairment loss
(or impairment reversal) in profit or loss. Notice that the effects of the credit risk will not be
double-counted in profit or loss because the fair value adjustments (which automatically include
the effects of changing credit risk) are recognised in other comprehensive income (OCI) and not
in profit or loss (P/L).
1004 Chapter 21
This can all be summarised as follows:

Classification of financial asset Loss allowance
FVPL (all sorts) Not applicable
FVOCI (equity investments ) Not applicable
FVOCI (debt instruments) Applicable: The FA is presented separately from its LA:
x Financial asset (A): Fair value
x Loss allowance (OCI – part of equity) See IFRS 9.5.5.2
Amortised cost (debt instruments) Applicable: The FA is presented net of its LA:
x Financial asset (A): GCA – Loss allowance (-A)
The ECL model does not only apply to the financial assets referred to above. Instead, the ECL
model applies to all the following assets:
x Financial assets at amortised cost (AC);
x Financial assets (debt) at fair value through other comprehensive income (FVOCI-debt);
x Lease receivables (see IFRS 16 Leases);
x Contract assets and trade receivables (see IFRS 15 Revenue from Contracts with Customers);
x Loan commitments and certain financial guarantee contracts. See IFRS 9.5.5.1 & 15
There are two approaches to the ECL model:
x the general approach and
x the simplified approach.
The general approach is always used for financial assets classified at AC and FVOCI-debt.
The simplified approach is only used in certain specific circumstances involving trade receivables,
contract assets and lease receivables.
The principles underlying the recognition of the loss allowance apply equally to both the general and
simplified approaches. The only difference is in the measurement of the loss allowance. Section 4.2
explains the very basic principle behind the measurement of the loss allowance under the ECL model.
Section 4.3 explains how to measure the loss allowance in terms of the general approach. Section 4.5
explains how and when to measure the loss allowance in terms of the simplified approach.
4.2 Explanation of the principles behind recognising a loss allowance

Financial assets are initially measured at fair value, where this Credit risk is defined as –
fair value will reflect the asset’s credit risk on this initial
recognition date. The loss allowance is thus measured at each The risk that one party to a
reporting date to reflect changes in credit risk since this initial financial instrument
will cause a financial loss for the
recognition date. The measurement of the loss allowance at other party
reporting date may need to reflect an amount equal to ‘12- by failing to discharge an obligation
IFRS 7 Appendix A
month expected credit losses’, ‘lifetime expected credit losses’
or just the ‘change in lifetime expected credit losses since initial recognition’.
The measurement of the loss allowance is based on what is referred to as the ECL model. This
model kicks in as soon as the financial asset is recognised in the financial statements. In other
words, it is not necessary for an impairment event (also known as a ‘credit event’ or ‘trigger’),
to be evident before the loss allowance is accounted for – we account for credit losses based on
expectations – we do not wait for them to occur.
Expected credit losses
The following explanation relates to financial assets that must are calculated as –
apply the impairment requirements under the general approach a probability-weighted estimate of
and where these assets are not already credit-impaired on credit losses (i.e. the present value
initial recognition. Financial assets that are already credit- of all cash shortfalls)
impaired on initial recognition were explained in section over the expected life of the
3.6.2.2 and are referred to again in section 4.3.2. financial instrument. IFRS 9.B5.5.28
As mentioned earlier, there is a general approach to the expected credit loss model (see
section 4.3) and a simplified approach (see section 4.5). The approach used will affect the
measurement of the loss allowance.
Chapter 21 1005
4.3 Expected credit loss model – the general approach (IFRS 9.5.5.1 – 14 & B5.5.33)
4.3.1 Assessment of credit risk on initial recognition date
Financial assets that are not credit-impaired on initial recognition:
If the assessment of the credit risk on initial recognition date Expected credit losses
are defined as –
indicates that the financial asset is not already credit-impaired
on initial recognition, then the loss allowance initially The weighted average of
recognised is measured at an amount equal to the credit losses credit losses with
expected in the next 12 months (i.e. the 12-month expected the respective risks of a default
occurring as the weights IFRS 9 App A
credit losses calculated from date of initial recognition).
Recognising the acquisition of the financial asset, which is measured at fair value, while
simultaneously recognising a loss allowance for the credit losses on this date, may seem a bit
confusing because the net carrying amount of the financial asset will obviously be below fair
value! However, the effective interest rate is calculated on contractual cash flows before
adjusting for any expected credit loss – this results in a higher effective interest rate and
consequently higher interest income than if the effective interest rate was adjusted for credit risk
(i.e. if a credit-adjusted effective interest rate was used). Thus, the IASB decided that
recognising a loss allowance to reflect the expected credit losses over the next 12 months (12m
ECL) would serve as a practical approximation of using a credit-adjusted effective interest rate
while avoiding the operational burden and costs of calculating a credit-adjusted effective interest
rate. See IFRS 9BC5.198
Financial assets that are already credit-impaired on initial recognition:
If the assessment of the credit risk on initial recognition date indicates that the financial asset is already
credit-impaired on initial recognition date, then we do not recognize a separate loss allowance on
this date . This is because, since the asset’s credit risk is so serious on initial recognition, we
will be measuring the asset and its related interest income using a credit-adjusted effective
interest rate (which is calculated by taking into account the expected cash flows rather than the
contractual cash flows – i.e. the rate takes into account the contractual cash flows after adjusting
for the expected credit losses that were estimated when assessing the credit risk on this initial
recognition date). (Please also see section 3.6.2.2)
The result of this is that the expected credit losses that were estimated based on the assessment of credit
risk on initial recognition date will automatically be recognized by way of a lower interest income over
the life of the asset, which also ensures that the asset has a lower carrying amount.
Thus, in other words, recognizing a loss allowance for the credit risks that existed on initial
recognition date would be duplicating the effects of having built this credit risk into the credit-
adjusted effective interest rate, which is then used in the measurement of the asset. See IFRS 9.5.5.13
4.3.2 Re-assessing the credit risk at reporting date
4.3.2.1 Overview
Financial assets that were not credit-impaired on initial recognition:
We need to re-assess the credit risk of the financial asset at each reporting date after initial
recognition and, depending on the outcome of this assessment, we must either
x continue measuring the loss allowance at an amount equal to the latest estimate of the '12-
month expected credit losses' or,
x if the credit risk has deteriorated significantly, we must measure the loss allowance at an
amount equal to the latest estimate of the 'lifetime expected credit losses'. See IFRS 9.5.5.9
1006 Chapter 21
Financial assets that were already credit-impaired on initial recognition:
The measurement of the loss allowance relating to an asset that was already credit-impaired on
initial recognition must always equal the latest estimate of the 'lifetime expected credit losses'.
In other words, the measurement of the loss allowance may never be changed to reflect 12-
month expected credit losses. See IFRS 9.5.5.13
4.3.2.2 Lifetime expected credit losses
The 'lifetime expected credit loss' is essentially the difference between the present value of the cash
flows due to an entity in terms of the contract, and the cash flows that the entity expects to actually
receive. By present-valuing the contractual and expected cash flows, we are taking into account the
timing of these cash flows. Due to the time value of money, receiving a contractual cash flow later
than expected will result in a lower present value of the financial asset. Thus, a credit loss will be
recognised even if the cash flows are merely expected to be late. See IFRS 9.B5.5.28
If the financial assets are not credit-impaired at initial recognition but subsequently become
credit-impaired, the lifetime expected credit losses are measured as the difference between the
gross carrying amount of the financial asset and the present value of the estimated future cash
flows discounted using the original effective interest rate (i.e. Lifetime credit losses for a credit
impaired asset = GCA – PV of estimated future cash flows, discounted using the original EIR).
See IFRS 9.B5.5.33
4.3.2.3 Assessing the credit risk
The assessment of whether there has been an increase in credit risk needs to consider all
reasonable and supportable information, including information that is forward-looking. We
may perform this assessment on an individual asset basis or on a collective basis. See IFRS 9.5.5.4
To assess if there has been a significant increase in the credit risk of a financial asset, we must focus
on the change in the risk of default (or probability of default: PD) occurring during the life of the
financial instrument, rather than the change in the amount of the expected credit losses. Thus, to
determine whether there has been a significant increase in credit risk, we compare the risk of default
as at reporting date with the risk of default that existed on initial recognition. In other words, a
significant increase in the amount of the expected credit losses since initial recognition is not an
indication that there has been a significant increase in the asset's credit risk. See IFRS 9.5.5.9
If a financial asset is regarded as having a low risk of default at the reporting date, then the
entity may automatically assume that there has not been any significant increase in credit risk
since initial recognition. See IFRS 9.5.5.10
There is a rebuttable presumption that if the contractual cash flows on a financial asset are 30 days or more
‘past due’ (30 days or more overdue), that there has been a significant increase in credit risk. See IFRS 9.5.5.11
If the contractual terms of a financial asset are modified, the basis for assessing the change in
credit risk is a comparison between the risk of default at reporting date (using the modified
contractual terms) and risk of default at initial recognition (based on original terms). See IFRS 9.5.5.12
4.3.2.4 The effect of the credit risk assessment at subsequent reporting dates
When a financial asset is already credit-impaired on initial recognition, the entity shall always apply
the credit-adjusted effective interest rate to the amortised cost of the financial assets. See IFRS 9.5.4.1(a)
Where the financial asset is not credit impaired on date of initial recognition, the remeasurement
of the loss allowance to the expected credit loss at reporting date must be determined by
comparing the assessment of the financial asset's credit risk (risk of default) at reporting date
with its credit risk (risk of default) at initial recognition.
Chapter 21 1007
We then categorise our financial asset into one of the following 3 stages:
x Stage 1:
If our asset's credit risk has not increased significantly since initial recognition, then our
asset is considered to be 'performing' and falls into stage 1.
We can assume the credit risk has not increased significantly if the credit risk is low.
If our asset falls into stage 1:
- the loss allowance continues to reflect only '12-month expected credit losses', and
- interest revenue is calculated by applying the effective interest rate to the gross carrying amount.
For an example of this, see example 13, Part A.
x Stage 2:
If the asset's credit risk has increased significantly since initial recognition, but there is no objective
evidence that it is credit-impaired, then it is said to be 'under-performing' and falls into stage 2.
- the loss allowance is increased to reflect 'lifetime expected credit losses', but
- interest revenue is still calculated by applying the effective interest rate to the gross
carrying amount.
For an example of this, see example 13, Part B and example 14, Part A.
x Stage 3: A credit-impaired
financial asset is defined
If objective evidence exists that the asset has become as a FA:
credit-impaired (i.e. events have already taken place that x whose estimated future cash flows
have decreased the asset's estimated future net cash x have been detrimentally affected
inflows), then our asset is considered to be 'not-performing' x by an event that has already
and falls into stage 3. occurred. IFRS 9 Appendix A (Reworded).

- the loss allowance is measured at 'lifetime expected credit losses', and
- interest revenue is now calculated by applying the effective interest rate to the
amortised cost (amortised cost = gross carrying amount – loss allowance).
For an example of this, see example 14 Part B.
4.4 Measurement of expected credit losses (IFRS 9.5.5.17 – 5.5.20)
When an entity measures expected credit losses on a financial instrument, it shall use
information that reflects the following:
x probability-weighted amounts that consider a range of possible outcomes,
x time value of money, and
x readily available information that is reasonable and supportable and falls within the
contractual period over which the entity is exposed to credit risk. IFRS 9.5.5.17-19
Please note that when we say that an expected credit loss must be measured using probability-
weighted amounts, it does not mean that every possibility must be taken into account in the
calculation. However, the probability of credit losses occurring must be considered even if the
possibility of the loss occurring is deemed low. See IFRS 9.5.5.18
The following events may indicate that a financial asset has become credit-impaired:
significant financial difficulty of the issuer or the borrower,

a breach of contract such as a default or ‘past due’ event,
the lender/s of the borrower, for economic or contractual reasons relating to the borrower’s financial
difficulty, having granted to the borrower a concession/s that the lender/s would not otherwise consider,
when it becomes probable that the borrower will enter bankruptcy or other financial reorganisation,
the disappearance of an active market for that financial asset because of financial difficulties, or
the purchase of origination of a financial asset at a deep discount (below market prices for instruments
of a similar profile) that reflects incurred credit losses. IFRS 9 Appendix A (Reworded).
1008 Chapter 21
Summary: General approach to the subsequent measurement of a loss allowance
Stage 1: Stage 2: Stage 3:

FA is still 'performing' i.e. FA is 'under-performing' i.e. FA is 'not performing' i.e.
x the FA's credit risk has not x the FA's credit risk has x objective evidence that the FA is
increase significantly; or increased significantly but 'credit-impaired'
x credit risk is still considered low x there is still no objective
evidence of being credit-impaired
Effect of the stage on the measurement of the FA's loss allowance
Measurement of loss allowance: Measurement of loss allowance: Measurement of loss allowance:

12-month expected credit losses lifetime expected credit losses lifetime expected credit losses
Effect of the stage on the measurement of the FA's interest income
Measurement of interest income: Measurement of interest income: Measurement of interest income:

EIR x GCA EIR x GCA EIR x (GCA – Loss allowance)
Gross carrying amount (GCA) is defined as the amortised cost of a FA, before adjusting for any loss allowance *
Amortised cost is the gross carrying amount after adjusting for any loss allowance (GCA – Loss allowance)
Example 12: Loss allowances – an example comparing the 3 stages

(Amortised cost – the basics)
An entity purchases debentures of C450 000 on 1 January 20X2, on which date they are
not considered to be credit-impaired.
The financial asset is classified at amortised cost and has an effective interest rate of 10%.
Interest on the debentures of C30 000 was received on 31 December 20X2.
The following information was relevant on 31 December 20X2:
Lifetime expected credit loss if there is a default (also called: Loss given default: LGD) 30%
Probability of default occurring within 12 months (12m PD) 10%
Probability of default occurring within lifetime (Lifetime PD) 12%
For your information:
A ‘loss given default (LGD)’ is an estimate of the loss arising after default on a financial asset. It is
measured as the difference between the expected cash flows from the financial asset and any collateral
the creditor may have. In other words, it is the actual percentage of expected credit loss that will be
incurred should a default occur. EY Applying IFRS (slightly reworded)
Required:
Calculate the loss allowance balance at 31 December 20X2, the interest income to be recognised for
the year ended 31 December 20X2 and for the year ended 31 December 20X3, assuming that the
assessment at 31 December 20X2 was that:
A. there was no significant increase in credit risk since initial recognition (i.e. the asset was stage 1).
B. there was a significant increase in credit risk since initial recognition (i.e. the asset was stage 2).
C. the asset had become credit-impaired (i.e. the asset was stage 3).
Solution 12: Loss allowances – an example comparing the 3 stages

Comment: Notice the following:
x Part B: Because the asset’s credit risk had increased significantly, we calculate the loss
allowance based on lifetime expected credit losses.
x Part C: Because the asset’s credit risk had increased so significantly that it also became credit-impaired,
we not only calculate the loss allowance based on lifetime expected credit losses but we now also
calculate the interest income based on the asset’s amortised cost (instead of on the gross carrying amount).
Chapter 21 1009
Part A Part B Part C

Stage 1 Asset Stage 2 Asset Stage 3 Asset
Initial debenture balance C450 000 C450 000 C450 000
Loss allowance balance at C13 950 C16 740 C16 740

31/12/20X2 (C450 000 + C45 000 – (C450 000 + C45 000 – (C450 000 + C45 000 –
C30 000) x 30% x 10% C30 000) x 30% x 12% C30 000) x 30% x 12%
Interest income in 20X2 C45 000 C45 000 C45 000

GCA: C450 000 x 10% GCA: C450 000 x 10% GCA: C450 000 x 10%
Interest income in 20X3 C46 500 C46 500 C44 826

GCA: (C450 000 + GCA: (C450 000 + AC: (C450 000 +
45 000 – 30 000) x 10% 45 000 – 30 000) x 10% 45 000 – 30 000 – loss
allowance: 16 740) x 10%
Example 13: Loss allowance - effect of increase in credit risk

(Amortised cost – the basics) (IFRS 9IG Example 8 – Adapted)
On 2 January 20X4, Joyous Limited provides a loan of C100 000 to Sadness Limited. The
interest rate on the loan is 12% p.a. and is due in 5 years. No payments were received from
Sadness during 20X4.
The loan is classified as a financial asset at amortised cost.
x The asset was not credit-impaired on initial recognition.
x On initial recognition Joyous estimates that the loan has a probability of default of 0.5% for the
next 12 months and estimates that if the loan defaults over the 5-year period (i.e. its lifetime), then
an estimated 20% of the gross carrying amount will be lost.
Required:
Discuss how Joyous Limited should account for the expected credit losses on the financial instrument
for the year ended 31 December 20X4 and show the journals for the initial recognition and any journal
adjusting the loss allowance at year-end assuming:
A. At 31 December 20X4, the lifetime expected credit loss remained unchanged, but the probability
of default increased to 1,5%, although this was not considered a significant increase in credit risk.
B. At 31 December 20X4, Joyous becomes aware that Sadness is considering filing for protection
from its creditors as it was possibly facing bankruptcy. This is assessed by the directors of Joyous
to be an objective indicator that Sadness will not be able to discharge all its financial obligations.
Consequently, the probability of default increased to 40%, which is considered to be a significant
increase in credit risk, although the lifetime expected credit loss remained unchanged.
Solution 13: Loss allowance – effect of increase in credit risk (AC – the basics)
Part A and Part B: As this is a financial asset at amortised cost, the general approach applies. Thus,
Joyous must recognise both the loan asset (gross carrying amount) and a related loss allowance. Since
the asset is classified at amortised cost, it is logical that the asset must be presented at amortised cost.
Presenting the asset at its amortised cost means that the loss allowance will be presented as a reduction
in the carrying amount of the loan asset. As the investment is not credit-impaired on initial recognition,
the loss allowance is initially measured based on 12-month expected credit losses.
By estimating that there is a 0.5% probability of a default occurring within the first 12 months, Joyous
is implicitly stating that there is a 99.5% probability that there will be no default in the first 12 months.
However, the total expected loss should a default occur is 20%. In other words, the ‘loss given default’
(LGD) is equal to 20%. However, our loss allowance must only equal the expected credit losses over
the next 12-month period.
x At initial recognition (02/01/20X4): Joyous must recognise a loss allowance equal to the 12-
month expected credit losses: C100
Exposure x LGD x Probability of default over 12 months [PD] =
= Amount receivable x % loss if the customer defaults during asset’s lifetime x probability of this
default occurring within 12 months
= C100 000 x 20% x 0.5% = C100
1010 Chapter 21
Therefore, at initial recognition, Joyous recognises the financial asset and also recognises an
allowance for credit losses equal to C100.
Initial recognition and measurement of loan Debit Credit

FA: Loan asset (A) 100 000
Bank (A) 100 000
Impairment loss (E) 100
FA: Loan: loss allowance (-A) C100 000 x 20% x 0.5% 100
Recognising loan granted to Sadness and related loss allowance
Part A only: No significant increase in credit risk:

x After initial recognition (31/12/20X4):
Although there has been an increase in the probability of default (from 0.5% to 1,5%), this was
not considered to be a significant increase in the credit risk of Sadness since initial recognition.
Thus, the loss allowance must still reflect '12-month expected credit losses'. The 12-month
expected credit loss has, however, increased to C336:
= (100 000 + interest income 12 000 – receipts: 0) x 20% x Probability 1,5% = C336.
Thus, the following journal is required:
Subsequent measurement of the loss allowance at reporting date Debit Credit
Impairment loss (E) 236

FA: Loan: loss allowance (-A) ECL at reporting date:336 –
Balance in this a/c: 100 236
Remeasurement of loss allowance due to insignificant increase in
credit risk: measurement still at '12-month expected credit losses'
Part B only: Significant increase in credit risk

x After initial recognition (31 December 20X4):
There has been an increase in the probability of default (from 0.5% to 40%), which is considered
to be a significant increase in the credit risk of Sadness since initial recognition. This means that
the loss allowance must now reflect the 'lifetime expected credit losses' of C8 960.
= (100 000 + interest income 12 000 – receipts: 0) x 20% x Probability 40% = C8 960.
Thus, the following journal is required:
Subsequent measurement of the loss allowance at reporting date Debit Credit
Impairment loss (E) ECL at reporting date:8 960 – 8 860

FA: Loan: loss allowance (-A) Balance in this a/c: 100 8 860
Remeasurement of loss allowance due to significant increase in
credit risk: measurement now at 'lifetime expected credit losses'
Example 14: Loss allowance – significant increase in credit risk

(Amortised cost – a complete picture) (IFRS 9IG Example 1 – Adapted)
On 2 January 20X4, Joyous Limited invested in 5 000 debentures issued by Ecstatic Limited.
The debentures are redeemable at C100 each.
Chapter 21 1011
The terms of the issue were as follows:

x Nominal value: C100 per debenture x Maturity date: 31 December 20X7
x Coupon rate: 9% (payable annually on 31 December) x Issue date: 2 January 20X4
x Issue price: C98 per debenture (fair value on issue date) x Effective interest rate: 9.4678% Note 1
x Transaction costs: C2 500
Note 1: The EIR was calculated as follows (PV = -((5 000 x C98) + C2 500) = -C492 500; N = 4; PMT =
(5 000 x C100 x 9%) = C45 000; FV = (5 000 x C100) = C500 000; Comp I = ???).
Joyous classified the investment in debentures as a financial asset at amortised cost.
On initial recognition, Joyous estimates 'lifetime expected credit losses' to be C15 000 and the '12-month
expected credit losses' to be C3 125. The investment was not credit-impaired on initial recognition.
On 31 December 20X4, due to its high debt ratio and declining profit margins, Ecstatic issues a warning to its
creditors that it is undergoing a business restructuring process aimed at saving the business from bankruptcy.
As a result, the directors of Joyous determine that there has been a significant increase in credit risk since the
initial recognition of the debentures issued by Ecstatic. On this date:
x the 'lifetime expected credit losses' had increased to C17 500 and
x the '12-month expected credit loss' had increased to C5 000.
At 31 December 20X5, the credit risk of the investment remained significantly higher than at initial
recognition. On this date:
x the 'lifetime expected credit losses' had increased to C20 000 and
x the '12-month expected credit loss' had increased to C8 000.
Required:
Prepare the journals for the years ended 31 December 20X4 and 31 December 20X5 assuming that the
director's assessment of the asset's credit risk meant that:
A. the asset was not credit-impaired at either 31 December 20X4 or 31 December 20X5.
B. the asset became credit-impaired at 31 December 20X4 and remained so at 31 December 20X5.
Solution 14: Loss allowance – significant increase in credit risk (AC - complete)
Comment:
x This example compares the situation of an asset that is not credit-impaired on initial recognition
but which experiences a significant increase in credit risk, but where there:
- was no objective evidence of it becoming credit-impaired (see Part A);
- was objective evidence of it becoming credit-impaired (see Part B).
x The FA is classified at amortised cost & thus (1) it is initially measured at fair value plus
transaction costs (2) a loss allowance must be recognised and (3) the general approach applies to
the measurement thereof.
x Using the general approach, we assess if the asset is credit-impaired on initial recognition. Since it is not,
the effective interest rate method involves using a ‘normal’ effective interest rate (not a ‘credit-adjusted
effective interest rate’).
x At 31 December 20X4, the reporting date, the debenture’s credit risk had significantly increased
since initial recognition and thus the loss allowance must, at this date, be measured at 'lifetime
expected credit losses'.
Furthermore:
- Part A only: Since the asset has not become credit-impaired, the interest income recognised
in future periods will continue to be calculated as: GCA x EIR.
- Part B only: Since the asset has become credit-impaired, the interest income recognised in
future periods will now be calculated as: Amortised cost x EIR.
In this regard, notice that since ‘amortised cost’ means ‘gross carrying amount – loss allowance’,
when we apply the EIR to the amortised cost, it means that both the ‘gross carrying amount’ and the
‘loss allowance’ are now discounted at the effective interest rate.
x At 31 December 20X5, the situation remains unchanged (the credit risk is still significantly higher
than at initial recognition date) and thus the loss allowance must still reflect lifetime expected
credit losses (though notice that the lifetime expected credit losses have increased since the
previous reporting date).
1012 Chapter 21

x Notice that, after an asset has become credit-impaired, the related interest income is lower than if it had
not become credit-impaired (interest income in 20X5 is C46 783 in Part A versus C45 126 in Part B).
This difference plays out in the impairment loss adjustment and thus the net effect on profit or loss is the
same (in both Part A and Part B, the net income in 20X5 is C44 283).
x Notice that, whether the asset has become credit-impaired or not, the statement of financial
position would still reflect the asset at its amortised cost.
31/12/20X5: Financial asset = GCA 494 129 – Loss allowance: 17 500 = C476 629 (amortised cost)
31/12/20X6: Financial asset = GCA 495 912 – Loss allowance: 20 000 = C475 912 (amortised cost)
Date Opening balance Effective interest Receipts Closing balance

@ 9,4678% C D
20X4 0
Note 1
492 500
20X4 492 500 46 629 (45 000) 494 129
20X5 215 610 46 783 (45 000) 495 912
20X6 231 484 46 952 (45 000) 497 864
20X7 47 136 (45 000) 500 000
(500 000) 0
187 500 (680 000)
Notes:
1) The financial asset is amortised cost, thus FV 490 000 + Transaction costs 2 500 = 492 500
Part A Part B
Journals Not credit- Credit-
impaired impaired
Debit/ Debit/
2 January 20X4
(Credit) (Credit)
Debentures: amortised cost (A) 5 000 x C98 490 000 490 000
Bank (A) (490 000) (490 000)
Purchase of debentures at fair value classified at amortised cost
Debentures: amortised cost (A) 2 500 2 500
Bank (A) (2 500) (2 500)
Transaction costs capitalised
Impairment loss (E) 3 125 3 125
Debentures: loss allowance (-A) (3 125) (3 125)
Recognition of loss allowance, measured at 12-month expected credit loss
31 December 20X4
Bank (A) 5 000 x C100 x 9% 45 000 45 000
Debentures: amortised cost (A) Balancing 1 629 1 629
Interest income (I) GCA: (490 000 + 2 500) x EIR: 9.4678% (46 629) (46 629)
Recognition of interest income (effective interest rate) and interest
received (coupon rate)
Impairment loss (E) LA at RD (Lifetime ECLs): 17 500 – 14 375 14 375
Debentures: loss allowance (-A) Balance in this a/c (12m ECLs): 3 125 (14 375) (14 375)
Remeasurement of loss allowance at reporting date (RD): ECLs are now
measured based on the lifetime expected credit losses of 17 500 (because
there has been a significant increase in credit risk)
Chapter 21 1013
Solution 14: Continued … Part A Part B

Not credit- Credit-
31 December 20X5 continued … impaired impaired
Bank (A) 5 000 x C100 x 9% 45 000 45 000
Debentures: amortised cost (A) Balancing 1 783 1 783
Interest income (I) Part A: GCA: 494 129 (W1) x EIR: 9.4678% (46 783) (45 126)
Part B: Amortised cost: (GCA: 494 129 (W1) –
loss allowance: 17 500) x EIR: 9.4678%
Debentures: loss allowance (-A) Part B only: 17 500 x EIR 9,4678% N/A (1 657)
Recognition of interest income (effective interest rate) and interest
received (coupon rate) (EIR method)
Impairment loss (E) Part A: LA at RD (lifetime ECLs): 20 000 – 2 500 843
Debentures: loss allowance (-A) Balance in this a/c: 17 500 (2 500) (843)
Part B: LA at RD (lifetime ECLs): 20 000 –
Balance in this a/c: (o/balance 17 500 + 1 657)
Remeasurement of loss allowance at reporting date (RD): still assessed as having
been a significant increase in credit risk since initial recognition and thus still
measured at lifetime ECLs, however a remeasurement of the allowance is needed
since the expected lifetime credit losses have since increased to C20 000
4.5 Expected credit loss model – the simplified approach (IFRS 9.5.5.15)
There is a simplified approach to the measurement of the loss allowance, where the loss
allowance is always measured at the lifetime expected credit losses.
This simplified approach is not available to all assets. An entity must use the simplified approach for
certain assets and has a choice as to whether to use it for other assets:
The entity must use the simplified approach for:
x a trade receivable and contract asset accounted for in terms of IFRS 15 Revenue from contracts
with customers:
- if it does not involve a significant financing component, or
- if it does involve a significant financing component, but where this has been ignored because
it involves financing for less than a year.
The entity may choose to use the simplified approach (i.e. as an accounting policy choice) for:
x a trade receivable or contract asset accounted for in terms of IFRS 15 Revenue from Contracts
with Customers if it does involve a significant financing component that has not been ignored (we
can apply the simplified approach to the ‘trade receivable’ and not to ‘contract assets’, or vice
versa, but must simply apply the accounting policy consistently);
x a lease receivable accounted for in terms of IFRS 16 Leases (we can apply the simplified approach
to ‘lease receivables from finance leases’ and not to ‘lease receivables from operating leases’, or
vice versa, but we must simply apply the accounting policy consistently).
Example 15: Expected credit losses – simplified approach – trade receivable
On 1 December 20X5, Happy entered into a contract with a customer for C500 000 and correctly
accounted for it in terms of IFRS 15 by crediting ‘revenue’ and debiting ‘trade receivable’ (all the
performance obligations were satisfied on this date and thus Happy was entitled to revenue of
C500 000). There is no significant financing component in the contract.
Based on its assessment of the customer’s credit risk, Happy estimated the following:
1 December 20X5 31 December 20X5
The probability of default over the next 12 months 4% 5%
The probability of default over the lifetime 6% 7%
Happy does not believe that the increase in credit risk since initial recognition is significant. If default occurs,
Happy expects to lose 80% of the gross carrying amount of the receivable.
The debtor pays Happy in full on 15 February 20X6.
Required: Provide the journal entries for the years ended 31 December 20X5 and 20X6.
1014 Chapter 21
Solution 15: Expected credit losses – simplified approach – trade receivable

Comment:
x Since the financial asset is a trade receivable in terms of IFRS 15, and does not involve a significant
financing component, the expected credit losses must be accounted for under the simplified approach.
x This means the loss allowance must be measured at the lifetime expected credit losses (i.e. even though the
asset was neither credit-impaired on initial recognition nor has there been a significant increase in credit risk
since initial recognition of the asset).
Debit Credit
1 December 20X5
Trade receivables (A) Given 500 000
Revenue (P/L: I) 500 000
Revenue recognised from satisfying all performance obligations
Impairment loss (P/L: E) Possible loss (500 000 x 80%) x probability of 24 000
Trade receivable: loss allowance (-A) this loss occurring: 6% 24 000
Recognition of loss allowance: measured at lifetime expected credit losses
because simplified approach used
31 December 20X5
Impairment loss (P/L: E) Possible loss (500 000 x 80%) x probability of 4 000
Trade receivable: loss allowance (-A) this loss occurring: 7% - Bal in this a/c: 24 000 4 000
Rmeasurement of loss allowance: measured at lifetime expected credit losses
because simplified approach used
15 February 20X6
Bank 500 000
Trade receivable: loss allowance (-A) 500 000
Cash received from debtor
Trade receivable: loss allowance (-A) 28 000
Impairment loss reversed (I: P/L)) 28 000
Loss allowance reversed on receipt of cash
Example 16: Expected credit loss– simplified approach – measurement of the

expected credit losses using a provision matrix
(IFRS 9IG Example 12 – Adapted)
Joyous has a portfolio of trade receivables of C9 250 000 at 31 December 20X4. The trade
receivables do not have a significant financing component in terms of IFRS 15 .
Joyous has constructed a reliable provision matrix to determine expected credit losses for the portfolio.
This provision matrix, based on the expected default rates per ageing category, has been included in the
current age analysis of trade receivables as follows:
Gross carrying amount Provision matrix reflecting

expected default rates
Current C3 750 000 0,30%
1 – 30 days past due C3 500 000 1,75%
31 – 60 days past due C1 000 000 3,60%
61 – 90 days past due C750 000 5,75%
More than 90 days past due C250 000 9,00%
Grand total C9 250 000
Required: Provide the loss allowance journal that will be processed assuming the balance in this
account at 31 December 20X3 was C50 000.
Solution 16 Expected credit loss measurement – simplified approach

Comment: Since the financial asset is a trade receivable in terms of IFRS 15 and does not involve a significant
financing component, the expected credit losses must be accounted for under the simplified approach: the loss
allowance must equal the lifetime expected credit losses on the portfolio of trade receivables.
Debit Credit
Impairment loss (E) ECL at reporting date: 174 125 (W1) 124 125
Trade receivables: loss allowance (-A) - Balance in this account: 50 000 124 125
Remeasurement of loss allowance on trade receivables based on lifetime expected
credit losses (because using the simplified approach)
Chapter 21 1015
W1. Loss allowance at 31 December 20X5:

Lifetime expected credit loss
GCA Default rate
allowance
Current C3 750 000 0.3% C11 250
1 – 30 days past due C3 500 000 1.75% C61 250
31 – 60 days past due C1 000 000 3.6% C36 000
61 – 90 days past due C750 000 5.75% C43 125
More than 90 days past due C250 000 9% C22 500
Grand total C9 250 000 C174 125
5. Financial assets: derecognition (IFRS 9.3.2)
5.1 Overview
Derecognition is
defined as:
A financial asset that is transferred may not always qualify
for derecognition. In fact, there are three possible outcomes: x the removal of
x The transfer does qualify for derecognition; x a previously recognised FA/ FL
x from an entity’s SOFP. IFRS 9 App A
x The transfer does not qualify for derecognition; or
x The transfer entails continuing involvement.
A single financial asset may be derecognised in full or could be partly derecognised. Equally,
a group of similar assets could be entirely derecognised, or this group could be partly
derecognised. An entity must derecognise a financial asset/s only if either:
x The contractual rights to the financial asset's cash flows have expired; or
x The entity has transferred a financial asset and the transfer qualifies for derecognition.
See IFRS 9.2.2.3
A financial asset is considered to have been transferred if:

A FA must be
x The entity has transferred its contractual right to receive derecognised if the:
the financial asset's cash flows; or x rights to the cash flows have
expired; or
x The entity has retained its contractual right to receive the x the FA has been transferred &
financial asset's cash flows, but has assumed a this transfer qualifies for
contractual obligation requiring it to pay these cash flows derecognition. See IFRS 9.3.2.3
'to one or more recipients in an arrangement that meets' all three of the following conditions:
x The entity is not obliged to pay the eventual recipients 'unless it collects equivalent
amounts from the original asset'.
x The transfer contract contains terms that prohibit the entity from selling or pledging the
original asset to anyone else (i.e. this condition would be met if the original asset was
only pledged as security to the eventual recipients in terms of the arrangement).
x The entity is obliged to remit (pass on) the cash flows collected on behalf of the eventual
recipients 'without material delay'. The entity must be prohibited from reinvesting the cash
flows received on behalf of the eventual recipients except to invest in cash or cash equivalents
during the period between collection date and date of required remittance and where this
period is short. Any interest earned on this short-term investment must also be paid over to
the eventual recipients. See IFRS 9.3.2.4-5
If, after considering the above, the asset is considered to have been transferred, then the next
step is to consider the risks and rewards of ownership of that asset.
x If substantially all the risks and rewards have been transferred, the asset is derecognised;
x If substantially all the risks and rewards have been retained, the asset transfer does not
qualify for derecognition (i.e. the asset remains in the books).
x If the substantial risks and rewards have neither been transferred nor retained, we need to
consider who controls the asset.
If the entity retains control of the asset, then the asset continues to be recognised to the
extent of its continuing involvement.
If the entity has lost control of the asset, then the asset is derecognised. See IFRS 9.3.2.6
1016 Chapter 21
An excellent summary flowchart is provided in IFRS 9 that outlines the process to be followed
in determining whether the asset should be derecognised, should not be derecognised or should
continue to be recognised but only to the extent of the continuing involvement. A part of this
flowchart is presented below (for the complete flowchart, please see IFRS 9.B3.2.1).
Diagram: Derecognition decision tree
Have the rights to the asset's cash flows Yes Derecognise the FA
expired? [IFRS 9.3.2.3(a)]
No
Yes Has the entity transferred its rights to
receive the cash flows from the asset?
[IFRS 9.3.2.4(a)]
No
Has the entity assumed an obligation to No
pay the cash flows from the asset that
Continue to recognise the FA
meets the conditions in IFRS 9.3.2.5
[IFRS 9.3.2.4(b)]
Yes
Has the entity transferred substantially Yes
Derecognise the FA
all risks and rewards? [IFRS 9.3.2.6 (a)]
No
Has the entity retained substantially all Yes
risks and rewards? Continue to recognise the FA
[IFRS 9.3.2.6 (b)]
No
Has the entity retained control of the asset? No
Derecognise the FA
[IFRS 9.3.2.6 (c)]
Yes
Continue to recognise the FA to the
extent of the entity's continuing
involvement
5.2 A transfer of a financial asset that qualifies for derecognition
Where a transfer of a financial asset qualifies for derecognition, we process journals to:
x remeasure the asset's carrying amount on date of derecognition;
x recognise the consideration received, derecognise the carrying amount, and if there is a
difference between these two amounts (i.e. proceeds – carrying amount = gain/loss)
recognise a gain or loss on derecognition in profit or loss;
x reclassify to profit or loss any gains or losses previously recognised in other comprehensive
(unless the asset is at FVOCI-equity, in which case reclassification is prohibited, but the
amount in other comprehensive income may be transferred to another equity account such
as retained earnings). See IFRS 9.3.2.12 & IFRS 9.B5.7.1
IFRS 9 is unclear on the accounting treatment of transaction costs that may be incurred in order
to transfer the financial asset, but, if one applies the principles contained in other standards (e.g.
sale of inventory, where related selling and distribution costs are expensed), it is submitted that
any transaction costs incurred should be expensed.
Example 17: Derecognition of financial assets (equity) – FVOCI & FVPL

Andile Limited sold an investment in shares for C60 000 on 20 April 20X6. The transaction
price was considered to be evidence of fair value. Andile paid C1 000 in related transaction
costs on the same day. The sale qualifies for derecognition.
These shares were originally purchased for C25 000 on 1 November 20X5 and had a fair value of C55 000
on 31 December 20X5 (its prior financial year-end).
Required: Show the necessary journal entries to account for the derecognition, assuming that:
A. The investment in shares had been classified at fair value through profit or loss.
Chapter 21 1017
B. The investment in shares had been classified at fair value through other comprehensive income.
Andile's policy on derecognition is to transfer to retained earnings any fair value gains or losses that
may have accumulated in other comprehensive income.
Solution 17: Derecognition of financial assets (equity) – FVPL and FVOCI

Comments relevant to both Part A and Part B:
x There is generally no profit or loss on derecognition when the asset is measured at fair value. This is
because the asset is measured to FV immediately before derecognition.
x However, although it may be unusual, if there was reliable evidence to suggest that the transaction
price was in fact not evidence of the asset's fair value, then the second journal above would have
resulted in a profit or loss on derecognition.
For example, if the TP was C60 000 but the FV was C59 000,
- the first journal would have been C4 000 (FV: 59 000 – CA: 55 000); and thus
- the second journal would have derecognised the asset at its CA of C59 000 with the result that a
profit on derecognition of C1 000 (proceeds: 60 000 – CA: 59 000) would have been recognised.
Solution 17A: Derecognition of financial assets (equity) – FVPL

FA: Shares at FVPL (A) FV: 60 000 – Prior CA: 55 000 5 000
FV gains (I: P/L) 5 000
Re-measurement of financial asset at FVPL to FV on date of
derecognition with FV gain in P/L
Bank Transaction price 60 000
FA: Shares at FVPL (A) Carrying amount (at FV) 60 000
Recognition of proceeds and derecognition of the investment in shares
Transaction costs (E: P/L) Transaction costs: given 1 000
Bank 1 000
Recognition of transaction costs paid as an expense in P/L
Solution 17B: Derecognition of financial assets (equity) – FVOCI

FA: Shares at FVOCI (A) FV: 60 000 – Prior CA: 55 000 5 000
FV gains (I: OCI) 5 000
Re-measurement of financial asset at FVOCI to FV on date of derecognition with
FV gain in OCI
Bank Transaction price: given 60 000
FA: Shares at FVOCI (A) Carrying amount (at FV) 60 000
Bank 1 000
FV gains (OCI) FV: 60 000 – Original purchase price: 25 000 35 000
Transfer of cumulative FV gains in OCI (part of equity) to retained earnings
(another equity account) on date of derecognition
Comment:
For FVOCI-equity financial assets; the cumulative gains/losses recognised in OCI are not permitted to be
reclassified to profit or loss but can be transferred to another equity account like retained earnings. See IFRS 9.B5.7.1
Example 18: Derecognition of financial assets (debt) – amortised cost

Bathead Limited sold an investment in debentures for C290 000 on 31 March 20X6. The
transaction price was considered to be evidence of fair value.
Bathead paid C1 000 in related transaction costs on the same day. The sale qualifies for derecognition.
1018 Chapter 21
The debentures were originally issued on 1 January 20X5 and had a carrying amount at its prior financial
year-end (31 December 20X5), measured at amortised cost, of C250 000. The effective interest rate on
these debentures is 10% with interest payable annually in arrears.
The debentures have never been credit-impaired. Ignore the loss allowance.
Required: Show the necessary journal entries to account for the derecognition.
Solution 18: Derecognition of financial assets (debt) – amortised cost

FA: Debenture asset at AC (A) Prior CA: 250 000 x EIR: 10% x 3/12 6 250
Interest on debentures (I: P/L) 6 250
Re-measurement of financial asset at amortised cost on date of
derecognition with interest income in P/L
Bank Transaction price 290 000
FA: Debenture asset at AC (A) Prior yr CA: 250 000 + Eff int: 6 250 256 250
Gain on sale of debentures (I: P/L) Balancing: 290 000 – 256 250 33 750
and recognition of a gain on sale in P/L
Bank 1 000
Comment:
x Notice that there was a gain on derecognition. It is normal for there to be a profit or loss on derecognition when the asset is
measured at amortised cost because it is unlikely that the asset's amortised cost would equal its fair value.
If only a part of an asset is transferred, it makes sense that only a part of the asset is
derecognised.
x The carrying amount of the part that is to be derecognised is measured by allocating the
carrying amount of the total asset between the part that is to be derecognised and the part
that remains based on their relative fair values on transfer date (i.e. CA of the derecognised
part = CA of total original asset ÷ FV of total original asset x FV of derecognised part).
x If the asset that is being partly derecognised has a cumulative gain or loss in other
comprehensive income (e.g. the financial asset is an investment in equity instruments at
FVOCI), then the balance in other comprehensive income will also be allocated based on
the relative fair values (determined on transfer date) of the part that is to be derecognised
and the part that remains.
5.3 A transfer of a financial asset that does not qualify for derecognition
If the entity transfers a financial asset in a way that leaves the entity still holding the significant
risks and rewards of ownership, the asset will not qualify for derecognition. For example, an
entity that has a loan asset which it sells, but in a way, that provides the purchaser with full
recourse over the entity in the event that the debtor defaults on the loan, is not a real sale because
the entity continues to hold the significant risks relating to the asset.
We account for the transfer of an asset that does not allow the asset to be derecognised as
follows:
x The asset remains in the entity's accounting records and any income on this asset, even
though it will no longer be received, continues to be recognised.
x The consideration that the entity receives when transferring this asset must be recognised
as a financial liability. Thus, the financial liability is initially measured at the amount of the
consideration received. This liability is then subsequently remeasured to reflect the change
in the extent of the obligation, with changes to the liability balance expensed.
x We may not offset this financial asset and its associated financial liability, and nor may we
offset any income arising on the asset against any expenses arising on the liability.
Chapter 21 1019
Example 19: Financial asset that does not qualify for derecognition
Meer Limited sells a loan asset of C330 000 on 1 January 20X1 at its fair value of
C310 000. This loan bears interest at 10% and is repayable in full on 1 January 20X2.
One of the effects of the sale agreement is that Meer Limited has indemnified the purchaser against
any loss in the event of a default on the loan. The debtor pays the loan principal plus interest in full on
1 January 20X2.
Required: Prepare all journals relating to the information above.
Solution 19: Financial asset that does not qualify for derecognition
Comments:
x Since the significant risks and rewards are retained by Meer, the asset may not be derecognised. Although
Meer will not receive further interest, it continues to recognise the interest income.
x Since the transfer does not lead to derecognition of the asset, the related consideration is recognised as a
liability. The financial liability is adjusted at reporting date to reflect its current obligation and the adjustment
is recognised as interest expense.

Bank Given 310 000
Fin. liability: FA not derecognised (L) 310 000
Sale of a financial asset that did not qualify for derecognition –
consideration received recognised as a financial liability
31 December 20X1
Loan receivable (A) 330 000 x 10% 33 000
Interest income on the loan asset that was sold but not derecognised
Interest expense (E) 53 000
Fin. liability: FA not derecognised (L) (Interest due: 33 000 + Capital repmt 53 000
due: 330 000) – FL bal: 310 000
Remeasure the FL obligation to reflect the full obligation based on the
possibility of the debtor defaulting (currently the debtor owes one year's
interest of 33 000 and the principal amount of 330 000), with the
increase in the liability recognised as an interest expense
1 January 20X2
Fin. liability: FA not derecognised (L) Interest: 33 000 + Capital: 330 000 363 000
Loan receivable (A) Orig bal:330 000 + Int 33 000 363 000
Loan asset matures successfully, extinguishing the related fin. liability
5.4 A transfer of a financial asset involving continuing involvement
If a financial asset is transferred but substantially all of the risks and rewards of ownership of
this asset have neither been transferred nor retained (i.e. some of the risks and rewards have
been transferred and some have been retained) and, at the same time, the entity has somehow
retained control of the asset, the asset remains recognised to the extent of this remaining
continuing involvement. In other words, the asset may be partially derecognised.
Substantially all of the risks and rewards would be considered to be neither transferred nor
retained if, for example, the entity and the purchaser of the asset agreed to share the risks.
Similarly, an entity would be considered to have retained control over a transferred asset if, for
example, the terms of the transfer prevented the purchaser from selling the asset or pledging it
as security to someone else.
We account for the continuing involvement in a transferred asset as follows:
x The asset remains in the accounting records, measured at an amount that reflects the extent
to which the entity 'is exposed to changes in the value of the transferred asset'. See IFRS 9.3.2.16
1020 Chapter 21
x On top of this, the entity must recognise an 'associated liability'. The liability must be
measured in a way that results in the net carrying amount of the transferred asset and
liability being equal to:
- the 'amortised cost of the rights and obligations retained by the entity', assuming the
financial asset is classified at amortised cost; or
- at the 'fair value of the rights and obligations retained by the entity', assuming the
financial asset is classified at fair value. IFRS 9.3.2.17 (extracts)
x Income on this asset is recognised to the extent of the continuing involvement. See IFRS 9.3.2.18
x Any expense incurred on the associated liability must also be recognised. See IFRS 9.3.2.18
The financial asset and the associated liability may not be offset. Similarly, the income from
the asset that continues to be recognised and any expenses recognised relating to the associated
liability may not be offset.
6. Financial Liabilities
6.1 Financial liabilities: identification (IAS 32.11)

For an item to be identified as a financial liability, it must obviously meet the definition of a
financial liability.
In this regard, the definition has it that any liability that meets any of the following descriptions
would be identified as a financial liability:
a) a contractual obligation: A financial liability is defined
- to deliver cash or another financial asset to as any liability that is:
another entity, or a) a contractual obligation to another
- to exchange financial assets or financial entity involving either the:
liabilities with another entity under conditions - delivery of cash or other FA, or the
potentially unfavourable to the entity; or - exchange of FAs/FLs under possibly
b) a contract that will or may be settled in the entity’s unfavourable conditions; or
own equity instruments and is: b) a contract to be settled in the
entity's own equity instruments, that
- a non-derivative for which the entity is or may is either a:
be obliged to deliver a variable number of the - non-derivative involving a variable #
entity’s own equity instruments; or of shares, or a
- a derivative that will or may be settled other - derivative involving a fixed # of share
than by the exchange of a fixed amount of See IAS 32.11 (Summarised)
cash or another financial asset for a fixed

number of the entity’s own equity instruments. IAS 32.11
Example 20: Financial liabilities
Discuss whether any of the following are financial liabilities:
a. Trade creditors
b. Compulsory redeemable preference shares
c. Warranty obligations
d. Current tax payable
Solution 20: Financial liabilities

a. A trade creditor is a financial liability because the entity is contractually obligated to settle the
creditor with cash.
b. The preference shares are a financial liability because they are redeemable, which means that the
entity must, in the future, refund the preference shareholders with cash.
c. If the warranty obligation requires the entity to make a cash payment to the customer, it is a
financial liability. However, if the warranty obligation only requires the entity to repair the goods,
there is no obligation to pay cash or other financial instrument. Thus, it is not be a financial liability.
d. Current tax payable is not a financial liability because a contractual obligation does not exist – the
obligation is a statutory obligation.
6.2 Financial liabilities: recognition (IFRS 9.3.1)

As with financial assets, financial liabilities are recognised when and only when the entity
becomes party to the contractual provisions of the instrument.
Chapter 21 1021
6.3 Financial liabilities: classification (IFRS 9.4.2)
6.3.1 General classification Financial liabilities are

classified as follows -
6.3.1.1 Overview x at fair value through profit or loss
x at amortised cost
Essentially, a financial liability is classified as at amortised
cost (AC) unless it meets the criteria to be classified as at fair
value through profit or loss (FVPL). See IFRS 9.4.2.1 Financial liabilities may
never be reclassified!
See IFRS 9.4.4.2
A liability will meet the criteria to be classified as at FVPL if
it meets the definition of 'held for trading' or is 'designated at fair value through profit or loss'. See IFRS 9
App A (definition of financial liability at fair value through profit or loss)
Figure: A summary of the classification of financial liabilities
Classification of financial liabilities
Fair value through profit or loss (FVPL) Amortised cost (AC)

FLs 'held for trading' Or FLs designated as FVPL Other FLs
(includes all derivatives) (i.e. not held for trading and not designated at FVPL)
Once the financial liability is classified, it may never be reclassified. IFRS 9.4.4.2
6.3.1.2 Held for trading
All financial liabilities that are 'held for trading' must be classified as at FVPL. A financial
liability is considered to be 'held for trading' if:
x it is a derivative (except if it is a derivative that is a contract providing a financial guarantee or
if it is a designated and effective hedging instrument); or
x its main purpose, from initial recognition, has been to
be sold or repurchased in the near term; Held for trading is
defined as a FA or FL that:
x from initial recognition, it has been managed as part
of a portfolio of financial instruments that has x is acquired or incurred principally for
the purpose of selling/ repurchasing
recently evidenced short-term profits. See IFRS 9 App A it in the near term; or
x is a derivative (except for a
6.3.1.3 Designated at FVPL derivative that is a financial
guarantee contract or is a designated
Financial liabilities that do not meet the definition of 'held for and effective hedging instrument); or
trading' may be designated as FVPL. Most designations at x on initial recognition, is part of a
FVPL may only take place on initial recognition and are portfolio of identified financial
instruments that are managed
irrevocable. The following summarises the conditions under together and for which there is
which a designation as at FVPL may occur. evidence of a recent actual pattern
of short-term profit-taking.
x Designations that are only possible on initial IFRS 9 App A
recognition and which are irrevocable include:

x Designating a liability as at FVPL in order to provide 'more relevant information' since
- by classifying it as at FVPL it avoids an accounting mismatch; or
- the liability is part of a 'group of financial liabilities' or a 'group of financial liabilities
and financial assets' that are managed and evaluated on a fair value basis. See IFRS 9.4.2.2
x If it involves a hybrid contract:
- that contains an embedded derivative
- within a host that is not a financial asset in terms of IFRS 9.
However, this designation would not be allowed if the embedded derivative:
- does not significantly change the required contractual cash flows; or
- is prohibited from being separated out. See IFRS 9.4.3.5
x Designations that are possible on initial recognition:
x In certain circumstances, a financial liability may be designated at FVPL if its credit risk
is being managed using a credit derivative that is also measured at FVPL. See IFRS 9.6.7.1
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6.3.2 Exceptions to the general classifications

There are four exceptions to the general classifications of amortised cost and fair value through
profit or loss. Under the exceptions, the measurement of the financial liability will differ
somewhat from the measurement requirements of the amortised cost (AC) or fair value through
profit or loss (FVPL) classifications. The four exceptions to the two general classifications are
as follows:
x Financial liabilities that arise when a transfer of a financial asset does not qualify for de-
recognition or when the continuing involvement approach applies.
- Should the entity retain substantially all the risks and rewards the financial liability is
measure at the amount of consideration received. Any subsequent movements to this
fair value are measured through profit and loss. IFRS 9.3.2.15 (slightly reworded)
- If the entity continues to recognise a financial asset due to continual involvement, the
liability is measured in a way that reflects the rights and obligations that the entity has
retained. In other words, if the financial asset retained is subsequently measured at AC,
then the financial liability is also subsequently measured at AC and if the financial asset
retained is subsequently measured at FVPL then the financial liability should also be
recognised subsequently at FVPL. IFRS 9.3.17 (slightly reworded)
x Financial guarantee contracts
- Financial guarantee contracts are contracts that require the issuer to make specific
payments to reimburse the holder for a loss it incurs because a specified debtor fails to
make payment when due in accordance with the original or modified terms of a debt
instrument. IFRS 9 Appendix A
- Financial guarantee contracts are initially recognised on the date the entity becomes
party to the irrevocable commitment. IFRS 9.5.5.6
- Financial guarantee contracts are initially recognised at fair value. See IFRS 9.5.1.1
- After initial recognition, financial guarantee contracts are subsequently measured at the
higher of: the amount of the loss allowance determined in accordance with IFRS 9.5.5
and the amount initially recognised less, when appropriate, the cumulative amount of
income recognised in accordance with IFRS 15. IFRS 9.4.2.1(c) (slightly reworded)
x Commitments to provide a loan at a below-market interest rate.
- Such a commitment is initially recognised at its fair value.
- An issuer of such a commitment shall subsequently measure the contract at the higher
of: the amount of the loss allowance determined in accordance with IFRS 9.5.5 and the
amount initially recognised less, when appropriate, the cumulative amount of income
recognised in accordance with IFRS 15. See IFRS 9.4.2.1(d)
x Contingent consideration recognised by the acquirer in a business combination (IFRS 3).
- Such consideration shall be initially recognised at fair value.
- subsequently it shall be recognised FVPL. See IFRS 9.4.2.1(e)
6.4 Financial liabilities: measurement overview
The measurement of financial liabilities can be split into:

x initial measurement; and
x subsequent measurement.
6.5 Financial liabilities: initial measurement (IFRS 9.5.1.1 & 9.5.1.1A)
Initial measurement of financial liabilities (and, in fact, all financial instruments) is always at:
x fair value, and
x may involve an adjustment for transaction costs (deducted in the case of financial liabilities).
Whether or not to adjust a financial liability's fair value for transaction costs depends on the
liability's classification. Transaction costs are defined and explained in section 3.5.1. This is
summarised below. See IFRS 9.5.1.1
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Classification Initial measurement:

Fair value through profit or loss Fair value *
Amortised cost Fair value – transaction costs
* in the case of FVPL, any transaction costs would be expensed
Worked example: Financial liabilities at amortised cost, with transaction cost

If an entity issued debentures for C100 000, whilst costing the entity C1 000 in transaction costs, the
entity would receive a net amount of C99 000. If the debentures were classified at amortised cost, the
initial recognition of the debenture liability would be measured at C99 000 and the subsequent
measurement using the effective interest rate table would also be based on this amount.
It can happen that the fair value on initial recognition does not equal the transaction price. This
results in what is referred to as a day-one gain or loss. This is explained in section 3.5.2.
6.6 Financial liabilities: subsequent measurement (IFRS 9.5.3 and IFRS 9.4.2.1-2)
6.6.1 Overview Financial liabilities at
amortised cost are
The subsequent measurement of a financial liability depends measured as follows -
on whether it was classified as:
x Initially measured at FV less
x Amortised cost or transaction costs
x Fair value through profit or loss. x Subsequently measured at
amortised cost using the
effective interest rate
However, different measurement rules would apply if the
financial liability fell within one of the exceptions to the general classifications (see
section 6.3.2). The following outlines the measurement of each of the classifications (ignoring
financial liabilities that are used in hedging relationships: hedging is explained in chapter 22).
6.6.2 Financial liabilities at amortised cost: subsequent measurement
Financial liabilities that are classified at amortised cost The effective interest rate,
are obviously measured at amortised cost. of a FL, is defined as
To be measured at amortised cost means that the x estimated future cash flows through the
expected life of the financial liability
subsequent measurement of a financial liability will x to the liability’s amortised cost.
involve using the effective interest rate method. This These cash flows are the contractual
method means that interest on the liability will be cash flows. See IFRS 9 App A (Reworded extract)
recognised in profit or loss over its life.
Example 21: Financial liabilities at amortised cost
Tempo Limited issued 150 000 C10 debentures on 1 January 20X4 at C10 each. Tempo
paid transaction costs of C100 000. The debentures have a coupon rate of 10% and are compulsorily
redeemable on 31 December 20X7 for C12 each (i.e. at a premium). These debentures are classified
at amortised cost.
Required: Prepare the effective interest rate table over the life of the debentures and then prepare the
journals for the year ended 31 December 20X4.
Solution 21: Financial liabilities at amortised cost

The effective interest rate is calculated using a financial calculator as 16,32688%
PV = 1 400 000 (150 000 x C10 – Transaction costs of C100 000)

FV= -1 800 000 (150 000 x C12)
Pmt = -150 000 (150 000 x C10 x 10%)
N= 4 COMP i
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Effective interest rate table:

Date Opening balance Effective interest Payments Closing balance
A B C D
Note 1 Note 2 Note3

20X4 1 400 000 228 576 (150 000) 1 478 576
20X5 1 478 576 241 405 (150 000) 1 569 982
20X6 1 569 982 256 329 (150 000) 1 676 311
Note 4
20X7 1 676 311 273 689 (150 000) 1 800 000
(1 800 000) 0
Note 5
1 000 000 (2 400 000)
Notes:
1) Measurement at initial recognition = (FV: 150 000 x C10 – Transaction costs: C100 000) = 1 400 000
2) Effective interest = Opening balance x EIR: 16,32688%
3) Payment of interest based on coupon interest = 150 000 debentures x C10 x 10% = C150 000
4) Payment of redemption amount = 150 000 debentures x C12 = C1 800 000
5) Notice how the effective interest charges total C1 000 000, which is the difference between the net amount
originally received (C1 400 000) and the total of the payments made (C2 400 000).
Journals:

Bank 1 500 000
FL: Debentures: amortised cost (L) 150 000 x C10 1 500 000
Issue of debentures
FL: Debentures: amortised cost (L) Given 100 000
Bank 100 000
Transaction costs on the issue of debentures debited to the liability,
because classified at amortised cost
31 December 20X4
Interest expense (E) Per the EIR Table 228 576
FL: Debentures: amortised cost (L) 228 576
Effective interest on debentures recognised as an expense in P/L
FL: Debentures: amortised cost (L) Per the EIR Table 150 000
Bank 150 000
Payment of annual debenture interest based upon the coupon rate
6.6.3 Financial liabilities at fair value through profit or loss: subsequent measurement
Financial liabilities that are classified at ‘fair value through profit or loss’ are initially measured at fair
value, with transaction costs expensed (see section 6.5) and are subsequently remeasured at each
reporting date to their latest fair values. The fair value adjustments (fair value gains or losses) are
generally recognised in profit or loss, although there are exceptions (see discussion overleaf).
Financial liabilities at
Financial liabilities generate cash outflows (e.g. interest fair value are measured
paid on a debenture liability, or dividends paid on a as follows -
redeemable preference share liability). IFRS 9 does not x Initially measured at fair value.
stipulate how to account for the cash flows, but the approach x Transaction costs are expensed
generally followed in practice is to: x Subsequently measured at fair value
x first recognise the expense (i.e. interest or dividend) when
it is incurred, by debiting the expense and crediting the financial liability, and
x then recognise the cash flow when we make the payment, by debiting the financial liability and
crediting bank.
This is the approach used in this text.
Chapter 21 1025
Other alternative approaches are possible. For example, we could simply recognise any cash
flow without first recognising a separate expense, and thus we could simply debit the financial
liability and credit bank. In this case, the interest or dividend, which would otherwise have been
recognised as a separate dividend/ interest expense, would now be absorbed into the fair value
adjustment. In other words, the approach used will affect the amount of the fair value
adjustment, but the effect on profit or loss will be the same.
Exceptions: when fair value gains are recognised in other comprehensive income instead
Fair value gains or losses at reporting date are generally recognised in profit or loss. However, there
are exceptions to this. Fair value gains or losses will be recognised in other comprehensive income if:
x the liability is part of a hedging relationship, and is a cash flow hedge (hedges are explained
in chapter 22); or
x the liability was designated as at fair value through profit or loss, in which case:
- the amount of a fair value adjustment that is attributable to changes in credit risk of that
liability (i.e. own credit risk) must be presented in other comprehensive income; and
- the rest of the fair value adjustment must be presented in profit or loss,
unless the financial liability is a financial guarantee contract, or a loan commitment, or if
recognising part of the fair value adjustment in ‘other comprehensive income’ would create
or enlarge an accounting mismatch in ‘profit or loss’, in which case the entire fair value
adjustment is presented in profit or loss. IFRS 9.4.2.2 & IFRS 9.5.7.1 & 5.7.7-.9
The credit risk referred to is the risk relating specifically to that liability rather than the
entity as a whole. This means that a liability that has been collateralised would be lower
than a liability for which no collateral has been offered.
The reason why the effect on fair value that is caused by changes to the 'liability's credit risk'
should not be included in profit or loss is interesting. As the credit risk of a financial liability
deteriorates, so its fair value drops (if it improved, the fair value would increase). Thus, if a
liability is measured at fair value and its credit risk deteriorates, the liability balance will be
decreased to the lower fair value and a fair value gain will have to be recognised.
Recognising a gain (or loss) because the credit risk of the liability deteriorated (or
improved) is clearly counter-intuitive (i.e. does not make sense). Thus, in order to ensure
that this counter-intuitive fair value gain (or loss) does not distort the entity's profit or loss,
it should be separated out and presented in other comprehensive income instead (unless by
doing so it creates or enlarges an accounting mismatch).
Fair value gains or losses that are recognised in other comprehensive income may not be
reclassified to profit or loss. However, the entity may subsequently transfer the cumulative
gains or losses to another equity account. IFRS 9.B5.7.9
Example 22 Financial liability at FVPL – no change in credit risk
Mousse Limited raised C200 000 through the issue of 100 000 10% debentures on
01/01/20X5. Mousse designated these debentures as at ‘fair value through profit or loss’.
x Transaction costs incurred by Mousse Limited came to a total of C1 000.
x Coupon interest of C20 000 is due and paid on 31 December 20X5
x On 31 December 20X5 the debentures had a fair value of C300 000.There had been
no change in the credit risk of the debentures since initial recognition.
Solution 22: Financial liability at FVPL – no change in credit risk

Bank Given 200 000
FL: Debentures: at FVPL (L) 200 000
Issue of debentures, classified at FVPL
Transaction costs (E: P/L) Given 1 000
Bank (A) 1 000
Transaction costs on debenture issue expensed (because FL is at FVPL)
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Solution 22 continued... Debit Credit

31 December 20X5
Interest expense Given (200 000 x 10%) 20 000
FL: Debentures at FVPL (L) 20 000
Interest expense on debentures (incurred on 31 December 20X5)
FL: Debentures at FVPL (L) 10% x 200 000 20 000
Bank (A) 20 000
Interest paid to debenture holders
Fair value loss (E: P/L) FV at reporting date: 300 000 – Balance 100 000
FL: Debentures: at FVPL (L) in this a/c: (200 000 + 20 000 – 20 000) 100 000
Re-measurement of debentures to FV at year-end – entire adjustment
recognised in P/L since there was no change in credit risk (which
would have otherwise been separated out and recognised in OCI)
Comment
The interest on the debentures was recognised as a separate interest expense. We could have chosen
to not recognise this and only recognise the interest payment. In this case, the fair value loss would
have been C120 000. The effect on profit or loss is the same.
Example 23 Financial liability at FVPL – with a change in credit risk
Use the same information as in the prior example, plus for the following extra information:
Part of the change in the liability’s fair value resulted from an increase in the entity’s credit risk.
The fair value gain caused by the increase in the entity’s credit risk is C30 000. Recognising this portion of
the fair value adjustment in OCI does not create or enlarge an accounting mismatch.
Solution 23: Financial liability at FVPL – with a change in credit risk
Bank Given 200 000
FL: Debentures: at FVPL (L) 200 000
Issue of debentures, classified at FVPL
Transaction costs (E) Given 1 000
Bank 1 000
Transaction costs on debenture issue expensed (since FL classified at FVPL
31 December 20X5
Interest expense Given (200 000 x 10%) 20 000
Interest expense on debentures (incurred on 31 December 20X)
Bank (A) 20 000
Interest paid to debenture holders
Fair value loss (E: P/L) Balancing (100 000 + 30 000) 130 000
Fair value gain - credit risk (I: OCI) Given 30 000
FL: Debentures: at FVPL (L) New FV: 300 000 – Balance in this 100 000
a/c:(200 000 – 20 000 + 20 000)
Re-measurement of debentures to FV at year-end – the entire FV
adjustment of C100 000 is not recognised in P/L because part of it was
due to a change in credit risk which must be separated out and
recognised in OCI (unless recognising in OCI causes an accounting
mismatch in which case, it would be recognised in P/L)
6.6.4 Financial liabilities general classification exceptions: subsequent measurement

As mentioned in section 6.3, although there are essentially two measurement classifications
(amortised cost and fair value through profit or loss), the following financial liabilities are
exceptions to these classifications and are thus measured slightly differently:
x financial liabilities that arise when a transfer of a financial asset
- does not qualify for de-recognition (i.e. a derecognition prohibition), or
- results in applying the continuing involvement approach (i.e. a partial derecognition);
x financial guarantee contracts;
x commitments to provide a loan at a below-market interest rate. IFRS 9.4.2.1 (b) – (d) (extracts)
Chapter 21 1027
6.6.4.1 Financial liabilities due to a derecognition prohibition (IFRS 9.3.2.15 and 9.3.2.11)
If the transfer of a financial asset does not qualify for derecognition (i.e. because the entity
retains significant risks and rewards of ownership), the consideration that the entity receives for
this asset must be recognised as a financial liability. This financial liability is thus initially
measured at the amount of the consideration received and any changes to this liability in
subsequent periods will be expensed.
We may not offset this financial asset and its associated financial liability. Similarly, we may
not offset any income arising on the asset against any expenses arising on the liability.
For an example of the recognition of a financial liability due to a transfer of an asset not
qualifying for derecognition, please see example 19 (Meer Limited) in section 5.3.
6.6.4.2 Financial liabilities due to continuing involvement (IFRS 9.3.2.16-17)
If a financial asset is transferred but the risks and rewards of ownership of this asset are only
partially transferred and the entity somehow retains control of the asset, the asset will only be
partially derecognised. In other words, the financial asset continues to be recognised to the
extent of the entity's continuing involvement. For example, if a financial asset is transferred but
the entity guarantees this asset to some extent, the financial asset will be measured at the lower
of (i) the amount of the asset and (ii) the amount of the guarantee. However, on top of this, the
entity must recognise an 'associated liability'. The liability must be measured in a way that
results in the net carrying amount of the transferred asset and liability being equal to:
x the 'amortised cost of the rights and obligations retained by the entity', assuming the
financial asset is classified at amortised cost; or
x at the 'fair value of the rights and obligations retained by the entity', assuming the financial
asset is classified at fair value. IFRS 9.3.2.17 (extracts)
6.6.4.3 Financial liabilities that are financial guarantee contracts (IFRS 9.4.2.1 (c))
If the financial liability arises from the issue of a financial guarantee contract, then the
liability is measured at the higher of:
(i) The loss allowance (in terms of IFRS 9.5.5); and
(ii) The amount initially recognised in terms of IFRS 9.5.1.1 (i.e. at fair value, possibly
adjusted for transaction costs and for day-one gains or losses) less the cumulative income
recognised in terms of IFRS 15, where applicable. See IFRS 9.4.2.1 (c)
The above measurement would not apply if the financial liability is classified at fair value
through profit or loss (see section 6.6.3) or if it was involved in the transfer of a financial asset
that either did not qualify for derecognition (see section 6.6.4.1) or qualified for only a partial
derecognition due to continuing involvement in the asset (see section 6.6.4.2).
6.6.4.4 Financial liabilities that are loan commitments at below-market interest rates
Where a financial liability arises due to the entity committing to provide a loan at an interest
rate that is below the market interest rate, it will be measured in the same way that a financial
guarantee contract referred to above is measured. See IFRS 9.4.2.1 (d)
This measurement would not apply if the financial liability is classified at fair value through
profit or loss (see section 6.6.3).
6.7 Financial liabilities: derecognition (IFRS 9.3.3.1-3; IFRIC 19)
6.7.1 Overview Derecognition of a FL
Financial liabilities may only be derecognised when: x Occurs when extinguished
x all obligations relating to that financial liability x Extinguishment = discharge,
have been extinguished (discharged, cancelled, or cancellation or expiry
x Gain or loss = Pmt made – CA of L
expired);
1028 Chapter 21
x debt instruments have been exchanged between a borrower and lender of debt instruments
with substantially different terms, resulting in the extinguishment of the original financial
liability and the recognition of a new financial liability; or
x there has been a substantial modification of the terms of a financial liability, accounted for
by extinguishment of the original financial liability and the recognition of a new financial
liability. See IFRS 9.3.3.1
6.7.2 Extinguishment results in the derecognition of the liability (IFRS 9.3.3.1)
An entity must remove a financial liability from its statement of financial position (i.e.
derecognise it) when it is extinguished. An extinguishment occurs when the contractual
obligation is discharged, cancelled or it simply expires. In other words, the entity either settles
its liability (discharges it) or is legally released from its liability (this could happen through
legal proceedings or the creditor itself could simply release the entity).
When derecognising a financial liability, any resulting gain or loss is recognised in profit or
loss. This gain or loss is calculated as the difference between:
x the carrying amount of the financial liability (or part of financial liability) extinguished or
transferred to another party; and
x the consideration paid, including any non-cash assets transferred or liabilities assumed.
Example 24: Financial liability extinguishment
Cream Limited owed a sum of C90 000 in terms of a loan received from a bank. Due to a
technicality in the manner in which the loan had been issued, the courts found in favour
of Cream being released from its obligation to the bank.
Required: Prepare the journals relating to the information above.
Solution 24: Financial liability extinguishment

Debit Credit
FL: bank loan (L) Given 90 000
Gain on derecognition of bank loan (I: P/L) 90 000
Extinguishment of bank loan following outcome of court proceedings
6.7.3 Extinguishment results in the derecognition of the liability but recognition of

another liability
An extinguishment could result in the derecognition of the original financial liability and the
recognition of a new financial liability in its place. This occurs when:
x 'there is an exchange between an existing borrower and lender of debt instruments with
substantially different terms';
x 'the terms of an existing financial liability' or part thereof are substantially modified. IFRS 9.3.3.2
Terms are considered to be substantially different if there is at least a 10% difference between:
x the present value of the new cash flows ('including any fees paid, net of any fees received'),
discounted at the original effective interest rate, and
x 'the discounted present value of the remaining cash flows of the original financial liability'.
IFRS 9.B3.3.6 (extracts)
Example 25: Financial liability: modified terms leads to extinguishment

Strawberry Limited had borrowed C200 000 from the bank. Due to cash flow problems,
Strawberry successfully negotiated new terms with the bank such that the interest rate on
the loan would be increased but Strawberry would be released from paying interest during the next
three years. Legal fees of C1 000 were incurred to renegotiate the terms. On the date these new terms
were concluded (1 January 20X3), the:
x carrying amount of the original loan liability was C120 000: at amortised cost; effective int.
rate:10%;
x present value of the cash flows under the new terms, discounted at 10% (the effective interest rate
of the original loan), was C138 000;
x fair value of this modified loan is C132 000 and its effective interest rate is 12%.
Required: Prepare the journals for the year ended 31 December 20X3.
Chapter 21 1029
Solution 25: Financial liability: modified terms leads to extinguishment

Comments:
x Notice that the PV of the new loan of C138 000 is simply used to assess whether there is at least a 10%
difference from the PV of the old loan of C120 000.
x The new PV represents a 15% difference from the original loan and thus the new terms are considered to be
substantially different (C138 000 – C120 000)/ C120 000 = 15% difference), thus derecognise the old loan
and recognised the new loan.
Debit Credit
1 January 20X3
FL: bank loan (L) Given: CA of original loan 120 000
FL: bank loan (L) Given: FV of new loan 132 000
Loss on derecognition of original loan (E) Balancing: 132 000 – 120 000 12 000
Legal fees (E) Given 1 000
Bank 1 000
Derecognition of original loan and recognition of a new loan due to
modification of original terms causing PV to change by at least 10%
31 December 20X3
Interest (E) FV 132 000 x new EIR 12% 15 840
FL: bank loan (L) 15 840
Interest expense recognised for the modified loan
6.7.4 Extinguishment using equity instruments after renegotiating the terms
IFRIC 19 explains the consequences of a debtor extinguishing its financial liability:

x by issuing its equity instruments to the creditor,
x when the terms of the financial liability are renegotiated.
The consensus provided in IFRIC 19 is that the equity instruments should be treated as ‘consideration
paid’ and, as a result:
x the issue of the equity instruments to the creditor should be recognised and measured at their fair value*;
x the liability should be reduced by the carrying amount of the financial liability that is settled
through this issue of equity instruments; and
x any difference between the fair value of the equity instruments and the carrying amount of the
liability extinguished is recognised in profit or loss.
*If the fair value of the equity instruments cannot be reliably measured, then the equity instruments
must be measured at the fair value of the financial liability extinguished.
If only part of the financial liability is extinguished, the entity must assess whether:
x some of the consideration paid relates to a modification of the terms of the liability outstanding,
in which case the entity will need to allocate the consideration paid between:
the part of the liability that is extinguished, and
the part of the liability that remains outstanding; or
x the terms of the remaining outstanding liability have been substantially modified, in which case
the entity must:
derecognise the original liability and recognise a new liability.
It is important to note that this interpretation does not apply where:

x extinguishing the financial liability by issuing equity shares is in accordance with the original
terms of the financial liability,
x the creditor is a direct or indirect shareholder and is acting in its capacity as a direct or indirect
existing shareholder; or
x the creditor and the entity are controlled by the same party before and after the transaction and the
substance of the transaction includes an equity distribution by, or contribution to, the entity.
IFRIC 19 also only explains how the debtor accounts for the issue of its equity instruments in order
to settle its liability. It does not explain how the creditor would account for the receipt of these equity
instruments.
1030 Chapter 21
Worked example: Use of equity to extinguish financial liability (‘debt for equity swaps’)
Papaya Limited borrowed C500 000 (a financial liability to Papaya) from Guava Limited on
31 December 20X6.
The gross carrying amount of the financial liability was C420 000 on 31 December 20X7. The financial
liability is accounted for at amortised cost. On this date, it was decided that Papaya would settle the financial
liability through the issue of 4000 equity shares after which it would be fully extinguished.
The fair values of Papaya’s equity shares are C100 on 31 December 20X6 and C103 on 31 December 20X7.
The journals to account for the derecognition of the financial liability are as follows:
Debit Credit
FL: loan from Guava (L) Given 420 000
Gain on derecognition of loan from Guava (I: P/L) Balancing 8 000
Equity: Share capital (Eq) 4 000 x 103 412 000
Extinguishment of loan following renegotiation of terms
7. Reclassification of Financial Instruments (IFRS 9.4.4 ; 9.5.6 and B4.4.1 – B4.4.3)
7.1 Reclassifications overview

Reclassifications
Financial liabilities may never be reclassified whereas
financial assets may be reclassified. However, the x Only possible for financial assets
reclassification of financial assets is only allowed when: x Both the following must have
x the entity changes its business model for managing occurred:
those specific assets; and - BM objective must have changed &
- New BM already in effect
x this change in the business model has already been put
x Reclassification accounted for:
into effect. See IFRS 9 B4.4.1-2 - from 1st day of the financial year
after the change;
The following changes are not considered to be changes in - prospectively with no
a business model: restatement
a) 'a change in intention related to particular financial
assets (even in circumstances of significant changes in The reclassification
date is defined as:
market conditions)'.
x the first day of the first reporting
b) the 'disappearance of a particular market for financial period
assets' that is temporary. x following the change in business
c) a transfer of financial assets from one part of an entity model that results in the entity
reclassifying financial assets.
to another part of the entity where these two parts IFRS 9 App A
operate under different business models. See IFRS 9 B4.4.3

The reclassification is accounted for prospectively from the first day of the financial year after
the change in business model is put into effect (i.e. prospectively from reclassification date).
There must be no restatement of gains, losses or interest previously recognised. See IFRS 9.5.6.1
Example 26: Reclassification date Adaptation of example in IFRS 9.B4.4.2
Faith decides to shut down its retail mortgage division. The decision to shut it down is
made on 1 November 20X7 but it continues operating this division (i.e. continues to create
loan assets) whilst looking for a purchaser for the division.
Three potential purchasers are found during February 20X8 and the division formally ceases to acquire
new retail mortgage business from 1 March 20X8.
Faith has a 31 December financial year-end.
Required: Explain when the reclassification date would be.
Solution 26: Reclassification date
x Although on 1 November 20X7 the business model objective is changed from one where the
intention is to collect contractual cash flows to one where the intention is to sell the asset, this
change in objective is not yet put into effect until 1 March 20X8.
x Both the objective must have changed and have been put into effect before it can be said that the
business model has changed.
x The business model is therefore said to have changed on 1 March 20X8.
x The reclassification date is the first day of the financial period following the change in the business
model and therefore the reclassification date is 1 January 20X9.
Chapter 21 1031
If the business model for managing a group of financial assets changes, all the affected financial
assets must be reclassified. See IFRS 9.4.4.1
However, when an entity sells a financial asset that it was holding to receive contractual cash
flows, it does not automatically mean that the entire portfolio should be reclassified. A
reclassification of financial assets can only take place if the business model that was used to
manage the asset changes. Whether or not a change in business model has been made:
x is determined by senior management,
x can be based on either external or internal changes,
x must be significant relative to the entity's operations, and
x must be 'demonstrable to external parties'. See IFRS 9.B4.4.1
You may recall that, when classifying financial assets, certain of the classifications were
irrevocable, which means that a reclassification out of this classification would not be allowed
(e.g. (1) classifying a debt instrument at FVPL in order to avoid an accounting mismatch when
it met the requirements to be classified at AC or FVOCI-debt and (2) classifying an equity
instrument not held for trading as FVOCI-equity instead of at FVPL). These irrevocable
classifications were also only available on initial recognition and thus there can be no
reclassifications into these classifications at a later date.
As a result, reclassifications of equity instruments will always be prohibited.
If we exclude any classification that was either irrevocable or only available on initial
recognition, we find that the only reclassifications possible are the following:
x AC to FVPL, or vice versa (i.e. when the business model changes from collecting contractual
cash flows to simply selling the asset, or vice versa)
x AC to FVOCI-debt, or vice versa (i.e. due to the business model changing from collecting
contractual cash flows to collecting cash flows and selling the asset, or vice versa);
x FVOCI-debt to FVPL, or vice versa (i.e. when the business model changes from collecting
contractual cash flows and selling the asset to simply selling the asset, or vice versa).
7.2 Reclassifying from amortised cost to fair value through profit or loss (IFRS 9.5.6.2)
To reclassify a financial asset from amortised cost (AC) to fair value through profit or loss
(FVPL) we must:
x determine the fair value on reclassification date;
x calculate, on reclassification date, the difference between the carrying amount of the
financial instrument measured at amortised cost and measured at fair value, and recognise
this difference in profit or loss.
Please remember that amortised cost is the gross carrying amount less the loss allowance (AC = GCA
– Loss allowance). This means that any loss allowance is derecognised on reclassification.
IFRS 9 is silent on how to account for any cash flows accruing on a financial asset at fair value
through profit or loss (for example interest on an investment in bonds or dividends on an
investment in redeemable preference shares). These accruals may be presented as a separate
income (interest or dividend income) or may be presented as part of the fair value gain or loss.
It is submitted that, if it is presented as a separate income (e.g. interest income), the income
should simply be measured based on the contractual terms. If it is not presented as a separate
income and is thus absorbed into the fair value gain or loss, we will need to disclose this fact
(see IFRS 7). This approach (showing the journals to process) was explained in section 3.6.5.
Example 27: Reclassification of a financial asset:
from amortised cost to fair value through profit or loss
On 1 January 20X1 ABC Limited invested C500 000 in government bonds.
x The bonds will mature after 10 years and pay out C550 000.
x Interest at 8% is paid each year in arrears.
x The effective interest rate is 8.6687%.
1032 Chapter 21
Initially, the bonds were being held to receive contractual cash flows. However, on 30 June 20X3,
management decided to manage these bonds within another portfolio of assets that are actively traded.
The change in the business model objective (i.e. from collecting contractual cash flows to being
actively traded) was put into immediate effect. Fair values of the investment in bonds were as follows:
x 30 June 20X3: C540 000
x 1 January 20X4: C510 000
x 31 December 20X4: C545 000
The bonds have never been credit-impaired and there have been no significant increases in the credit
risk of the bonds since their initial recognition. The expected credit losses were estimated as:
12 month expected credit Lifetime expected credit
losses: losses:
x 01 January 20X1 5 000 12 500
x 31 December 20X1 7 000 15 000
x 31 December 20X2 8 000 16 700
x 31 December 20X3 9 200 17 000
Required: Provide the journals for the year ended 31 December 20X3 and 31 December 20X4.
Solution 27: Reclassification of financial asset from amortised cost to FVPL

Workings:
W1: Effective interest rate table (extract)
Date Effective interest Receipts Balance
A×8.6687% A× 8% A
01 January 20X1 500 000
31 December 20X1 43 344 (40 000) 503 344
31 December 20X2 43 633 (40 000) 506 977
31 December 20X3 43 948 (40 000) 510 925
Journals:
Bank 500 000×8% 40 000
Interest income (I: P/L) W1: EIRT 43 948
FA: Bond at AC (A) Balancing 3 948
Measure debentures at amortised cost (AC) and recognise the related
interest income based on effective interest rate (still classified as AC)
Impairment loss (E: P/L) Latest estimate of 12m expected credit losses: 9 1 200
FA: Bond: Loss allowance (-A) 200 – previous balance: 8 000 1 200
Remeasure loss allowance: no significant increase in credit risk since
initial recognition, thus still measured at 12-month expected credit
losses, recognised as an asset measurement account (negative asset)
1 January 20X4
FA: Bond at FVPL (A) Balancing: 510 925 – 9 200 501 725
FA: Bond: Loss allowance (-A) CA of FA's loss allowance (given) 9 200
FA: Bond at AC (A) CA of FA at GCA (W1) 510 925
Reclassification of FA, from AC (amortised cost) to FVPL: transfer the two
account balances representing the asset measured at AC (GCA – Loss
allowance) into the new FVPL account
FA: Bond at FVPL (A) FV on reclassification date: 510 000 – CA: 8 275
Fair value gain (I: P/L) 501 725 8 275
Reclassification: remeasure asset to fair value on reclassification date
31 December 20X4
Bank C500 000 x 8% 40 000
Interest receipt based on the coupon rate of 8%
FA: Bond: fair value (A) FV at reporting date: 545 000 – Balance in 35 000
Fair value gain (P/L) this a/c: 510 000 (501 725 + 8 275) 35 000
Remeasure asset to fair value at year-end
Comment: Notice how even though the business model changed from 30 June 20X3, the new measurement
model is only applied from the first day of the year after the business model changes.
Chapter 21 1033
7.3 Reclassifying from fair value through profit or loss to amortised cost (IFRS 9.5.6.3)
To reclassify a financial asset from fair value through profit or loss (FVPL) to amortised cost (AC) we
must:
x use the fair value on reclassification date as the new gross carrying amount;
x thereafter, measure the asset and related interest income using the amortised cost method, having
calculated the effective interest rate as if the reclassification date was the date of initial recognition;
x recognise a loss allowance based on credit risks that existed on reclassification date (i.e. as
if this date was the date of initial recognition) and recognise changes to this loss allowance
at each subsequent reporting date. See IFRS 9.B5.6.2
Example 28: Reclassification of financial asset from:
fair value through profit or loss to amortised cost (FVPL – AC)
Change Limited purchased bonds in Leverage Limited a few years ago. The bonds were
classified at fair value through profit or loss since they were held for trading in the near
future.
The face value of the bonds is C500 000 and interest is paid annually in arrears at 10% per annum
and will be redeemed at a premium of C100 000.
With the recent change in market interest rates, the return on the bonds improved relative to other
market investments. As a consequence, at a meeting on 1 July 20X2, when the maturity date was
exactly 6 years away, Change’s board of directors passed a resolution that the bonds would now be
held until maturity. This change was brought into effect immediately.
The relevant fair values are:
x 31 December 20X1 C545 000
x 1 July 20X2 C570 000
x 31 December 20X2 and 1 January 20X3 C590 000
The bonds have never been credit-impaired and there have been no significant increases in the credit
risk of the bonds since initial recognition. The expected credit losses were estimated as:
12 month expected credit losses Lifetime expected credit losses
x 01 January 20X1 5 000 12 500
x 31 December 20X1 7 000 15 000
x 31 December 20X2 8 000 16 700
x 31 December 20X3 9 200 17 000
Required: Provide the journal entries for the year ended 31 December 20X2 and 31 December 20X3.
Solution 28: Reclassification of financial asset from

fair value through profit or loss to amortised cost (FVPL – AC)
Workings:
W1: Effective interest rate:

n=5.5 PV=-590 000 PMT=50 000 FV=600 000 COMP i =8.7271%
W2: Effective interest rate table

Effective interest Receipts Balance
@8.7271%
31 December 20X2 590 000
31 December 20X3 51 490 (50 000) 591 490
31 December 20X4 51 620 (50 000) 593 110
31 December 20X5 51 761 (50 000) 594 871
31 December 20X6 51 915 (50 000) 596 786
31 December 20X7 52 082 (50 000) 598 868
(a)
30 June 20X8 26 132 (25 000) 600 000
285 000 (275 000)
(a) 598 868 x 8.7271% x 6/12
1034 Chapter 21

Journals:

Bank Interest on bonds at the coupon rate: 50 000
Interest income (I) C500 000 x 10% 50 000
Interest receipt on bonds classified at FVPL
FA: Bonds at FVPL (A) FV on reporting date: 590 000 – 45 000
Fair value gain (I: P/L) Bal in this account: 545 000 45 000
Remeasurement of bonds at FVPL to the fair value at reporting date
1 January 20X3:
FA: Bonds at amortised cost (A) At latest FV 590 000
FA: Bonds at FVPL (A) 590 000
Reclassification of bonds from FVPL to Amortised cost (AC)
Impairment loss (E: P/L) 12m expected credit loss (given) 8 000
FA: Bonds: Loss allowance (-A) 8 000
Recognising a loss allowance (because the asset is now classified as AC) based on
the assessment of credit risk on initial recognition: not credit-impaired & thus
measured at 12-m expected credit losses, recognised as a credit to the asset
31 December 20X3
Bank C500 000 x 10% 50 000
Interest income (I: P/L) C590 000 x EIR 8,7271% (W1) 51 490
FA: Bonds at amortised cost (A) Balancing 1 490
Measure bonds at amortised cost and related interest recognised based on th
effective interest rate that was calculated at reclassification date
Impairment loss (E: P/L) Latest estimate of 12m expected credit 1 200
FA: Bonds: Loss allowance (-A) losses: 9 200 – Balance in this a/c: 8 000 1 200
Loss allowance remeasured: no significant increase in credit risk since
losses, recognised as a credit to the asset
7.4 Reclassifying from amortised cost to fair value through other comprehensive income
(IFRS 9.5.6.4 & IFRS 9.B5.6.1)
To reclassify a financial asset from amortised cost (AC) to fair value through other
comprehensive income (FVOCI-debt) we must:
x determine the fair value on reclassification date;
x transfer the asset's carrying amount from its amortised cost account to a new account
identifying the asset to be at fair value through other comprehensive income;
x remeasure the asset to its fair value on reclassification date and recognise this difference
(i.e. the asset's CA at amortised cost – the asset's fair value on reclassification date) as an
adjustment in other comprehensive income.
x Transfer the asset's loss allowance account to a loss reserve account in other comprehensive
income. See IFRS 9.B5.6.1
There is no change needed to the loss allowance because both these classifications apply the
same impairment requirements … however it should be remembered that, although both these
classifications recognise the ‘impairment adjustments’ in ‘profit or loss’, the AC classification
recognises the ‘loss allowance account’ as an ‘asset measurement account’ (i.e. an account that
acts to reduce the carrying amount of the asset), whereas the FVOCI-debt classification
recognises the loss allowance as a loss reserve in OCI.
Chapter 21 1035
There is also no change needed to the recognition of interest income or the effective interest rate,
since both classifications require the same recognition of the effective interest on the asset.
Example 29: Reclassification of financial asset from amortised cost to

fair value through other comprehensive income (AC to FVOCI)
Revolution Limited purchased debentures in Staid Limited on 1 January 20X1 at the fair
value of C147 408.
The face value of the debentures is C100 000 and interest is paid annually in arrears at a coupon rate
of 20% per annum. The debentures will be redeemed at a premium of C30 000 on 31 December
20X3. The subsequent fair values of the debentures were as follows:
The debentures have never been credit-impaired and there have been no significant increases in the
credit risk of the debentures since their initial recognition. Expected credit losses were estimated as:
12 month expected credit losses Lifetime expected credit losses
x 01 January 20X1 5 000 12 500
x 31 December 20X1 7 000 15 000
x 31 December 20X2 8 000 16 700
Required:
Provide the journals for the year ended 31 December 20X1 and 31 December 20X2 assuming that the
debentures were classified at amortised cost on initial recognition but need to be reclassified to fair
value through other comprehensive income (FVOCI-debt).
The reason for the reclassification is that Revolution purchased another business on 1 September 20X1,
and this business was immediately tasked with managing the debentures as part of one of its own
portfolio of assets. This portfolio is managed with the objective of both collecting the contractual cash
flows and selling the assets.
Solution 29: Reclassification of financial asset from amortised cost to fair value
through other comprehensive income (AC to FVOCI)
Comment:
x The reclassification date is 1 January 20X2, being the first day on the year following the change in the
business model that has been put into effect. Thus, 1 September 20X1 is irrelevant.
x Both the AC and FVOCI-debt classifications use the effective interest rate method and both account for
expected credit losses in the same way. However, credit losses are recognised in OCI under the FVOCI-debt
classification but recognised as a credit to the asset account under the AC classification.
Workings:

PV=-147 408 PMT=20 000 n=3 FV=130 000 COMP i= 10%

@10% (coupon interest @ 20%)
01 January 20X1 147 408
31 December 20X1 14 741 (20 000) (a) 142 149
31 December 20X2 14 215 (20 000) 136 364
31 December 20X3 13 636 (20 000) 130 000
(130 000) (b) 0
42 592 (190 000)
(a) Face value: 100 000 x Coupon rate 20% = C20 000
(b) Face value: C100 000 + Premium: C30 000 = C130 000
1036 Chapter 21

FA: Debentures at amortised cost (A) Fair value (given) 147 408
Bank 147 408
Impairment loss (E: P/L) 12m expected credit loss: 5 000 (given) 5 000
FA: Debentures: Loss allowance (-A) 5 000
Recognising a loss allowance, measured at 12-month ECLs (since the
assessment of credit risk on initial recognition was that the FA was not
credit-impaired) P.S. LA is an ‘asset measurement account ‘ (it will
reduce the FA’s carrying amount)
31 December 20X1
Bank 100 000 x Coupon rate 20% (or W1) 20 000
Interest income (I: P/L) (147 408 x EIR: 10%) or (W1) 14 741
FA: Debentures at amortised cost (A) Balancing 5 259
Debentures measured at amortised cost and related interest recognised
based on the effective interest rate in P/L
FA: Debentures: Loss allowance (-A) losses: 7 000 – previous balance: 5 000 2 000
Remeasurement of loss allowance: no significant increase in credit risk
since initial recognition, thus still measured at 12-month expected credit
losses, and recognised as a credit to the asset
1 January 20X2
FA: Debentures at FVOCI (A) Transferred at the prior yr CA 142 149
FA: Debentures at amortised cost (A) (W2) or (147 408 - 5 259) 142 149
Reclassification of debentures from AC to FVOCI-debt: transfer of the
asset’s carrying amount into the asset’s new FVOCI-debt account
FA: Debentures: Loss allowance (-A) The prior yr balance in this account 7 000
FA: Debentures: Loss allowance (OCI) (5 000 + 2 000) 7 000
Reclassification of debentures: transfer of the loss allowance, previously
recognised as a credit to the asset, now recognised as a reserve in OCI
FA: Debentures at FVOCI (A) FV on reclassification date: 145 350 3 201
Fair value gain (I: OCI) – CA at amortised cost: 142 149 3 201
Reclassification of debentures: remeasurement of debentures from
amortised cost to fair value on reclassification date
31 December 20X2
Interest income (I: P/L) (142 149 x EIR: 10%) or (W1) 14 215
based on the effective interest rate method (interest income in P/L)
FA: Debentures: Loss allowance (OCI) losses: 8 000 – previous balance: 7 000 1 000
Remeasurement of loss allowance: no significant increase in credit risk
since initial recognition, thus still measured at 12-month expected credit
losses, but now loss allowance is a reserve account in OCI
FA: Debentures at FVOCI (A) Latest FV: 148 850 – (136 364 + 3 201) 9 285
Fair value gain (I: OCI) 9 285
Remeasurement of debentures to fair value at reporting date
Chapter 21 1037
7.5 Reclassifying from fair value through other comprehensive income to amortised cost
(IFRS 9.5.6.5 & IFRS 9.B5.6.1)
To reclassify a financial asset from fair value through other comprehensive income (FVOCI-
debt) to amortised cost (AC) we must:
x Transfer the asset's carrying amount (i.e. which will be its fair value) from its FVOCI
account to a new account that identifies the asset as now being at amortised cost (i.e. an
amortised cost account).
x Transfer the balance in the ‘cumulative fair value gains or losses account’ in other
comprehensive income (being the difference between the latest fair value and the gross
carrying amount) and recognise this as an adjustment to the asset’s carrying amount. This
has the effect of re-adjusting the asset's carrying amount to its gross carrying amount so
that the asset is now measured as if it had always been classified as at amortised cost. *
x Transfer the balance in the asset's ‘expected credit loss reserve account’ in other
comprehensive income to the 'asset's loss allowance account'. *
* Notice that, when transferring the balance in the ‘expected credit loss reserve account’ (OCI) to
the asset's ‘loss allowance account’ and when transferring the ‘cumulative fair value gains or
losses’ (OCI) to the asset’s ‘cost account’ (gross carrying amount), these transfers are made from
OCI to an asset account. Since these transfers from OCI do not affect profit or loss, they are not
reclassification adjustments.
From this point onwards, one simply continues to recognise the interest income on the effective
interest rate method, using the same effective interest rate as was used when recognising this
interest income under the previous FVOCI classification (remember, both these classifications
require the recognition of the effective interest on the asset).
Similarly, one then also simply continues to recognise the adjustments to the loss allowance
because both these classifications apply the same impairment requirements. However, although
the expected credit loss adjustment is expensed, the contra entry is now credited directly to the
asset's loss allowance account (whereas it was previously credited to the expected credit loss
reserve in OCI).
Example 30: Reclassification of financial asset from fair value through other
comprehensive income to amortised cost (FVOCI to AC)
Use the same information as that provided in the previous example (Revolution), with
the exception of the different assumptions provided in the 'required' below.
Required:
Provide the journals for the year ended 31 December 20X1 and 31 December 20X2 assuming that the
debentures were classified at fair value through other comprehensive income (FVOCI-debt) on initial
recognition but need to be reclassified to amortised cost (AC). The reason for the reclassification is that,
on 1 September 20X1, Revolution purchased another business, which was immediately tasked with managing
the debentures as part of one of its own portfolio of assets. This portfolio is managed with the objective of
simply collecting the contractual cash flows.
Solution 30: Reclassification of financial asset from fair value through other
comprehensive income to amortised cost (FVOCI-debt to AC)
Comment:
x The reclassification date is 1 January 20X2, being the first day on the year following the change
in the business model that has been put into effect. Thus, 1 September 20X1 is irrelevant.
x Both the AC and FVOCI-debt classifications use the effective interest rate method and both
account for expected credit losses. However, credit losses are recognised in OCI under the FVOCI-
debt classification but recognised as a credit to the asset account under the AC classification
1038 Chapter 21

Workings:
PV=-147 408 PMT=20 000 n=3 FV=130 000 COMP i= 10%
@10% (coupon interest @ 20%)
01 January 20X1 147 408
31 December 20X1 14 741 (20 000) (a) 142 149
31 December 20X2 14 215 (20 000) 136 364
31 December 20X3 13 636 (20 000) 130 000
(130 000) (b) 0
42 592 (190 000)
(a) Face value: 100 000 x Coupon rate 20% = C20 000
(b) Face value: C100 000 + Premium: C30 000 = C130 000
Journals:
FA: Debentures at FVOCI (A) Fair value (given) 147 408
Bank 147 408
Impairment loss (E: P/L) 12m expected credit loss: 5 000 (given) 5 000
FA: Debentures: Loss allowance (OCI) 5 000
Recognising a loss allowance, measured at the 12-month ECL (since the
assessment of risk on initial recognition was that it was not credit-impaired)
P.S. Since the FA was measured at FVOCI-debt, this loss allowance is
recognised in OCI and is NOT a ‘negative asset’ measurement account
31 December 20X1
Interest income (I: P/L) (GCA: 147 408 x EIR: 10%) or (W1) 14 741
FA: Debentures at FVOCI (A) Balancing 5 259
Debentures at FVOCI first measured as if classified at amortised cost
& related interest recognised based on the effective interest rate in P/L
FA: Debentures at FVOCI (A) Latest FV: 145 350 – 3 201
Fair value gain (I: OCI) Previous CA:(147 408 – 5 259) 3 201
Remeasurement of debentures to fair value at reporting date
FA: Debentures: Loss allowance (OCI) losses: 7 000 – previous balance: 5 000 2 000
Remeasuring loss allowance: no significant increase in credit risk since
initial recognition, thus still measured at 12-month expected credit losses
1 January 20X2
FA: Debentures at amortised cost (A) Transferred at the prior yr CA = FV 145 350
FA: Debentures at FVOCI (A) 145 350
Reclassification of debentures: transfer from 'asset at FVOCI' account
to the 'asset at AC' account; at prior year carrying amount (FV)
Fair value gain (OCI) See journal at 31 Dec 20X1 3 201
FA: Debentures at amortised cost(A) 3 201
Reclassification of debentures: transfer of the cumulative FV gains or
losses, previously recognised in OCI, to asset's amortised cost account
Chapter 21 1039

FA: Debentures: Loss allowance (OCI) The prior yr balance in this account 7 000
FA: Debentures: Loss allowance (-A) (5 000 + 2 000) 7 000
Reclassification of debentures: transfer of the balance in the ‘OCI loss
allowance’ to the asset's ‘loss allowance measurement account’
31 December 20X2
Interest income (I: P/L) (GCA: 142 149* x EIR: 10%) or (W1) 14 215
based on the effective interest rate in P/L
*GCA = 145 350 – 3 201 = 142 149 (or see W1: EIRT)
FA: Debentures: Loss allowance (-A) losses: 8 000 – previous balance: 7 000 1 000
Loss allowance remeasured: no significant increase in credit risk since
losses, but now recognised as a credit to the asset
7.6 Reclassifying from fair value through other comprehensive income to fair value
through profit or loss (IFRS 9.5.6.7)
To reclassify a financial asset from fair value through other comprehensive income (FVOCI-
debt) to fair value through profit or loss (FVPL), the asset continues to be measured at fair
value. However:
x We must reclassify the cumulative gains or losses due to fair value adjustments that were
previously recognised in ‘other comprehensive income’ to ‘profit or loss’.
x Similarly, we must also reclassify the cumulative gains or losses due to loss allowance
adjustments that were previously recognised in ‘other comprehensive income’ to ‘profit or
loss’ (remember that an impairment loss within the FVOCI classification, although
recognised as an expense in profit or loss, would have been credited to a loss allowance
reserve in other comprehensive income).
Please note that, the transfer from other comprehensive income to profit or loss, is referred to
as a reclassification adjustment.
7.7 Reclassifying from fair value through profit or loss to fair value through other
comprehensive income (IFRS 9.5.6.6 & IFRS 9.B5.6.2)
To reclassify a financial asset from fair value through profit or loss (FVPL) to fair value through
other comprehensive income (FVOCI-debt) it continues to be measured at fair value, but we:
x Recognise the fair value gains or losses in OCI (instead of in P/L);
x Recognise a loss allowance account (the FVPL asset would not have had a loss allowance
account). When measuring the loss allowance, we use the date of reclassification as if it
was the date of initial recognition.
8. Compound Financial Instruments (IAS 32.28 - .32)
8.1 Overview
Non-derivative financial instruments must be classified by the issuers thereof as equity
instruments or financial liabilities by analysing the terms of issue. In other words, a non-
derivative financial instrument must be classified by its issuer based on its substance rather than
its legal form. See IAS 32.28
1040 Chapter 21
Essentially, the difference between the financial liability and equity instruments is that:
x financial liabilities involve a contractual obligation to
Compound financial
deliver cash or another financial asset or exchange instruments (CFIs) are:
financial instruments with another entity under
conditions that are potentially unfavourable and where x Non-derivative FIs
the issuer of the financial liability does not have an x That, from the issuer's perspective,
contain both:
unconditional right to avoid settling the obligation, - A financial liability; and
whereas - An equity instrument. See IAS 32.28
x equity instruments involve no such obligations (the
equity is simply the residual interest in the asset after deducting the liability).
While analysing the terms of an issued non-derivative financial instrument, we may find that:
x some terms meet the definition of a financial liability (e.g. the terms may result in the issuer
having an obligation to deliver cash, such as interest payments and/ or redemption of the
'principal' amount), whereas
x some terms meet the definition of an equity instrument (e.g. the terms may give the holder
the option to convert the liability instrument into a fixed number of the entity's equity
instruments, such as ordinary shares).
A non-derivative financial instrument that contains both a financial liability component and an
equity instrument component is called a compound financial instrument.
The issuer of a compound financial instrument must split the instrument, thereby recognising
the financial liability and equity instrument components separately. This is commonly referred
to as 'split accounting'.
It is interesting to note that a compound financial instrument must always be split. In other words,
the issuer of a compound financial instrument must always recognise the financial liability
component and equity instrument component separately, even if the issuer does not believe that
a potential equity instrument will ever come into existence. For example, imagine that our
financial instrument is a debenture that contains an obligation to pay interest and possibly redeem
the debenture (both are financial liabilities) but also gives the holder the option to choose to
convert the debenture into a fixed number of equity instruments (equity instrument) instead of
having the debentures redeemed. We must split the debenture, thus recognising the financial
liability and equity instrument separately, even if we did not believe that the debenture holder
would ever choose to convert its debentures into equity instruments. See IAS 32.30
Correctly splitting the instrument into its financial liability component and equity instrument
component is very important because:
x it affects a host of ratios used by financial analysts (e.g. the debt ratio); and
x it affects the measurement of the instrument both on date of initial issue and subsequently:
- Liabilities are initially measured at fair value and subsequently measured at either fair
value or amortised cost; whereas
- Equity is initially measured at the residual of the assets after deducting liabilities and is
not subsequently remeasured.
The initial measurement of the components under 'split accounting' involves 3 steps:
Step 1: Determine the fair value of the compound financial instrument as a whole
The fair value of the whole compound financial instrument (CFI) is normally the
transaction price, being the proceeds received on the issue (i.e. proceeds received from
the issue = fair value of the CFI).
However, if the proceeds on date of issue do not equal the fair value of the whole
instrument on this day, then a day-one gain or loss is recognised. Day-one gains or
losses are recognised in profit or loss. These are explained in section 3.5.2 under
'financial assets', but the principle of accounting for day-one gains or losses applies
equally to all financial instruments. See IFRS 9.5.1.1 and IFRS 9.B5.1.2A
Chapter 21 1041
Step 2: Determine the fair value of the financial liability component

The liability component is measured at its fair value on the date of issue. See IFRS 9.5.1.1
The fair value of the liability portion is determined based on the fair value of another
similar financial liability that is not part of a compound financial instrument (i.e. a
similar financial instrument that does not include an equity component). See IAS 32.32
For example: If we were measuring the liability portion of a 5%, 10-year, convertible
debenture, we would try to use the fair value of a similar 5%, 10-year debenture but
one that was a non-convertible debenture.
Step 3: Determine the value of the equity instrument component
The equity portion is measured as a residual amount, calculated as the difference
between the fair value of the whole compound financial instrument (CFI) and the fair
value of the financial liability portion (FV of the CFI – FV of the L). See IAS 32.31
If directly attributable transaction costs are incurred when issuing a compound financial
instrument, these costs must be deducted from the equity and liability components in the same
proportion as the proceeds are allocated to the equity and liability components. For example:
The proceeds on issue are C100 000, of which C80 000 (80%) is credited to the financial
liability account and C20 000 (20%) is credited to the equity instrument account. If the
transaction costs are C1 000, then C800 (80%) will be debited to this liability account and C200
(20%) will be debited to this equity account. See IAS 32.38
The liability portion is subsequently measured in terms of IFRS 9, either at fair value or
amortised cost, whereas there is no subsequent measurement of the equity portion. In other
words, whatever value is initially given to the equity instrument will remain unchanged for the
life of the instrument.
Example 31: Compound financial instruments: initial recognition &

measurement
Loopy Limited issued 100 000 non-derivative financial instruments for C100 000. The fair
value of these financial instruments was C95 000. These financial instruments contained both a
financial liability and equity component and are thus considered to be compound financial instruments.
The fair value of the liability component is C80 000.
Required: Show the journal entry in Loopy's books on date of issue.
Solution 31: Compound financial instruments: recognition & measurement

Comment:
x Notice that although we receive C100 000 and know that the fair value of the liability is C80 000,
we do not measure the equity instrument at C20 000, (i.e. Proceeds: 100 000 – FV of the L: 80 000).
x This is because the proceeds of C100 000 did not reflect the fair value of the compound financial
instrument (CFI) as a whole, which we are told is C95 000.
x Instead, we must first recognise the difference of C5 000 between the proceeds (100 000) and the
fair value of the CFI (95 000) as a day-one gain.
x This day-one gain is recognised in P/L if the fair value of the CFI was determined reliably (using
level 1 or level 2 inputs) but will be recognised as a deferred gain instead if the fair value was less
reliably determined (using level 3 inputs). The journal below assumes the fair value was reliable.
Debit Credit
Bank Proceeds: given 100 000
Day-one gain (I: P/L) Proceeds 100 000 – FV: 95 000 5 000
CFI: financial liability (L) FV: given 80 000
CFI: equity instrument (Eq) Balancing: FV of CFI: 95 000 – FV of L: 80 000 15 000
Issue of compound financial instruments
The classification of a financial instrument as a financial liability, equity instrument or a

combination of both, determines whether the related dividends, interest, gains and losses will be
recognised as income and expenses in profit or loss or as distributions to equity participants.
1042 Chapter 21
Any dividends, interest, gains or losses on an instrument classified as:

x an equity instrument, will be recognised directly in equity (i.e. within the SOCIE);
x a financial liability will be recognised in profit or loss (i.e. within the SOCI). See IAS 32.35
Thus, a compound financial instrument (i.e. classified partly as financial liability and partly as
an equity instrument), would result in the recognition of any related interest, dividends, gains
or losses partly in profit or loss (e.g. as an interest expense) and partly in equity (e.g. as a
dividend declared to an equity participant). It can happen that a dividend on a share that is
classified as a compound financial instrument gets recognised as an interest expense instead.
The main body of IAS 32 refers to compound financial instruments as those instruments that
create a financial liability for the entity and yet also create an equity component due to the fact
that the instrument has given the holder the option to convert the instrument into a fixed number
of equity instruments (e.g. convertible debentures, bonds, preference shares or similar). These
are referred to as 'convertible instruments'. However, the application guidance within
IAS 32 also refers to certain preference shares, which are not convertible, as being compound
financial instruments. See IAS 32.29 & IAS 32.AG37
Let us now look at the concept of compound financial instruments first in terms of 'convertible
instruments' and then in terms of 'non-convertible preference shares'.
8.2 Compound financial instruments consisting of convertible instruments
Non-derivative financial instruments would, from the

A financial liability
issuer's perspective, be accounted for as compound represents:
financial instruments (CFIs) if the instrument is a
x A contractual obligation requiring us:
convertible instrument that has the effect of creating for
- to deliver cash or another FA or
the issuing entity: - exchange FIs under potentially
x a financial liability, for example through the unfavourable conditions; or
compound instrument creating a contractual x A contract that we may have to
obligation to deliver cash or another financial asset to settle using our equity instruments
and where the contract is:
the holder of the instrument (e.g. the obligation to pay
- A non-derivative the settlement of
interest to a debenture holder); and also which may involve a variable
x an equity instrument, through the compound number of our eq. instruments; or
instrument giving the holder the option to convert it - A derivative the settlement of
which may involve a fixed number
(or being compulsorily convertible) into a fixed of our own eq. instruments.
number of equity instruments (e.g. a debenture holder See IAS 32.11
who is given the option to convert his debentures into

a fixed number of ordinary shares). See IAS 32.29
Please note that for a convertible non-derivative financial instrument to land up being a
compound financial instrument, it is essential that the
possible conversion of the instrument involves conversion An equity instrument is
into a fixed number of equity instruments. If the non- defined as:
derivative instrument was convertible into a variable x a contract that evidences a
number of equity instruments, then the possible x residual interest in the entity's As
conversion would meet the definition of a financial x after deducting all of its Ls.
liability (please re-read this definition). IAS 32.11 (slightly reworded)
For example: Consider a debenture that is convertible into a variable number of ordinary shares,
the exact number of which will only be determined in the future based on the market value of the
debenture on the date of conversion. In this case, the entire debenture would be classified as a
liability because the obligation to pay interest meets the definition of a financial liability
(obligation to deliver cash) and the obligation to potentially have to convert the debentures into a
variable number of ordinary shares also meets the definition of a financial liability (a non-
derivative settled in a variable number of equity instruments). Thus, this convertible debenture is
a pure financial liability and does not have an equity instrument component, meaning that it is not
a compound financial instrument. See IAS 32.11: the 'financial liability' definition
Chapter 21 1043
Example 32: Convertible debentures – theory

Lostit Limited issued 1 000 redeemable debentures for total proceeds of C100 000, being
their fair value. The debentures carry a coupon rate of 5% and, at the option of the holder,
are either redeemable at C100 000 after 5 years or convertible into 5 000 ordinary shares.
Required: Discuss in detail whether or not the issue of debentures is a compound financial instrument.
Solution 32: Convertible debentures – theory
Answer: The debenture issue is a compound financial instrument.
Explanation: The terms of the debenture issue create an obligation to pay the holder interest on the
debentures (at the coupon rate of 5%) and to either redeem the principal of C100 000 or convert the
debentures into 5 000 ordinary shares (a fixed number of equity instruments).
x The terms require Lostit to pay interest and to possibly also redeem the debentures. This meets
the definition of a liability since it represents a contractual obligation to deliver cash.
x However, further terms give the holder the option to convert the debentures into Lostit's equity
instruments. This means that Lostit could possibly be required to settle the debenture liability with
the issue of its own equity instruments instead of with cash.
At first glance, these terms may appear to meet the definition of a financial liability. However,
since the debenture is a non-derivative that the entity may be required to settle by way of delivering
a fixed (not variable) number of equity instruments, the possible conversion of the debenture does
not meet the definition of a liability. Since it is not a liability, it must be recognised as an equity
instrument instead. The reason we deduce that it must be an equity instrument is as follows:
- We received proceeds on the issue, which is an asset.
- Only a portion of these proceeds is a financial liability.
- Thus, the rest of the asset (proceeds – financial liability) represents a residual interest in assets
after deducting the liability, thus meeting the definition of an equity instrument.
Since the debenture is a non-derivative that has a component that meets the definition of a liability
(i.e. the interest and possible redemption) and also has a component that meets the definition of an
equity instrument (i.e. the holder's option to convert the debenture into a fixed number of ordinary
shares), the debenture is considered to be a compound financial instrument.
Example 33: Convertible debentures – calculations

Barmy Limited issued 100 000 debentures on 1 January 20X5 at their face value of C5
each (considered to be fair value on issue date). The debentures offered interest based on a
coupon rate of 10%:
x The debenture holder has the option to convert the debentures on 31 December 20X7 into 1 000
ordinary shares. If they are not converted they will be redeemed on this date at C5 each.
x The market interest rate for similar debt but without the option to convert is 15%.
x The risk-free annual interest rate is 8%.
x The debentures are not held for trading.
Required: Journalise the issue of the preference shares on 1 January 20X5 in Barmy Limited's books.
Solution 33: Convertible debentures – calculations

Comment:
The debentures that Barmy issued are convertible into ordinary shares. The conversion is at the option
of the holder and involves the possible conversion into a fixed number of Barmy's ordinary shares.
The issue of debentures is considered to be a compound financial instrument because the issue involves
both a financial liability (i.e. interest payments on debentures are mandatory and the redemption is at
the option of the holder, thus Barmy does not have the unconditional right to avoid either of these
potential cash outflows) and an equity instrument (the holder has the option to convert the debentures
into a fixed number of the entity's equity instruments).
When measuring the components of this compound financial instrument, we must remember that, although
the debenture-holder may choose to convert the debentures into ordinary shares instead of having the
debentures redeemed, in order to be prudent, we assume the worst from a cash flow point of view.
1044 Chapter 21
Thus, we measure the financial liability based on the assumption that all the debenture-holders will
choose to have the debentures redeemed rather than converted.
The potential liability that Barmy is facing is thus measured based on

(1) the debenture interest that Barmy must pay each year for three years, plus
(2) the possible redemption amount (repayment of the 'principal') after three years.
This total potential liability is recognised as a financial liability and must be measured at its fair value,
being the present value of these two cash outflows. The rate at which we discount the cash outflows
is 15%, being the market rate that applies to similar debt without the option to convert.
The difference between the fair value of the debentures as a whole, (which we are told equals the
proceeds received), and the fair value of the financial liability (measured at its present value) is
recognised as an equity instrument.
Debit Credit
1 January 20X5
Bank 100 000 x C5 500 000
Debenture: financial liability W1.3 442 210
Debenture: equity instrument W2 57 090
Issue of convertible preference shares
W1: Calculate the financial liability portion
1.1 Interest annuity
Interest payment each year for 3 yrs 100 000 x C5 x 10% 50 000
Discount factor for 3 years Discount factor for a 3-year annuity at 15%* 2.2832
PV of this portion of the liability 114 160
1.2 Redemption
Lump sum payment after 3 years 100 000 x C5 500 000
Discount factor after 3 years Discount factor for a single pmt after 3 yrs at 15%* 0.6575
PV of this portion of the liability 328 750
* Discount factor at 15% for a 3-year annuity:

For a payment after 1 year 1/ 1.15 0.8696
For a payment after 2 years 0.8696/ 1.15 0.7561
For a payment after 3 years 0.7561/ 1.15 0.6575
For a 3-year annuity payment 2.2832
1.3 Total liability
Present value of the 3 interest payments W1.1 114 160
Present value of the lump-sum payment W1.2 328 750
Financial liability portion 442 910
W2: Calculate the equity instrument portion

Fair value of the issue (equal to proceeds) 100 000 x C5 500 000
Less recognised as a liability W1.3 (442 910)
Equity instrument portion Balancing 57 090
Example 34: Compulsorily convertible debentures

On 2 January 20X4 Crazee Limited issued 500 000, 20% debentures at the face value of
C15 each (which represented their fair value on issue date).
The 20% debenture interest is payable on 31 December each year and the debentures are compulsorily
convertible into ordinary shares (1 ordinary share for every 5 debentures held) on 31 December 20X6.
An appropriate adjusted market dividend rate for ‘pure’ redeemable debentures: 25%.
The debentures are not held for trading.
Required:
Prepare journals to record the financial instrument over its three-year life in the accounting records of
Crazee Limited. You may ignore the journal entry for its conversion on 31 December 20X6.
Chapter 21 1045
Solution 34: Compulsorily convertible debentures

Comment:
x The debentures that were issued are convertible into a fixed number of ordinary shares. The
conversion is compulsory, which means that Crazee will definitely not have to repay the principal
(i.e. the debentures are non-redeemable).
x Thus, the potential liability is only the annual debenture interest that must be paid each year for
three years. The liability is measured at the present value of these cash outflows.
x The difference between the fair value of the debentures as a whole and the fair value of the
financial liability (measured at present value) is recognised as the equity instrument.
Debit Credit
2 January 20X4
Bank 500 000 x C1.50 7 500 000
Debenture: financial liability W1 2 928 000
Debenture: equity instrument W2 4 572 000
Issue of convertible debentures
31 December 20X4
Finance costs (E: P/L) W3 732 000
Debenture: financial liability Balancing 768 000
Bank 500 000 x C15 x 20% 1 500 000
Payment of interest on debentures
31 December 20X5
Finance costs W3 540 000
Debenture: financial liability Balancing 960 000
Bank 500 000 x C15 x 20% 1 500 000
31 December 20X6
Finance costs W3 300 000
Debenture: financial liability Balancing 1 200 000
Bank 500 000 x C15 x 20% 1 500 000
Debenture: equity instrument W2 4 572 000
Ordinary stated capital 4 572 000
Conversion of debentures into ordinary shares
Workings:
W1: Calculate the financial liability portion
Interest payment each year for 3 years 500 000 x C15 x 20% 1 500 000
Discount factor for 3 years (discounted at 25%) PVF for 25% and a 3-year annuity * 1.952
Financial liability portion 2 928 000
* Discount factor (present value factor: PVF) at 25% for a 3-year annuity
1/ 1.25 0.800
0.8/ 1.25 0.640
0.64/ 1.25 0.512
1.952
W2: Calculate the equity instrument portion
Fair value of the compound financial
instrument 500 000 x C15 7 500 000
Less recognised as a financial liability W1 (2 928 000)
Equity instrument portion Balancing 4 572 000
W3: Financial liability amortisation table Interest at Cash inflows/ Liability

25% (outflows)
02 Jan 20X4 2 928 000 2 928 000
31 Dec 20X4 732 000 (1 500 000) 2 160 000
31 Dec 20X5 540 000 (1 500 000) 1 200 000
31 Dec 20X6 300 000 (1 500 000) 0
1 572 000 (1 572 000)
1046 Chapter 21
8.3 Compound financial instruments consisting of non-convertible preference shares

(IAS 32.18(a); IAS 32.AG25-26 & IAS 32.AG37)
8.3.1 Overview
Although the body of IAS 32 focused exclusively on compound financial instruments that arose
due to the holder having the option to convert the instrument into a fixed number of equity
instruments, the application guidance in IAS 32 also indicated that certain preference shares,
which were non-convertible, could also be compound financial instruments.
The reason for this is that preference shares frequently offer a combination of terms which could
result in both the financial liability definition and the equity instrument definition being met.
Preference shares could give the preference shareholder the right to preference dividends and/or
the right to receive an amount on redemption. Each of these 'legs' (dividends and redemption)
should be considered separately.
8.3.2 Preference share: dividends
Preference dividends are based on a coupon rate. Preference dividends based on a coupon rate is similar
to debenture interest based on a coupon rate. However, the payment of debenture interest is always
compulsory whereas the payment of preference dividends is not. The terms of the preference share may
result in these dividends being either non-discretionary dividends (i.e. mandatory or compulsory) or
discretionary dividends (i.e. dividends payable at the discretion of the issuing entity).
x If the dividend is non-discretionary (i.e. mandatory or compulsory), the issuing entity does not
have an unconditional right to avoid the delivery of cash (i.e. the entity has an obligation to
pay the dividend) and thus the financial liability definition is met.
x If the dividend is discretionary, the issuing entity has the ability to avoid the delivery of cash
(i.e. the entity does not have an obligation to pay the dividend) and thus the dividend will not
meet the financial liability definition. However, this means, by default, that the discretionary
dividend meets the definition of an equity instrument.
Please note that preference dividends are often referred to as either being cumulative or non-
cumulative. These terms have no bearing on whether an obligation exists to pay the dividend.
If a preference dividend is cumulative, it simply means that if it is not declared in any one year,
no dividend may be declared to the ordinary shareholders until this preference dividend is
declared. This does not mean that the entity is obliged to declare the preference dividend
because the entity is not obliged to declare an ordinary dividend. If a preference dividend is
non-cumulative, it simply means that if this dividend is not declared in any one year, the
shareholder's right to ever receive this dividend lapses.
A non-discretionary dividend (i.e. mandatory or compulsory) is effectively a liability. This

liability is measured at the present value of the future dividends, discounted at an appropriate
market rate. Thus, whether or not the dividends have been declared, mandatory dividends will
be recognised as interest (and presented in profit or loss) over the period of the liability, based
on the unwinding of the discounted liability at the same appropriate market rate (i.e. using the
effective interest rate method).
A discretionary dividend does not lead to an obligation. Since it is thus not a liability, it is
equity. These dividends are recognised as distributions of equity to equity participants (and
presented in the statement of changes in equity) and will only be recognised if and when they
are declared.
8.3.3 Preference share: redemptions
Preference shares are either redeemable or non-redeemable. A redemption refers to the

repayment of the 'principal amount' at par value or at a premium (more than the par value) or
at a discount (less than the par value).
Chapter 21 1047
In the case of redeemable preference shares, the terms of the preference shares could indicate
that the redemption:
x is mandatory (i.e. the terms stipulate that the preference shares are redeemable on a certain
date in the future at a determinable amount);
x is at the option of the holder; or
x is at the option of the issuing entity.
If the redemption is either mandatory or at the option of the holder, the issuing entity would not
have an unconditional right to avoid the outflow of cash on redemption and thus the cash
outflow – or possible cash outflow – on redemption meets the definition of a financial liability
(i.e. the entity has an obligation to deliver cash on redemption that it does not have an
unconditional right to avoid). See IAS 32.AG25
However, if the redemption is at the option of the issuing entity, the possible cash outflow on
redemption does not meet the definition of a financial liability because the entity can avoid this
cash outflow (i.e. the entity effectively does not have a present contractual obligation to deliver
cash on redemption). Thus, this means that, by default, this possible cash outflow on redemption
meets the definition of an equity instrument. See IAS 32.AG25
In the case of non-redeemable preference shares, the issuing entity clearly does not have an
obligation to deliver cash on redemption. This means that the financial liability definition is not
met and thus that the definition of an equity instrument would be met instead. However, the
classification of a non-redeemable preference share may not necessarily be that of a pure equity
instrument because the preference share may involve other rights (e.g. mandatory dividends)
that may need to be classified as a financial liability. We must look at all the rights attaching to
the share in combination. See IAS 32.AG26
Thus, if we look at both of these legs (preference dividends and redemption) in combination, we may
find ourselves with a dividend and a redemption that both meet the definition of an equity instrument
or a dividend and a redemption that both meet the definition of a financial liability. In such cases, the
preference share is not a compound financial instrument because it is classified either entirely as an
equity instrument or entirely as a financial liability. However, if the dividend meets the definition of a
financial liability and the redemption meets the definition of an equity instrument (or vice versa), then
we would have a compound financial instrument. In this case, the principles of accounting for
compound financial instruments would apply.
A summary of the various terms relating to preference shares and the resulting accounting
treatment is outlined in the table below:
Summary: Accounting for preference shares based on the relevant terms of issue
Please note: to illustrate the basic principles of separating an issue into its L & Eq components, the
following summary assumes that, if there is a liability component, it is classified at amortised cost
Redeemable/ Pref dividends: Pref dividends:
Non-redeemable Non-discretionary (i.e. mandatory) (L) Discretionary (Eq)
Redeemable: Pure liability Compound financial instrument
x mandatory or
x at the holder's option (L) Liability initially measured at FV: Liability initially measured at FV:
x PV of the redemption amt + x PV of the redemption amt
x PV of the dividends Equity measured as residual:
x FV of CFI – FV of L
The preference dividends and the The preference dividends will be
effect of the redemption will be recognised as a distribution of equity
recognised as an interest expense in (in the SOCIE)
P/L (in the SOCI) due to the process The effect of the redemption will
of unwinding of the L using the EIR result in the recognition of interest in
method P/L (in the SOCI) due to the process
of unwinding the L using the EIR
method
See IAS 32.AG25 See IAS 32.AG37
1048 Chapter 21
Summary: continuation…
Redeemable/ Pref dividends: Pref dividends:
Non-redeemable Non-discretionary (i.e. mandatory) (L) Discretionary (Eq)
Redeemable: Compound financial instrument Pure equity
x at the issuer's option (Eq)
Liability initially measured at FV: Equity measured at the entire proceeds
x PV of the dividends
Equity measured as residual: P.S. There is no need to determine
x FV of CFI – FV of L FVs because equity is the residual
interest in the A (the proceeds) after
deducting the L (nil).
The preference dividends will be The preference dividends will be
recognised as an interest expense in P/L recognised as a distribution of equity
(in the SOCI) due to the process of (in the SOCIE)
unwinding of the L using the EIR method
See IAS 32.AG25 See IAS 32.AG25-.26
Note 1
Non-redeemable (Eq) Pure liability or a Pure equity
Note 1, 2 & 3
Compound financial instrument
Liability initially measured at FV: Equity measured at the entire proceeds

x PV of the dividends
Equity measured as residual: P.S. There is no need to determine
x FV of CFI – FV of L Note 1, 2 & 3 FVs because equity is the residual
interest in the A (the proceeds)
after deducting the L (nil).
The mandatory preference dividends The preference dividends will be
will be recognised as an interest recognised as a distribution of equity
expense in P/L (in the SOCI) due to (in the SOCIE)
the process of unwinding of the L
using the EIR method Note 2 & Note 3
See IAS 32.AG26 See IAS 32.AG26
Comments:
x The PV is calculated by discounting the cash flows using an appropriate market-related rate.
x If the proceeds on issue (i.e. the transaction price) reflect the fair value of the compound financial
instrument as a whole, then the market rate will equal the instrument's effective interest rate.
Note 1:
x In effect, non-redeemable preference shares will always be classified based on the classification of
the other rights attaching to the share.
- If the non-redeemable share offers discretionary dividends (equity), the entire instrument ends
up being classified as equity (i.e. it is, in effect, similar to an ordinary share).
- If the non-redeemable share offers mandatory dividends (liability), the entire instrument ends up
being classified as a financial liability (i.e. the instrument is, in effect, a perpetual debt instrument).
- If the non-redeemable share offers mandatory dividends (liability) plus additional discretionary
dividends (equity) the instrument is a compound financial instrument: the mandatory dividends are
a financial liability whereas the discretionary dividends are an equity instrument. See IAS 32.AG26
Note 2:
x Where a preference share is non-redeemable but carries with it the right to receive mandatory
dividends, then, if the dividends are set at a market-related rate that is reflected in the transaction
price (proceeds), then the entire proceeds will be classified as a financial liability with no equity
instrument recognised.
x This is because the fair value of the liability, calculated at the present value of the mandatory perpetual
dividend annuity, discounted at the market rate, would then equal the transaction price.
x Recognising these shares as pure liability makes sense since the combination of being non-redeemable
together with rights to mandatory dividends effectively make them perpetual debt instruments.
x The preference dividends in this situation would be recognised as interest in P/L based on the unwinding
of the L using the EIR method (i.e. presented in the SOCI).
Chapter 21 1049
Note 3:
x If a non-redeemable preference share carries with it the right not only to mandatory dividends (which
will effectively mean dividends in perpetuity) but also to discretionary dividends (e.g. a further
preference dividend based on 5% of any ordinary dividend), then the transaction price (proceeds) should
reflect that there is both a mandatory perpetual dividend stream (liability) and a discretionary dividend
stream (equity).
x The present value of the obligation to pay the mandatory dividend stream (the FV of the financial
liability) would be calculated by discounting the mandatory perpetual dividends using the market rate
relevant to similar debt instruments that offer mandatory perpetual dividends but do not offer the
discretionary dividends as well. The balance of the proceeds received would then be allocated to the
equity instrument.
x The mandatory preference dividends would be recognised as interest in P/L based on the unwinding of
the L using the EIR method (i.e. in the SOCI) but the discretionary preference dividends would be
recognised as a distribution to equity participants (i.e. in the SOCIE).
Example 35: Non-redeemable preference shares – discretionary dividends

On 4 January 20X3, Dippy Limited issued 125 000 'C1 8% preference shares' for
C130 000, considered to be the fair value of these preference shares. These shares are non-
redeemable but carry with them a preference dividend based on a coupon rate of 8%. The payment of
these dividends is entirely at Dippy's discretion. Dippy paid the 8% dividend on 31 December 20X3.
Required: Prepare Dippy's journals to record the transactions for the year ended 31 December 20X3.
Solution 35: Non-redeemable preference shares – discretionary dividends
Comment:
x Dippy has no obligation at all (there is no obligation to redeem the shares and no obligation to
pay dividends). Thus, whatever amount Dippy receives on the issue of these shares is simply
recognised as an equity instrument. The equity is measured at the net interest in the asset
(whatever amount Dippy receives) after deducting the liability (nil).
x Since we only recognise an equity instrument with no related financial liability component, these
preference shares are not compound financial instruments.
x Notice that the preference dividend is based on the coupon rate which is applied to the par value
(or face value) of the preference share (125 000 shares x C1 = C125 000 – it is not applied to the
amount credited to the equity instrument on the date of issue (C130 000).
Debit Credit
4 January 20X3
Bank Given 130 000
Equity instrument: Preference shares (Eq) 100% of the amount received 130 000
Issue of convertible debentures
31 December 20X3
Preference dividend (Eq. distribution) 125 000 x C1 x 8% 10 000
Bank 10 000
Payment of preference dividends
Example 36: Non-redeemable preference shares – mandatory dividends

On 01/01/20X1, Kooky Limited issued 125 000 'C1 8% preference shares' for C125 000, an
amount considered to be a fair value for these preference shares. These shares are non-redeemable
but carry with them a preference dividend based on a coupon rate of 8%. Kooky has determined that any
liability component will be subsequently measured using the amortised cost method.
x The payment of these dividends is mandatory.
x Kooky paid the 8% dividend on 31 December 20X1.
Required:
Prepare Kooky's journals to record the transactions during the year ended 31 December 20X1
assuming:
A. An appropriate market-related rate is 8% and the proceeds on issue totalled C125 000, being a
fair value for these preference shares.
B. An appropriate market-related rate is 10% and the proceeds on issue totalled C100 000, being a
fair value for these preference shares.
1050 Chapter 21
Solution 36: Non-redeemable preference shares – mandatory dividends

Comment:
x Kooky has no obligation to redeem the shares but has the obligation to pay preference dividends
at 8% of the face value of the shares. In essence, this instrument is a perpetual debt instrument.
x The fair value of the financial liability component is measured at the present value of the dividend
stream discounted using an appropriate market-related rate: Dividend stream ÷ Market-related rate
x Interest is recognised on this financial liability, based on the concept of unwinding the discount.
This it is calculated as: Liability balance x Market-related rate.
x The preference dividend is paid based on the coupon rate: face value x coupon rate.
x The transaction price was considered to be a fair value of the preference shares issued in both parts A
and B and thus reflected the fair value of the liability that was calculated in each of these parts (i.e. the
present value of the dividend stream, discounted at market rates).
Thus, the proceeds equalled the financial liability, and thus no equity instrument was recognised.
This means that these preference shares are not compound financial instruments.
If the transaction price had not reflected the fair value of the preference share issue, a day-one gain or
loss would have been recognised (i.e. an equity instrument would still not have been recognised).
Part A
Debit/ Part B
1 January 20X1 (Credit) Debit/ (Credit)
Bank Given 125 000 100 000
FL: Preference shares (L) A: (125 000 x C1 x 8%) ÷ 8%
B: (125 000 x C1 x 8%) ÷ 10% (125 000) (100 000)
Issue of preference shares – financial liability measured at the PV
of the dividend stream, discounted at the market rate
31 December 20X1
Interest expense (E: P/L) A: C125 000 x mkt rate 8% 10 000 10 000
FL: Preference shares (L) B: C100 000 x mkt rate 10% (10 000) (10 000)
Interest on pref share liability: unwinding the discount (use mkt rate)
FL: Preference shares (L) 125 000 x C1 x coupon rate 8% 10 000 10 000
Bank (10 000) (10 000)
Payment of preference dividends
Example 37: Non-redeemable preference shares –

x mandatory and discretionary dividends
On 1 January 20X1, Dotty Limited issued 125 000 'C1 8% preference shares' for C150 000,
an amount considered to be a fair value for these preference shares.
x These shares are non-redeemable but carry with them a mandatory preference dividend based on
a coupon rate of 8%, payable on 31 December each year.
x In addition to the 8% dividend, the preference shareholders have the right to receive dividends
equal to 10% of the ordinary dividend declared in any one year.
x The 8% coupon rate is well below the market-related rate of 11% which applies to similar debt
instruments that do not offer discretionary dividends.
x Dotty declared and paid an ordinary dividend of C220 000 plus both preference dividends on
31 December 20X1.
x Dotty has determined that any liability component of the preference shares will be subsequently
measured using the amortised cost model.
Required: Prepare Dotty's journals to record the transactions for the year ended 31 December 20X1.
Solution 37: Non-redeemable preference shares – mandatory & discretionary dividends

Comment:
x The mandatory perpetual dividend is an obligation and thus represents a financial liability,
whereas the discretionary dividend is not an obligation and thus represents an equity instrument.
These preference shares are thus compound financial instruments.
x The financial liability is measured at the present value of this mandatory perpetual dividend
stream, discounted using a market-related rate: Dividend stream ÷ Market-related rate
x The equity instrument will be recognised as a residual amount.
Chapter 21 1051

x The mandatory preference dividend (the perpetual dividend) is thus recognised as interest expense
(based on the concept of unwinding the discount): Liability balance x Market-related rate.
x The discretionary preference dividend will be recognised as a distribution to equity participants
if and when it is declared.
Bank Given 150 000
FL: Preference shares (L) (125 000 x C1 x 8%) ÷ 11% 90 909
Equity: Preference shares (Eq) FV of CFI: 150 000 – FV of L: 90 909 59 091
Issue of preference shares – financial liability at amortised cost, measured at
the PV of the dividend stream, discounted at the market rate
31 December 20X1
Interest expense (E: P/L) L bal: C90 909 x 11% 10 000
FL: Preference shares (L) 10 000
Interest on pref share liability: unwinding of the discount (use mkt rate)
FL: Preference shares (L) 125 000 x C1 x coupon rate 8% 10 000
Bank 10 000
Mandatory preference dividends at 8% on face value: declared and paid
Preference dividend (Eq. distribution) Ordinary dividend: 220 000 x 10% 22 000
Bank 22 000
Discretionary preference dividends at 10% of ord div: declared and pd
Ordinary dividend (Eq. distribution) Given 220 000
Bank 220 000
Ordinary dividend declared and paid
Example 38: Redeemable preference shares – discretionary dividends

On 1 January 20X1, Daffy Limited issued 125 000 'C1 8% preference shares' for C130 000,
an amount considered to be a fair value for these preference shares.
x These shares are compulsorily redeemable at a premium of C0,20 per share on
31 December 20X2.
x The 8% preference dividend is payable on 31 December, but payment is at Daffy's discretion.
x An appropriate market related discount rate for similar debt instruments that do not offer
discretionary dividends is 10%.
x Daffy declared and paid the 8% preference dividends on 31 December 20X1 but did not declare
a dividend in 20X2. The shares were redeemed on 31 December 20X2.
x Daffy has determined that any liability component of the preference shares will be subsequently
measured using the amortised cost model.
Required: Prepare Daffy's journals for the years ended 31 December 20X1 & 20X2.
Solution 38: Redeemable preference shares – discretionary dividends
Comment:
x The redemption is mandatory and is thus an obligation that must be recognised as a financial
liability. But the preference dividend is discretionary and thus not an obligation, with the result
that it is an equity instrument. These preference shares are thus compound financial instruments.
x The financial liability is measured at the PV of this redemption amount, discounted using a
market-related rate: Redemption amount x Discount factor for a market rate of 10% after 2 years
= C150 000 x 0,826446 = C123 967
The discount factor for a market rate of 10% after 2 years = 1 ÷ (1,1) ÷ (1,1) = 0,826446
x The equity instrument will be recognised as a residual amount:
FV of CFI C130 000 – FV of L C123 967 = C6 033
x Interest expense on the financial liability will be recognised in profit or loss, based on the
unwinding of the discount at the market rate of 10%: Liability balance x Market-related rate.
x The discretionary preference dividend will be recognised as a distribution to equity participants
if and when it is declared.
x Notice that the equity instrument component of C6 033 remains in the accounting records even
after redemption. According to IAS 32, this equity may be transferred 'from one line within equity
to another' if desired, but it does not give further suggestions. See IAS 32.AG32 and IAS 32.IE46
1052 Chapter 21

Bank Given 130 000
FL: Preference shares (L) C150 000 x 0,826446 123 967
Or C150 000 ÷ 1.1 ÷ 1.1
Equity: Preference shares (Eq) FV of CFI: 130 000 – FV of L: 123 967 6 033
Issue of preference shares – financial liability measured at the PV of
the dividend stream, discounted at the market rate
31 December 20X1
Interest expense (E: P/L) L bal: C123 967 x 10% 12 397
Preference dividends (Eq distribution) 125 000 x C1 x coupon rate 8% 10 000
Bank 10 000
Discretionary pref. dividends at 8% on face value: declared and paid
31 December 20X2
Interest expense (E: P/L) L bal: (C123 967 + 12 397) x 10% 13 636
FL: Preference shares (L) L bal: (C123 967 + 12 397 + 13 636) 150 000
Bank 125 000 x (C1 + premium C0.20) 150 000
Redemption of the preference shares
9. Settlement in Entity’s Own Equity Instruments (IAS 32.21-24 and AG 27)
A contract that will be settled by delivering a fixed number of its own equity instruments
(shares) in exchange for a fixed amount of cash or another financial asset is an equity
instrument.
A contract that will be settled in a variable number of the entity’s own equity instruments
(shares) whose value equals a fixed amount, or an amount based on changes in an underlying
variable (eg. a commodity price) is a financial liability.
Example 39: Settlement in entity’s own equity instruments

Us Ltd buys a machine worth C600 000 on 1 August 20X5 from Me Ltd.
Us Ltd shares had a market price of C4 on 1 August 20X5 and C6 on 31 December 20X5.
Required: Prepare journals in the accounting records of Us Ltd for each of the following scenarios:
A. Us Ltd issues 120 000 of its shares to Me Ltd on 31/12/20X5 in exchange for the machine.
B. Us Ltd issues C600 000 worth of its shares to Me Ltd on 31/12/20X5 in exchange for the machine.
Solution 39A: Settlement in entity’s own equity instruments

Comment:
x Notice that the number of shares to be issued is fixed and therefore we regard this as an equity
instrument from the outset.
x Also notice that since we have to issue 120 000 shares on 31 December 20X5 to settle a liability
of C600 000, the issue price is effectively C5 per share (600 000 / 120 000 shares), which happens
to be less than the market price on this date.
x It is also worth noting that this transaction is in the scope of IFRS 2 Share based payments. This
is an equity settled share based payment. The machine (asset) and related equity should be
recognised at the fair value of the goods received.
1 August 20X5 Debit Credit
Machine: cost 600 000
Stated capital – deferred shares (Eq) 600 000
Purchase of a machine for a fixed number of shares on 31 Dec X5
Chapter 21 1053

31 December 20X5
Stated capital – deferred shares (Eq) 600 000
Stated capital (Eq) 600 000
Issue of 120 000 shares (at C6 per share)
Comment:
Since the value of the shares to be issued by the machine is fixed at C600 000, but the market price on
the date of the future issue is not known on the date the machine is bought, the number of future shares
to be issued on 31 December 20X5 is variable: thus, we initially record this as a financial liability.
1 August 20X5 Debit Credit
Machine: cost 600 000
Debenture liability (L) 600 000
Purchase of a machine for a variable number of shares
31 December 20X5
Debenture liability (L) 600 000
Issue of 100 000 shares (at C6 per share)
10. Interest, dividends, gains and losses (IAS 32.35 - .41)
The classification of a financial instrument as either a financial liability or equity instrument

determines how we account for the interest, dividend, gains and losses related to that instrument
(items). See IAS 32.35
Basically, the intention behind this is that if an instrument is recognised in the statement of
financial position, then any items related to that instrument must be recognised in the profit or
loss section of the statement of comprehensive income. Conversely, if the instrument is
recognised in the statement of changes in equity, then any items relating to that instrument must
also be recognised in the statement of changes in equity.
If the instrument is classified as:
x a financial liability or financial asset (i.e. presented in the statement of financial position),
then any related interest, dividends, gains and losses must be recognised in profit or loss;
x an equity instrument (i.e. presented in the statement of changes in equity), then any related
interest, dividends, gains and losses must be recognised directly in equity. See IAS 32.35
This approach may require, for example, that dividends declared be recognised in profit or loss
because they relate to the issue of a share that is classified as a financial liability. In this case,
this dividend declaration may end up being included with other traditional interest (such as
interest on loans). However, in the event that, for example, the tax deductibility of the 'dividend
recognised as an expense' and the tax deductibility of 'real interest' differ, it may, in the interests
of improved usefulness, be better to present 'dividends recognised as expenses' separately from
the 'real interest expenses'. See IAS 32.40
We would apply these same principles if the financial instrument was considered to be a
compound financial instrument (i.e. if part of the instrument is classified as a financial liability
and part as an equity instrument). Thus, items relating to a compound financial instrument will
be partly recognised:
x as an income or expense in profit or loss to the extent that they relate to the financial
liability; and
x as a direct adjustment to equity to the extent that they relate to the equity instrument.
Transaction costs incurred on the issue of equity instruments are deducted from the equity
instrument account (although these costs must be separately disclosed, according to IAS 1).
However, if transaction costs are incurred but the issue of the equity instrument fails to
materialise, then these costs are simply expensed. See IAS 32.35 & .37
1054 Chapter 21
Transaction costs that apply to compound financial instruments are allocated to the financial
liability component and the equity instrument component in the same proportion that the
proceeds received on the issue of the instrument as a whole was allocated to these separate
components. See IAS 32.38
11. Derivatives (IAS 32.AG15 - .AG19; IFRS 9.4.3 & IFRS 9.BA.1 – .BA.5)
11.1 Overview
Financial instruments are either non-derivative (also called primary) or derivative instruments.
If you were to ask a man on the street what he understood the word derivative to mean, he
would say it is a spin-off, an off-shoot or by-product. A derivative, in financial terms, is much
the same. A derivative is simply a financial instrument whose value is derived (determined)
from the value of something else. A derivative may result in a financial asset or financial
liability, depending on the nature of the derivative and the movement of the underlying variable
on which the value of the derivative depends.
x Derivatives held for trading are accounted for at fair value through profit and loss. This is
appropriate as a derivative does not meet the BM or SPPI test, thus cannot be measured at
amortised cost or at fair value through other comprehensive income. In addition, financial
liabilities held for trading are accounted for as fair value through profit or loss. See IFRS 9.4.2.1
& IFRS 9.4.1.4
x Derivatives utilised for hedging are accounted for in terms of IFRS 9.6 (see chapter 22).
If one simplifies this definition of a derivative, a derivative is just an instrument whose value is
derived from another specified variable, requires little or no investment and will be settled in
the future. There are many examples of derivatives of which we will discuss a few:
x options,
x swaps, and
x futures.
A derivative is defined as:
A financial instrument or other contract within the scope of this Standard with all three of the
following characteristics.
a) its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other variable, provided in the case of a non-financial variable that the variable is
not specific to a party to the contract (sometimes called the ‘underlying’).
b) it requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors.
c) it is settled at a future date. IFRS 9 Appendix A
There are two types of derivatives: stand-alone derivatives and embedded derivatives. Stand-
alone derivatives meet the definition of a derivative in their own right (in a single contract).
Embedded derivatives exist as part of a combination of a number of instruments in a single
contract, where one or more of these instruments is a derivative (see section 10.5).
11.2 Options (IAS 32.AG17)
An option gives the holder the right (but not the obligation) to buy or sell a financial instrument
on a future date at a specified price.
The most common option that we see are options to buy shares on a future date at a specific
price (strike or exercise price). These are often granted to directors or employees of companies.
Another example is an option to purchase currency on a future date at a specific exchange rate.
Options may be used to limit risks (as the exercise price of an option is always specified) or
they may be used for speculative purposes (i.e. to trade with).
Chapter 21 1055
11.3 Swaps (IAS 32.AG19)
A swap is when two entities agree to exchange their future cash flows relating to their financial
instruments with one another. A common such agreement is an ‘interest rate swap’. For example, one
entity (A) has a fixed-rate loan and another entity (B) has a variable-rate loan. If A would prefer a
variable rate and B would prefer a fixed rate, the two entities may agree to exchange their interest rates.
Example 40: Swaps

Company A and Company B agree to swap their interest rates.
x Company A has a loan of C100 000 with a fixed interest rate of 10% per annum.
x Company B has a loan of C100 000 with a variable interest rate, which was 10% p.a.
in year 1. The variable rate changed to 12% in year 2 and to 8% in year 3.
Required: Journalise the receipts/ payments of cash in Company A’s books for year 2 and year 3.
Solution 40: Swaps

Year 2 Debit Credit
Finance cost (expense) 100 000 x 10% 10 000
Bank 10 000
Interest on fixed rate loan paid to lender
Finance cost (expense) 100 000 x (12% - 10%) 2 000
Bank 2 000
Difference between variable and fixed rate loan paid to Company B
Year 3
Finance cost (expense) 100 000 x 10% 10 000
Bank 10 000
Interest on fixed rate loan paid to lender
Bank 100 000 x (10% - 8%) 2 000
Difference between variable & fixed rate loan received from Co. B
11.4 Futures and forwards (IAS 32.AG18 - .AG19)
A future is an agreement to buy or sell a specified type and quantity of a financial instrument
on a specified future date at a specified price. For example, if A does not have the cash to
purchase shares immediately but believes that they are a worthwhile investment, it may enter
into a futures contract with another entity (B) whereby A commits to buying them on a future
date. The difference between a future and an option is that a ‘future’ commits (i.e. obligates)
the entity whereas an ‘option’ does not.
A forward contract is identical to a futures contract except for the form the contract takes:
x A futures contract is a standard contract drawn up by a financial services company that
operates an exchange
x A forward contract is based on a non-standard contract written up by the parties themselves.
11.5 Embedded derivatives (IFRS 9.4.3)
An embedded derivative is simply a:

x derivative that is rooted in a combined instrument;
x where the combined instrument is created through a hybrid contract;
x where this hybrid contract includes both the derivative and a non-derivative host,
x where some of the cash flows of the combined instrument vary in the same way as had they
come from an individual derivative; and
x where the embedded derivative may not be contractually transferred separately from and does not
have a different counterparty to the other financial instruments within the hybrid contract.
1056 Chapter 21
It may sound complicated but is not complex at all. Essentially, there is a contract that combines
a number of instruments where one or more of these instruments is a derivative. For this
derivative to be embedded, it must be unable to be transferred (e.g. sold) separately from the
host contract and must not have a separate counterparty to the counterparties of the other
financial instruments within the contract.
The entire hybrid contract, provided the host contract is a financial asset per IFRS 9, is
accounted for as a single instrument. In other words, it would be accounted for based on the
normal classification criteria. IFRS 9.4.3.2
If the host contract is not a financial asset, then IFRS 9 requires the embedded derivative to be
separated from the host and accounted for as a derivative under IFRS 9 if, and only if:
x the economic characteristics and risks of the embedded derivative are not closely related
those of the host
x the separate instrument meets the definition of a derivative per IFRS 9 and
x the hybrid contract has not been designated at fair value through profit and loss See IFRS 9.4.3.3
The separated host and derivative shall be accounted for in accordance with appropriate
standards. See IFRS 9.4.3.4
Example 41: Hybrid instruments

Company ABC purchased mandatorily convertible debentures issued by company XYZ.
These debentures pay compulsory annual coupons.
The principal will be settled (on redemption date) by the conversion of the debentures into a fixed
number of XYZ’s own shares.
Required:
Discuss the accounting treatment for these debentures in both ABC’s and XYZ’s financial statements.
Solution 41: Hybrid instruments

ABC’s financial statements
ABC has purchased these debentures, and with this, ABC obtains the contractual right to receive cash
(in the form of coupons) and equity instruments (upon redemption) in the future.
The debentures meet the definition of a financial asset (see IAS 32.11 and section 3.1).
The mandatorily convertible debentures exhibit the characteristics of a hybrid instrument:
x it consists of a non-derivative host (the contractual right to receive coupons in the future – see
IAS 32.11) and
x an embedded derivative (a forward contract obliging ABC to buy a fixed amount of shares on
redemption date – ABC is effectively obliged use the principle to purchase a fixed amount of
XYZ shares in the future).
The non-derivative host is a financial asset (contractual right to receive cash – see IAS 32.11) and as
such the entire instrument will be classified per normal classification principles (see IFRS 9.4.3.2).
Because this contract (the mandatorily convertible debentures) will not result in ABC receiving solely
payments of interest and the principal (ABC also receives shares on redemption date), this instrument
cannot be classified as subsequently measured at AC nor at FVOCI. Thus, the mandatorily convertible
debentures will be classified as subsequently measured at FVPL in ABC’s financial statements.
XYZ’s financial statements
XYZ has issued these debentures and, for the same reason as above, the contract is a hybrid instrument.
However, from XYZ’s perspective, the non-derivative host is not a financial asset (XYZ has the
contractual obligation to make coupon payments – a financial liability, see IAS 32.11).
Chapter 21 1057

IFRS 9 thus requires XYZ to separate the embedded derivative from the non-derivative host and
account for them separately in accordance with the appropriate standards.
x The non-derivative host (contractual obligation to make coupon payments) meets the definition
on a financial liability and will be accounted for in accordance with IFRS 9. The non-derivative
host is not held for trading nor has it been designated as measured at fair value through profit and
loss and as such will be accounted for at amortised cost.
x Once separated, the embedded derivative meets the definition of an equity instrument in accordance
with IAS 32: settlement of the transaction will result in XYZ delivering a fixed number of its own
shares in settlement for a fixed amount of debt owing to ABC (see IAS 32.21-24). Equity
instruments are initially recognised at the residual of the assets after all liabilities, and this amount
is never subsequently remeasured (see section 8.1).
12. Offsetting of Financial Assets and Liabilities (IAS 32.42 - .50, AG38A-38F, IFRS 7.13C-13E)
Financial assets and liabilities may not be offset against one another unless:
x the entity has a legally enforceable right to set-off the recognised asset and liability; and
x the entity intends to realise the asset and settle the liability simultaneously or on a net basis.
When an entity has the right to receive or pay a single net amount and intends to do so, it has,
in effect, only a single financial asset or financial liability. However, the existence of an
enforceable right, by itself, is not a sufficient basis for offsetting. There has to be an intention
to exercise this right or to settle simultaneously. Conversely, an intention to settle on a net basis
without the legal right to do so is not sufficient to justify offsetting.
In order to have a legally enforceable right to set-off, the right of set-off:
x must not be contingent upon a future event (i.e. the right is only exercisable on the occurrence of
some future event, such as default, insolvency or bankruptcy of one of the counterparties); and
x must be legally enforceable in all of the following circumstances:
- in the normal course of business,
- in the event of default, and
- in the event of insolvency and bankruptcy of the entity and all of the counterparties.
It is important to note that offsetting a financial asset and a financial liability (presenting the net
amount) differs from derecognising a financial asset and a financial liability. This is because
derecognising a financial instrument not only results in the removal of the previously recognised item
in the statement of financial position but may also result in the recognition of a gain or loss in the
statement of comprehensive income whereas this does not occur in the case of offsetting.
IFRS 7 requires the following disclosures regarding set-offs:
x the gross amount of those recognised financial assets and financial liabilities
x the net amounts presented in the statement of financial position
x the amounts subject to an enforceable master netting arrangement or similar agreement
x a description of the nature of the rights of set-off associated with the entity’s financial assets
and financial liabilities subject to enforceable master netting arrangements
13. Deferred tax consequences of financial instruments
13.1 Overview
The measurement of deferred tax in respect of financial assets is dependent on management’s
intention in recovering the future economic benefits of a financial asset or the settlement of a
financial liability. However, the accounting for deferred tax is complicated by the detailed and
complex legislation governing the tax consequences of financial instruments. The following
explanation applies the income tax legislation applicable in South Africa.
The section below addresses the tax consequences of ‘plain vanilla’ financial instruments.
1058 Chapter 21
13.2 Financial assets and liabilities subsequently measured at amortised cost
The amortised cost method requires the calculation of the effective interest rate, which takes
into account premiums, discounts, as well as the amount and timing of future cash flows. These
calculations are the same as those used to determine the “yield to maturity” in terms of the
South African Income Tax (this is the tax term for effective interest rate). As a result, the tax
base of a financial instrument carried at amortised cost will usually equal it’s carrying amount,
and thus, no temporary difference will arise.
13.3 Financial assets subsequently measured at fair value

Financial assets held for trading: For tax purposes: FAs
that are held for trading
If management’s intention is to hold financial assets for (fail BM test):
trading purposes (i.e. speculative), the financial asset is x FA is measured at FVPL
accounted for at FVPL (because the business model test is x Thus, carrying amount = FV;
failed). Similarly, when management intends trading with the x Tax base = Cost
financial assets, the trading stock provisions of the Income
Tax Act will apply. These provisions require that the opening and closing stock be measured at cost
and therefore the tax base of the financial asset will be its cost.
Thus, deferred tax will arise because the carrying amount of the financial asset will be its fair
value and yet its tax base will be its cost.
For tax purposes: FAs that
Financial assets held to collect dividends: are neither held for trading
nor amortised cost:
If management intends to hold the financial asset for the x FA is measured at
purposes of collecting dividend income, but the financial FVPL or FVOCI-equity
instrument has been designated as FV (i.e. it does not meet the x Thus, carrying amount = FV;
SPPI test), the tax base of the financial asset will be its base x Tax base = Cost
cost. Since local dividend income is exempt from taxable
income, deferred tax on local instruments would be calculated at 0% of the temporary difference.
The movement in deferred tax may be presented:
x in profit or loss, if the financial asset is classified as subsequently measured at FVPL; or
x in other comprehensive income, if the financial asset is classified as subsequently measured
at FVOCI-equity.
Other financial assets:
In all other cases, the future economic benefits of the financial asset will be consumed through
the eventual sale of the financial asset. Thus, the tax base of the financial asset will equal its
base cost and deferred tax will be measured on the effective capital gains tax rate.
Example 42: Deferred tax consequences of financial assets
FI Limited holds a number of investments in financial instruments. Additionally, FI
Limited is involved in the trading of shares. The details of all financial instruments held
are as follows:
Description Classification Original FV on FV on
cost 1 Jan 20X5 31 Dec 20X5
C C C
A Shares held for trading FVPL 5 000 6 000 8 000
B Shares held to collect dividends FVPL 4 000 5 000 5 500
C Shares held for long-term capital growth FVPL 8 000 10 500 11 750
The entity has elected that the shares in portfolio C will be measured at FVOCI. No other elective
provisions have been applied. The corporate tax rate is 30%, and the CGT inclusion rate is 80%.
Required: Prepare the journal entries to record the implications of the investments in financial
instruments for the year ended 31 December 20X5.
Chapter 21 1059
Solution 42: Deferred tax consequences of financial instruments

Comments:
x Share in portfolio A will be accounted for at FVPL – fails BM and SPPI test. Tax base = cost.
x Shares in portfolio B will be accounted for at FVPL - fails BM and SPPI test. Tax base = cost.
x Shares in portfolio C will be accounted for at FVOCI – elective classification. The tax authorities
will apply capital gains tax on the eventual sale of the shares. Thus, the tax base is equal to the base
cost of the shares. The deferred tax arising from the resulting temporary difference is calculated using
the effective rate of 24% (corporate tax rate of 30% x CGT inclusion rate of 80%)
Portfolio A Portfolio B Portfolio C
(W1) (W2) (W3)
Dr (Cr) Dr (Cr) Dr (Cr)
31 December 20X5
FA: Shares at FVOCI (A) - - 1 250
Gain on financial asset (I: OCI) - - (1250)
FA: Shares at FVPL (A) 2 000 500 -
Gain on shares at FVPL (I: P/L) (2 000) (500) -
Re-measurement of shares to FV at year-end
Tax expense (P/L) 600 0 -
Gain on financial asset (I: OCI) - - 300
Deferred tax: income tax (L) (600) (0) (300)
Deferred tax on shares
Workings:
W1. Portfolio A amount base Difference tax
Opening Balance: 20X5 6 000 5 000 (1 000) (300) L
Movement 2 000 0 (2 000) (600) Cr DT; Dr TE;
Closing Balance: 20X5 8 000 5 000 (3 000) (900) L
W2. Portfolio B Note 1

Opening Balance: 20X5 5 000 4 000 (5 000) 0 L
Movement 500 0 (500) 0
Closing Balance: 20X5 5 500 4 000 (5 500) 0 L
Note 1: A tax rate of 0% has been used as dividend income is exempt.
W3. Portfolio C Note 2

Opening Balance: 20X5 10 500 8 000 (2 500) (600) L
Movement 1 250 0 (1 250) (300) Cr DT; Dr OCI;
Closing Balance: 20X5 11 750 8 000 (3 750) (900) L
Note 2: The effective tax rate of 24% has been used, due to CGT effects.
14. Financial Risks (IFRS 7)
14.1 Overview
There are three categories of financial risks and they are:

x market risk;
x credit risk; and
x liquidity risk.
14.2 Market risk (IFRS 7: Appendix A)
Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate
because of changes in market prices. It is affected by interest rate, currency and price risk.
1060 Chapter 21
14.2.1 Interest rate risk
Interest rate risk is the risk that the fair value or the future cash flows of a financial instrument will
fluctuate with changes in the market interest rate. A typical example is a bond: a bond of C100 earning
a fixed interest of 10% (i.e. C10) would decrease in value if the market interest rate changed to 20%,
(theoretically, the value would halve to C50: C10/ 20%). If the bond earned a variable interest rate
instead, the value of the bond would not be affected by interest rate fluctuations.
14.2.2 Currency risk
Currency risk is the risk that the value or the future cash flows of a financial instrument will
fluctuate because of changes in the foreign exchange rates. A typical example would be where
we have purchased an asset from a foreign supplier for $1 000 and at the date of order, the
exchange rate is $1: C10, but where the local currency weakens to $1: C15. The amount owing
to the foreign creditor has now grown in local currency to C15 000 (from C10 000).
14.2.3 Price risk
Other price risk is the risk that the value or the future cash flows of the financial instrument will
fluctuate because of changes in the market prices (other than those arising from interest rate risk
or currency risk). For example: imagine that we committed ourselves to purchasing 1 000 shares
on a certain future date, when the share price was C10 on commitment date. This commitment
opens us to the risk that the share price increases (e.g. if the share price increases to C15, we
will have to pay C15 000 instead of only C10 000).
14.3 Credit risk
This is the risk that the one party to a financial instrument will fail to discharge an obligation
and cause the other party to incur a financial loss. A typical example is a debtor, being a financial
asset to the entity, who may become insolvent and not pay the debt due (i.e. where a debtor
becomes a bad debt).
14.4 Liquidity risk
This is the risk that an entity will experience difficulty in meeting obligations associated with
financial liabilities. An example: the risk that we (the entity) find ourselves with insufficient
cash to pay our suppliers (i.e. where we risk becoming a bad debt to one of our creditors).
15. Disclosure (IFRS 7)
The following narrative disclosure is required (by IFRS 7):

x For credit risk:
- An analysis of financial assets past due/ impaired.
- The amount of maximum exposure to credit risk
- Collateral held as security
- Other credit enhancements
- Credit quality of financial assets (neither past due, nor impaired)
- The nature and carrying amount of financial and non-financial assets obtained during
the period by taking possession of collateral it holds as security or calling on other
credit enhancements, provided these meet the recognition criteria in the IFRSs.
x For liquidity risk:
- Maturity analysis for derivative and non-derivative financial liabilities
- Description of how liquidity risk is managed.
Chapter 21 1061
x For market risk

- Sensitivity analysis for each market risk
- Methods and assumptions used in the analysis
- Any changes in the above assumptions, together with reasons for the changes.
- For each class of financial assets and liabilities:
- The criteria for recognition;
- Basis for measurement
- Methods and assumptions made to determine fair value
- Fair value of the financial instrument (or the reasons why it cannot be determined,
information about the related market and the range of possible fair values).
The following figures must be separately disclosed:

x Finance costs from financial liabilities must be presented as a separate line item
x The total change in fair value of the instruments reported in profit or loss
x The changes in fair value that were taken directly to other comprehensive income (equity)
x Any impairment loss reversal on a financial liability.
For reclassifications, the following disclosures are required: IFRS 7.12

x The date of reclassification
x A detailed explanation of the change in business model and a qualitative description of the
effect on the financial statements
x The amount reclassified into and out of each category
IAS 1 requires that on the face of the statement of comprehensive income, the movement in
other comprehensive income must be shown in total and must be split between:
x Items that may be subsequently reclassified to profit of loss, and
x Items that may never be subsequently reclassified to profit or loss
The following is a suggested disclosure layout that you may find useful.
Name of Company
Note 20X5 20X4
EQUITY AND LIABILITIES or ASSETS* C C
Loans/ debentures xxx xxx
Financial instruments 39 xxx xxx
Preference shares xxx xxx
*Assets and liabilities must be classified as current and non-current
Name of Company
Ordinary Retained Gains/ losses on Gains/ losses on Total
shares earnings financial assets cash flow hedge
at FVOCI
C C C C C
Balance: 1 January 20X5 xxx xxx xxx xxx xxx
Ordinary shares issued xxx xxx
Total comprehensive income xxx xxx xxx xxx
Balance: 31 December 20X5 xxx xxx xxx xxx xxx
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Name of Company
Note 20X5 20X4
C C
Revenue xxx Xxx
Other income:
x Fair value adjustment of financial asset through profit or loss xxx Xxx
x Fair value gains/(losses) on reclassifications of financial assets
Impairment losses (expected credit losses) (xxx) (xxx)
Distribution costs (xxx) (xxx)
Profit before finance costs xxx Xxx
Finance costs (xxx) (xxx)
Taxation expense xxx Xxx
Profit for the year xxx Xxx
Other comprehensive income for the year xxx xxx
x Items that may be reclassified to profit of loss
- Cumulative gain/loss on financial assets classified at
FVOCI-debt derecognised/reclassified to FVPL
- Gain/(loss) on cash flow hedge, net of reclassification 23 xxx xxx
adjustments and tax
x Items that may never be reclassified to profit or loss
- Gain/ loss on the portion of a financial liability 24 xxx xxx
designated at fair value through profit or loss that relates
to the changes in fair value due to changing credit risk,
net of tax
- Gain/ loss on a financial asset that is an investment in 25 xxx xxx
equity instruments elected to be measured at fair value
through other comprehensive income, net of tax
- (Increase)/decrease in loss allowance on financial assets
classified at FVOCI-debt
Total comprehensive income for the year xxx xxx
Name of Company
20X5 20X4
1. Statement of compliance C C
…
2.1 Financial instruments
The following recognition criteria are used for financial instruments…
The fair values of the financial instruments are determined with reference to …
23. Other comprehensive income: cash flow hedge, net of reclassifications and tax
Cash flow hedge gain / (loss) xxx (xxx)
Tax on gain / (loss) (xxx) xxx
Reclassification of cash flow gain / (loss) (xxx) xxx

Tax on reclassification of cash flow gain / (loss) xxx (xxx)
Cash flow hedge gain/ (loss), net of reclassification and tax xxx xxx
24. Other comprehensive income: gain or loss on a financial liability designated at fair value
through profit or loss relating to credit risk, net of tax
Fair value gain / (loss) xxx xxx
Tax on fair value gain / (loss) (xxx) (xxx)
Fair value adjustment of financial instrument, net of tax xxx xxx
Chapter 21 1063
Name of Company
25. Other comprehensive income: gain or loss on a financial asset that is an investment in
equity instruments at fair value
Fair value gain / (loss) xxx xxx
Tax on fair value gain / (loss) (xxx) (xxx)
Fair value adjustment of financial instrument, net of tax xxx xxx
39. Financial instruments

The company uses … to manage financial risks.
Such risks and methods are:
x We are exposed to Currency risk in … and Foreign Currency risk is managed by …
x We are exposed to Interest rate risk in … and Interest rate risk is managed by …
x We are exposed to Market risk in … and Market risk is managed by …
x We are exposed to Credit risk in … and Credit risk is managed by …
x We are exposed to Liquidity Risk in … and Liquidity Risk is managed by …
1064 Chapter 21
16. Summary
Financial Assets: Classification Process
Step 1: CCF Test (contractual cash flows)

Do the contractual terms of the FA give rise, No Is it a derivative? Yes
x on specified dates, No
x to cash flows that are SPPI …i.e. solely payments of:
x principal and Is it an investment in No
x interest on the principal amount outstanding? an equity instrument?
Yes Yes
Step 2: Business model (BM) Test Is it held for trading? Yes
No
Elect to classify at FVOCI? No
Is the BM 'held to Is the BM 'held to Yes
FV through P/ L
collect'? collect and sell'?
i.e. is the objective to i.e. is the objective to FV through OCI
collect only the: collect both the: (equity instrument)
x contractual cash x contractual cash
flows (i.e. the entity flows; and
does not intend x cash flows from
dealing in the selling the asset
instruments) No (Neither BM applies)
Yes Yes
Would classification at amortised cost / FV through Yes

OCI cause an accounting mismatch and, if so, do you
wish to designate as FV through P/L instead?
No No
Amortised cost FV through OCI

(debt instrument) (debt instrument)
Financial Assets: Measurement overview per classification

Classification: Amortised cost FV through OCI FV through OCI FV through P/L
– debt – equity (debt, equity,
(always debt) (always debt) (always equity) derivatives)
Initial measurement: FV + trans costs FV + trans costs FV + trans costs FV
Subsequent Amortised cost Amortised cost Fair value Fair value
measurement: (EIR method) (EIR method) & FV adj in OCI FV adj in P/L
All adj’s in P/L Dividend/ interest Dividend/ interest
Then to FV
FV adj in OCI income in P/L income in P/L
Other adj in P/L
Impairment testing: Yes Yes No No
Financial Assets: Impairment Testing

(FVPL & FVOCI-equity are not subject to impairment requirements)
General approach: FA other than FAs that were already credit-impaired on initial recognition
Compare credit risk at reporting date to credit risk on initial recognition:
- not a significant increase: LA measured the LA at 12-month ECLs (apply a ‘normal’ EIR to the GCA)
- significant increase in credit risk: LA measured at lifetime ECLs (apply a ‘normal’ EIR to the GCA)
- become credit-impaired: LA measured at lifetime ECLs (apply a ‘normal’ EIR to the Amortised cost)
(i.e. no longer: ‘normal EIR’ x GCA)
FAs at FVOCI-debt: use a ‘loss allowance reserve’ recognised in OCI instead of a ‘loss allowance’ that is
recognised as an asset measurement account (i.e. the loss allowance is not recognised as a ‘negative asset’
that is used to measure the CA of the financial asset). Imp losses/ reversals always recognised in P/L
General approach: FAs that were already credit-impaired on initial recognition
- LA always based on lifetime ECLs, but will reflect only the change in lifetime ECLs since initial
recognition (apply a credit-adjusted EIR to the amortised cost)
Simplified approach (only applies to certain trade receivables, contract assets and lease receivables)
- LA always at lifetime ECLs
Chapter 21 1065
Financial Assets: Subsequent measurement in more detail

Classification Subsequent measurement:
Amortised cost Measure the asset using the EIR method with interest income,
(debt instruments) impairment gains/losses recognised in P/L
Loss allowance: recognised as an asset measurement account
See IFRS 9.5.7.2
Any related foreign exchange gains/losses in P/L *.
FV through profit or loss Measure the asset to FV on subsequent reporting dates with FV
(debt instruments, all derivatives and gains or losses accounted for in P/L.
See IFRS 9.5.7.1
investments in equity instruments) Loss allowance: N/A
FV through other comprehensive income Measure the asset as if it was at amortised cost (i.e. using the EIR
(debt instruments) method with interest income, impairment gains or losses and foreign
exchange gains or losses recognised in P/L*); then
Measure the asset to FV on subsequent reporting dates with all
other gains or losses recognised in OCI.
Gains or losses in OCI are reclassified to P/L on derecognition.
Loss allowance: recognised in OCI (does not reduce the assets’ CA),
See IFRS 9.5.7.10 and B.5.7.1A
FV through other comprehensive income Measure the asset at fair value on subsequent reporting dates with
(investments in equity instruments) FV gains/losses in OCI (foreign exchange gains/losses also in OCI*);
Dividend income in P/L (unless part recovery of the asset’s cost).
Gains/losses in OCI may not be reclassified to P/L. See IFRS 9.B.5.7.1 & .3
Loss allowance: N/A
* IAS 21 Foreign currency transactions requires foreign exchange gains or losses on monetary items to
be recognised in P/L. Since a debt instrument is a monetary item whereas an equity instrument is not a
monetary item, foreign exchange gains or losses:
x are recognised in P/L under the FVOCI classification for debt instruments; whereas they
x are recognised in OCI under the FVOCI classification for equity instruments. See IFRS 9.B.5.7.2-3
Financial liabilities: Measurement

Classification: Amortised cost Fair value through P/L
(By default) (Subject to specific requirements)
Initial Fair value less transaction costs Fair value
measurement: (Transaction costs expensed)
Subsequent Amortised cost (using the EIR Fair value
measurement: method) Gains/losses related to credit risk – OCI
Other gains/losses – P/L
Deciding if a FI is a Liability or Equity or a Compound FI (Liability & Equity)

E.g. Imagine the following terms of a preference share issue (look at redemption & dividends)
Redemption? Dividend? Accounting treatment
Redeemable: Mandatory (L) Pure liability
x mandatory or x L measured at FV, being the PV of the redemption
x at the option of the holder (L) amt plus the PV of the dividends
Discretionary (Eq) Compound financial instrument
x L measured at FV, being the PV of the redemption amt
x Eq measured as the residual
Redeemable: Mandatory (L) Compound financial instrument
x at the option of the entity (Eq) x L measured at FV, being the PV of the dividends
Discretionary (Eq) Pure equity
x Eq measured as the entire proceeds
Non-redeemable (Eq) Mandatory (L) Compound financial instrument
x L measured at FV, being the PV of the dividends
Discretionary (Eq) Pure equity
x Eq measured as the entire proceeds
1066 Chapter 21
Gripping GAAP Financial instruments - hedge accounting
Chapter 22
Financial Instruments – Hedge Accounting
Reference: IAS 32, IFRS 7, IFRS 9 and IFRS 13 (including any amendments to 1 December 2018)
Contents: Page
1. The basics of hedge accounting 1068
1.1 Overview 1068
1.2 What is a hedge? 1068
1.3 What is a hedged item? 1068
Worked example 1: Hedged items 1068
1.3.1 Recognised transactions 1070
1.3.2 Forecast transactions (an uncommitted future transaction) 1070
1.3.3 Firm commitments (committed future transaction) 1070
1.4 What is a hedging instrument? 1071
1.5 How hedging is achieved using a forward exchange contract 1071
Worked example 2: Accounting for FEC’s 1072
1.6 How to measure a forward exchange contract at its present value 1073
Example 1: Present value of a FEC 1074
2. Hedge accounting 1075
2.1 Hedge accounting qualifying criteria 1075
2.2 Hedge effectiveness as a qualifying criterion 1076
2.3 Types of hedges 1076
3. Fair value hedges 1077
3.1 What is a fair value hedge? 1077
Worked example 3: Fair value hedge of a foreign debtor 1077
3.2 Accounting for a fair value hedge 1077
4. Cash flow hedges 1078
4.1 What is a cash flow hedge? 1078
Worked example 4: Cash flow hedge of a foreign creditor 1078
4.2 Accounting for a cash flow hedge 1078
4.2.1 General approach 1078
4.2.2 Accounting for a cash flow hedge that contains an ineffective portion 1079
4.2.3 Calculating the effective and ineffective portions of a cash flow hedge 1079
Example 2: Cash flow hedges and the concept of ineffective portions 1080
5. Designation of hedging instruments 1081
Example 3: Splitting the interest element and the spot price of a FEC 1081
6. Discontinuance of hedge accounting 1082
6.1 Discontinuing hedge accounting 1082
6.2 How to stop using cash flow hedge accounting 1082
6.3 Rebalancing 1083
Worked example 5: A rebalancing exercise 1083
7. Hedging across the timeline – application of the theory 1083
7.1 Overview 1083
7.2 Accounting for hedges involving forward exchange contracts 1086
7.3 Hedges in the post-transaction period 1086
Example 4: FEC taken out in the post-transaction period: fair value hedge 1086
7.4 Hedges in the pre-transaction period 1088
7.4.1 Overview 1088
7.4.2 Hedges in the pre-transaction period where no firm commitment was made 1088
Example 5: Cash flow hedge with a non-financial asset (basis adjustment) 1089
Example 6: Cash flow hedge with a financial asset (reclassification adjustment) 1091
7.4.3 Hedges in the pre-transaction period where a firm commitment was made 1092
Example 7: FEC taken out pre-transaction: Firm commitment as a cash flow hedge 1093
Example 8: FEC taken out pre-transaction: Firm commitment as a fair value hedge 1094
Example 9: FEC taken out pre-transaction: Transaction date after year-end 1096
8. Tax consequences 1098
9. Disclosure 1099
Example 10: Disclosure: cash flow hedge: basis vs reclassification adjustments 1099
10. Summary 1102
Chapter 22 1067
1. The Basics of Hedge Accounting
1.1 Overview
You may be forgiven for thinking that a hedge is simply a row of green bushes planted around
the perimeter of a property. You may also be forgiven for thinking that the hedged item would
be the house in the middle of the property and that the hedging instrument is the pair of garden
shears that we use to trim the hedge.
As you are hopefully beginning to realise, the world of accounting has many odd and interesting
concepts, including hedges, hedged items and hedging instruments. However, although many
people find hedge accounting a fuzzy topic, it has nothing to do with fuzzy green bushes!
This chapter will first explain the theory of hedge accounting and then show you how to apply
this theory through a series of examples. These examples will focus on the hedging of items that
are exposed to foreign currency risks using a common hedging instrument: the forward
exchange contract (FEC).
1.2 What is a hedge?
So, what is a hedge if it is not a green bush? There are various definitions of ‘hedging’
including the following:
x ‘to minimise or protect against loss by counterbalancing one transaction, such as a bet
against another’; The American Heritage® Dictionary of the English Language, Fourth Edition and
x ‘any technique designed to reduce or eliminate financial risk; for example, taking two
positions that will offset each other if prices change’. WordNet ® 2.0, © 2003 Princeton University
However, with reference to the hedging of a foreign currency transaction, it means:

x taking a position in a hedging instrument that would
x counter any change (position) in the hedged item;
x caused by a currency exchange rate fluctuation.
1.3 What is a hedged item? (IFRS 9.6.3) A hedged item is defined
as:
What is a hedged item if it is not the house in the middle
x a recognised asset or liability, or
of the hedged property? A house is exposed to the wind,
x a firm commitment, or
against which it would need protection (a hedge). A x highly probable forecast transaction,
hedged item from an accounting perspective is very or
similar to this. It is an item that is exposed in some way x net investment in a foreign operation,
or another to a risk/s. For example, a foreign currency x that:
denominated item (transaction) is exposed to the risk that - is reliably measured, and
its related cash flows could deteriorate due to changes in - involves a party external to the
the foreign currency exchange rate. This particular risk is reporting entity IFRS 9.6.3 (reworded)
referred to as a foreign currency risk.
A hedged item is a defined term. A hedged item can be any:

x recognised asset or liability,
x unrecognised firm commitment, Note 1 & 2
x unrecognised highly probable forecast transaction; Note 2 or
x a net investment in a foreign operation.
(1): See section 1.3.3.
(2): These are unrecognised since they would not meet the definition and recognition criteria of an asset or liability.
Worked example 1: Hedged items

Hedged items, are items that expose an entity to a risk/s, hedging instruments protect
against those risks. Consider an import transaction:
We are in South Africa (functional and presentation currency = Rands). We import plant for
$10 000 on 1 January 20X3.
We plan to pay the foreign creditor on 31 March 20X3.
1068 Chapter 22
Until we pay this creditor, our creditor's balance will fluctuate with the fluctuating exchange rates.
Let us assume two scenarios (A and B), as reflected by the following spot rates (SR):
Spot currency exchange rates Scenario A Scenario B
1 January 20X3 (Transaction date – TD) R10: $1 R10: $1
31 March 20X3 (Settlement date – SD) R 8: $1 R14: $1
In scenario A, the strengthening Rand reduces the amount we owe our creditor (good) whereas in scenario B,
the weakening Rand increases the amount we owe our creditor (bad). This is journalised as follows:
1 January 20X3 (transaction date = TD) Dr/ (Cr) Dr/ (Cr)
Inventory (A) A & B: $10 000 x SR on TD: R10 100 000 100 000
Creditor (L) (100 000) (100 000)
Purchase of inventory from foreign supplier (import)
31 March 20X3 (settlement date = SD)
Foreign exchange gain (I) A: $10 000 x (SR on SD: R8 – SR on TD: R10) (20 000) -
Foreign exchange loss (E) B: $10 000 x (SR on SD: R14 – SR on TD: R10) - 40 000
Creditor (L) 20 000 (40 000)
Remeasurement of creditor on settlement date
Creditor (L) A: $10 000 x SR on SD: R8 80 000 140 000

Bank B: $10 000 x SR on SD: R14 (80 000) (140 000)
Payment of creditor on settlement date
As you can see the amount we had to eventually pay was dependent on the exchange rate ruling when
we made the payment. In scenario A, the exchange rate moved in a way that was favourable to us but in
scenario B the exchange rate moved against us.
When we enter into a foreign currency denominated transaction such as this one, we can either decide
to take a chance that the exchange rate will move in our favour (like scenario A) or we could decide to
hedge against the possibility of the movement in the exchange rate being unfavourable to us (like
scenario B).
If we decide to hedge the item, we will need to choose an instrument to hedge it with (see section 1.4).
Please note: if we had a foreign debtor that owed us $10 000 (instead of us owing a foreign creditor),
then scenario A would represent an exchange rate that was moving unfavourably for us (our debtor
would pay us less) whereas scenario B would be an exchange rate movement that was favourable to us
(our debtor would pay us more).
A hedged item can be a single asset or liability, firm commitment or forecast transaction or a
group thereof, or even just a part thereof.
If it is a group thereof, certain extra criteria must be met before this group can be designate as a
hedge item (i.e. the items in the group must, individually, be eligible hedged items, and must be
managed together for risk purposes). See IFRS 9.6.6.1
Generally, a hedged item is protected against all changes to its cash flows or fair value (e.g. all
changes in the cash flows or fair value of a recognised asset). However, an entity may choose to
designate only a part of the changes in the cash flows or fair value as the hedged item in a
hedging relationship. If only parts of these changes are designated as the hedged item, we refer
to that hedged part as a hedged component.
We are only allowed to designate the following types of components as hedged items (although
combinations thereof are also possible):
x Only changes in fair value or cash flows linked to a specific risk that are separately
identifiable and reliably measurable (i.e. ‘components of a hedged item);’ IFRS 9.6.3.7(a) or
x Selected contractual cash flows; IFRS 9.6.3.7(b) or
x A component of a nominal amount (a specified part of the amount of an item). IFRS 9.6.3.7(a) - (c)
In all cases, hedged items must be reliably measurable and must involve parties external to the
entity – in other words, we may not designate a firm commitment (see section 1.3.3) as a hedged
item unless it involves a commitment with a third party. See IFRS 9.6.3.2 and 6.3.5
Chapter 22 1069
Components of a hedged item may be contractually or non-contractually specified.

x The risk components are contractually specified if a contract defines the pricing elements.
For example, the price of electricity may be contractually linked to a coal benchmark price,
transmission prices and indexed to inflation. Note, there is a rebuttable presumption that
unless inflation is contractually specified, it is not separately identifiable or reliably
measurable. See Hedge Accounting under IFRS 9 (EY: February 2014) & IFRS 9.B6.3.13
x The risk components are not contractually specified if the contract price is not contractually linked to a
benchmark price. A non-contractually specified component can be seen in the airline industry. Crude
oil impacts the price of refined oil products, such as jet fuel. Thus, the purchase of jet fuel includes a
crude oil risk component, even though it may not be mentioned in any contract. See IFRS 9.B6.3.10
Components of a nominal amount can be designated on a proportional or layer basis. If 50% of
the contractual cash flows of a loan are designated as a hedged item, this represents the
proportional basis. If purchases after the first C200 000 sales are designated as a hedged item,
this represents designation on a layer basis. See IFRS 9.B6.3.17 & .18
1.3.1 Recognised transactions
We mentioned that the hedged item could be a recognised asset or liability, unrecognised firm
commitment or unrecognised highly probable forecast transaction. A recognised asset or
liability is an asset or liability that has been recognised in our accounting records. For example,
an account payable is a recognised liability – and if it was denominated in a foreign currency, we
may choose to protect it against changes in foreign exchange rate fluctuations.
1.3.2 Forecast transactions (an uncommitted future transaction)
A forecast transaction is a transaction that has: A forecast transaction is
x not yet happened (i.e. it is a future transaction); and defined as:
x not yet been committed to (no firm order exists); but x an uncommitted but anticipated
x is expected to happen. x future transaction. IFRS 9 Appendix A
An entity can hedge a forecast transaction but can only account for it as a hedge item if it is
highly probable that the transaction will occur (just ‘expecting it’ is not good enough!).
1.3.3 Firm commitments (committed future transaction)
A firm commitment is defined as ‘a binding agreement for Highly probable is not
the exchange of a specified quantity of resources at a defined in IFRS 9 but it
specified price on a specified future date or dates’. In other is defined in IFRS 5 as:
x significantly more likely
words, it is a future transaction (i.e. one that has not yet x than probable IFRS 5 App A
happened) but one that we have already committed to – a Thus it means 'likely to occur'.
transaction we cannot avoid. IFRS 9 Appendix A
A commitment is binding if it is enforceable, legally or
otherwise. Something would be enforceable if non- A firm commitment is
defined as: IFRS 9Appendix A
performance would result in penalties, whether these were
x a binding agreement
stipulated in the agreement or would apply for other
x for the exchange of a specified
reasons (e.g. through a court of law).
quantity of resources
An example of a firm commitment is when an entity signs a x at a specified price
legally binding contract (i.e. enforceable) ordering goods to be x on a specified future date/ dates.
delivered from a foreign supplier. In this example, the future transaction is a future purchase but the
fact that we signed a legally binding contract makes the order enforceable. It is this enforceability that
has now made our future transaction a 'firm commitment'.
Our firm commitment will exist from the date we made the commitment until the transaction is
eventually recognised in our books. In our example, this recognition date would be the day we
obtain control over the imported goods.
In other words, the life-span of a firm commitment begins on the date we make a commitment
and ends on the date of the transaction (the date the transaction is recognised). (See section 7
for details on how firm commitments can be hedged).
1070 Chapter 22
A summary of the periods during which items may be hedged are as follows:
Date a future transaction Date that a firm Date the transaction Date the transaction
becomes highly probable commitment is made is recognised is settled
N/A Hedge of a highly probable Hedge of a Hedge of a N/A

forecast transaction firm commitment recognised A/L
Pre-transaction period Post-transaction period
It is important to realise we do not have to enter into a firm commitment before a transaction is entered
into – nor do future expected transactions always become highly probable before actually happening.
We also do not have to hedge during all of these periods. For example, we could just hedge an item
after the transaction has occurred in which case we would be hedging a recognised asset or liability.
1.4 What is a hedging instrument? (IFRS 9.6.2) A hedging instrument could
be:
So, what is a hedging instrument if it is not the pair of
x Designated derivatives measured at
garden shears that keeps the hedge around the house neat FV through P/L (except for some
and an effective barrier against the wind? written options), or
x Designated non-derivative financial
A hedging instrument is a financial instrument that is A/Ls measured at FV through P/L;
expected to gain in value when the hedged item loses and
value or vice versa. There are many financial instruments x Only contracts with external
parties may be designated as
that can be utilised as hedging instruments, for example: hedging instruments.
IFRS 9.6.2.1-3(reworded)
x certain derivatives, including options, swaps, futures
and forward exchange contracts;
x certain non-derivatives, including natural hedges such as internal matching that minimises foreign
currency risk (e.g. foreign debtors & foreign creditors in the same currency).
The equity instruments of an entity cannot be a hedging instrument as these are not financial
assets or liabilities. For risks other than foreign currency risk, if the designated hedging
instrument is a non-derivative instrument measured at fair value through profit or loss, it will
need to be designated as a hedging instrument either in its entirety or as a proportion thereof (i.e.
a proportion of the nominal amount). See IFRS 9.6.2.4, IFRS 9.B6.2.2 & B6.2.5
If the hedged item is, for example, a recognised liability denominated in a foreign currency (e.g. an
amount payable to a foreign creditor) we could use a forward exchange contract (FEC) as the
hedging instrument. This chapter’s focus is hedging foreign currency denominated items (i.e. the
hedged items), with the use of forward exchange contracts (FEC’s) (i.e. the hedging instrument).
FEC’s are entered into between an entity and a bank or other financing house.
1.5 How hedging is achieved using a forward exchange contract
To explain how to account for hedges, this chapter will A forward exchange contract
use a forward exchange contract (FEC) as the instrument (FEC) is defined as:
that hedges an item against foreign currency risks. x an agreement between two parties
x to exchange a given amount of
By hedging against currency risks, an entity hopes that currency
any gain or loss on a foreign currency denominated item, x for another currency
x at a predetermined exchange rate
such as a foreign creditor (hedged item) will be offset by and
an opposite loss or gain on the FEC (hedging instrument). x at a predetermined future date.
http://www.nasdaq.com/investing/glossary
For example, imagine we expect the spot exchange rate to move in a way that will result in us
needing an extra LC100 when we settle a foreign liability in a few months from now (i.e. we
expect the value of our local currency to weaken and thus the foreign liability balance to be
increased when we remeasure it to the spot rate on settlement date). We could hedge against
this possible loss by using a FEC to ‘lock in’ a specific future exchange rate (called a forward
rate). This contract allows the entity to avoid or minimise possible losses on the hedged item
due to a fluctuating exchange rate. However, the contract may work against us instead,
resulting in us losing, or reducing possible gains!
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The forward rate agreed upon in the FEC contract (the FEC rate) will differ from the spot
rate available on that same date. This is because the FEC's forward rate reflects the financing
house's prediction of what the spot rate will be on the date the FEC is set to expire. Thus,
depending on the financing house’s expectations about the exchange rate movements and the
contract terms (e.g. whether the contract covers a future receipt or future payment of foreign
currency), the forward rate that we would be offered would consist of the current spot rate
plus a premium, or less a discount.
When the FEC expires, the difference between the Important comparison!
forward rate agreed to in the contract and the spot x The spot rate is the exchange
rate that is being offered at
rate ruling on expiry date will get settled. Settling any one given point in time.
the difference means either: x The forward rate is the
x we pay the difference to the financing house, in exchange rate you agree to pay
or receive in the future.
which case we would have recognised a FEC
liability and a loss, or
x we receive the difference from the financing house, in which case we would have
recognised a FEC asset and a gain
Thus, whether our forward exchange contract (FEC) will result in a gain or loss to us will
obviously only be known on expiry date, when we know the final spot rate. When our FEC
expires, our accounting records will be updated to reflect either the FEC asset and gain, or the
FEC liability and loss, measured by comparing:
x the forward rate agreed to in our forward exchange contract (FEC); and
x the spot rate ruling on expiry of the FEC.
However, it may take a long time before this expiry date, and since during this period we can’t
possibly know what the final spot rate will be, we can only recognise an estimated FEC asset
and gain or estimated FEC liability and loss. This estimate is based on the difference between:
x the forward rate agreed to in our forward exchange contract (FEC); and
x the forward rate currently (i.e. on whatever date we are valuing our FEC asset or liability)
being offered in similar forward exchange contracts that expire on the same date as our FEC.
Worked example 2: Accounting for FEC’s
Hedging instruments are useful because they help us to lock-in to a known amount. Let's
assume our hedging instrument is a FEC. If we enter into an FEC to hedge a transaction
involving a foreign creditor, for example, we would then know how much we will end up paying the
creditor – we would no longer be at the mercy of the fluctuating exchange rate.
When signing an FEC with a bank, we are effectively gambling on the exchange rates. When signing the
FEC, we secure a forward rate to cover either a future foreign currency denominated payment or receipt.
When we agree to this forward rate, we are hoping that when the FEC expires, our forward rate
compared to the spot rate will result in the bank having to pay us rather than us having to pay the bank.
Imagine we secure a forward rate of R11: $1 in an FEC to cover a future payment of $10 000. If the spot
rate is R9: $1 when this FEC expires, we will regret having entered into the FEC. This is because the
FEC commits us to paying R110 000 ($10 000 x R11), whereas had we not signed the FEC and thus
simply been left exposed to the spot rate, we would have only needed to pay R90 000 ($10 000 x R9). In
this example, we will need to pay the bank R20 000 ($10 000 x FR: R11 - $10 000 x SR: R9) when the
FEC expires, which means that the FEC had ultimately represented a liability to us.
However, if this same FEC (with a forward rate of R11: $1) had been covering a future receipt of
$10 000, then a spot rate of R9: $1 on the date the FEC expires would have been a 'good thing'. This is
because the FEC ensured we receive R110 000 ($10 000 x R11) – had we not signed the FEC and thus
been left exposed to the spot rate, we would have only received R90 000 ($10 000 x R9). In this
example, the bank will pay us R20 000 when the FEC expires, and thus that the FEC was an asset to us.
Thus, depending on which way the spot rate goes, and depending on whether we are effectively hedging
a future payment or receipt, we may either be glad we entered into the FEC or we may regret it.
We will only know whether entering into the FEC was a 'good thing' or a 'bad thing' when it expires.
When we enter into the FEC, we do not know whether the 'gamble' will pay off or not. Thus, we do not
recognise a journal when we enter into the FEC. However, even a few days down the line we can start
estimating whether it is working in our favour or not.
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A FEC is not recognised when it is entered into because it has not yet generated any value (good or bad)
for the entity. Its value only becomes evident as time passes because the entity can then compare the
forward rate that the FEC has locked the entity into with the rates currently available in FECs expiring
on the same date. We can then assess if our forward rate is working for (asset) or against us (liability).
Thus, we measure the FEC asset or liability at every reporting date (if any) prior to the FEC being
settled. When we reach settlement date, we remeasure the FEC asset or liability by comparing the
forward rate obtained with the actual spot rate ruling on settlement date (and make the necessary
adjustment to its previous measurement). Once the FEC asset or liability is settled, it is immediately
derecognised since it offers no further value to the entity (the contract has ended).
To illustrate the accounting treatment of a normal FEC (not used as a hedging instrument), consider the
following example: imagine that our functional currency is Rands and we sign an FEC that will expire
on 31 March, and in so doing we lock into a forward rate of R11: $1. By doing this, we now know and
have comfort, that when we pay our creditor on 31 March, it will cost us R110 000 ($10 000 x R11).
However, if a few days after signing the FEC we notice that the financing house is now offering forward
rates of R9: $1 on similar FECs that expire on 31 March, it means that the financing house is now
predicting that our local currency will have strengthened by 31 March. Although we have the comfort of
knowing that our creditor will cost us R110 000 and nothing more, we will be regretting that we 'locked-
in' at R11: $1 instead of at R9: $1 (if we had locked-in at R9: $1, paying our creditor would cost us
R90 000 instead of R110 000). This 'regret', or the fact that the FEC is working against us, is recognised
as a FEC liability and loss (credit: FEC liability and debit: loss).
Obviously, it is too time-consuming to keep checking daily to see what the latest forward rates on offer
are and comparing these to the forward rate we secured and to keep adjusting the extent of our liability
and loss (or asset and gain). Thus, we simply check whether the FEC is working for or against us on
certain specific dates, such as every reporting date until the FEC expires and the final expiry date. When
the FEC expires, we will then know for sure whether the FEC worked for or against us by comparing the
forward rate we secured with the final spot rate on 31 March.
The table below summarises the information involving the FEC.
Spot exchange rate Forward rate Spot exchange rate Forward rate
1 January 20X3 R10: $1 R11: $1 R10: $1 R11: $1
31 January 20X3 R 9: $1 R 9: $1 R12: $1 R13: $1
31 March 20X3 R 8: $1 N/A R14: $1 N/A
In scenario A, the strengthening Rand (see the spot rates) reduces the amount we owe our creditor
(good) but our FEC locked us into a higher forward rate than if we simply been left exposed to the spot
rates (bad) – thus the FEC in this case was a liability to us. In scenario B, the weakening Rand (see the
spot rates) increases the amount we owe our creditor (bad) but our FEC locked us into a lower forward
rate than if we had been left exposed to the spot rate (good) – thus the FEC was an asset to us.
31 March 20X3 (settlement date = SD)
Dr/ (Cr) Dr/ (Cr)
FEC liability (L) A: $10 000 x (SR on SD: R8 – FR secured: R11) (30 000) -
Foreign exchange loss (E) 30 000 -
FEC asset (A) B: $10 000 x (SR on SD: R14 – FR secured: R11) 30 000
Foreign exchange gain (I) (30 000)
Recognising the FEC asset or liability (and resulting gain or loss)
FEC liability (L) The balance in the FEC liability a/c on expiry 30 000 -
FEC asset (A) The balance in the FEC asset a/c on expiry (30 000)
Bank (30 000) 30 000
Settling the FEC when it expires: if the FEC is a liability it means we
will pay the bank, whereas if the FEC is an asset, the bank will pay us
Notice that we did not bother recording the fact that the forward rates being offered on 31 January
would have made us 'unhappy' in scenario A and 'happy' in scenario B. This is because this was not a
'special date'. Had it been a year-end, for example, we would have recognised the movement in the
forward rates as an estimated liability in scenario A and an estimated asset in scenario B. Recognising
estimated FEC assets or liabilities on reporting dates is explained in future examples.
1.6 How to measure a forward exchange contract at its present value

As the cash flow when settling the FEC will only occur in the future, this future cash flow
should be discounted to its present value, assuming the effects of present valuing are material.
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This next example shows the effect of present valuing, but all other examples thereafter will
ignore present valuing in order to better illustrate hedging principles.
Example 1: Present value of a FEC
A German entity (functional currency: Euro) signs an FEC on 28 February 20X5 to hedge
an import transaction worth ¥1 000 000, recognised on the same day and to be settled on
30 November 20X5. The following FECs were available on the following dates:
Forward Rate to 30 November 20X5
28 February 20X5 €0.007131 : ¥1
30 June 20X5 €0.007404 : ¥1
31 August 20X5 €0.006820 : ¥1
An appropriate discount rate for cash flow evaluations is 10% per annum.
Required:
A. Calculate the value of the FEC in the German entity's functional currency (€) on;
x 30 June 20X5;
x 31 August 20X5.
B. Show all journals needed to recognise the FEC in the German entity’s books.
Solution 1A: Present value of a FEC
Answer:
The value of the FEC is as follows:
x 30 June 20X5 (i.e. 5 months to expiry): €263 Asset W1
x 31 August 20X5 (i.e. 3 months to expiry): €304 Liability W2
Explanation: at 30 June 20X5

x The German entity entered into an FEC on 28 February 20X5 and has thus locked in at an exchange rate of
€0.007131 and will have to pay €7 131.
x Had it waited and entered into the FEC on 30 June 20X5, it would have obtained a rate of €0.007404 and had
to pay €7 404.
x By entering the FEC on 28 February rather than on 30 June 20X5, it saved €273 in absolute terms.
x There are 5 months until the contract will be settled and thus the present value of the gain is based on the
present value factor for 5 months: €263 (i.e. FEC asset/ gain measured in ‘real money’).
W1. Value of the FEC on 30 June 20X5:

Present values (5 months to
30 June 20X5 Rate Amount (¥) Amount payable (€ ): FV expiry)
Rate acquired 0.007131 1 000 000 7 131 1 000 000 x 0.007131 6 853 7 131 / [1.1 ^ (5/12)]
Rate now available 0.007404 1 000 000 7 404 1 000 000 x 0.007404 7 116 7 404 / [1.1 ^ (5/12)]
€273 Asset/ gain €263 Asset/ gain
The present value can be calculated using a financial calculator:

(1) FV = 7 131 N = 5/12 I = 10 Comp PV: 6 853
(2) FV = 7 404 N = 5/12 I = 10 Comp PV: 7 116
Explanation: at 31 August 20X5

x The German entity took out an FEC on 28 February 20X5 and has thus locked in at an exchange rate of
€0.007131 and will have to pay €7 131.
x Had it waited and taken out the FEC on 31 August 20X5, it would have obtained a rate of €0.00682 and had
to pay €6 820.
x By taking out the FEC on 28 February rather than on 31 August 20X5, it has to pay an extra €311 thus losing
€311 (in absolute terms).
x There are now only 3 months to the settlement of the contract and therefore the present value is based on the
present value factor for the next 3 months: €304 (i.e. the latest estimate is that the FEC represents a liability /
loss, measured at €304 in ‘real money’).
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Solution 1A: Continued …

W2. Value of the FEC on 31 August 20X5:
31 August 20X5 Rate Amount (¥) Amount payable (€ ): FV Present values (3 m to expiry)
Rate acquired 0.007131 1 000 000 7 131 1 000 000 x 0.007131 6 963 7 131 / [(1.1 ^ (3/12)]
Rate now available 0.006820 1 000 000 6 820 1 000 000 x 0.006820 6 659 6 820 / [1.1 ^ (3/12)]
€ (311) Liability/ loss € (304) Liability/ loss
The present value can be calculated using a financial calculator:
(1) FV = 7 131 N = 3/12 I = 10 Comp PV: 6 963
(2) FV = 6 820 N = 3/12 I = 10 Comp PV: 6 659

Comment: The journal on 31 August is a net adjustment. It may be easier for you to understand that the FEC
asset of 263 (or 273) is being reversed and a liability of 304 (or 311) is being recognised in its place.
Not Present Valued Present Valued

30 June 20X5 Debit Credit Debit Credit
FEC asset W1 273 263
Forex gain (I: P/L) 273 263
Recognising FEC asset.
31 August 20X5
Forex loss (E: P/L) 584 567
FEC liability If no PVs: New bal 311 (L) + Old bal 273 (A) 584 567
If PVs: New bal 304 (L) (W2) + Old bal 263 (A)
Re-measuring the FEC on 31 August 20X5
2. Hedge Accounting
2.1 Hedge accounting qualifying criteria (IFRS 9.6.4)
If you have an item that you believe is at risk, you may decide to hedge these risks, by using an
instrument that you believe will offset these risks. Should the requirements per sections 1.3 and 1.4
be met at this point, you would have a hedged item and a hedging instrument respectively.
Although you have the two ingredients necessary for hedge accounting, you may only
account for the relationship between the hedged item and the hedging instrument as a hedge if
you meet 3 criteria. These are listed in the grey block below.
Hedge accounting may only be applied if all of the following 3 criteria are met:
x The hedging relationship must consist only of eligible hedging instruments and hedged items.
IFRS 9.6.4.1 (a)
x At the inception of the hedging relationship, there must be a formal designation and
documentation of the hedging relationship and the entity’s risk management objectives and
strategy for undertaking the hedge.
That documentation shall include identification of:
the hedging instrument,
the hedged item,
the nature of the risk being hedged (e.g. in the case of this chapter, foreign exchange
risk), and
how the entity will assess the hedging instrument’s effectiveness. IFRS 9.6.4.1 (b) (slightly reworded)
x The hedging relationship must meet all of the following hedge effectiveness requirements:
an economic relationship must exist between the hedged item and the hedging instrument,
the effect of credit risk must not dominate the value changes that result from that
economic relationship, and
the hedge ratio of the hedging relationship for accounting purposes must mirror the ratio
for risk management purposes. IFRS 9.6.4.1 (c)(reworded)
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2.2 Hedge effectiveness as a qualifying criterion
One of the criteria to be met before being able to apply hedge accounting is that the entity
needs to document how it will assess the effectiveness of the hedging instrument. There is no
absolute ratio of hedge effectiveness required for purposes of assessing whether the criterion
of hedge effectiveness is met (e.g. it does not have to be 100% or 80% effective etc).
Instead, IFRS 9 defines an effective hedge as one that is characterised by 3 features:
x An economic relationship must exist between the hedging instrument and the hedged item.
Since the objective is to offset gains on one item with losses on the other, it is implied that
the values of the hedging instrument and the hedged item need to be moving in opposite
directions due to the same (but opposite) risks.
x The fair value changes within the economic Credit risk is defined as:
relationship are not driven primarily by the impact of
credit risk. This requires an entity to monitor changes x The risk that one party to a
in the fair value of the instruments within the x financial instrument
Will cause financial loss to the
economic relationship and assess the extent to which other party
such changes are driven by changes in credit risk. x By failing to discharge an
obligation
x The hedge ratio for accounting purposes mirrors the IFRS 7 Appendix A
hedge ratio for risk management purposes, provided
the ratio does not reflect a deliberate imbalance
Hedge ratio is defined as
designed to achieve an accounting outcome that is
the relationship between
not consistent with the purposes of either hedge
See IFRS 9.6.4.1(c) x the quantity of the hedging
accounting or risk management. instrument and
x the quantity of the hedged item
Despite the fact that there is no pre-determined level of x in terms of their relative weighting.
hedge effectiveness required for this particular qualifying IFRS 9 Appendix A
criterion to be met, it is important to understand what is

meant when people refer to the level of hedge effectiveness. The level of hedge effectiveness is
simply a comparison between the movement in the value of the hedging instrument compared to the
movement in the value of the hedged item, where this comparison is generally expressed as a
percentage or ratio.
If, for example, a gain on a hedging instrument equals the loss on the hedged item, the instrument
is said to be 100% effective. It is, however, highly unlikely that the hedging instrument is 100%
effective. For example, a weakening exchange rate may result in us needing an extra LC100 to
settle a foreign creditor, while the FEC only gains in value by LC80. In this case, the hedge is no
longer 100% effective, but 80% effective (gain on instrument: 80 ÷ loss on item: 100).
2.3 Types of hedges (IFRS 9.6.5)
There are three types of hedges: fair value hedges, cash
flow hedges and a hedge of a net investment in a foreign The 3 types of hedges:
operation. The hedge of a net investment in a foreign
x Cash flow hedges;
operation is outside the scope of this chapter. However,
x Fair value hedges; and
the fair value hedge and the cash flow hedge will be
x Hedges of a net investment in a
discussed in detail. foreign operation. See IFRS 9.6.5.2
In simple terms, a fair value hedge is a hedge that protects against changes in the fair value of
the hedged item whereas a cash flow hedge is a hedge that protects against changes in the
cash flows relating to the hedged item.
Fair value hedges and cash flow hedges are accounted for differently. Although the
accounting is similar to the extent that, in both cases, we recognise the effect of the hedging
instrument (e.g. FEC contract) as an FEC asset or liability, it differs in that the increase or
decrease in the value of this asset or liability will be immediately recognised as a gain or loss:
x in the case of a fair value hedge, in 'profit or loss' (P/L), whereas
x in the case of a cash flow hedge, in 'other comprehensive income' (OCI).
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3. Fair value hedges (IFRS 9.6.5.2)
3.1 What is a fair value hedge?

A fair value hedge is
A fair value hedge is one that is trying to protect our defined as:
profit or loss from being affected by changes in the fair x a hedge of the exposure to
value of a specific item, where these fair value changes x changes in fair value of:
are expected due to certain risks. a recognised asset or liability; or
an unrecognised firm commitment; or
Although the definition refers to the protection of an a component of such asset, liability
entity’s profit or loss, there is one exception where the or firm commitment;
hedge is trying to protect other comprehensive income: x that is attributable to a particular risk
(e.g. a foreign currency risk); &
this is where the hedged item is an investment in equity
x could affect P/L. IFRS 9.6.5.2(a)
instruments that is classified at fair value through other
comprehensive income (FVOCI-equity).
Thus, a fair value hedge that is hedging (protecting) against the effects of changes in fair
value on our profit or loss (or, in the case of the abovementioned exception, the effects on our
other comprehensive income) is a hedge that is trying to protect:
x a recognised asset or liability (or part thereof), or
x an unrecognised firm commitment (or part thereof),
x against changes in its fair value
x that may result from changing economic circumstances (such as fluctuations in the
exchange rates)
Worked example 3: Fair value hedge of a foreign debtor

Imagine that our functional currency is South African Rands (R) and that:
x We have a foreign debtor who owed us $100 000 at the end of the prior year and still
owes us the same amount now; and
x At the end of the prior year, $1 bought R5, but now $1 buys R4 (i.e. the $ weakened).
The value of our foreign debtor has thus dropped from R500 000 ($100 000 x R5) to R400 000
($100 000 x R4). A fair value hedge would attempt to neutralise any such decrease in value.
3.2 Accounting for a fair value hedge (IFRS 9.6.5.8)
When accounting for a fair value hedge, we recognise the movement in the value of the
hedging instrument (e.g. a FEC) as an asset or liability and generally:
x recognise the gains or losses on the hedging instrument in profit or loss; and
x recognise the gains or losses on the hedged item in profit or loss See IFRS 9.6.5.8
There are two exceptions to the above general rules of fair value hedge accounting:
Exception 1: If the hedged item is an investment in equity instruments that is classified at fair
value through other comprehensive income (i.e. FVOCI-equity), then:
x The gains or losses on the hedging instrument must also be recognised in other
comprehensive income (not in profit or loss);
x The gains or losses on the hedged item (i.e. the equity instruments) will be recognised in
other comprehensive income (i.e. as they would normally be). See IFRS 9.6.5.8(b)
Exception 2: If the hedged item is an unrecognised firm commitment (or part thereof), then, in
addition to recognising the hedging instrument as an asset or liability, we also recognise the
movement in the value of this firm commitment (i.e. the hedged item) as an asset or liability:
x The cumulative change in the fair value of the hedged item (from the date that it was
designated as being the hedged item) is recognised as a firm commitment asset or liability
with a corresponding gain or loss in profit or loss.
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x When the firm commitment (or part thereof) finally results in the acquisition of the asset
or liability (i.e. the entity met its firm commitment, and thus no longer has the firm
commitment but has now recognised the related asset or liability), the balance on the firm
commitment asset or liability must be derecognised and recognised as an adjustment to
the initial carrying amount of this acquired asset or liability. See IFRS 9.6.5.8 (b) and IFRS 9.6.5.9
Examples showing how to account for fair value hedges:
Where can you find examples showing how to account for a fair value hedge?
x Hedges of recognised assets or liabilities as fair value hedges:
Example 4 is a basic example involving a hedge of a recognised asset accounted for as a fair value hedge.
Examples 5 - 9 also involve cash flow hedges of firm commitments and forecast transactions, but in each
case, the hedge of the recognised asset or liability has been accounted for as a fair value hedge.
x Hedges of firm commitments as fair value hedges:
Example 8 and 9 show how to account for a firm commitment as a fair value hedge.
4. Cash flow hedges (IFRS 9.6.5.2 & .4 and 6.5.11-12)
4.1 What is a cash flow hedge?

A cash flow hedge is:
A cash flow hedge is a hedge that is protecting against x a hedge of the exposure to
specific risks that could cause variability in the cash x changes in cash flows of:
flows relating to a specific item (the item to be hedged), a recognised asset or liability; or
of a highly probable forecast
where changes in the cash flows could end up affecting transaction; or
profit or loss and where these cash flows relate to: a firm commitment*
x a recognised asset or liability (or part thereof); or x attributable to a particular risk; and
x that could affect P/L.
x a highly probable forecast transaction (or part IFRS 9.6.5.2(b) reworded
thereof); or *A hedge of a FC can only be accounted

x a firm commitment (but only if it is being hedged for as a CFH if the hedge is protecting
the FC against foreign currency risks.
against foreign currency risk!). See IFRS 9.6.5.2 & .4 See IFRS 9.6.5.4
For example:
A cash flow hedge that is being used to hedge against foreign currency risks on an account
payable (a recognised liability) is a hedge that is effectively protecting against an increase in
cash outflows due to exchange rate fluctuations.
Worked example 4: Cash flow hedge of a foreign creditor
Imagine that our functional currency is South African Rands (R) and that:
x We owe a foreign creditor $100 000.
x At transaction date, it took R5 to buy $1, but $1 now costs R6 (i.e. the Rand weakened).
The settlement of our foreign creditor will now require a cash outflow of R600 000 ($100 000 x R6)
instead of only R500 000 ($100 000 x R5). A cash flow hedge would attempt to neutralise such an
increase in the potential cash outflow arising from exchange rate fluctuations.
4.2 Accounting for a cash flow hedge (IFRS 9.6.5.11)
4.2.1 General approach
When accounting for cash flow hedges, we recognise the change in the value of the hedging
instrument (e.g. FEC) as an asset or liability with its related gain or loss recognised in other
comprehensive income (fair value hedges recognise these gains or losses in profit or loss). Gains
or losses that accumulate in other comprehensive income are eventually reversed to profit or
loss, either by using a reclassification adjustment (affecting profit or loss directly) or a basis
adjustment (affecting profit or loss indirectly). Gains or losses are thus recognised as follows:
x initially recognised in other comprehensive income (the 'cash flow hedge reserve account');
x on settlement, the cumulative gains or losses in other comprehensive income are then either:
set-off (as one single adjustment) against the carrying amount of the hedged item (i.e. a
basis adjustment); or
reclassified to profit or loss as and when the related hedged item affects profit or loss
(i.e. a reclassification adjustment). See IFRS 9.6.5.11 (d)
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Whether and when to use the basis adjustment or reclassification adjustment is decided as follows:
x The basis adjustment must be used when we have been hedging a forecast transaction that
involved a non-financial asset or liability. It is journalised when this forecast transaction:
has now resulted in the recognition of this non-financial asset or liability (e.g. plant); or
has now become a firm commitment instead and where this firm commitment is to be
accounted for as a fair value hedge.
The basis adjustment is processed directly through equity; it is not a reclassification adjustment
and hence it does not affect the other comprehensive income amount. See IFRS 9.6.5.11(d)(i)
x The reclassification adjustment must be used in all other cases (e.g. where the underlying
transaction involves a financial asset or liability). This adjustment must be journalised when
the expected future cash flows affect profit or loss (e.g. when our forecast sale occurs or
when our forecast interest income is earned). See IFRS 9.6.5.11(d) (i) & (ii)
This is a reclassification adjustment, and is processed through other comprehensive income.
However, if the amount recognised in the cash flow hedge reserve account (OCI) is a loss that
we believe will never be recovered, this loss must be immediately reversed to profit or loss (i.e.
as a reclassification adjustment), ignoring the normal decision process above. See IFRS 9.6.5.11(d)(iii)
A slightly different approach applies if the cash flow hedge is deemed to contain what is
referred to as an 'ineffective portion' (see section 4.2.2 below).
Examples showing how to account for cash flow hedges (CFHs) without an ineffective portion:
Examples 5 – 10 show hedges of highly probable forecast transactions accounted for as CFHs
Example 7 also shows the hedge of a firm commitment accounted for as a CFH.
4.2.2 Accounting for a cash flow hedge that contains an ineffective portion
Hedges can sometimes be ineffective. It generally happens that the change in the value of a
hedged item does not match exactly the change in the value of the hedging instrument. Where
there is this 'mismatch', a part of the hedge may end up being deemed ineffective. If this happens,
the hedge is considered to be effective to the extent that it covered the hedged item's gains or
losses (the change in the item's expected cash flows) but ineffective to the extent that it covered
more than these gains or losses.
Accounting for such a hedging instrument would then be made up of two aspects – accounting
for the effective portion and ineffective portion. We would recognise the hedging instrument (e.g.
FEC) as an asset or liability as usual, but the related gains or losses would be split between
gains or losses on the effective portion and the gains or losses on the ineffective portion:
x Gains or losses on the effective portion are initially recognised in other comprehensive
income (in the 'cash flow hedge reserve account') and then subsequently accounted for using
either a basis adjustment or a reclassification adjustment. However, if the effective portion
relates to a loss that is not expected to be recovered, this loss is immediately reclassified to
profit or loss. Thus, an effective portion is accounted for in the usual way (see section 4.2.3).
x The excess (i.e. the amount by which the hedging instrument's gains or losses are bigger than
the hedged item's losses or gains), is called the ineffective portion and must be recognised
directly in profit or loss (i.e. not in other comprehensive income). See IFRS 9.6.5.11(b); (c)
4.2.3 Calculating the effective and ineffective portions of a cash flow hedge
The portion of the gain or loss on the hedging instrument that is accounted for as being effective,
and is thus recognised in other comprehensive income, is calculated by adjusting the cash flow
hedge reserve to the lower of:
x 'The cumulative gain or loss on the hedging instrument from inception of the hedge; and
x The cumulative change in the fair value (present value) of the hedged item (i.e. the present value of
the cumulative change in the hedged expected future cash flows) from inception of the hedge.'
IFRS 6.5.11 (a) extracts and see IFRS 6.5.11 (b)
Any remaining gain or loss on the hedging instrument is considered to be ineffective and is
recognised (directly) in profit or loss. See IFRS 9.6.5.11 (c)
Chapter 22 1079
Example 2: Cash flow hedges and the concept of ineffective portions

Joe Limited's functional currency is the Rand (R). Joe entered into a highly probable
forecast transaction on 1 January 20X4, where the forecast transaction involves an intended
purchase of inventory from a foreign supplier for $100 000. Joe immediately entered into an FEC to
hedge the currency risk of the transaction.
x On this date the spot rate was R7:$1.
x The FEC stipulates a forward rate of R8:$1 and an expiry date of 30 June 20X4.
x The transaction became a firm commitment on 1 March 20X4 on which date the rate of a similar
FEC expiring on 30 June 20X4 was R10:$1.
x The expected payment date was 30 June 20X4.
Required: Provide the journals to account for the FEC during the period the FEC was hedging a highly
probable forecast transaction (i.e. to 1 March 20X4) and assuming the spot rate on 1 March 20X4 was:
a) R8.50:$1
b) R9.50:$1
Assume all hedging requirements were met (i.e. per IFRS 9.6.4), including hedge effectiveness.
Solution 2: Cash flow hedge and the concept of ineffective portions

Comment:
x Since this is a hedge of a highly probable forecast transaction, it is accounted for as a cash flow hedge.
x When accounting for a cash flow hedge, we need to ensure that it is only the gains or losses on the
effective portion that are recognised in other comprehensive income. In other words, if any part of
the hedge is ineffective, the ineffective portion must be recognised in profit or loss.
x Part (a) shows a hedge that contains an ineffective portion: the hedging instrument offsets more than
just the movement in the hedged item (i.e. it is over-effective – see workings below). Only the
effective portion may be recognised as a cash flow hedge (OCI), and the rest is recognised in P/L.
The first step is to calculate the cumulative gain or loss on the hedging instrument, which we will
recognise as an asset: R200 000
FEC Amt $100 000 x (Latest FEC rates on offer: R10 – FEC rate obtained: R8) = R200 000
The second step is to calculate the cumulative change in the fair value of the hedged item from
hedge inception:
Future foreign currency outflow: $100 000 x (Spot rate now: R8.50 – Spot rate then: R7.00) = R150 000
The third step is to compare the two amounts (in absolute terms) and choose the lower of the two
as being the effective portion (recognised in OCI) with any excess being the ineffective portion
(recognised in P/L):
Effective portion: Lower of R200 000 and R150 000 = R150 000
Ineffective portion: Total gain R200 000 – Gain on effective portion: R150 000 = R50 000
x Part (b) shows a hedge that does not contain an ineffective portion: the hedging instrument did not
move sufficiently in the opposite direction to offset the movement in the hedged item (i.e. it was
under-effective – please note that 'under-effective' is not the same as 'ineffective'!). The entire
movement in the hedging instrument may thus be recognised in other comprehensive income.
The first step is to calculate the cumulative gain or loss on the hedging instrument, which we will
recognise as an asset: R200 000
FEC Amt $100 000 x (Latest FEC rates on offer: R10 – FEC rate obtained: R8) = R200 000
The second step is to calculate the cumulative change in the fair value of the hedged item from
hedge inception:
Future foreign currency outflow: $100 000 x (Spot rate now: R9.50 – Spot rate then: R7.00) = R250 000
The third step is to compare the two amounts (in absolute terms) and choose the lower of the two
as being the effective portion (recognised in OCI) with any excess being the ineffective portion
(recognised in P/L):
Effective portion: Lower of R200 000 and R250 000 = R200 000
Ineffective portion: Total gain R200 000 – Gain on effective portion: R200 000 = nil
1080 Chapter 22
Part a): Journal on 1 March Debit Credit

FEC asset FEC Amt: $100 000 x (Latest FR on offer: 200 000
R10 – FR obtained: R8)
Cash flow hedge reserve (OCI) Lower of gain of R200 000 and movement in 150 000
hedged item of R150 000 [$100 000 x (Latest
SR: R8.50 – Previous SR: R7.00)]
Forex gain (P/L) Balancing: 200 000 – 150 000 50 000
Cash flow hedge: gain on FEC, partly recognised in OCI (effective
portion: total gain, limited to movement in hedged item) & partly
recognised in P/L (ineffective portion: the remaining 'excessive' gain)
Part b): Journal on 1 March Debit Credit

FEC asset FEC Amt: $100 000 x (Latest FR on offer: 200 000
R10 – FR obtained: R8)
Cash flow hedge reserve (OCI) Lower of gain of R200 000 and movement 200 000
in hedged item of R250 000 [$100 000 x
(Latest SR: R9.50 – Previous SR: R7.00)]
Cash flow hedge: gain on FEC, all recognised as OCI (the total gain of
R200 000 was less than the movement of R250 000 in the hedged item and
thus was not limited)
5. Designation of hedging instruments (IFRS 9.6.2.4)
Qualifying instruments must be designated as hedging instruments in their entirety. However,

there are three exceptions where an instrument may be designated differently, depending on an
entity’s objectives:
x separating the forward element and the spot element of a forward contract and only
designating the changes in the value of the spot element as the hedging instrument;
x separating the intrinsic value and the time value of an option contract and only designating
the changes in the intrinsic value as the hedging instrument; or
x designating a portion of an instrument (e.g. 50% of the nominal amount) as the hedging
instrument. See IFRS 9.6.2.4
Where an entity designates only the change in the value of the spot element as the hedging
instrument, the entity is only concerned about movements in the spot rate, and not changes due
to interest rates, which is the forward element. The difference between the forward rate and the
spot rate represents the interest differential between the two currencies, thus the forward
element can be viewed as an adjustment to the investment yield on foreign currency
assets/liabilities. This gives rise to a need to adjust profit or loss to reflect the cost of achieving
a locked-in return. See Practical Guide: General Hedge Accounting (PWC: December 2016) & IFRS 9.BC6.425
The following example shows how the forward element (interest) and spot rate are separated.
Example 3: Splitting the interest element and the spot price of a FEC
On 31 March 20X1 a South African company (with a functional currency of Rands: R)
entered into a FEC for $100 000 to hedge the import of a plant, and expiring on 31 Dec 20X1.
Date Spot rates (SR) Forward rates (FEC rate)

31 March 20X1 R7.50: $1 R8.00: $1
30 June 20X1 R7.90: $1 R8.50: $1
Required:
Prepare the journal for the year ended 30 June 20X1 to record the movement on the FEC if the spot
element is designated as the hedging instrument and accounted for as a cash flow hedge.
Chapter 22 1081
Solution 3: Splitting the interest element and the spot price of an FEC
Comment: Note the following:
x The FEC asset & gain is still measured using forward rates: R50 000 ($100 000 x R8.5 - $100 000 xR8).
x However, the component of the gain on the cash flow hedge to be recognised in equity (OCI) is
now determined using the spot rates because the spot rates were designated as the hedging
instrument. The remaining gain is recognised in profit or loss.
Journals:
FEC asset $100 000 x (Latest FR now on offer 8.50 – 50 000
FR obtained: 8)
Cash flow hedge reserve: $100 000 × (Latest SR: 7.90 – Prior SR: 7.50) 40 000
- Spot element (OCI)
Forex gain: Balancing figure 10 000
- Forward element (P/L)
Recognising the FEC as an asset at 30 June 20X1, the gain caused by the
movement in the spot element in OCI & the remaining gain caused by the
movement in the forward element (interest) in P/L
6. Discontinuance of hedge accounting
6.1 Discontinuing hedge accounting (IFRS 9.6.5.5-.7)

Although hedge accounting is voluntary (assuming the qualifying criteria for hedge accounting are
met), once we start hedge accounting we are actually not allowed to voluntarily stop hedge
accounting. However, we are forced to stop hedge accounting under the following circumstances:
x Hedge accounting must stop if the qualifying criteria for hedge accounting (see section 2.1)
are no longer met: this can result in hedge accounting having to stop for either the entire
hedging relationship or just a part of it.
x Hedge accounting must stop if the hedging instrument expires or is sold, terminated or
exercised. A replacement or rollover of a hedging instrument into another hedging
instrument would be considered to be an expiry or termination and would thus lead to the
cessation of hedge accounting, unless the replacement of rollover was part of the entity’s
documented hedging strategy, in which case hedge accounting would not stop. See IFRS 9.6.5.6
When we stop hedge accounting, we stop prospectively. In other words, we do not restate our
comparative figures. This applies to both cash flow hedges and fair value hedges.
6.2 How to stop using cash flow hedge accounting (IFRS 9.6.5.12)
Hedge accounting is always simply stopped prospectively (see section 6.1). However, if we
had been accounting for our hedge as a cash flow hedge, the cumulative gain or loss in the
cash flow hedge reserve account (i.e. an equity account reflecting the cumulative OCI
adjustments) must somehow get released. When and how it gets released depends on our
expectation of whether the hedged future cash flows are still expected to occur.
If the hedged future cash flows are still expected to occur, the balance in the cash flow hedge
reserve account (equity) will be released and either accounted for as a basis adjustment or a
reclassification adjustment when the cash flows occur or, if it is an irrecoverable loss, it is
immediately reclassified to profit or loss (i.e. we follow the normal approach to the subsequent
accounting for any gains or losses that were recognised in OCI – see section 4.2).
However, if the hedged future cash flows are no longer expected to occur, then the entire
balance in the cash flow hedge reserve account (equity) must immediately be reclassified to
profit or loss (i.e. using the reclassification adjustment approach).
1082 Chapter 22
6.3 Rebalancing
One of the qualifying criteria for hedge accounting is that the hedging relationship is considered
to be effective. However, if we believe that our hedging relationship is no longer effective
because there is an imbalance in the hedge ratio, we may not simply stop hedge accounting.
Generally, an imbalance will arise where the hedge ratio used for risk management and financial
reporting purposes differs. Hedge ineffectiveness arising from a fluctuation around an otherwise
valid hedge ratio cannot be reduced by adjusting the hedge ratio, and rebalancing will not be
required in this scenario. If there is an imbalance in the hedge ratio, but the risk management
objective remains the same, we must first adjust the hedge ratio of the hedging relationship so
that the hedging relationship meets the qualifying criteria again. This is a ‘rebalancing’ exercise.
It requires the quantities of the hedged item or hedging instrument to be adjusted in a way that
leads to the hedge ratio complying with the hedge effectiveness requirements of IFRS 9.
Changes to the quantities of the designated items for any other purpose are not classified as
‘rebalancing’ adjustments.
Worked example 5: A rebalancing exercise

Imagine that we want to sell 100 tonnes of sunflowers in the future but we are worried about
potential future decreasing prices. To hedge against this risk, we entered into a forward
contract to sell 105 tonnes of sunflower oil at R100/tonne (this contract would be settled net
– see comment below) at a fixed price (exercise price – EP). We entered a sunflower oil forward
contract because a sunflower forward contract is not available. We used sunflower oil because there is
an economic relationship between the prices of sunflowers and those of sunflower oil (SP): when the
price of sunflowers decreases, so does the price of sunflower oil. We entered a contract to sell because,
as the price of sunflower oil decrease (as we expect) we will make a gain on the difference between the
price of sunflower oil (SP) and the exercise price (EP) in the forward contract (EP>SP).
The hedge ratio in terms of our initial strategy was 1.05: 1 (105 tonnes: 100 tonnes). However, if the
price of sunflowers decreases at a greater rate than the decrease in the price of sunflower oil, we will
need to get more sunflower oil forwards to hedge out the extra risk. This is a rebalancing exercise,
which arises due to a change in the economic relationship between sunflowers and sunflower oil, and
not merely due to volatility in the prices of sunflowers and sunflower oil.
Comment:
Net settled contracts are those that on settlement date, actual products are not exchanged, instead, the parties to
the contract settle the price differential between the exercise price (EP) and the current prevailing price (SP) of
the underlying (in this case, sunflower oil). A gross settled contract is one that will be settled by actually
transferring the underlying (in this case, we would actually have to deliver sunflower oil).
However, if, after trying this ‘rebalancing’ exercise, we still believe our hedging relationship
no longer meets the criteria for hedge effectiveness, we must stop hedge accounting.
7. Hedging across the timeline – application of the theory
7.1 Overview
Now that we have covered the theory behind what constitutes a fair value hedge and a cash flow
hedge and how to account for each, let us now apply this theory to practical examples. Our
hedging instrument in all these examples is a FEC but the principles applied would be identical
for other hedging instruments used.
As we go through these examples, you will see that we use a timeline. A timeline can be useful
because whether we account for our hedge as a cash flow hedge or fair value hedge is not only
affected by whether the hedge is protecting against changes in fair value (fair value hedge) or
changes in the cash flows (cash flow hedge), but is also affected by whether the hedged item is a
recognised asset/ liability (A/L), firm commitment (FC) or highly probable forecast transaction
(HPFT). This timeline makes it easy to identify what we are hedging at any point in time.
By constructing a timeline showing all the relevant dates and then inserting the date on which
the hedging instrument was entered into, we will be able to easily identify which of these items
the hedging instrument is currently hedging (i.e. an A/L, FC or HPFT).
Chapter 22 1083
Consider the following:

x If we enter into a hedging instrument on the date that a forecast transaction becomes highly
probable, then we would be hedging a highly probable forecast transaction (let's call this phase 1).
x If we then entered into a firm commitment a little bit later, our highly probable forecast
transaction would now have morphed into a firm commitment and thus we would no longer
be hedging a highly probable forecast transaction but hedging a firm commitment (let's call
this phase 2).
x Then, on transaction date, the firm commitment falls away as we now have a recognised
asset or liability and thus, if our hedging instrument still exists at this point, it would no
longer be hedging a firm commitment but would be hedging the recognised asset or liability
instead (let's call this phase 3).
This sequence of events is presented in the timeline below.
Date the forecast transaction Date a firm commitment Date the transaction Date the transaction
becomes highly probable is made is recognised is settled
Hedge of a HP forecast transaction Hedge of a firm commitment Hedge of a recognised A/L

N/A Phase 1 Phase 2 Phase 3 N/A
Uncommitted pre-transaction period Committed pre-transaction period Post-transaction period
Please note:
x The two 'N/A's' on either end of the timeline indicate the fact that we may not use hedge accounting
before a forecast transaction has become highly probable, nor after the transaction has been settled.
x Please also bear in mind that a hedging instrument could be entered into at any stage during this
timeline (e.g. we may only decide to enter into a hedging relationship on or after transaction date in
which case we would only be hedging a recognised asset or liability). In other words, it does not
have to be entered into when our forecast transaction becomes highly probable.
x The circumstances of our particular transaction may not necessarily involve all three phases. For
example, we may simply enter into a transaction that gets recognised immediately (e.g. without it
first being a highly probable forecast transaction or without first entering into a firm commitment).
Once we have identified the item that we are hedging by using this timeline, we need to re-look
at the relevant definitions. If we look at the definition of a fair value hedge (see section 3.1), we
see that it only refers to hedges of recognised assets or liabilities and firm commitments. On the
other hand, the definition of a cash flow hedge (see section 4.1) refers to hedges of recognised
assets or liabilities, firm commitments (in the case of foreign currency risk) and highly probable
forecast transactions. Thus, hedges of highly probable forecast transactions are always
accounted for as cash flow hedges.
These options as to how to account for the hedges can be summarised on the same timeline as
follows:
Date the forecast transaction Date a firm commitment Date the transaction Date the transaction
becomes highly probable is made is recognised is settled
N/A Hedge of a HP forecast transaction Hedge of a firm commitment Hedge of a recognised A/L N/A
Phase 1 Phase 2 Phase 3
CFH CFH/ FVH CFH/ FVH
Thus, we use our timeline to analyse what the hedged item is and then to consider this in
context of the definitions of a cash flow hedge and fair value hedge as follows:
x If we entered into a hedging instrument only on or after the transaction was recognised (i.e.
on or after transaction date), we would be hedging a recognised asset or liability. This
hedge, depending on the risk being hedged, may be accounted for as either a fair value
hedge or cash flow hedge. (Phase 3).
1084 Chapter 22
x If we entered into a hedging instrument before the transaction was recognised (before
transaction date), but a firm commitment had already been entered into by that stage, we
would be hedging a firm commitment and thus this hedge could be accounted for as either a
fair value hedge or cash flow hedge, depending again on the risk being hedged. It must be
noted that the only instance when a firm commitment will expose an entity to a cash flow
risk (and thus cash flow hedge accounting is applied) is if the firm commitment related to a
foreign currency risk. (Phase 2)
x If a hedge was entered into before the transaction was recognised (i.e. before transaction
date), and no firm commitment had been entered into, this hedge would simply be hedging a
forecast transaction. If the forecast transaction was not yet probable, hedge accounting may
not be applied at all. However, if the forecast transaction was considered to be highly
probable, then the instrument would be hedging a highly probable forecast transaction and
thus the hedge would have to be accounted for as a cash flow hedge – hedges of highly
probable forecast transactions may never be accounted for as fair value hedges. (Phase 1)
The decision on whether to apply fair value or cash flow hedge accounting is driven by the risk
we are exposed to, and thus the risk we are hedging. If we were exposed to and hedging against
changes to the item's fair value, we apply fair value hedge accounting. If we are exposed to the
variability in the cash flows associated with the item, we adopt cash flow hedge accounting. In
phase 1 we are not exposed to variations in the fair value of the item, for that reason we cannot
apply fair value hedge accounting. Consider this example: if we are certain we will purchase a
vehicle in 3 months (HPFT) and the price today is R100 000. Should the price increase to
R120 000 in 3 months, we will pay R20 000 more than if we bought the vehicle 3 months ago
(there is a cash flow risk associated with the HPFT). Once paid for, we will receive a vehicle of
a fair value of the amount we paid (R120 000). Thus, we are not exposed to fair value risk.
The dates on this timeline are also important because they lead to certain adjustments, such as the
recognition and measurement of the hedged item (e.g. a recognised liability such as a foreign
account payable) and hedging instrument (e.g. a forward exchange contract). For example: a
recognised liability such as a foreign account payable would need to be recognised and measured
on transaction date and remeasured on settlement date. An extra date that may need to be inserted
onto the timeline for measurement purposes is the reporting date (e.g. the financial year-end),
since hedged items and hedging instruments existing on this date must also be remeasured at this
point.
Please remember that hedge accounting may not be applied before a forecast transaction
becomes highly probable (even if the hedging instrument was entered into before this date).
Similarly, hedge accounting may not be applied after the transaction has been settled. In fact, it
is important to remember that hedge accounting may have to cease even earlier than this date if
the criteria for discontinuance of hedge accounting are met (see section 6).
Reminder: accounting for cash flow hedges versus fair value hedges
The main difference in accounting for cash flow hedges and fair value hedges is that:
x Fair value hedges:
The change in the value of the hedging instrument is recognised as an asset or liability (FEC A/L) and the
related gain or loss is immediately recognised in P/L.
Exception #1: If the hedged item is an investment in equity instruments on which the FV gains or losses
will be recognised in OCI (i.e. FVOCI-equity), the gains or losses on the hedging instrument must also be
recognised in OCI (not in P/L).
Exception #2: If the hedged item is a firm commitment then, in addition to the changes in the value of
the hedging instrument being recognised as an asset or liability (e.g. FEC A/L), the changes in the value of
the firm commitment must also be recognised as an asset or liability (i.e. firm commitment A/L). The
gains or losses relating to the firm commitment A/L are recognised in P/L. When the transaction date is
reached and we thus recognise the underlying asset or liability, the firm commitment A/ L is derecognised
and recognised as an adjustment to the carrying amount of this newly recognised asset or liability.
See IFRS 9.6.5.8
x Cash flow hedges:
The change in the value of the hedging instrument is recognised as an asset or liability (FEC A/L) and the
related gain or loss is first recognised in OCI (except for gains or losses on an ineffective portion of a
hedge, if any, in which case the gain or loss on the ineffective portion is recognised directly in P/L).
Chapter 22 1085
Exception #3: If the hedged item is an equity instrument at FVOCI-equity, hedge effectiveness is
recognised in OCI.
Then, depending on the situation, this OCI will either have to be:
immediately reclassified to P/L (i.e. a reclassification adjustment) if the entity believes the OCI is
an irrecoverable loss; or
reclassified to P/L (i.e. a reclassification adjustment), if the underlying transaction involves a
financial A/L, and where the reclassification adjustment/s are journalised in the period/s that the
financial A/L affects P/L; or
set-off against the carrying amount of the hedged item (i.e. a basis adjustment), if the underlying
transaction involves a non-financial A/L and where this adjustment is journalised on transaction date.
See IFRS 9.6.5.11
7.2 Accounting for hedges involving forward exchange contracts (IFRS 9.6.5)
This section involves a series of examples showing how to apply hedge accounting theory.
These examples will involve:
x the hedged item: being a foreign currency denominated highly probable forecast transaction
(HPFT), firm commitment (FC) and/ or recognised asset or liability; and
x the hedging instrument: a forward exchange contract (FEC).
7.3 Hedges in the post-transaction period (phase 3)
Transaction date Settlement date
Phase 3: Post-transaction period

What are we hedging? A recognised asset or liability
How do we account for this hedge? As a cash flow hedge or fair value hedge
If a hedging instrument (e.g. FEC) is entered into (or already Hedges of a recognised
exists) on or after the date on which the transaction is A/L are accounted for:
x as CFHs or FVHs
recognised (i.e. on or after transaction date) it means the
instrument is hedging a recognised asset or liability.
Thus, depending on whether it is hedging against changes in the hedged item's fair value or
cash flows, it will be accounted for as either: Important dates in the
x a fair value hedge; or post-transaction period:
x a cash flow hedge.
x transaction date
The basic foreign currency denominated transaction is x settlement date
recognised and measured using the spot rate on x reporting date (normally a
financial year-end)
transaction date. Any monetary item is remeasured to
spot rates on any subsequent reporting date/s and again on settlement date (see chapter 20).
Example 4: FEC taken out in the post-transaction period: fair value hedge
Our functional currency is the Rand. We purchase inventory on 1 March 20X1 for $100 000.
Payment is 7 July 20X1. The inventory is sold on 15 July 20X1 for R1 000 000.
x A FEC is taken out on transaction date at a forward rate of R9: $1: the FEC expires on payment date.
x At 30 June 20X1 (year-end), the rate available on similar FEC’s expiring on this date is R9,50: $1.
x The entity designates the hedge as a fair value hedge.
Fair value hedge
Recognised A/L (Phase 3)
1 March 20X1 30 June 20X1 7 July 20X1

Dates: Transaction date Year-end Payment date
and FEC date
FEC rates (expiry date: 7/07/X1): R9.00 R9.50 N/A
Spot rate: R9.15 R9.55 R10
Required: Show all related journals. Assume all hedging requirements are met.
1086 Chapter 22
Solution 4: FEC in the post-transaction period as a fair value hedge

Comments:
x The FEC is entered into on transaction date and thus we are dealing with a hedge of a recognised asset
or liability. This could be accounted for either as a cash flow hedge or fair value hedge. However, it was
designated as a fair value hedge in this example.
x By entering into the FEC, we know that we will effectively have to pay $100 000 x 9 = R900 000 since
this is the rate we committed to in the FEC.
x If we look at the spot rate on payment date, we can see that had we not taken out the FEC, we would
have had to pay $100 000 x 10 = R1 000 000.
x The FEC has therefore saved us R1 000 000 – R900 000 = R100 000. Notice that the FEC asset
eventually reflects this saving of R100 000, with the contra entries recognised as a forex gain.
x These gains are recognised over the life of the FEC (R50 000 at year-end and R50 000 on payment date).
x However, the net foreign exchange gain is only R15 000. This is after taking into account the forex
losses recognised on the creditor. The net gain of R15 000 reflects the discount of R0.15 we received off
the spot rate when we entered into the FEC at a forward rate of R9 (FR we secured: R9 – SR on this
date: R9.15).
x Notice the inventory cost remains unchanged even though there are fluctuations in the exchange rates.
x Notice that the basic foreign currency denominated transaction (hedged item) and the FEC (hedging
instrument) are journalised separately.
1 March 20X1: transaction date Debit Credit

Inventory $100 000 x R9.15 spot rate on transaction date 915 000
Foreign creditor 915 000
Inventory purchased & related creditor, measured at spot rate on
transaction date
30 June 20X1: year-end
Forex loss (E: P/L) $100 000 x R9.55: spot rate at year-end – 40 000
Foreign creditor $100 000 x R9.15 previous spot rate 40 000
Foreign creditor remeasured to spot rate at year-end – loss
FEC asset $100 000 x R9.50 forward rate at year-end – 50 000
Forex gain (I: P/L) $100 000 x R9 forward rate obtained 50 000
Fair value hedge: gain/ loss on FEC recognised at YE in P/L
7 July 20X1: payment date
Forex loss (E: P/L) $100 000 x R10: spot rate at payment date – 45 000
Foreign creditor remeasured on payment date, at spot rates
FEC asset $100 000 x R10 spot rate on payment date – 50 000
Forex gain (I: P/L) $100 000 x R9.50 prior forward rate (30/6/X1) 50 000
Fair value hedge: gain/ loss on FEC recognised at payment date in P/L
Foreign creditor $100 000 x R10; Or the balance in the creditor 1 000 000
Bank a/c: R915 000 + R40 000 + R45 000 1 000 000
Payment of creditor: based on the spot rate on payment date
Bank $100 000 x (R9: the FR we obtained – R10: the 100 000
spot rate on expiry date)
FEC asset Or: the FEC asset balance: R50 000 + R50 000 100 000
Receipt from the financing house on expiry of the FEC: FR versus SR
15 July 20X1: on sale of inventory (not required)
Cost of sales (E: P/L) R915 000 x 100% 915 000
Inventory 915 000
Debtor Given 1 000 000
Sales (I: P/L) 1 000 000
Sale of 100% of the inventory
Chapter 22 1087
7.4 Hedges in the pre-transaction period (phases 1 & 2)

7.4.1 Overview
If a hedging instrument (e.g. FEC) is entered into before the transaction is recognised (i.e.
before transaction date), we have begun hedging during the 'pre-transaction period'. We may
apply hedge accounting to hedges during the pre-transaction period anytime from the date on
which the forecast transaction becomes highly probable, but not before. Thus, although it is
possible for a hedging instrument (e.g. FEC) to be entered into before a forecast transaction is
considered to be highly probable, we would simply not be able to apply hedge accounting yet.
Date forecast transaction Transaction
becomes highly probable date
Pre-transaction period (Phase 1 &/ or Phase 2)
If the hedging instrument (e.g. FEC) exists in the pre-transaction period (i.e. before the
transaction date) it may be hedging one of the following (or a combination thereof):
x A forecast transaction (hedge accounting is not allowed); or
x A highly probable forecast transaction (phase 1); or
x A firm commitment (phase 2).
Hedges of highly probable forecast transactions (HPFT) are always accounted for as cash flow
hedges, but hedges of firm commitments could be accounted for as either fair value hedges or
cash flow hedges when foreign currency risk is being hedged against. Thus, if a hedge exists in
the pre-transaction period, we must ascertain whether a firm commitment was made before
transaction date or not.
7.4.2 Hedges in the pre-transaction period where no firm commitment was made (phase 1)
Since, hedges of HPFTs are always accounted for as cash flow hedges, gains or losses arising on
the FEC asset or liability are recognised in other comprehensive income (in the cash flow hedge
reserve account).
Date forecast transaction Transaction
becomes highly probable date
Phase 1: Uncommitted pre-transaction period

What are we hedging (the item)? A highly probable forecast transaction (HPFT)
How do we account for this hedge? As a cash flow hedge (always)
When the transaction is eventually entered into (i.e. Accounting for a hedge of a
transaction date), the asset or liability that was the highly probable forecast
ultimate purpose of the forecast transaction will then transaction:
be recognised (e.g. purchased inventory is recognised).
x Must be accounted for as a CFH
At this point we no longer have a highly probable x Recognise an FEC asset/ liability
forecast transaction, since it has been replaced by the (measured at FEC rates) and
actual transaction. Thus, the hedge of the highly x Gains or losses recognised in OCI
probable forecast transaction comes to an end on transaction date. At this point, the cumulative
gains or losses in the cash flow hedge reserve account (OCI) must now be released to profit or
loss (P/L).
This is either achieved:
x Indirectly, by way of a basis adjustment: this adjustment must be used if a non-financial
asset/liability will be acquired (e.g. inventory) – a basis adjustment reverses OCI and
recognises it as an adjustment to the carrying amount of the asset or liability acquired; or
x Directly, by way of a reclassification adjustment: this adjustment must be used if a financial
asset/ liability will be acquired (e.g. a foreign debtor) – a reclassification adjustment
reverses OCI and recognises it as an income or expense in profit or loss. See IFRS 9.6.5.11(d)
1088 Chapter 22
After the transaction has been recognised, the hedging instrument (if it still exists) is now
hedging a recognised asset or liability. From this point onwards, the hedging instrument would
either be recognised as a cash flow hedge or a fair value hedge.
The basic foreign currency denominated transaction recognised on transaction date is measured
using the spot rate on the transaction date. Any monetary item is remeasured to the spot rate
on any subsequent reporting dates and on settlement date. This was explained in chapter 20.
Example 5: Cash flow hedge with a non-financial asset (basis adjustment)
Our functional currency is the Rand (R). We purchase inventory on 1 March 20X1 for
$100 000. A FEC was entered into on 15 February 20X1, before transaction date, when the
forecast transaction was considered to be highly probable.
x No firm commitment was made before transaction date.
x The hedge of the recognised asset or liability was designated as a fair value hedge.
x The FEC rate obtained was R9: $1. This FEC will expire on payment date (7 July 20X1).
x FEC rates available on the relevant dates, on similar FEC’s that would expire on this same
payment date, are shown below.
x We sold 40% of the inventory on 15 July 20X1 for R400 000 and we sold the remaining 60% of
the inventory on 20 August 20X1 for R600 000.
Cash flow hedge Fair value hedge
HPFT (Phase 1) Recognised A/ L (Phase 3)
15 February 20X1 1 March 20X1 30 June 20X1 7 July 20X1

Dates: FEC date Transaction date Year-end Payment date
FEC rates: 9.00 9.10 9.60 N/A
Spot rate: 8.90 9.00 9.60 10
Required: Show all related journal entries.

Assume all hedging requirements of IFRS 9 are met and that any ineffective portion that may exist is
considered immaterial.
Solution 5: Cash flow hedge with a non-financial asset (basis adjustment)

Quick explanation:
x The FEC was entered into before transaction date when there was no firm commitment, but the
forecast transaction was considered to be highly probable. Thus, as this started out as a hedge of a
highly probable forecast transaction it had to be accounted for as a cash flow hedge.
x Since the ultimate asset underlying this transaction is non-financial (inventory), the gain or loss in
OCI is released by way of a basis adjustment.
x From transaction date onwards, the hedge becomes a hedge of a recognised asset or liability and
could thus be accounted for either as a cash flow hedge or fair value hedge. However, it was
designated as a fair value hedge in this example.
x We will effectively pay $100 000 x 9 = R900 000 since this is the rate we committed to in the FEC.
x If we look at the spot rate on payment date, we can see that had we not taken out the FEC, we
would have had to pay $100 000 x 10 = R1 000 000.
x The FEC has therefore saved us R1 000 000 – R900 000 = R100 000.
Journals:
15 February 20X1: FEC entered into Debit Credit
No entries relating to the FEC are processed, as the passage of time is
necessary for the FEC to have value
1 March 20X1: transaction date (TD)
Inventory (A) $100 000 x R9.00 spot rate on TD 900 000
Inventory purchased & related creditor, at spot rate on trans. date
Chapter 22 1089
Solution 5: Continued … Debit Credit
1 March 20X1: transaction date (TD) continued

FEC asset (A) $100 000 x R9.10 FR on TD – 10 000
Cash flow hedge reserve (OCI) $100 000 x R9 FR obtained 10 000
Cash flow hedge: gain/ loss on FEC on transaction date in OCI
Cash flow hedge reserve (Eq) 10 000
Cash flow hedge basis adjustment: this basis adjustment is processed
directly through equity
30 June 20X1: year-end (reporting date = RD)
FEC asset (A) $100 000 x R9.60 FR at year end – 50 000
Forex gain (I: P/L) $100 000 x R9.10 previous FR 50 000
Fair value hedge: gain/ loss on FEC recognised at year-end in P/L
Forex loss (E: P/L) $100 000 x R9.60 SR at year-end – 60 000
Foreign creditor (L) $100 000 x R9.00 previous SR 60 000
Foreign creditor remeasured at spot rate at year-end
Fair value hedge: gain/ loss on FEC recognised on payment date
Forex loss (E: P/L) $100 000 x R10 spot rate at year end – 40 000
Foreign creditor (L) $100 000 x R9.60 previous spot rate 40 000
Foreign creditor remeasured at spot rate on payment date
Foreign creditor $100 000 x R10 SR on pmt date; 1 000 000
Bank Or the creditor balance: (900 000 + 60 000 + 40 000) 1 000 000
Bank $100 000 x R9: the FR we obtained – 100 000
$100 000 x R10: the SR on expiry date
FEC asset Or: Balance in the FEC asset: (R10 000 + 100 000
R50 000 + R40 000)
15 July 20X1: on sale of inventory
Cost of sales (E: P/L) (900 000 – 10 000) x 40% 356 000
Debtor (A) Given 400 000
Sales (I: P/L) 400 000
Sale of 40% of inventory: sales and cost of sales
20 August 20X1: on sale of inventory
Cost of sales (E: P/L) (900 000 – 10 000) x 60% 534 000
Debtor (A) Given 600 000
Sales (I: P/L) 600 000
Sale of 60% of inventory: sales and cost of sales
Comment:
x The basis adjustment decreases the cost of inventory.
x This then decreases cost of sales as the inventory is sold.
x The gain that had accumulated in OCI is thus indirectly taken to profit or loss as and when the
hedged item (inventory) affects profit/ loss by way of cost of sales.
The above example shows the cash flow hedge reserve being released on transaction date using
a basis adjustment because the forecast transaction involved a non-financial asset. However, if
the forecast transaction that is being hedged involves a financial asset or liability, then cash
flow hedge reserve is released to profit or loss using a reclassification adjustment/s in the same
period/s that the hedged expected future cash flows are expected to affect profit or loss (e.g.
when forecast interest is recognised or when a forecast sale occurs). Example 6 shows this.
1090 Chapter 22
Example 6: Cash flow hedge with a financial asset (reclassification adjustment)

Required: Repeat example 5, assuming the entity had purchased a financial asset instead of inventory
(i.e. instead of a non-financial asset) and thus that a reclassification adjustment had to be used when
'releasing' the balance in the cash flow hedge reserve account (other comprehensive income).
Solution 6: Cash flow hedge with a financial asset (reclassification adjustment)
Comment:
x This example is the same as example 5 except that the hedged item (i.e. the asset being purchased)
is now a financial asset and thus the gains or losses in OCI must be transferred to P/L using the
reclassification adjustment approach rather than the basis adjustment approach.
x Thus, the basis adjustment journal in example 5 that reversed OCI to the hedged item (inventory)
on transaction date does not happen when using a reclassification adjustment in example 6.
x All differences are highlighted with asterisks so that you are able to compare the journals of
example 6 (reclassification adjustment) with those of example 5 (basis adjustment).
15 February 20X1: FEC entered into Debit Credit
No entries relating to the FEC are processed
1 March 20X1: transaction date
Financial asset * $100 000 x R9.00 spot rate on trans. date 900 000
Financial asset purchased recognised at spot rate on transaction date
FEC asset $100 000 x R9.10 FR on trans. date – 10 000
Cash flow hedge reserve (OCI) $100 000 x R9 FR obtained 10 000
Cash flow hedge: gain/ loss on FEC on transaction date, in OCI
FEC asset $100 000 x R9.60 FR at year-end – 50 000
Fair value hedge: gain/ loss on FEC at year-end, in P/L
Forex loss (E: P/L) $100 000 x R9.60 spot rate at year-end – 60 000
Foreign creditor remeasured to the spot rate at year-end
Fair value hedge: gain/ loss on FEC recognised on payment date, in P/L
Forex loss (E: P/L) $100 000 x R10 spot rate at payment date – 40 000
Foreign creditor remeasured to the spot rate on payment date
Foreign creditor $100 000 x R10 SR on pmt date; Or the creditor 1 000 000
Bank balance: (900 000 + 60 000 + 40 000) 1 000 000
Bank $100 000 x (R9: the FR we obtained – R10: 100 000
the SR on expiry date)
FEC asset Or: Balance in the FEC asset: (10 000 + 100 000
50 000 + 40 000)
15 July 20X1: sale of hedged item (monetary asset)
Financial asset expensed (E: P/L)* 900 000 x 40% 360 000
Financial asset * 360 000
Debtor Given 400 000
Revenue (I: P/L) 400 000
Sale of 40% of hedged item: asset is expensed and revenue is recognised
Cash flow hedge reserve (OCI) * 10 000 x 40% 4 000
FEC gain (I: P/L) * 4 000
Reclassification adjustment of the cash flow hedge: reclassifying 40% of
the OCI to P/L when 40% of the hedged item is sold
Chapter 22 1091
Journals: continued … Debit Credit

20 August 20X1: sale of hedged item
Financial asset expensed (E: P/L)* 900 000 x 60% 540 000
Financial asset * 540 000
Revenue (I: P/L) 600 000
Sale of 60% of hedged item: asset is expensed and revenue is recognised
Cash flow hedge reserve (OCI) * 10 000 x 60% 6 000
FEC gain (I: P/L) * 6 000
Reclassification adjustment of the cash flow hedge: reclassifying 60% of
the OCI to P/L when 60% of the hedged item is sold
7.4.3 Hedges in the pre-transaction period where a firm commitment was made (phase 2)
If the hedging instrument (FEC) exists before transaction date, we are dealing with a hedge in
the pre-transaction period. If a firm commitment (e.g. a firm order) was made during the pre-
transaction period, this period is split into:
x before firm commitment is made: the uncommitted period (phase 1); and
x after firm commitment is made but before transaction date: the committed period (phase 2).
Date forecast transaction Date of firm Transaction

becomes highly probable commitment date
Pre-transaction period
Phase 1: Phase 2:
Uncommitted pre-transaction period Committed pre-transaction period
What are we hedging? What are we hedging?
A highly probable forecast A firm commitment (FC)
transaction (HPFT)
How do we account for this How do we account for this
hedge? hedge?
As a CFH (always) As a CFH or FVH
A hedging instrument (FEC) that exists before commitment date (i.e. in phase 1), could be
hedging a forecast transaction, where hedge accounting would not have applied, or be hedging
a highly probable forecast transaction, which must be accounted for as a cash flow hedge,
(there is no option here). This was explained in the previous section and in examples 5 and 6.
When a firm commitment is made, the forecast A hedge of a firm
transaction, or highly probable forecast transaction commitment can be
(phase 1), falls away and is now referred to as a firm accounted for as either a:
commitment (phase 2). A hedging instrument (FEC) that x CFH: if we are hedging against
existed anytime from the date a commitment is made but foreign currency risks; or
before transaction date (i.e. during phase 2) is a hedge of x FVH.
a firm commitment. Hedges of firm commitments may be
accounted for either:
x as a cash flow hedge (but only if we were hedging against foreign currency risks); or
x as a fair value hedge.
Accounting for a hedge of
The principles we used when accounting for a hedge of a a firm commitment as a
highly probable forecast transaction (HPFT) (phase 1) CFH:
as a cash flow hedge (see section 7.4.2) are exactly the x Recognise an FEC asset/ liability
(measured at FEC rates) and
same principles that we use to account for a hedge of a
x Gains or losses recognised in OCI
firm commitment (FC) (phase 2) as a cash flow hedge.
This next example (example 7) shows a hedge of a HPFT (phase 1) switching into being a
hedge of a FC (phase 2), but where both these hedges are accounted for as cash flow hedges.
1092 Chapter 22
The example after this (example 8) then takes it to the next level, showing how to account for a switch
from a hedge of a HPFT as a cash flow hedge to the hedge of a FC as a fair value hedge.
Example 7: FEC taken out in the pre-transaction period:
Firm commitment as a cash flow hedge
This example is the same as example 5 except that a firm commitment is entered into before
transaction date. Example 5 is repeated below together with the details regarding the firm commitment.
Our functional currency is the Rand (R). We purchase inventory on 1 March 20X1 for $100 000. A FEC
was entered into on 15 February 20X1, when the forecast transaction was considered to be highly
probable. A firm commitment was then made on 22 February 20X1.
x The hedge of the firm commitment was designated as a cash flow hedge.
x The FEC rate obtained was C9: $1. This FEC will expire on payment date (7 July 20X1).
x We sell 40% of the inventory on 15 July 20X1 for R400 000 & 60% on 20 August 20X1 for R600 000.
x FEC rates available on similar FEC’s that will expire on the same payment date, are shown below.
Cash flow hedge Fair value hedge
HPFT: Phase 1 FC: Phase 2 Recognised A/L: Phase 3
15 Feb 20X1 22 Feb 20X1 1 March 20X1 30 June 20X1 7 July 20X1
FEC taken out Firm commitment Transaction date Year-end Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.96 9.00 9.60 10.00
Required: Show only the extra journals relating to the hedge of the firm commitment (i.e. you are not
required to repeat the journals that were given to example 5).
Assume all hedging requirements were met and no part of the hedge was considered to be ineffective.
Solution 7: Firm commitment to transaction date as a cash flow hedge

The hedge of a HPFT (phase 1) must always be accounted for as a cash flow hedge. However, the
hedge of a FC (phase 2) could be accounted for as either a cash flow hedge or a fair value hedge. In this
example we are told that the hedge of the FC (phase 2) is accounted for as a cash flow hedge.
Since the hedge of the HPFT (phase 1) and the hedge of the FC (phase 2) are both accounted for as
cash flow hedges, the switch on 22 Feb 20X1 from being a hedge of a HPFT to being a hedge of a FC
does not result in a journal. Thus, the journals in example 7 are identical to the journals in example 5.
As mentioned above, an entity may account for the hedge of the firm commitment (phase 2) as
a cash flow hedge or as a fair value hedge. Accounting for a hedge of
a firm commitment as a
When accounting for a hedge of a firm commitment as a FVH:
cash flow hedge, we recognise the value of the hedging x recognise an FEC asset/ liability
instrument as an asset or liability (FEC A/L) with the (measured at FEC rates) and
related gains and losses first recognised in other x recognise a FC asset/ liability
comprehensive income. (measured at spot rates).
Gains or losses recognised in P/L
However, when accounting for the hedge of a firm
commitment as a fair value hedge:
x we recognise the value of the hedging instrument as an asset or liability (FEC A/L) ; and
x we also recognise the change in the value of the hedged item as an asset or liability (this
means we must also recognise a firm commitment A/L).
Gains or losses on both the hedging instrument asset or liability (FEC A/L) as well as the
hedged item asset or liability (firm commitment A/L) are generally always recognised in profit
or loss (not in other comprehensive income, as was the case in a cash flow hedge). An
exception applies if the firm commitment involves acquiring an investment in equity
instruments that the entity has elected to measure at fair value through other comprehensive
income (FVOCI-equity), in which case all related gains or losses will be recognised in other
comprehensive income.
Chapter 22 1093
The firm commitment asset or liability will be derecognised and recognised as an adjustment to
the carrying amount of the asset or liability that is recognised on transaction date. See IFRS 9.6.5.8 – 10
Thus, when accounting for a hedge of a firm commitment (phase 2) as a fair value hedge:
x We recognise a hedged item asset/ liability (i.e. firm commitment asset/ liability):
We measure the firm commitment asset/ liability using the movement in the spot rates.
This is generally journalised as:
Dr/ Cr: Firm commitment asset/ liability and
Cr/ Dr Forex gains/losses (Profit or loss)
We derecognise the firm commitment asset/ liability on transaction date and recognise
the contra entry as an adjustment to the carrying amount of the asset that is acquired
(or the liability that is assumed).
x We recognise a hedging instrument asset/ liability (e.g. FEC asset/ liability):
We measure the FEC asset/ liability based on the movement in the forward rates.
This is generally journalised as:
Dr/ Cr: FEC asset/ liability and
Cr/ Dr Forex gains/losses (Profit or loss)
We derecognise the FEC asset or liability when the FEC is finally settled.
Example 8: FEC taken out in the pre-transaction period:

Firm commitment as a fair value hedge
Use the same information that was provided in example 7 except that the hedge of the firm
commitment (phase 2) is designated as a fair value hedge (not a cash flow hedge).
The revised timeline will be as follows:
Cash flow hedge Fair value hedge Fair value hedge
HPFT: Phase 1 FC: Phase 2 Recognised A/L: Phase 3
15 Feb 20X1 22 Feb 20X1 1 March 20X1 30 June 20X1 7 July 20X1
FEC taken out Firm commitment Transaction date Year-end Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.96 9.00 9.60 10.00
Required: Show all related journals. Assume there is no ineffective portion on the hedge.
Solution 8: FEC taken out in the pre-transaction period: firm commitment as a FV hedge
Comment:
x We start with a hedge of a highly probable forecast transaction (HPFT), which is always accounted
for as a cash flow hedge. Then it became a hedge of a firm commitment (FC), which can be
accounted for as a cash flow hedge or fair value hedge. In this example it was designated as a fair
value hedge.
x When the cash flow hedge of the HPFT switches to being a fair value hedge of a FC, we cease
recognising the gains or losses on the FEC asset/liability in OCI and recognise them in P/L instead.
x As soon as we start hedging the FC as a fair value hedge, we also recognise a FC asset or liability.
x Since the underlying transaction involves a non-financial asset (inventory), gains or losses in OCI
will be released using a basis adjustment. This adjustment is not processed on the day that the cash
flow hedge of the HPFT ends and the fair value hedge of the FC begins (i.e. the basis adjustment is
not processed on firm commitment date). Instead, we must wait until transaction date to process it.
x As with the previous examples, the FEC has saved us R1 000 000 – R900 000 = R100 000.
x The total FEC gain of R100 000 is eventually recognised in P/L: the gain on the CFH (R6 000) will
effectively be recognised in P/L when the inventory is sold; whereas the gains on the FVH will be
recognised in P/L as they arise: R4 000 on trans. date, R50 000 at yr-end and R40 000 on pmt date.
15 February 20X1: date FEC entered into Debit Credit

1094 Chapter 22
Debit Credit
22 February 20X1: firm commitment date
FEC asset $100 000 x R9.06 FR on firm commitment 6 000
Cash flow hedge reserve (OCI) date – $100 000 x R9 FR obtained 6 000
Cash flow hedge: gain/ loss on FEC on firm commitment date, in OCI
1 March 20X1: transaction date
Inventory $100 000 x R9.00 spot rate on transact date 900 000
Inventory purchased, measured at spot rate on transaction date
Cash flow hedge reserve (Eq) 6 000
Inventory 6 000
CFH basis adjustment: processed directly through equity
FEC asset $100 000 x R9.10 FR on transaction date – 4 000
Fair value hedge: FEC: gain/ loss on FEC on transaction date, in P/L
Forex loss (E: P/L) $100 000 x R9.00 spot rate on transact. date – 4 000
Firm commitment liability $100 000 x R8.96 spot rate on firm commit. date 4 000
Fair value hedge: FC: gain/ loss on firm commit. on trans. date, in P/L
Firm commitment liability 4 000
Inventory 4 000
Fair value hedge: FC: Firm commitment liability is derecognised and
recognised as an adjustment to the carrying amount of the asset
acquired on transaction date (inventory)
FEC asset $100 000 x R9.60 FR at year-end – 50 000
Fair value hedge: FEC: gain/ loss on FEC at year-end, in P/L
Forex loss (E: P/L) $100 000 x R9.60 spot rate at year-end – 60 000
Foreign creditor remeasured to spot rate at year-end
Fair value hedge: FEC: gain/ loss on FEC at pmt date, in P/L
Forex loss (E: P/L) $100 000 x R10 spot rate on payment date – 40 000
Foreign creditor remeasured to spot rate on payment date
Foreign creditor $100 000 x R10 SR on pmt date; Or the creditor 1 000 000
Bank balance: (900 000 + 60 000 + 40 000) 1 000 000
Bank $100 000 x (R9: the FR we obtained – R10: 100 000
the SR on expiry date)
FEC asset Or: Balance in the FEC asset: 100 000
(6 000 + 4 000 + 50 000 + 40 000)
15 July 20X1: date of sale of inventory
Cost of sales (E: P/L) (900 000 – 6 000 – 4 000) x 40% 356 000
Inventory 356 000
Sales (I: P/L) 400 000
Sale of 40% of inventory: sales and cost of goods sold
Chapter 22 1095
Debit Credit
20 August 20X1: date of sale of inventory
Cost of sales (E: P/L) (900 000 – 6 000 – 4 000) x 60% 534 000
Inventory 534 000
Sales (I: P/L) 600 000
Sale of 60% of inventory: sales and cost of goods sold
Notice: The measurement of inventory was affected by the cash flow hedge when the other
comprehensive income was reversed to inventory using the basis adjustment and also by the fair value
hedge when the firm commitment liability was reversed to inventory:
x Inventory recognised at spot rate on transaction date 100 000 x 9.00 900 000
x FVH: Firm commitment liability reversed to inventory on transaction date (4 000)
x CFH: Gains on the FEC in OCI reversed to inventory on transaction date (basis adjustment) (6 000)
890 000
Example 9: FEC taken out in the pre-transaction period with a year-end

between firm commitment date and transaction date
Apple Limited's functional currency is the Rand (R). It purchases an asset for $100 000. A
FEC was taken out before transaction date and before a firm commitment was made and
was scheduled to expire on 31 August (payment date).
x The hedge of the firm commitment was designated as a fair value hedge.
x FEC rates available on FEC’s expiring on 31 August 20X1 are shown below.
x 40% of this asset was sold on 27 September 20X1 and 60% on 1 November 20X1.
Cash flow hedge Fair value hedge Fair value hedge
HPFT: FC: Recognised A/L:
Phase 1 Phase 2 Phase 3
1 March 20X1 15 April 20X1 30 June 20X1 20 July 20X1 31 Aug 20X1
FEC taken out Firm commitment Year-end Transaction date Payment date
FEC rates: 9.00 9.06 9.10 9.60 N/A
Spot rates: 8.90 8.30 8.45 8.50 10.00
Required: Show the related journals assuming that:
A. The asset that was purchased was a non-financial asset.
B. The asset that was purchased was a financial asset.
Assume all hedging requirements are met and that any portion of a CFH that may be ineffective is immaterial. The
and deferred tax implications have been ignored
Solution 9: FEC taken out in the pre-transaction period with a year-end between firm
commitment date and transaction date
Ex 9A Ex 9B
1 March 20X1: date FEC entered into Dr/ (Cr) Dr/ (Cr)
15 April 20X1: firm commitment date
FEC asset $100 000 x R9.06 FR on firm commit date – 6 000 6 000
Cash flow hedge reserve (OCI) $100 000 x R9 FR obtained (6 000) (6 000)
Cash flow hedge: gain/ loss on FEC on firm commitment date, in OCI
FEC asset $100 000 x R9.10 FR at year-end – 4 000 4 000
Forex gain (P/L) $100 000 x R9.06 previous FR (4 000) (4 000)
Fair value hedge: FEC: gain/ loss on FEC at year-end, in P/L
Forex loss (P/L) $100 000 x R8.45 SR at yr-end – 15 000 15 000
Firm commitment liability $100 000 x R8.30 SR on firm commit. date (15 000) (15 000)
Fair value hedge: FC: gain/ loss on firm commit. at year-end, in P/L
1096 Chapter 22
Solution 9: Continued … Ex 9A Ex 9B
Dr/ (Cr) Dr/ (Cr)
20 July 20X1: transaction date
Non-financial asset Part A: $100 000 x R8.5 SR on trans. date 850 000 N/A
Financial asset Part B: $100 000 x R8.5 SR on trans. date N/A 850 000
Foreign creditor (850 000) (850 000)
Purchase of the asset and related creditor, at spot rate on transaction
date
FEC asset $100 000 x R9.6 FR on transaction date – 50 000 50 000
Fair value hedge: FEC: gain/ loss on FEC on transaction date, in P/L
Forex loss (P/L) $100 000 x R8.5 SR on trans date – 5 000 5 000
Firm commitment liability $100 000 x R8.45 prior SR (5 000) (5 000)
Fair value hedge: FC: gain/ loss on firm commit. on trans. date, in P/L
Firm commitment liability 15 000 + 5 000 20 000 20 000
Non-financial/ Financial asset (20 000) (20 000)
Fair value hedge: FC: firm commitment A/L derecognised and
recognised as an adjustment to the carrying amount of the acquired
asset on trans. date
Cash flow hedge reserve(Eq) ONLY Part A: 6 000 N/A
Non-financial asset (6 000) N/A
Cash flow hedge: basis adjustment transferring the reserve to the
hedged item on transact date (this is only done if the asset acquired is
non-financial)
31 August 20X1: payment date
FEC asset $100 000 x R10 spot rate on payment date – 40 000 40 000
Fair value hedge: FEC: gain/ loss on FEC on payment date, in P/L
Forex loss (P/L) $100 000 x R10 SR on payment date – 150 000 150 000
Foreign creditor $100 000 x R8.5 previous SR (150 000) (150 000)
Foreign creditor remeasured to spot rate on payment date
Foreign creditor $100 000 x R10 SR on pmt date; Or the creditor 1 000 000 1 000 000
Bank balance: (900 000 + 60 000 + 40 000) (1 000 000) (1 000 000)
Bank $100 000 x (R9: the FR we obtained – R10: the SR 100 000 100 000
on expiry date); Or: Balance in the FEC
FEC asset asset: (6 000 + 4 000 + 50 000 + 40 000) (100 000) (100 000)
27 September 20X1: sale of 40% of the asset
Hedged item expense 329 600 332 000
Non-financial asset Part A: (850 000 – 20 000 – 6 000) x 40% (329 600) N/A
Financial asset Part B: (850 000 – 20 000) x 40% N/A (332 000)
Sale of 40% of the asset
Cash flow hedge reserve (OCI) ONLY Part B: 6 000 x 40% N/A 2 400
FEC gain (P/L) N/A (2 400)
Cash flow hedge – reclassification adjustment: reclassifying 40% of
the OCI to profit or loss when 40% of the non-financial asset is sold
1 November 20X1: sale of 60% of the asset
Hedged item expense 494 400 498 000
Non-financial asset Part A: (850 000 – 20 000 – 6 000) x 60% (494 400) N/A
Financial asset Part B: (850 000 – 20 000) x 60% N/A (498 000)
Sale of 60% of the asset
Chapter 22 1097
Solution 9: Continued … Ex 9A Ex 9B
Dr/ (Cr) Dr/ (Cr)
1 November 20X1: continued …
Cash flow hedge reserve (OCI) ONLY Part B: 6 000 x 60% N/A 3 600
FEC gain (P/L) N/A (3 600)
Cash flow hedge – reclassification adjustment: reclassifying 60% of the
OCI to profit or loss when 60% of the non-financial asset is sold
8. Tax Consequences
The current South African Income Tax Act and the IFRSs treat foreign exchange gains or losses
and forward exchange contracts in almost the same way. The Income Tax Act deals with:
x hedged items under s25D and
x hedging instruments under s24I.
The Income Tax Act measures the cost of a foreign-denominated item, (e.g. imported plant), the
hedged item, at the spot rate on transaction date (s25D). This is the same spot rate used to measure
the item in terms of IFRSs and thus there are generally no temporary differences on initial
recognition of the hedged item (e.g. plant) as the carrying amount and tax base would be the same.
As we know, foreign exchange gains or losses can arise on both hedged items and hedging
instruments. The Income Tax Act taxes all foreign exchange gains and deducts all foreign
exchange losses. However, if the foreign exchange gain or loss relates to a hedging
instrument, the taxing of the gain or the deducting of the loss may be deferred. This happens
when the gain or loss on the instrument arises before the hedged item has been recognised.
This is explained below.
In relation to hedging instruments, the Income Tax Act distinguishes between:
x basic 'FECs' and
x 'affected FECs'.
A basic 'FEC' is one that is taken after the transaction date.
x If we have a basic 'FEC', the foreign exchange gains or losses on both the hedging
instrument and the hedged item are included in the taxable profit calculation. In other
words, the taxable profit calculation includes the gains or losses arising from transaction
date on the hedged item and on the hedging instrument (the FEC), and where these gains
or losses will offset each other to some degree or another.
x The IFRS treatment is generally the same (i.e. these gains or losses are generally
included in profit or loss) and thus the FEC asset's or liability's carrying amount and tax
base will generally be the same with the result that deferred tax will not arise, except for
the case when an FEC is an ‘affected FEC’.
An 'affected FEC' is an FEC taken before transaction date (e.g. a cash flow hedge of a
forecast transaction or firm commitment or a fair value hedge of a firm commitment).
x By definition, this means that if we have an 'affected FEC', the hedged item will obviously not
have been recognised. This means that the foreign exchange gains or losses from the time the
‘affected FEC’ (the hedging instrument) was taken until transaction date could thus not be
offset by foreign exchange gains or losses on the hedged item.
x In order to avoid this mismatch, the Income Tax Act defers all foreign exchange gains or losses
on the 'affected FEC' until transaction date. To calculate the taxable profit in this case, we
simply reverse the gains or losses included in profit or loss if they relate to 'affected FECs'.
When the hedged item is eventually recognised on transaction date, the FEC will no longer be
an 'affected FEC', from which point the tax rules relevant to a basic 'FEC' will apply.
x For IFRS purposes, the affected FEC in the pre-transaction period is accounted for using
the forward rates available on translation date (e.g. reporting date). Thus, the carrying
amount of the FEC on reporting date will differ from its tax base and deferred taxation
will be recognised.
1098 Chapter 22
9. Disclosure (IAS 32 and IFRS 7)
Disclosure requirements for hedges are set out in IAS 32, IFRS 7 and IAS 1.
x An entity shall describe its financial risk management objectives and policies including its
policy for hedging each main type of forecast transaction that is accounted for as a hedge.
x An entity shall disclose the following for designated fair value and cash flow hedges:
a description of the hedge;
a description of the financial instruments designated as hedging instruments and
their fair values at the end of the reporting period;
the nature of the risks being hedged; and
for cash flow hedges: the periods in which the cash flows are expected to occur,
when they are expected to affect profit or loss and a description of any forecast
transaction for which hedge accounting had been used but which is no longer
expected to occur.
x When a gain or loss on a hedging instrument in a cash flow hedge has been recognised in
other comprehensive income, an entity shall disclose the amount that was:
recognised in other comprehensive income during the period;
reclassified from OCI and included in P/L for the period (reclassification adjustment); or
removed from OCI during the period and included in the initial measurement of the
acquisition cost or carrying amount of a non-financial asset or liability (basis adjustment).
x The tax consequences of all items in OCI must be disclosed, including the tax effect of
reclassification adjustments. Items presented in OCI may be presented net of their related
tax effects or before their related tax effects, with one amount shown for the aggregate
amount of income tax relating to all items in OCI. IAS 1.91 (slightly reworded)
Example 10: Disclosure: cash flow hedge: basis vs reclassification adjustments
Use the same information as that provided in example 9 together with the following:
Revenue in 20X2: C1 000 000, entirely constituted by 2 sales involving the imported asset.
Revenue in 20X1: C600 000, constituted entirely by services rendered.
Required: Provide the disclosure for Apple Limited's year ended 30 June 20X2 (ignore tax) assuming:
A The asset that was acquired was non-financial and thus the basis adjustment was used.
B The asset that was acquired was financial and thus the reclassification adjustment was used
Solution 10A: Disclosure: cash flow hedge: basis adjustment
Comment: Note that this example ignores the effects of current and deferred tax. However, amounts
that are supposed to be presented net of current and deferred tax have been identified as such.
Apple Limited
For the year ended 30 June 20X2
Notes 20X2 20X1
C C
Revenue Given 1 000 000 600 000
Expense of the hedged item 20X2: 329 600 + 494 400 (824 000) (0)
Foreign exchange gains 20X2: 50 000 + 40 000 90 000 4 000
Foreign exchange losses 20X2: 5 000 + 150 000 (155 000) (15 000)
Profit before tax 10 111 000 589 000
Tax expense (ignored) 0 0
Other comprehensive income for the year 11 0 6 000
- Cash flow hedges, net of tax 0 6 000
x Items that may be reclassified to profit or loss 0 0
Total comprehensive income for the year 111 000 595 000
Chapter 22 1099
Apple Limited
Retained earnings Cash flow hedges Total
C C C
Balance 1/7/20X0 xxx 0 xxx
Balance 30/6/20X1 xxx 6 000 xxx
Basis adjustment 0 (6 000)
Apple Limited
20X2 20X1
This is stated after taking into account the following separately disclosable (income)/ expense items:
x Foreign exchange gain 20X2: 50 000 + 40 000 (90 000) (4 000)
x Foreign exchange loss 20X2: 5 000 + 150 000 155 000 15 000
11. Other comprehensive income

- Gain arising on movement in cash flow hedge 6 000
x Items that may be reclassified to profit or loss 0 0
Solution 10B: Disclosure: cash flow hedge: reclassification adjustment

The differences from 10A are highlighted with asterisks so that you can compare 10A and 10B easier.
Apple Limited
Notes 20X2 20X1
C C
Revenue 1 000 000 600 000
Expense of the hedged item 332 000 + 498 000 * (830 000) (0)
Foreign exchange gain 20X2: 50 000 + 40 000 10 90 000 4 000
Foreign exchange reclassification adj. 20X2: 2 400 + 3 600 10 *6 000 0
Other expenses 20X2: 5 000 + 150 000 10 (155 000) (15 000)
Profit before tax 10 111 000 589 000
Tax expense (ignored) 0 0
Other comprehensive income for the year 11 (6 000) 6 000
- Cash flow hedges, net of tax (reclassification adjustment) (6 000) 6 000
x Items that may never be reclassified to profit or loss 0 0
Total comprehensive income for the year 105 000 695 000
1100 Chapter 22
Apple Limited
Retained earnings Cash flow hedges Total
C C C
Balance 30/6/20X1 xxx 6 000 xxx
Total comprehensive income 111 000 (6 000) 105 000
Apple Limited
20X2 20X1
This is stated after taking into account the following separately disclosable (income)/ expense items
x Foreign exchange gain 20X2: 50 000 + 40 000 (90 000) (4 000)
x Foreign exchange loss 20X2: 5 000 + 150 000 155 000 15 000
x FEC gain: reclassification adjustment* 20X2: 2 400 + 3 600 *(6 000)
11. Other comprehensive income

- Gain arising on movement in cash flow hedge 0 6 000
- Reclassification adjustment to profit or loss (2 400 + 3600)* *(6 000) 0
x Items that may not be reclassified to profit or loss 0 0

* These amounts should be presented net of tax. This example has ignored
the effects of taxation.
Chapter 22 1101
10. Summary
Types of Hedges:
Fair value hedge (FVH) Cash flow hedge (CFH)
Definition of a FVH Definition of a CFH

A hedge of the exposure to: A hedge of the exposure to:
x changes in fair value of: x changes in cash flows of:
a recognised asset or liability; or a recognised asset or liability; or
an unrecognised firm commitment; or of a highly probable forecast transaction; or
a component of such asset, liability or firm a firm commitment*
commitment; x attributable to a particular risk; and
x that is attributable to a particular risk (e.g. a x that could affect P/L. IFRS 9.6.5.2(b) reworded
foreign currency risk); and
*A hedge of a FC can only be accounted for as a CFH
x could affect profit or loss. IFRS 9.6.5.2(a) if the hedge is protecting the FC against foreign
currency risks. See IFRS 9.6.5.4
Accounting for a FVH Accounting for a CFH

Recognise a FEC A/L with related gains or losses: Recognise a FEC A/L with related gains or losses:
x recognised directly in P/L x recognised first in OCI and
x then go to P/L
If FEC (hedging instrument) is hedging a firm - directly via a reclassification adjustment; or
commitment (hedged item), then we also: - indirectly via a basis adjustment.
Recognise a FC A/L with related gains or losses When estimating the FEC A/L (i.e. before expiry) we
x recognised in P/L (measured using SR) measure it: FR obtained vs FRs now available.
On expiry, we measure: FR secured vs SR on expiry
Reclassification Adjustment Basis Adjustment

Use if the transaction involves a financial A/L Use if the transaction. involves a non-financial A/L
Affects P/L Directly Affects P/L Indirectly
Journals: Journals:
x Debit: OCI x Debit: Equity
x Credit: P/L x Credit: the hedged item (e.g. PPE)
Or vice versa Or vice versa
This transfer is done gradually as and when the This transfer is done on trans. date i.e. when the non-
hedged item affects profit or loss (e.g. when a fin. asset (e.g. PPE) is recognised. It thus affects P/L
forecast sale is made or interest expense is incurred) when this asset affects P/L (e.g. depr on the PPE)
Hedges and Important Dates / Periods
Date trans became Date firm Date transaction Date transaction

highly probable commitment is made is recognised is settled
FC date (FD) Trans date (TD) Settlement date (SD)
Hedge of a HPFT Hedge of a FC Hedge of a recognised A/L

Uncommitted period Committed period Transaction period
N/A N/A
(phase 1) (phase 2) (phase 3)
CFH CFH/ FVH CFH/ FVH
1102 Chapter 22
Gripping GAAP Share capital: equity instruments and financial liabilities
Chapter 23
Share Capital: Equity Instruments and Financial Liabilities
Reference: Companies Act of 2008, Companies Regulations of 2011, IFRS 7, IFRS 9, IAS 32
(including amendments to 1 December 2018)
Contents: Page
1. Introduction 1104
2. Ordinary shares and preference shares 1104
2.1 Ordinary share and preference shares on liquidation 1104
2.2 Ordinary dividends and preference dividends 1104
Worked example 1: Dividend obligations – proposal vs declaration dates 1105
Example 1: Preference dividend 1105
2.3 Redeemable and non-redeemable preference shares 1106
2.3.1 Overview 1106
2.3.2 Redeemable preference shares 1106
2.3.3 Non-redeemable preference shares 1106
Example 2: Issue of non-redeemable preference shares recognised as equity 1106
Example 3: Issue of -redeemable preference shares recognised as a liability 1108
2.4 Participating and non-participating preference shares 1111
Example 4: Participating dividend 1112
3. Changes to share capital 1113
3.1 Par value and no par value shares 1113
Example 5: Issue at par value and above par value 1113
Example 6: Issue of ordinary shares 1114
3.2 Share issue costs and preliminary costs 1114
Example 7: Share issue costs and preliminary costs 1114
3.3 Conversion of shares 1115
Example 8: Converting ordinary shares into preference shares 1115
3.4 Rights issue 1115
Example 9: Rights issue 1116
3.5 Share splits 1116
Example 10: Share split 1116
3.6 Share consolidations (Reverse share split) 1116
Example 11: Share consolidation 1116
3.7 Capitalisation issue 1117
Example 12: Capitalisation issue 1117
3.8 Share buy-backs (treasury shares and other distributions made by the company 1118
Example 13: Share buy-back 1119
3.9 Redemption of preference shares 1120
3.9.1 Overview 1120
3.9.2 Financing of the redemption 1120
Example 14: Redemption at issue price – share issue is financing of last resort 1120
3.9.3 Redemption at a premium 1122
Example 15: Redemption at premium –shares were recognised as equity 1122
Example 16: Redemption at a premium – shares were recognised as a liability 1123
3.10 Solvency and liquidity test 1125
4. Summary 1126
Chapter 23 1103
1. Introduction
A business entity requires funds to start and continue running a business. These funds can be
obtained from any of the following:
x Raising funds from owners (shares);
x Making profits (an internal source); and
x Borrowing through loans or debentures (an external source).
In the case of a partnership the owners would be referred to as partners. In the case of a close
corporation, the owners would be referred to as members (please note that close corporations
still exist but are being phased out since the introduction of the new Companies Act of 2008).
In the case of companies, the owners would be referred to as shareholders. This chapter
concentrates on the acquisition of funds by a company through its shareholders.
A share issued by an entity to a shareholder is:

x an equity instrument to the entity (or, in some cases, a financial liability); and
x a financial asset to the shareholder.
An equity instrument is a contract in which the holder has a residual An equity

interest in the assets of the entity after deducting its liabilities (i.e. E = A instrument is
defined as:
– L; the accounting equation). When issuing a share, our bank account
increases (i.e. an increase in assets) and since there is no obligation to x any contract
return the funds to the shareholder (i.e. there is no increase in liabilities), x that evidences a
residual interest in
our equity increases, making it an equity instrument. the assets of an
entity
This chapter looks at shares from the perspective of the entity that x after deducting all of
issued the shares. Share capital from the perspective of the investor is its liabilities. IAS32.11
explained in the financial instruments chapter.
There are two classes of shares that a company can issue:
x ordinary shares (also called common stock); and
x preference shares (also called preferred stock).
The company’s Memorandum of Incorporation must specify each Shares must

class of shares, the description of each class and the maximum number be authorised
of shares within each class that the company is authorised to issue. before they may
Only authorised shares may be issued to shareholders. See Co’s Act s36 & s38 be issued. See Co’s Act s38
2. Ordinary Shares and Preference Shares
2.1 Ordinary shares and preference shares on liquidation
Preference shareholders have preference over ordinary shareholders if the issuing company is
liquidated. Thus, from the investor’s perspective, preference shares are safer than ordinary shares.
However, the prices of ordinary shares that are traded on a stock market (i.e. securities exchange)
usually outperform preference share prices.
2.2 Ordinary dividends and preference dividends
Ordinary shareholders are not guaranteed to receive dividends because ordinary dividends are
dependent on both the profitability of the company and its cash flow. It should be noted that
an interim ordinary dividend is often declared during the year with a final ordinary dividend
declared at year-end or shortly thereafter. Since ordinary shares are equity instruments,
dividends on ordinary shares are recognised as distributions to equity shareholders – not as
expenses (distributions to equity participants are specifically excluded from the definition of
an expense). Thus, ordinary dividends declared will always appear as a reduction in equity,
presented in the statement of changes in equity. See IAS 32.35
1104 Chapter 23
It is important to note that a dividend to a shareholder should only be recognised when the
company has a present obligation to pay the dividend (i.e. when this obligation occurs, we
will recognise the liability and the dividend: credit liability and debit equity).
A dividend only becomes a present obligation once it has been appropriately authorised and is
no longer at the discretion of the entity. This obligation generally arises when the dividends
are declared: dividends are first proposed in a meeting and if the proposal is accepted, the
entity will then declare the dividend. Declaring a dividend means publicly announcing that
the dividend will be paid on a specific date in the future. In some jurisdictions, a declaration
still needs further approval before an obligation arises (e.g. it may be declared by the board of
directors but this declaration by the directors may still need to be approved by the
shareholders). See IFRIC 17.10 & IAS 10.13 & Co’s Act s46
Worked example 1: Dividend obligations – proposal vs declaration dates

A company declares two dividends for the financial year ended 31 December 20X2:
x interim dividend of C10 000: proposed and declared on 6 July 20X2; and
x final dividend of C15 000: proposed on 15 December 20X2 & declared on 3 January 20X3.
In this case, only the interim dividend is recognised during the 20X2 financial period because it
was only this dividend that was declared, creating an obligation during 20X2. The fact that the
final dividend was proposed before the end of 20X2 does not lead to an obligation during 20X2.
The entity’s profitability and liquidity determines both whether an ordinary dividend is
actually declared and the amount of the dividend. In contrast to this, preference shareholders
are often offered preference dividends of a fixed amount, calculated based on a coupon rate.
Example 1: Preference dividend

A company has 1 000 12% preference shares in issue (all issued at C2 each).
Required: Calculate the preference dividend for the year.
Solution 1: Preference dividend

1 000 x C2 x 12% (coupon rate) = C240
Whether this dividend is recognised depends on if the dividend discretionary or non-discretionary. This
also affects the timing of its recognition (when):this is explained below.
The terms of the preference share could indicate that the preference dividend is:
x discretionary (i.e. the company can choose whether to pay the dividend or not), or
x non-discretionary (i.e. mandatory) (i.e. the company must pay the dividends).
If the preference dividend is discretionary, the dividend is only recognised once it has been
declared (i.e. it is recognised in the same way as an ordinary dividend).
However, if the dividend is non-discretionary (i.e. mandatory), then the company has created
an obligation to pay all future preference dividends from day one. In other words, the
company has created a liability for all future preference dividends on the day the preference
share is issued. This liability must be recognised on the day the preference share is issued and
will be measured at the present value of these future preference dividends. These preference
dividends will be recognised as an interest expense, through the process of unwinding the
discount, rather than as a distribution to equity shareholders.
Irrespective of whether the preference dividend is discretionary or non-discretionary (i.e.

mandatory), the dividend could be cumulative or non-cumulative. Preference dividends are
normally considered to be cumulative unless specifically identified as being non-cumulative.
Non-cumulative preference dividends are dividends that, if not declared in a particular year,
need never be declared in future. In other words, if the entity does not declare the preference
dividend, the preference shareholder's right to the dividend falls away on the date that it
should have been declared.
Chapter 23 1105
Cumulative preference dividends are dividends that, if not declared in a particular year, will
have to be declared in a following year if an ordinary dividend is ever to be declared. In other
words, the entity is not allowed to declare a dividend to the ordinary shareholders until such
time as all cumulative dividends promised to the preference shareholder have been declared.
However, it is important to note that, even though the dividend may be cumulative, it does not
mean that the entity has an obligation to pay that dividend – whether or not the company has
an obligation (and thus whether it should recognise a liability for the dividend) depends on
whether or not the dividend is non-discretionary (i.e. mandatory).
To redeem
2.3 Redeemable and non-redeemable preference shares means:
2.3.1 Overview x to return capital
Some preference shares are redeemable and some are non-redeemable. Redeeming a
preference share means returning the capital to the preference shareholder. Although shares
are equity from a legal point of view, we must classify them based on their substance rather
than their legal form. Thus, whether the shares are redeemable or non-redeemable will affect
whether the shares are to be classified as equity instruments or financial liabilities.
2.3.2 Redeemable preference shares (IAS 32.AG25)
If a preference share is redeemable, the first thing we must ascertain is whether the future
redemption will be at the discretion of the entity or not.
If the redemption is at the issuing entity’s discretion (i.e. the entity can choose not to redeem
the shares), this entity can avoid the redemption. If it can avoid the redemption, it does not
have a present obligation and so this aspect of the shares represents equity. See IAS 32.AG25
However, if the redemption is non-discretionary (i.e. the issuing entity does not have the right
to choose whether to redeem the shares or not), then the issuing entity has created an
obligation on the date that it issues the shares and so it must recognise a liability. The
redemption would be considered to be non-discretionary (i.e. mandatory) if the terms of the
preference share stipulate either that the:
x shareholder has the option to choose whether or not the shares should be redeemed; or
x redemption must take place on a specific future date.
2.3.3 Non-redeemable preference shares (IAS 32.AG26)
If the shares are non-redeemable, the classification as equity or liability depends on the other
rights attached to the shares. For example, if the preference share comes with the right to
receive dividends but where the payment of these dividends is at the discretion of the issuing
entity, then the share is classified as an equity instrument. If, on the other hand, the payment
of dividends is not at the entity’s discretion (i.e. the payment of dividends is mandatory), then
the share issue is classified as a financial liability.
Example 2: Issue of non-redeemable preference shares recognised as equity

On 1 January 20X1 (date of incorporation) Green Glow Limited issued:
x 100 000 ordinary shares at C3,50 each.
x 50 000 10% non-cumulative, non-redeemable preference shares at C2 each.
Half of the authorised ordinary and preference shares have been issued. The preference dividends are
discretionary dividends. All preference dividends were declared and paid before year-end with the
exception of 20X6, when the preference dividend was declared but not yet paid at 31 December 20X6.
Required:
A. Provide all journal entries from the date of issue of the preference shares to 31 December 20X6.
B. Disclose the ordinary and preference shares in the financial statements for all years affected
including 20X6. Show the statement of changes in equity for 20X6 only (with no comparatives).
1106 Chapter 23
Solution 2A: Issue of non-redeemable preference shares recognised as equity

Comment: Because the preference shares are non-redeemable, we must first consider the other rights attaching to
the shares when deciding how to classify the shares. The payment of dividends is entirely at the discretion of
Green Glow Limited. For this reason, the shares are classified as equity.

Bank(A) 50 000 x C2 100 000
Preference share capital (Eq) 100 000
Issue of 50 000 10% non-redeemable preference shares at C2 each
31/12/20X1 – 31/12/20X6 *
Preference dividends (distribution to equity holders – negative equity) 10 000
Preference shareholders for dividends (L) 50 000 x C2 x 10% 10 000
Preference dividends *
31/12/20X1 – 31/12/20X5 **
Preference shareholders for dividends (L) 10 000
Bank 50 000 x C2 x 10% 10 000
Payment of preference dividend **
Note:
* The above journal would be repeated on 31/12/20X2; 31/12/20X3; 31/12/20X4, 31/12/20X5 and 31/12/20X6.
** The above journal would be repeated on 31/12/20X2; 31/12/20X3; 31/12/20X4 and 31/12/20X5 but not on
31/12/20X6, since the dividends were not paid in 20X6 (presented as a current liability).
Solution 2B: Issue of non-redeemable preference shares recognised as equity
Green Glow Limited

3. Ordinary share capital 20X6 20X5 20X4 20X3 20X2 20X1
Number Number Number Number Number Number
Authorised:
Ordinary shares of no par value NOTE 200 000 200 000 200 000 200 000 200 000 200 000
Issued:
Shares in issue: opening balance 100 000 100 000 100 000 100 000 100 000 0
Issued during the year 0 0 0 0 0 100 000
Shares in issue: closing balance 100 000 100 000 100 000 100 000 100 000 100 000
4. Preference share capital 20X6 20X5 20X4 20X3 20X2 20X1
Number Number Number Number Number Number
Authorised:
10% non-redeemable non-cumulative 100 000 100 000 100 000 100 000 100 000 100 000
preference shares of no par value NOTE
Issued:
Shares in issue: opening balance 50 000 50 000 50 000 50 000 50 000 0
Issued during the year 0 0 0 0 0 50 000
Shares in issue: closing balance 50 000 50 000 50 000 50 000 50 000 50 000
Note:
Since all shares in South Africa will, in future, be issued at no par value (see 3.1), it may seem odd to disclose this
fact in the share capital notes. However, IAS 1 requires disclosure of whether the shares have a par value or not,
and thus this disclosure is required even though the option of par value shares is not available in South Africa any
longer. See IAS 1.79(a)(iii)
Chapter 23 1107
Green Glow Limited

At 31 December 20X6
Note 20X6 20X5 20X4 20X3 20X2 20X1
Equity and Liabilities C C C C C C
Issued share capital and reserves
Ordinary share capital 3 350 000 350 000 350 000 350 000 350 000 350 000
Preference share capital 4 100 000 100 000 100 000 100 000 100 000 100 000
Current liabilities
Preference shareholders for dividends 10 000 0 0 0 0 0
Green Glow Limited

For the year ended 31 Dec 20X6
Ordinary Preference Retained Total
share capital share capital earnings
C C C C
Opening balance 350 000 (1) 100 000 (2) xxx xxx
Ordinary dividends declared (xxx) (xxx)
Preference dividends declared (10 000) (10 000)
Closing balance 350 000 100 000 xxx xxx
Calculations:
(1) ordinary shares: 100 000 shares x C3,50 each
(2) preference shares: 50 000 x C2
Example 3: Issue of redeemable preference shares recognised as a liability

On 1 January 20X1, date of incorporation, a company issued:
x 100 000 ordinary shares, issued at C3,50 each;
x 50 000 10% redeemable preference shares, issued at C2 each (fair value).
The preference shares must be redeemed on 31 December 20X6 at a premium of C0,20 per share.
Payment of preference dividends is mandatory and is payable on 31 December each year at the 10%
coupon rate applied to a deemed value of C2 per share.
The proceeds on each share issue were considered to be market-related (i.e. a reflection of the fair value
of the shares). The effective interest rate on the preference share liability is 11,25563551%.
Other information:
x There are a total of 120 000 authorised ordinary shares (unchanged since incorporation).
x Half of the authorised preference shares have been issued.
x Retained earnings on 1 January 20X5 was C150 000.
x Total comprehensive income (after taking into account the above) was C80 000 in 20X5.
x An ordinary dividend of C10 000 was declared in 20X5.
x These preference shares are subsequently measured using the amortised cost method.
Required:
A. Calculate and show all journal entries from the date of issue to the date of redemption of the
preference shares (excluding the redemption).
B. Disclose the ordinary and preference shares in the financial statements for all years affected
excluding 20X6 (the year of redemption). Show the statement of changes in equity for 20X5 only.
Solution 3A: Issue of redeemable preference shares recognised as a liability

Preference share liability:
Effective interest rate = 11,25563551% (given)
This rate could have been calculated as the internal rate of return using a financial calculator:
PV = 100 000
FV = -110 000 (C2,20 x 50 000 shares)
PMT = -10 000 (50 000 x C2 x 10%)
n=6
COMP i = 11.25563551%
1108 Chapter 23

W1: Effective interest rate table: Interest Bank Liability
Dr/ (Cr) Dr/ (Cr) balance
Dr/ (Cr)
01/01/20X1 100 000 (100 000)
31/12/20X1 11 256 (10 000) (101 256)
31/12/20X2 11 397 (10 000) (102 653)
31/12/20X3 11 554 (10 000) (104 207)
31/12/20X4 11 729 (10 000) (105 936)
31/12/20X5 11 924 (10 000) (107 860)
31/12/20X6 12 140 (10 000) (110 000)
31/12/20X6 (110 000) 0
70 000 (70 000) -
Notice that the total interest of C70 000 equals:

Dividends of C60 000 (C10 000 x 6 years) + premium on redemption of C10 000 (50 000 x C0.20)

Bank (A) 50 000 x C2 100 000
Preference share liability (L) 100 000
Issue of 50 000 10% redeemable preference shares at C2 each
31/12/20X1
Interest expense (E) 100 000 x 11.25563551% 11 256
Interest incurred on preference shares
Preference share liability (L) 50 000 x C2 x 10% 10 000
Bank 10 000
Payment of mandatory preference dividend
31/12/20X2
Bank 10 000
31/12/20X3
Bank 10 000
31/12/20X4
Bank 10 000
31/12/20X5
Chapter 23 1109

Bank 10 000
31/12/20X6
Bank 10 000
Preference share liability (L) 50 000 x C2 x (100% + 10%) 110 000
Bank 110 000
Redemption of preference shares at a premium
Solution 3B: Issue of redeemable preference shares recognised as a liability
Company name
2.8 Preference shares
Preference shares that are redeemable on a specific date or at the option of the shareholder are
recognised as liabilities, as in substance they are borrowings. The dividends on these preference
shares are mandatory and so the mandatory dividend stream is also recognised as a liability. Thus,
these dividends are presented in profit or loss as part of the interest expense that is recognised when
unwinding both these liabilities using the effective interest rate method.
3. Ordinary share capital 20X5 20X4 20X3 20X2 20X1

Number Number Number Number Number
Authorised:
Ordinary shares of no par value 120 000 120 000 120 000 120 000 120 000
Issued:
Shares in issue: opening balance 100 000 100 000 100 000 100 000 0
Issued during the year 0 0 0 0 100 000
Shares in issue: closing balance 100 000 100 000 100 000 100 000 100 000
4. Redeemable preference share liability 20X5 20X4 20X3 20X2 20X1

Number Number Number Number Number
Authorised:
10% redeemable preference shares 100 000 100 000 100 000 100 000 100 000
Issued:
Shares in issue: opening balance 50 000 50 000 50 000 50 000 0
Issued during the year 0 0 0 0 50 000
Shares in issue: closing balance 50 000 50 000 50 000 50 000 50 000
The redeemable preference shares, of no par value, are compulsorily redeemable on
31 December 20X6 at a premium of C0,20 per share. The 10% preference dividend is cumulative
and mandatory and calculated on a deemed value of C2 per share. The effective interest rate is
11,25563551%. Per IFRS 7.6 and IFRS 7 Appendix B3
1110 Chapter 23

Company name
20X5 20X4 20X3 20X2 20X1
C C C C C
Profit before finance charges xxx xxx Xxx xxx xxx
Finance charges (11 924) (11 729) (11 554) (11 397) (11 256)
Profit before tax xxx xxx Xxx xxx xxx
Tax xxx xxx Xxx xxx xxx
Profit for the year xxx xxx Xxx xxx xxx
Other comprehensive income for the year xxx xxx Xxx xxx xxx
Total comprehensive income for the year 80 000 xxx Xxx xxx xxx
Company name
Ordinary share capital Retained earnings Total
C C C
Opening balance – 20X5 350 000 150 000 500 000
Ordinary dividends declared (10 000) (10 000)
Closing balance 350 000 220 000 570 000
Note: The preference shares are not presented in the statement of changes in equity since they are included as a
liability in the statement of financial position. Similarly, the preference dividends are not presented in the statement of
changes in equity since they are included as finance charges in the statement of comprehensive income.
Company name
Note 20X5 20X4 20X3 20X2 20X1
Equity and liabilities C C C C C
Issued share capital and reserves 570 000 500 000 Xxx xxx xxx
Ordinary share capital 3 350 000 350 000 350 000 350 000 350 000
Retained earnings 220 000 150 000 Xxx xxx xxx
Redeemable preference shares 4 0 105 936 104 207 102 653 101 256
Current liabilities
Redeemable preference shares 4 107 860 0 0 0 0
Note: If the dividend was declared before year-end but only paid after year-end, the dividends on the ‘preference
shareholders’ account at year-end would be disclosed in the statement of financial position as ‘preference
shareholders for dividends’ (or ‘dividends payable’) under the heading of ‘current liabilities’.
For the purposes of the remainder of this chapter, you may assume, unless specifically stated
otherwise, that the preference shares are non-redeemable. You may also assume that the related
preference dividends are discretionary and thus that the preference shares are classified as equity.
2.4 Participating and non-participating preference shares Participating pref

shares result in:
Non-participating preference shares are those where the shareholder x the preference
does not participate in profits except to the extent of the fixed shareholder also earning
annual dividend, which is based on the coupon rate. Participating a variable dividend from
preference shares are those where the shareholders receive, in profits generated.
addition to the fixed annual dividend, a fluctuating dividend, which fluctuates in accordance
with the ordinary dividend.
Chapter 23 1111
Example 4: Participating dividend

A company has 1 000 12% non-cumulative, non-redeemable preference shares in issue (all
issued at C2 each). The payment of the 12% preference dividends is entirely discretionary.
These preference shares participate to the extent of 1/5 of the ordinary dividend per share.
The ordinary dividend declared is C0,10 per share. There are 1 000 ordinary shares in issue.
The ordinary dividends and preference dividends were declared on 25 December 20X5.
Required: Journalise the ordinary and preference dividends.
Solution 4: Participating dividend

Ordinary dividends (Distribution of equity) 1 000 x C0,10 100
Ordinary shareholders for dividends (L) 100
Ordinary dividends declared
Preference dividends (Distribution of equity) 1 000 x C2 x 12% 240
Preference shareholders for dividends (L) 240
Fixed preference dividend owing
Preference dividends (Distribution of equity) 1 000 x C0,10 x 1/ 5 20
Preference shareholders for dividends (L) 20
Participating preference dividend owing
Please note: The ordinary dividend will appear in the statement of changes in equity as a distribution to equity
participants. Similarly, the preference dividend will also appear in the statement of changes in equity as a
distribution to equity participants. This is because the preference shares are non-redeemable and so their
classification depends on their other rights. Since these preference shares only have rights to discretionary
dividends, the shares are classified as equity and thus their related dividends are treated as a distribution of equity.
Summary: Ordinary shares vs. preference shares
Ordinary shares Preference shares (have two aspect)
Element: Equity
The ‘Redemption' Aspect The 'Dividend' Aspect
x Non-redeemable x Mandatory
– Equity (if divs are discretionary) – Liability, thus the div will
– Liability (if divs are mandatory) Note 1 be recognised as interest
Dividend: x Redemption is mandatory as this L is 'unwound' (P/L)
Equity distribution – Liability x Discretionary
x Redemption is at the option of holder – Equity, thus the div will be
– Liability recognised as distribution to
x Redemption is at the option of issuer equity participants (SOCIE)
– Equity
Other information relevant to preference dividends:

x Cumulative / non-cumulative has no bearing on whether the dividend should be classified as a L or Eq:
– Cumulative divs: we must pay out pref divs that are in arrears before paying ordinary divs
– Non-cumulative divs: if unpaid in a year, we need never pay it (the shareholder's right to that
pref dividend simply expires)
x Participating / non-participating: participating shares get an extra variable dividend based on profits
– Participating shares: we pay a fixed dividend (coupon), which could be discretionary/mandatory,
and an extra variable dividend (e.g. % of the ordinary dividend), which is generally discretionary.
– Non-participating shares: we pay a fixed dividend (coupon) only, which could be discretionary or
mandatory.
Note 1: Non-redeemable are classified based on the other rights attaching to them:. If their divs:
x are discretionary: the share remains equity and the dividend is an equity distribution; or
x are mandatory: the share is a perpetual debt instrument and so it is a L & the dividend is interest.
See IAS32.AG26
1112 Chapter 23
3. Changes to Share Capital
3.1 Par value and no par value shares

Under the previous South African Companies Act of 1973, each class of shares either had a
par value or had no par value. This situation changed with the introduction of the Companies
Act of 2008 (‘the Companies Act’). This new Act states that shares may no longer have a
nominal or par value. See s35 Companies Act The separate Regulations (which accompany this
Companies Act) explain that, with the exception of banks, companies that had par value
shares in existence at effective date must deal with their par value shares as follows:
x If the company had an authorised class of par value shares, where none had been issued
by the effective date, those shares could not be issued until they had been converted into
‘no par value shares’. The same applies for any class of shares where all those shares had
been issued but since been re-acquired by the company by the effective date. Regulations 31 (3)
reworded
x If the company had authorised par value shares, only some of which had been issued at
effective date (i.e. outstanding issued shares), the company may continue to issue the
unissued authorised par value shares until the company publishes a proposal to convert
these shares into no par value shares, but it may not increase the number of these
authorised shares. Regulations 31 (5) reworded
Since the intention is that all shares in future be ‘no par value With the new
shares’, this text focuses on no par value shares. However, since Co’s Act:
par value shares still exist in South Africa and in many countries x only no par value shares
around the world, a brief explanation and example is included to can be issued; but
x par value shares still exist
show how par value shares are accounted for (see example 5).
Shares with a par value (in countries where par value shares are issuable) may be issued:
x at their par value (in which case there would be no share premium);
x above their par value (in which case there would be a share premium); or
x below their par value (often subject to certain conditions laid down in that country’s
legislation).
Example 5: Issues at par value and above par value
X Ltd issued 100 ordinary shares with a par value of C1 each at an issue price of C1 each.
Required:
A. Journalise this share issue if the shares are issued at C1 each (i.e. issued at par value).
B. Journalise this share issue if the shares are issued at C1,10 each (i.e. issued above par value) and
show how this would be reflected in the statement of changes in equity.
Solution 5A: Issued at par value

Debit Credit
Bank (A) 100 x C1 100
Ordinary share capital (Eq) 100
Issue of C1 par value ordinary shares for C1
Solution 5B: Issued above par value

Comment:
x Journals: Notice that the amount paid in excess of the par value is recorded separately as a ‘share premium’. Both the
‘share capital account’ and the ‘share premium account’ are classified as ‘owners’ equity’.
x Disclosure: Notice that the entire amount of cash received is recognised as equity (share capital column: 100,
share premium column: 10 and total equity column: 110).
Debit Credit
Bank (A) 110
Ordinary share capital (Eq) 100 x C1 100
Share premium (Eq) 100 x C0,10 10
Issue of C1 par value ordinary shares for C1.10
Chapter 23 1113
X Limited
Ordinary Share Retained Total
shares premium earnings C
C C C
Opening balance 0 0 xxx xxx
Ordinary shares issued 100 10 110
Closing balance 100 10 xxx xxx
Example 6: Issue of ordinary shares

On 1 January 20X1, Wallington Limited issued 100 ordinary no par value shares at C1 each.
Required: Journalise this share issue.
Solution 6: Issue of ordinary shares

Bank (A) 100
Ordinary share capital (Eq) 100 x C1 100
Issue of ordinary shares for C1
3.2 Share issue costs and preliminary costs (IAS 32.37 and IAS 38.69)
Share issue costs and preliminary costs are not the same thing.
x Share issue costs (also called transaction costs) are the costs incurred in issuing shares.
These must be set-off against the equity account, unless the issue of shares is abandoned,
in which case the share issue costs will be expensed in profit or loss. This is in terms of
IAS 32. However, please note that IAS 32 does not specify which equity account must be
used to absorb the share issue costs and thus the entity should choose which equity
account it will use (i.e. as an accounting policy) and must apply it consistently. See IAS 32.37
x Preliminary costs (also called start-up costs) is an initial cost incurred in starting up a
business, an example being ‘legal and secretarial costs incurred in establishing a legal
entity’. These costs are accounted for in the same way that we account for most other such
costs incurred in start-up activities, which is to expense them in profit or loss. see IAS 38.69.
Example 7: Share issue costs and preliminary costs
Wacko Limited was incorporated during 20X1:
x Preliminary costs (legal costs incurred in connection with the start-up of the company)
of C10 000 were paid on 2 January 20X1.
x 2 000 ordinary no par value shares were issued at C100 each on 5 January 20X1.
x Share issue costs of C2 000 were paid on 5 January 20X1.
x The draft statement of comprehensive income for 20X1, before processing any
adjustments for the above transactions, reflected total comprehensive income for 20X1
of C120 000 (components of other comprehensive income: C0).
Required:
A. Process journals to account for the preliminary costs, share issue and the related share issue costs.
B. Disclose this in the statement of changes in equity for the year ended 31 December 20X1.
Solution 7A: Share issue costs and preliminary costs
Preliminary costs (E) Given 10 000
Bank (A) 10 000
Preliminary costs paid are expensed
5 January 20X1
Bank (A) 200 000
Ordinary share capital (Eq) 2 000 x C100 200 000
Issue of 2 000 ordinary shares at C100 each
Ordinary share capital (Eq) Given 2 000
Bank (A) 2 000
Share issue costs paid deducted from equity
1114 Chapter 23
Solution 7B: Share issue costs and preliminary costs

Wallington Limited
C C C
Opening balance 0 0 0
Ordinary shares issued 200 000 0 200 000
Share issue costs set-off (2 000) 0 (2 000)
Total comprehensive income W1 110 000 110 000
Closing balance 198 000 110 000 308 000
W1: Corrected total comprehensive income: Given: C120 000 – preliminary costs expensed: C10 000 = C110 000
3.3 Conversion of shares
Shares of one class may be converted into shares of another class (for example, preference
shares may be converted into ordinary shares, or vice versa).
Example 8: Converting ordinary shares into preference shares
Craig Limited had 1 000 ordinary shares in issue (having been issued at C1,20).
On 1 January 20X2, 500 of these shares were converted into 12% preference share equity.
Required:
A. Journalise this conversion.
B. Disclose this in the statement of changes in equity for the year ended 31 December 20X2.
Solution 8A: Converting ordinary shares into preference shares

Ordinary share capital (Eq) 500 x C1,20 600
Preference share capital (Eq) 600
Conversion of ordinary shares into preference shares
Solution 8B: Converting ordinary shares into preference shares
Craig Limited
Ordinary Preference Retained Total
share share earnings
capital capital
C C C C
Opening balance 1 200 0 xxx xxx
Conversion of ordinary shares to preference shares (600) 600 0
Comment:
Notice that the net balance on these equity accounts remains at C1 200 and total equity is not affected. Also note
that such a change in the company’s share capital has no impact on cash reserves.
3.4 Rights issue
Rights issues are the offering of a certain number of shares to existing shareholders in
proportion to their existing shareholding at an issue price that is lower than the market price.
The lower price provides an incentive to invest capital in the company. Note that shareholders
are not obliged to purchase the shares offered.
Chapter 23 1115
Example 9: Rights issue

A company has 1 000 ordinary shares in issue, each issued at C2,50. The company wishes
to offer its shareholders 1 share for every 4 shares held at an issue price of C3.
x The current market price immediately before this issue is C4.
x All the shareholders had accepted the offer by the last day of the offer.
Required:
A. Journalise this issue.
B. Disclose this in the statement of changes in equity.
Solution 9A: Rights issue
W1: Calculations
Number of shares issued 1 000/ 4 x 1 250
Proceeds received 250 x C3 C750
Bank (A) W1 750
Shares issued to existing shareholders (1:4) at C3 each (market price: C4)
Solution 9B: Rights issue

Company name
C C C
Opening balance 1 000 x 2.50 2 500 xxx xxx
Issue of shares in terms of a rights issue 750 750
3.5 Share splits

A share split involves the company splitting its authorised and issued share capital into more
shares. This has the effect of reducing the market value per share, since there are suddenly
more shares on the market, while the net asset value of the company has not changed. A
company may perform a share split if it feels that its share price is too high, because a lower
price may attract new investors and increase the liquidity of its shares.
Example 10: Share split
A company has 1 000 shares, issued at C2 each, which it converts into 2 000 shares.
Required: Journalise the conversion.
Solution 10: Share split

Although the number of the authorised and issued share capital will change in the notes, there is no
journal entry since there is no change in either the share capital or cash resources:
Previously: 1 000 shares at C2 each = C2 000 Now: 2 000 shares at C1^ each = C2 000
^C2 000 / 2 000
3.6 Share consolidations (Reverse share split)

This is the opposite of a share split and is often implemented when the company believes its
share price is too low: the company reduces the number of authorised and issued shares. This
should increase the market value per share, as there are now fewer shares on the market, yet
the company’s net asset value remains the same.
Example 11: Share consolidation
A company has 1 000 shares, issued at C2 each, which it converts into 500 shares.
Required: Journalise the conversion.
1116 Chapter 23
Solution 11: Share consolidation

Although the number of the authorised and issued share capital will change in the notes, there is no
journal entry since there is no change in either the share capital or cash resources:
Previously: 1 000 shares at C2 each = C2 000 Now: 500 shares at C4^ each = C2 000
^C2 000 / 500
3.7 Capitalisation issue

A company may issue shares to existing shareholders for free. A capitalisation
Similarly, it may issue shares of one class to shareholders of issue is defined as:
another class. These capitalisation shares are often referred to as
x a free issue of shares to
‘fully paid up’ shares (or scrip dividends) meaning that the shareholders
shareholder does not pay for them.
A capitalisation issue is often made in order to make use of the company’s idle reserves. For
example, they could be used by simply converting them into capital, or could be used to make
a dividend payment instead of paying in cash (e.g. due to a shortage of cash).
The Companies Act s40 requires authorised shares (including capitalisation issues) to be
issued for ‘adequate consideration’. In this text it is assumed that the market price of a share
is ‘adequate consideration’ for the purposes of measuring a capitalisation issue.
Companies sometimes offer their shareholders cash payments in lieu of a capitalisation share.
However, this optional cash payment may only be offered if the offer complies with s46 of the
Companies Act. This is the same section that must be applied before declaring dividends (or
making any distribution, which is defined as a cash payment or cash payment in lieu of a
capitalisation issue). This section (s46) requires that the solvency and liquidity test would be
satisfied immediately after the capitalisation issue takes place in the event that all
shareholders opt to receive the cash payment (see section 3.10 for a more detailed discussion
about s46 and the solvency and liquidity test).
Example 12: Capitalisation issue
At the start of the year, a company has 1 000 ordinary shares in issue (issued at C1,50 each).
It then issued a further 600 fully paid-up shares to its existing shareholders in proportion to
their existing shareholding at the current market price of C1 each. The company had retained earnings
of C800 at the beginning of the year and total comprehensive income of C150 for the year.
Required:
A. Journalise the issue.
B. Disclose the issue in the statement of changes in equity.
Solution 12A: Capitalisation issue

Debit Credit
Retained earnings (Eq) C1 x 600 600
Capitalisation issue of 600 ordinary shares to existing shareholders
Solution 12B: Capitalisation issue

Company name
C C C
Opening balance 1 500 800 2 300
Capitalisation issue 600 (600) 0
Closing balance 2 100 350 2 450
Note: there is no change in either the total equity or the cash resources of the company.
Chapter 23 1117
3.8 Share buy-backs (treasury shares) and other distributions made by the company
(Companies Act s46 and s48 and IAS 32.33) Treasury
shares:
A company may, in certain situations and for various reasons, buy- x a
re an entity’s shares
back its own shares from its own shareholders. The reason that it that it has bought back
may decide to buy back its own shares could be, for example, in an x have no voting rights or
effort to increase the share price (remember: the laws of supply and dividends
demand suggest that if the supply of an item is lower than the x are no longer outstanding
must be separately
demand for it, the price of the item will increase) or even to prevent x disclosed.
a hostile takeover. Interestingly, it may also be used as a device to See IAS 32.34 & IAS 1.79(a)(vi)
increase the earnings per share that must be disclosed in terms of

IAS 33 Earnings per share (see chapter 24) because a share buy-back reduces the number of
shares in issue (thus increasing the earnings per share).
IAS 1 requires that, when an entity holds its own shares, these shares must be separately
disclosed. Disclosure could be made on the face of the statement of financial position, statement
of changes in equity or in the notes to the financial statements. IAS 1.79(a)(vi)
Shares that are bought back by the entity are called treasury shares. Treasury shares have no
rights attached to them, which means that the holder of a treasury share (i.e. the entity itself)
will have no voting rights and will not receive dividends. A company buying back its own
shares can signal to the market that management (knowing the real value of their company)
believes the share is under-priced.
Treasury shares, being shares that an entity holds in itself, are commonly described as ‘issued
shares that are not outstanding shares’. The term outstanding shares is the term used to describe
shares that are held by investors (unlike shares now held by the issuing entity itself).
However, in South Africa, the Companies Act states that shares that have been bought back by
the issuing company should be considered to be authorised but not issued. Thus, in South
Africa, a treasury share would be described as a share that is held by the entity itself but is
‘neither issued nor outstanding’. Treasury shares may be re-issued at a later date.
In South Africa, a company may buy back its shares only on condition that the requirements of
Companies Act 2008 are met:
x The buy-back must satisfy the requirements of section 46 (including the solvency and
liquidity test: see section 3.10 for further details on the solvency and liquidity test); and
x After the buy-back, there must be shares in existence other than:
- shares that are owned by one or more of its subsidiaries; or
- convertible or redeemable shares. See Co’s Act s48
The reason for these restrictions is that both the cash reserves and capital base of the company
are diminished through a share buy-back – putting other shareholders and creditors at risk.
Thus, the solvency and liquidity test helps to protect their financial interests in the entity.
IAS 32 explains that when buying back shares, the consideration paid for these shares must be
debited directly to equity and no gain or loss may be recognised in profit or loss. Although
IAS 32 requires that the buy-back of shares must be debited to equity, it does not specify which
equity accounts should be debited. See IAS 32.33
It is suggested that, if the entity pays more for a share than it was issued for (or more than the
average share issue price, where the share capital of an entity constitutes shares issued at various
different share prices), then the amount that is debited to the share capital account (or in the case of
par value shares, the amount that is debited to the share capital and share premium accounts), should
be limited to the average share issue price. If we don’t limit it to the original average issue price of
the shares, then the share capital account/s could end up with a debit balance. Any difference
between the total amount paid for the share and this average share issue price should be processed as
an adjustment directly to retained earnings (the adjustment may not be made to profit or loss because
IAS 32 expressly prohibits a gain or loss from being recognised on such a transaction). See IAS 32.33
1118 Chapter 23
Example 13: Share buy-back

A company's ordinary shares (no par value) consist of 1 000 authorised unissued shares and
750 issued shares (issued over a number of years at varying issue prices).
The total balance on the share capital account for this class of shares is C1 500.
The company buys back 250 of these shares at their market price of C3 per share.
Required: Journalise the buy-back and disclose in the notes and statement of changes in equity.
Solution 13: Share buy-back

Debit Credit
Ordinary share capital (Eq) C1 500/ 750 shares = C2 average price/share x 250 shares 500
Retained earnings (Eq) Balancing: C750 paid – C500 average issue price 250
Bank (A) C3 per share x 250 shares 750
Buy-back of 250 shares in terms of s48: excess over average price debited to RE
Company name
Statement of changes in equity (extract)
Ordinary Retained Total
share capital earnings
C C C
Acquisition of shares by the company (s48): treasury shares (500) (250) (750)
Company name
3. Ordinary share capital

Number of authorised shares: Number
Ordinary shares of no par value 1 750
Number of outstanding shares:

Shares outstanding at the beginning of the year 750
Acquisition of shares by the company in terms of s48: treasury shares (250)
Shares outstanding at year-end 500
Comment:
The total authorised shares that are available to be issued has now increased by 250 shares to 1 250 shares, (as 250
shares have been bought back):
x There were 1 000 shares available for issue (Authorised: 1 750 – Issued & outstanding: 750); but
x There are now 1 250 shares available for issue (Authorised: 1 750 – Issued & outstanding: 500).
Summary: Movements in issued shares
Increase in number Decrease in number
Share splits Share issue Share consolidation Share buy-back

x existing shares x for value: mkt price x existing shares x reduce share
split into more x for free: cap issue combined into capital a/c
shares: no journal x combo: rights issue fewer shares: no x adjust retained
journal earnings a/c with
difference between
average issue price
and buy-back price.
Chapter 23 1119
3.9 Redemption of preference shares (Companies Act: s4 & s46 )
3.9.1 Overview
The redemption of a preference share entails the company

Redeemable pref shares
paying out the preference shareholder for the preference can be liability/ equity
share. This redemption could be mandatory, at the option of depending on the terms
the company or at the option of the shareholder: of the redemption:
compulsory/at option of
If, when the preference shares were originally issued, the x shareholder: liability
company knew that they would be compulsorily x at option of company: equity
redeemed or that the holders could choose to have them
redeemed, then the company would have created an obligation on issue date. In this case,
the share issue is recorded as a liability, and not equity.
x If, on the other hand, the preference shares could be redeemed in the future, but such
redemption would be at the option of the company, then there is no obligation at the time
of issue and therefore such preference shares are recognised as equity.
Although preference shares that are either ‘mandatorily

redeemable’ or ‘redeemable at the option of the holder’ are The S&L test must
recognised as liabilities, they are still considered to be shares again be satisfied
from a legal point of view and thus, their redemption must before preference shares are
still comply with the Companies Act. As such, the solvency redeemed!
and liquidity test must also be met (see section 3.10), as well as the other provisions of s46.
When redeeming shares, both the capital and the company’s cash reserves are reduced, thus
possibly putting the other remaining shareholders and creditors at risk. To counter this risk,
the Companies Act requires that the provisions of section 46 (including the solvency and
liquidity test discussed in section 3.10) be complied with before the redemption takes place.
3.9.2 Financing of the redemption
How the payment is made is referred to as the ‘financing of the redemption’. A company may
finance the redemption of shares by, for example, issuing new shares, issuing debentures,
raising a loan or an overdraft.
Example 14: Redemption at issue price – share issue is financing of last resort
A company must redeem all its preference shares at their original issue price of C2.
It prefers not to have to issue any further ordinary shares unless absolutely necessary but if
such an issue is necessary, these ordinary shares will be issued at C6 each.
The company has C80 000 in the bank. The directors feel that only C30 000 of this should be used for
the redemption.
Any further cash required should be acquired via an issue of up to 10 000 debentures at C1 each
(redeemable after 3 years at C1 each).
If further cash is still required, a bank loan of up to C40 000 (repayable after 4 years) may be raised.
There is a balance of C150 000 in the retained earnings account.
x Scenario (i): there are 10 000 preference shares to be redeemed
x Scenario (ii): there are 35 000 preference shares to be redeemed
x Scenario (iii): there are 70 000 preference shares to be redeemed
Required:
For each of the scenarios listed above:
A. Calculate the number of ordinary shares that would need to be issued to finance the redemption.
B. Show all related journal entries.
1120 Chapter 23
Solution 14A: Calculating the financing plan

Scenarios
(i): 10 000 (ii): 35 000 (iii): 70 000
pref shares pref shares pref shares
Cash needed for the redemption (i): 10 000 x 2; (ii): 35 000 x 2 20 000 70 000 140 000
(iii): 70 000 x 2
Cash available through:
- cash in bank Given (30 000) (30 000) (30 000)
- new debenture issue 10 000 x 1 (0) (10 000) (10 000)
- new bank loan Balancing up to 40 000 (0) (30 000) (40 000)
- new share issue Balancing (0) (0) (60 000)
Cash shortage/ (surplus) (10 000) 0 0
Shares to be issued (i) & (ii): 0/ 6; (iii) = 60 000/ 6 0 0 10 000
Comment:
It is important to pay attention to the order in which the company plans to source funding for the redemption.
For example: Assume that the required redemption amount is C140 000 (as in scenario iii above), but that, in order
to fund the redemption, the company planned to raise a C30 000 bank loan, issue ordinary shares up to a max of
15 000 shares (at C6 each), and that any further funds would be sourced from a debenture issue (at C1 each), up to a
max of 30 000 debentures (i.e. cash reserves were to be used as a last resort).
The bank loan would be used first, then ordinary shares would be issued and then debentures would be the
balancing figure (unless 30 000 debentures was insufficient, in which case the cash reserves would be the balancing
figure), represented as follows:
Cash needed for the redemption Given 140 000

- new bank loan Given (30 000)
- new share issue 15 000 x C6 (90 000)
- new debenture issue Balancing (20 000)
Cash shortage/ (surplus) 0
Debentures to be issued C20 000 ÷ C1 20 000

Scenario (i) Scenario (ii) Scenario (iii)
Debit Credit Debit Credit Debit Credit
Preference shares (non-current liability) 20 000 70 000 140 000
Preference shares (current liability) 20 000 70 000 140 000
Preference shares to be redeemed
(i): 10 000 x 2; (ii): 35 000 x 2; (iii): 70 000 x 2
Bank (A) N/A 10 000 10 000

Debentures liability (L) N/A 10 000 10 000
Issue of debentures
(i): N/A; (ii): 10 000 x 1; (iii): 10 000 x 1
Bank (A) N/A 30 000 40 000

Loan liability (L) N/A 30 000 40 000
Loan raised
Bank (A) N/A N/A 60 000
Ordinary share capital (Eq) N/A N/A 60 000
Issue of ordinary shares (10 000 x C6)
Preference shares (current liability) 20 000 70 000 140 000
Bank (A) 20 000 70 000 140 000
Preference shares redeemed
Chapter 23 1121
3.9.3 Redemption at a premium
A redemption that requires a company to pay the preference shareholder an amount in excess
of its issue price is referred to as a redemption at a premium.
x If the preference share was mandatorily redeemable, the original share issue would have
been recognised as a preference share liability and the mandatory premium would have
been included in the measurement of this liability balance (furthermore, irrespective of
whether the liability was measured at amortised cost or at fair value through profit or loss
(FVPL), the premium will have been included in the interest expense, and this will have
automatically reduced retained earnings).
x If the preference share was not mandatorily redeemable, the original share issue would
have been recognised as equity. In this case, if a premium is paid on redemption, the
amount paid will exceed the amount originally recognised in the share capital equity
account when the shares were issued. Thus, when these shares are redeemed, we will have
to first debit the share capital equity account, bringing it to zero, and then the extra
premium paid will need to be debited to another distributable reserve equity account, such
as retained earnings.
Example 15: Redemption at a premium -

Preference shares recognised as equity
A company is opting to redeem all of its 20 000 preference shares (having an issue price of
C2) at C3 each (i.e. at a premium over the original issue price).
The company will fund this out of a new share issue of 10 000 ordinary shares.
The rest of the redemption payment must be funded by raising a bank loan.
These preference shares were being redeemed at the option of the company and had therefore been
recognised as equity.
Scenario (i): the ordinary shares are to be issued at C4 each
Scenario (ii): the ordinary shares are to be issued at C3 each
Required: For each of the scenarios listed above:
A. Calculate the cash required to finance the redemption.
B. Show all related journal entries.
Solution 15A: Calculation of the financing plan

Scenario (i) Scenario (ii)
Issue price C4 Issue price C3
Need to redeem preference shares 20 000 x 3 60 000 60 000
- new share issue (i): 10 000 x 4; (ii): 10 000 x 3 (40 000) (30 000)
- new bank loan needed Balancing (20 000) (30 000)
Cash shortage/ (surplus) 0 0
Solution 15B: Journals - shares were recognised as equity

Scenario (i) Scenario (ii)
Debit Credit Debit Credit
Preference share capital (Eq) 20 000 x 2 40 000 40 000
Retained earnings (Eq) 20 000 x 1 20 000 20 000
Preference shares (current liability) 60 000 60 000
Preference shares to be redeemed
Bank (A) (i): 10 000 x 4; 40 000 30 000
Ordinary share capital (Eq) (ii): 10 000 x 3. 40 000 30 000
Issue of ordinary shares
Bank (A) See Sol 15A 20 000 30 000
Loan (L) 20 000 30 000
Loan raised
Preference shares (current liability) 60 000 60 000
Bank (A) 60 000 60 000
Preference shares redeemed
1122 Chapter 23
Example 16: Redemption at a premium –

Preference shares were recognised as a liability
On 1 January 20X1 (date of incorporation) a company issued:
x 100 000 ordinary shares with no par value, issued at C3,50 each; and
x 50 000 10% redeemable preference shares issued at C2 each.
These preference shares must be redeemed on 31 December 20X6, at a premium of C0,20 per share.
The 10% preference dividend is based on a deemed value of C2 per share. The payment of the dividend
is mandatory and is due on 31 December each year.
The proceeds on each share issue were considered to be market-related (i.e. a reflection of the fair value
of the shares). The effective interest rate on the preference share liability is 11,25563551%.
The authorised share capital consists of:
x 120 000 authorised ordinary shares; and
x 100 000 authorised preference shares.
The company redeems the preference shares on due date, 31 December 20X6. In order to finance the
redemption, it issued the remaining authorised ordinary shares on 20 December 20X6, at C4 each, after which,
any extra funds needed were to be sourced as follows: if further cash was required, C20 000 cash was be taken
from the savings account and a bank overdraft arranged for any further cash required.
The accounting policy is to set-off any premium on redemption against retained earnings. The balance
of the retained earnings is C200 000 immediately before the redemption.
The preference shares have been correctly classified as amortised cost financial liabilities.
Required:
A. Show all journals relating to the redemption, including journals relating to the financing thereof.
B. Disclose the shares in the financial statements for the year ended 31 December 20X6 (the year of
redemption). The statement of changes in equity is only required for 20X6.
Solution 16A: Redemption at a premium – shares were recognised as a liability

Comment:
x The issued preference shares are a pure liability because both the redemption and the dividends are mandatory.
x The liability has been classified at amortised cost. This means it will be measured using the effective
interest rate method. A liability is classified at amortised cost if it is not held for trading and not designated
at fair value through profit or loss (see chapter 21).
x The company chose to set-off the premium on redemption against retained earnings: no journal entry is
required to do this because the preference shares were recognised as a liability with the result that both the
premium payable on redemption and the preference dividends have already been included in finance charges
(an expense) over the life of the preference shares. The premium has therefore already reduced the profits.
Please note: Calculations of the balance on the ‘redeemable preference share’ account each year, are shown in example 3.

Bank (A) (Authorised 120 000 – Already 80 000
Ordinary share capital (Eq) issued: 100 000) x C4 80 000
Issue of 20 000 ordinary shares at an issue price of C4 each
31 December 20X6
FL: Preference share (L) 50 000 x C2.20 110 000
Preference shareholders (current liability) 110 000
Redemption of preference shares due
Preference shareholders (current liability) 110 000
Bank: savings account (A) 20 000 + 80 000 cash from the issue 100 000
Bank: overdraft (L) Balancing: 110 000 – 100 000 10 000
Redemption of preference shares - payment to shareholders
W1: Calculation of the financing plan C

Cash needed for the redemption of shares 50 000 x (issue price C2 + premium C0,20) 110 000
- new share issue (Authorised 120 000 - already issued 100 000) x 4 (80 000)
- cash in bank Given (20 000)
- bank overdraft utilised Balancing (10 000)
Chapter 23 1123
Solution 16B: Redemption at a premium – shares were recognised as a liability
Company name
20X6 20X5 20X4 20X3 20X2 20X1
C C C C C C
Profit before finance charges xxx xxx xxx xxx xxx xxx
Finance charges (see example 3) 12 140 11 924 11 729 11 554 11 397 11 256
Profit before tax xxx xxx xxx xxx xxx xxx
Tax expense xxx xxx xxx xxx xxx xxx
Profit for the year xxx xxx xxx xxx xxx xxx
Other comprehensive income xxx xxx xxx xxx xxx xxx
Total comprehensive income xxx xxx xxx xxx xxx xxx
Company name
C C C
Ordinary shares issued 80 000 80 000
Total comprehensive income xxx – 12 140 xxx
Comment:
The preference shares did not appear in the SOCIE since they appear in the SOFP as a liability instead.
Company name
Note 20X6 20X5 20X4 20X3 20X2 20X1
Equity and liabilities C C C C C C
Issued share capital and reserves

Ordinary share capital 3 430 000 350 000 350 000 350 000 350 000 350 000
Redeemable preference shares 4 0 0 105 936 104 207 102 653 101 256
Current liabilities
Redeemable preference shares 4 0 107 860 0 0 0 0
Please note:
x The 20X1 – 20X4 figures are not required and are given for explanatory purposes only.
x Detailed calculations of the ‘redeemable preference share’ account over the years are in example 3.
Comment: Did you notice how the redeemable preference share liability:
x gradually increases over the years until the date of redemption arrives (20X1: 101 256; 20X2: 102 653 etc,
until 20X5: 107 860) and then
x in the year of redemption (20X6), the balance of the ‘redeemable preference share liability’ account will
first grow to C110 000 (the amount to be redeemed); and then, after redemption, the balance on the
account will be reduced to zero.
Movement on the preference share liability account during 20X6 C
Opening balance – 20X6 107 860
Premium accrued (see example 3) Interest: 12 140 - Coupon payment: 10 000 2 140
Balance immediately before redemption 110 000
Redemption (debit preference share liability and credit bank) (110 000)
0
1124 Chapter 23
Company name
2.5 Preference shares
Redeemable preference shares, which are redeemable on a specific date or at the option of the shareholder
are recognised as liabilities, as the substance is ‘borrowings’. The dividends on such preference shares are
mandatory and so the mandatory dividend stream is also recognised as a liability. These dividends are
presented in profit or loss as part of the interest expense recognised when unwinding both these liabilities
using the effective interest rate method.
20X6 20X5
3. Ordinary share capital Number Number
Authorised: Ordinary shares of no par value 120 000 120 000
Issued: Shares in issue: opening balance 100 000 100 000
Issued during the year 20 000 0
Shares in issue at year-end 120 000 100 000
4. Redeemable preference share liability Number Number

Authorised: 10% redeemable preference shares of no par value 100 000 100 000
Issued: 50 000 10% redeemable preference shares in issue 50 000 50 000
Redeemed during the year (50 000) 0
Balance at year-end 0 50 000
The redeemable preference shares were compulsorily redeemable on 31 December 20X6 at a premium of
C0,20 per share. The 10% preference dividend is mandatory and cumulative and is based on a deemed value
of C2 per share. The effective interest rate is 11,25563551%. Per IFRS 7.6 and IFRS 7 Appendix B3
3.10 Solvency and liquidity test (Companies Act s4 & s46)

A S&L test means
satisfying test of:
The Companies Act states that a company may not make any
x solvency = A(FV) ≥ L(FV)
proposed distribution to shareholders (such as a dividend payment,
x liquidity = ability to pay
a redemption of preference shares or a buy-back of ordinary shares) current debts as and when
unless: they fall due See Co’s Act s4
x The distribution is:

- pursuant to an existing legal obligation of the company, or
- pursuant to a court order; or
- the board of the company, by resolution, has authorised the distribution; and
x It reasonably appears that the company will satisfy the
solvency and liquidity test immediately after The S&L test
completing the proposed distribution; and helps to protect
the financial interests of
x The board of the company, by resolution, has shareholders with
acknowledged that it has applied the solvency and smaller shareholdings and
liquidity test, and concluded that the company will creditors
satisfy the solvency and liquidity test immediately after completing the proposed
distribution. See Companies Act s46
The solvency and liquidity test will be satisfied at a given time if, considering all reasonably
foreseeable financial information:
x The assets of the company, fairly valued, equal or exceed its liabilities, fairly valued; and
x It appears that the company will be able to pay its debts as they become due in the ordinary
course of business for a 12-month period after the test or, in the case of a distribution, for a
12-month period following that distribution. Companies Act s4 (slightly reworded)
Chapter 23 1125
4. Summary
Ordinary vs. preference share capital
Ordinary shares Preference shares (have two possible aspects)
Element: Equity
The 'Redemption' Aspect The 'Dividend' Aspect
x If mandatory
x If non-redeemable
– Liability: div is recog. in P/L
– Equity (if divs are discretionary)
if Amort. cost = interest exp.
– Liability (if divs are mandatory) Note
1 (using EIR)
Dividend: if FVPL = dividend expense
x If redeemable and mandatory
Equity distribution (using the amount declared)
– Liability
x If discretionary
x If redeemable: but it’s holder option
– Equity: this div will be
– Liability
recognised as distrib to equity
x If redemption: at option of issuer
participants (SOCIE)
– Equity
Other information relevant to preference dividends:

x Cumulative / non-cumulative has no bearing on whether the dividend should be classified as a L or Eq:
– Cumulative divs: we must pay out arrear pref divs before paying ordinary divs
– Non-cumulative divs: if unpaid in a year, we need never pay it (the shareholder's right to that
pref dividend simply expires)
x Participating / non-participating: participating shares get an extra variable dividend based on profits
– Participating shares: we pay a fixed dividend (coupon), which could be discretionary/mandatory, and
an extra variable dividend (e.g. % of the ordinary dividend), which is generally discretionary.
– Non-participating shares: we pay a fixed dividend (coupon) only, which could be discretionary/ mandatory.
Note 1: Non-redeemable PS are classified based on the other rights attaching to them. So, if their divs are:
x discretionary: the share remains equity and the dividend is an equity distribution; or
x mandatory: the share is effectively a perpetual debt instrument and is thus recognised as a liability
& the dividend is recognised as an interest expense. See IAS32.AG26
Movements in issued shares
Increase in number Decrease in number
Share
Share splits Share issue Share buy-back
consolidation
x for value: mkt price existing shares
existing shares split
x for free: cap issue combined into fewer reduce share capital a/c
into more shares
x combo: rights issue shares
No journal No journal
Journals
Share issue:
x Issue at mkt price: Normal issue: Proceeds on issue (Dr Bank and Cr Ord SC)
x Issue for free: Cap issue: Amt of reserves to be capitalised (Dr RE Cr Ord SC)
x Combination issue: Rights issue: Proceeds on issue (Dr Bank and Cr Ord SC) (i.e. same as
for an issue at mkt price)
Share buy-back: Payment made (Cr Bank; Dr SC and Dr/Cr RE)
Transaction costs and preliminary expenses:

Share issues are often accompanied by certain costs such as transaction costs and
preliminary costs:
x Transaction costs (Cr Bank and Dr Stated capital) –
x Preliminary costs are always expensed (Cr Bank and Dr Prelim cost expense (P/L))
1126 Chapter 23
Gripping GAAP Earnings per share
Chapter 24
Earnings per Share
Reference:
IAS 33; Circular 4/2018, IAS 10 and IFRIC 17 (incl. any amendments to 10 December 2018)
Contents: Page
2. Types of shareholders 1129

2.1 Ordinary shareholders 1129
2.2 Preference shareholders 1130
3. Basic earnings per share 1131

3.1 Overview 1131
3.2 Basic earnings (the numerator) 1131
3.2.1 The basic calculation 1131
3.2.2 Where there are only ordinary shares 1132
Example 1: Ordinary shares only 1132
3.2.3 Where there are ordinary and preference shares 1132
Example 2: Ordinary and non-participating preference shares 1132
Example 3: Preference shares and preference dividends – equity versus
liability 1133
3.2.4 Where there are ordinary shares and participating preference shares 1133
Example 4: Ordinary and participating preference shares 1134
3.3 Basic number of shares (the denominator) 1135
3.3.1 Overview 1135
3.3.2 Issue for value 1136
3.3.2.1 Issues at the beginning of the current year 1136
Example 5: Issue for value at the beginning of the year 1136
3.3.2.2 Issues at the end of the year or during the year 1137
Example 6: Issue for value at the end of the year 1137
Example 7: Issue for value during the year 1137
3.3.3 Issue for no value 1138
Example 8: Issue for no value 113
Example 9: Issue for no value after an issue for value 1139
3.3.4 Combination issues 1140
Example 10: Rights issue 1140
Example 11: Various issues over three years 1141
3.3.5 Contingently issuable shares 1143
Example 12: Contingently issuable shares 1143
Example 13: Deferred shares 1144
3.3.6 Contingently returnable shares 1145
3.3.7 Share buy-back 1145
Example 14: Share buy-back 1145
3.3.8 Reverse share split (share consolidation) 1145
Example 15: Reverse share split (share consolidation) 1146
3.3.9 Retrospective adjustments 1146
Chapter 24 1127
4. Headline earnings per share 1146

4.1 Overview 1146
4.2 Measurement of the headline earnings per share 1148
4.2.1 Headline earnings (the numerator) 1148
Example 16: Conversion: basic earnings to headline earnings 1149
4.2.2 Number of shares (the denominator) 1149
Example 17: Headline earnings per share 1150
4.3 Disclosure of the headline earnings per share 1150
Example 18: Headline earnings per share - disclosure 1150
5. Diluted earnings per share 1151

5.1 Overview 1151
Example 19: Diluted earnings per share: simple example 1151
5.2 Potential shares 1152
5.2.1 Options 1153
Example 20: Options to acquire shares 1153
5.2.2 Purchased options and written put options 1154
5.2.3 Convertible instruments 1154
Example 21: Convertible debentures 1155
Example 22: Convertible preference shares 1156
5.2.4 Contingent shares 1157
5.2.4.1 Where time is the only condition 1157
5.2.4.2 Where there are multiple conditions including time 1157
Example 23: Contingent shares 1157
5.3 Multiple dilutive instruments 1158
Example 24: Multiple dilutive instruments 1158
6. Presentation and disclosure 1159

6.1 Overview 1159
6.1.1 Statement of comprehensive income 1160
6.1.2 Notes to the financial statements 1160
6.1.3 Sample note disclosure involving earnings per share 1161
6.2 Disclosure of further variations of earnings per share 1162
Example 25: Disclosure of rights issue, basic and headline earnings per share 1162
Example 26: Disclosure involving multiple dilutive instruments 1164
7. Summary 1166
1128 Chapter 24
1. Introduction
‘Earnings per share’ is essentially a ratio used in the financial analysis of a set of financial
statements and therefore falls under the chapter on financial analysis as well. It takes into
account the number of shares in issue, and is thus a comparable, relative measure. This ratio
is, however, so useful and popular that the standard, IAS 33, had to be developed to control
the method of calculation thereof. This standard sets out how to calculate:
x the numerator: earnings; and
x the denominator: the number of shares
for each class of equity share (where each class has a varying right to receive dividends).
Although IAS 33 states that earnings per share must

An ordinary share is defined
be calculated for all ordinary shares, it is possible as:
for there to be more than one class of ordinary share
(i.e. where the entity has shares that share in x an equity instrument
dividends at different rates). In this case, the x that is subordinate
earnings per share would need to be disclosed for x to all other classes of equity instruments.
IAS 33.5
each class of ordinary share.
IAS 33 refers to two different types of earnings per share: basic earnings per share and diluted
earnings per share. It allows other variations of earnings per share to be presented as well
(although these other per share figures may not be presented on the face of the statement of
comprehensive income, but may only be presented in the notes). In South Africa, companies
wishing to be listed or to remain listed on the JSE Exchange must comply with the JSE
Listing Requirements, which requires that headline earnings per share be presented. The
various earnings per share figures can be summarised as follows:
Earnings per share:

A summary of the different types
Basic Diluted Headline Other variations

(IAS 33) (IAS 33) (Circular 04/2018) (IAS 33)
Required by IFRS Required by IFRS if the Not required by IFRSs; Allowed if given in
entity had dilutive but is required for all SA addition to the
potential ordinary companies wishing to list/ BEPS (and DEPS
shares be listed on the JSE (a where applicable)
See IAS 33.73
JSE Listing Requirement)
The ‘basic earnings per share’ figure may be extremely volatile since all items of income and
expenses are included in the calculation thereof. In order to compensate for this volatility, the
calculation of ‘headline earnings per share’ has been introduced, which excludes income and
expenses of a capital nature and those that are ‘highly abnormal’. Headline earnings are
therefore a better indicator of ‘maintainable earnings’. ‘Diluted earnings per share’ is also
covered by IAS 33. This is covered later in this chapter.
2. Types of Shareholders
2.1 Ordinary shareholders

Ordinary shareholders buy a share in a company to earn dividends and for capital growth.
These dividends fluctuate annually depending on profits and available cash reserves etc. As
the terms ‘ordinary’ and ‘preference’ implies, the ordinary shareholders have fewer rights
than the preference shareholders. For example, assuming a company with both preference and
ordinary shareholders is liquidated: the preference shareholders will have their capital
returned first and only if there are sufficient funds left over, will the ordinary shareholders
have their capital paid out.
Chapter 24 1129
2.2 Preference shareholders Preference share capital may be:

x redeemable or non-redeemable
Preference shareholders have more rights
than ordinary shareholders. Not only do they have preference on liquidation, but they also
have a fixed amount paid out each year in dividends (as opposed to ordinary shareholders
whose dividends are at the discretion of the entity and are largely dependent on profits and
available cash reserves). The dividend amount is based on the share’s coupon rate (e.g. 10%).
A shareholder owning 1 000 preference shares of C2 each with a coupon rate of 10% will
expect dividends of C200 per year (C2 x 1 000 x 10%).
As was explained in previous chapters, Redeemable vs Non-redeemable

preference shares could be classified as pure x redeemable means the capital is
equity, pure liability or as compound financial returned to the shareholder
instruments (partly equity and partly liability). x non-redeemable means the capital is not
The classification is based on assessing all returned to the shareholder
aspects of the share: whether the capital is redeemable or non-redeemable and whether the
dividends are mandatory or discretionary.
It is important to understand whether a preference share will be classified as liability or

equity. If necessary, please revise chapter 21 section 7 (compound financial instruments) and
chapter 23 section 2 (preference shares).
Preference share dividends may be
Of particular importance to the earnings per x mandatory or discretionary
share calculation is whether the dividend x cumulative or non-cumulative
stream was classified as a liability or equity. x participating or non-participating
x If the preference dividend is mandatory it means that the entity cannot avoid paying it
with the result that this aspect of the share represents a liability to the entity. In other
words, on the date the shares are issued, the entity has an obligation to pay all future
dividends. Thus, the entity recognises the present value of the future dividend stream as a
liability on the day the shares are issued. These dividends will then be recognised as an
interest expense as the present value of the dividends unwinds.
x If the preference dividend is discretionary it means the entity can choose whether or not
to pay it. Since there is no obligation to pay a discretionary dividend, this is recognised as
a distribution of equity in the same way as ordinary dividends. In other words, it will only
be recognised as a distribution of equity once the dividend has been appropriately
authorised and is no longer at the discretion of the entity. Therefore, it is only recognised
once the entity has created for itself an obligation to pay the dividend (in most
jurisdictions, this is the date that the dividends are publicly declared). See IAS 10.13 & IFRIC 17.10
When calculating earnings per share, it is Cumulative vs Non-cumulative
also important to identify whether a dividend x Cumulative: must pay out arrear pref divs
is cumulative or non-cumulative: before paying ordinary divs
x Non-cumulative: arrear pref divs need never
x If the preference dividend is cumulative, be paid
it means that, if they are not declared in
a particular year, (perhaps due to insufficient funds), they will have to be declared before
declaring any ordinary dividend.
x Non-cumulative preference dividends mean that, if the dividend is not declared in a year,
this dividend need never be declared (the shareholder's right to this dividend falls away).
Participating vs Non-participating
There is a further variation relating to
x Participating: the shareholder gets a fixed
preference shares: the shares may be termed dividend & a share in the profits
participating or non-participating: x Non-participating: the shareholder gets a
x Most preference shareholders are non- fixed dividend only
participating, meaning they do not
participate in the profits except to the extent of the fixed coupon dividend.
x However, preference shareholders may have a right to participate (share) in a certain
percentage of the profits in addition to their fixed preference dividend and will thus be
termed ‘participating preference shareholders’. See section 3.2.4 and example 4.
1130 Chapter 24
3. Basic Earnings Per Share (IAS 33.9 - .29)
3.1 Overview
IAS 33 states that 'the objective of basic earnings per share information is to provide a
measure of the interests of each ordinary share of a parent entity in the performance of the
entity over the reporting period’.IAS 33.11 In other words, we disclose the basic earnings per
share to show users how much of the earnings for the period ('performance') belongs to each
share We can disclose earnings per share for every entity, but if the entity is part of a group of
entities, it need only be provided for the parent entity (i.e. the entity with ultimate control).
Basic earnings per share is calculated by dividing earnings

Earnings
attributable to the ordinary shareholders by the weighted BEPS:
average number of ordinary shares in issue during the year. Number of shares
In the event that the entity reports a loss instead of a profit, the earnings per share will be
reported as a loss per share instead. See IAS 33.69
3.2 Basic earnings (the numerator) (IAS 33.12 - .18)

3.2.1 The basic calculation
In order to calculate the earnings attributable to the ordinary shareholders, one should start
with the ‘profit for the period’ per the statement of comprehensive income and deduct the
profits attributable to the preference shareholders that are classified as equity.
Basic Earnings C
Profit (or loss) for the period (after tax) xxx
Less fixed preference dividend (coupon rate) (equity distributions only) NOTE 1 (xxx)
Less variable div: share of profits belonging to participating preference shareholders (xxx)
= Earnings attributable to ordinary shareholders xxx
Note 1: Preference dividends are, in fact, not always deducted. As explained already, some
dividends represent liabilities and are thus recognised as interest expense whereas other
dividends represent equity and are thus recognised as distributions of equity (true dividends).
We only deduct preference dividends if they are recognised as distributions of equity. If these
true preference dividends are not declared, they would obviously not be recognised. However,
if they are cumulative it means that ordinary shareholders will not be able to receive a
dividend until these arrear dividends are paid. Thus, when calculating the basic earnings
belonging to ordinary shareholders, we must remember to deduct any undeclared preference
dividends that are cumulative. In summary, when dealing with preference dividends that are
recognised as distributions of equity:
x if the dividends are non-cumulative, deduct only the preference dividends that
are declared in respect of that period; and
x if the dividends are cumulative, deduct the total required preference dividends for the
period (in accordance with the preference share’s coupon rate), regardless of whether or
not these dividends have been declared. See IAS 33.14
When preference dividends represent liabilities, they are recognised as interest expense. In
this case, they will have already been deducted in the calculation of ‘profit or loss for the
period’ and thus they must obviously not be deducted again when calculating ‘earnings
attributable to the ordinary shareholders’.
Deducting preference dividends in the BE calculation:

The preference dividends deducted in the BE calculation should:
x only be those preference dividends that are recognised as distributions of equity
x be the dividend actually declared if the preference share is non-cumulative
x be the required dividend (i.e. even if it was not declared) if the preference share is cumulative. See ex 3.
Chapter 24 1131
3.2.2 Where there are only ordinary shares

If there are only ordinary shareholders, it stands to reason that the entire profit or loss of the
company belongs to the ordinary shareholders (owners).
Example 1: Ordinary shares only

A company has 10 000 ordinary shares in issue throughout 20X1.
The company earns a profit after tax of C100 000.
Required: Calculate the basic earnings per ordinary share.
Solution 1: Ordinary shares only

Basic earnings per share = C10 per ordinary share (W1&W2)
W1: Earnings belonging to ordinary shareholders: C

Profit (or loss) for the year (per the statement of comprehensive income) 100 000
Less fixed preference dividends (0)
Less share of profits belonging to participating preference shareholders (0)
Earnings belonging to ordinary shareholders 100 000
W2: Earnings per ordinary share:

Earnings belonging to ordinary shareholders C100 000
= = = C10 per ordinary share
Number of ordinary shares 10 000
3.2.3 Where there are ordinary and preference shares

If there are both ordinary and preference shareholders, and if these preference dividends are
classified as equity, we will need to set aside the portion of the profit for the year that belongs
to these preference shareholders (i.e. the portion needed to cover the preference dividend). If
the dividend has not been declared, it will not have been recognised. However, if this
dividend is cumulative, we will still make an adjustment for that year's dividend.
As mentioned already, some preference dividends represent liabilities rather than equity and
thus these dividends end up being recognised as interest expense rather than as dividends. In
these instances, even if the dividend has not yet been declared as at the end of the reporting
period, the dividend will be recognised as an interest expense. Therefore, since these
preference dividends are always effectively taken into account when calculating the profit for
the year, no adjustment is made when calculating the basic earnings.
Example 2: Ordinary and non-participating preference shares

A company has the following shares in issue throughout 20X1: 10 000 ordinary shares and
10 000 non-redeemable 10% preference shares. Preference dividends are discretionary and
non-cumulative and based on a deemed value of C2 per share. The company earns a profit after tax of
C100 000. The company declared the full 20X1 dividends owing to the preference shareholders.
Required: Calculate the basic earnings per ordinary share.
Solution 2: Ordinary and non-participating preference shares

Basic earnings per share = C9,80 per ordinary share (W1&W2)
Profit (or loss) for the year 100 000
Less fixed preference dividends declared (10 000 x C2 x 10%) (2 000)
Less share of profits belonging to participating preference shareholders (0)
Earnings belonging to ordinary shareholders 98 000
W2: Earnings per ordinary share:
= = = C9,80 per ordinary share
1132 Chapter 24
Example 3: Preference shares and preference dividends: equity versus liability

A company has 10 000 ordinary shares and 10 000 10% preference shares in issue
throughout 20X2 with a deemed value of C2 each. The 20X2 profit after tax was C100 000.
Required: Calculate the basic earnings in 20X2, assuming that the preference shares are:
A Non-redeemable and the dividends are discretionary & non-cumulative: the dividend is declared.
B Non-redeemable and the dividends are discretionary & non-cumulative: the dividend is not declared.
C Non-redeemable and the dividends are discretionary & cumulative: the dividend is not declared.
D Redeemable and the dividends are mandatory & cumulative: the dividend is declared.
E Redeemable and the dividends are mandatory & cumulative: the dividend is not declared.
Solution 3: Preference shares (equity) and declared dividends

W1: Earnings belonging to ordinary Ex3A Ex3B Ex3C Ex3D Ex3E
shareholders C C C C C
Profit (or loss) for the year 100 000 100 000 100 000 100 000 100 000
Less preference dividends (see comments) (2 000) (0) (2 000) (0) (0)
Earnings belonging to ordinary 98 000 100 000 98 000 100 000 100 000
shareholders
Comment:
3A: The dividend is discretionary and is thus recognised as a distribution of equity (in the statement
of changes in equity), but only if it is declared. This dividend was declared and will thus have
been recognised as a distribution of equity. We deduct it from the profit for the period to determine
how much of the profit belongs to the ordinary shareholders: 10 000 x C2 x 10% = C2 000.
3B: The dividend is discretionary and is thus recognised as a distribution of equity (in the statement
of changes in equity), but only if it is declared. This dividend was not declared and thus won't
have been recognised as a distribution of equity. Since the undeclared dividend is non-
cumulative, we do not deduct it from the profit when calculating basic earnings.
3C: The dividend is discretionary and is thus recognised as a distribution of equity (i.e. in the
statement of changes in equity), but only if it is declared. This dividend was not declared and
thus won't have been recognised as a distribution of equity. However, since the undeclared
dividend is cumulative we must deduct it from the profit when calculating basic earnings.
3D: The dividend is mandatory and is thus recognised as an interest expense using the effective
interest rate method. This dividend has thus effectively already been deducted in calculating the
profit of C100 000 and thus no adjustment is necessary.
3E: The dividend is mandatory and is thus recognised as an interest expense using the effective
interest rate method. Thus, even though this dividend is not declared, it will have already been
deducted in calculating the profit of C100 000 and thus no adjustment is necessary.
3.2.4 Where there are ordinary shares and participating preference shares
If participating preference shares are in issue, then the company's equity actually belongs in a
specific ratio between these preference shareholders and the ordinary shareholders. In other
words, there would be effectively two equity share types in issue. This means that, when
calculating basic earnings, we first deduct from the profit the amount needed to pay the
preference shareholders their fixed dividend, and then we share the remaining profit between
the ordinary shareholders and the participating preference shareholders. In other words, when
calculating the basic earnings belonging to the ordinary shares, the portion of the profit that is
deducted because it belongs to participating preference shareholders would now be
constituted by two components:
x a fixed component – the fixed dividend based on the coupon rate; and
x a variable component – a variable dividend based on the specific proportion in which the
preference shareholder is to share in profits with the ordinary shareholder.
Although there are two equity share types in issue, please remember that earnings per share is
only disclosed in respect of the ordinary shares.
Chapter 24 1133
Example 4: Ordinary and participating preference shares

A company has the following shares in issue throughout 20X1:
x 10 000 ordinary shares, and
x 10 000 non-redeemable, 10% discretionary, participating preference shares (at C2 each).
The company earns a profit after tax of C100 000.
The preference shares participate to the extent of ¼ of the dividends declared to ordinary shareholders.
The total ordinary dividend declared for 20X1 was C4 000. The company declared the full 20X1
dividends owing to the preference shareholders.
Required: Calculate the following:
A earnings per ordinary share and indicate if it is disclosable;
B earnings per participating preference share and indicate if it is disclosable;
C the total dividend belonging to the participating preference shareholders; and
D the total variable dividends in 20X1.
Ignore tax.
Solution 4: Ordinary and participating preference shares

A Earnings per ordinary share = C7,84 – this is disclosable (W1&W4)
B Earnings per participating share = C2,16 – this is not disclosable (W1-3&W5)
C Total dividend to participating shareholders = C3 000 (W6)
D Total variable dividends = C5 000 (W7)
Profit (or loss) for the year 100 000

Less preference dividends (fixed) declared (10 000 x C2 x 10%) (2 000)
Earnings to be shared 98 000
Less earnings attributable to participating preference shareholders (see W2) (19 600)
Earnings belonging to ordinary shareholders (referred to as: basic earnings) 78 400
W2: Earnings belonging to participating preference shareholders: C
Earnings attributable to ordinary and participating preference shares 98 000

- portion belonging to ordinary shareholders (4/5 x C98 000: see W3) 78 400
- portion belonging to participating preference shareholders (1/5 x C98 000: see W3) 19 600
W3: The ratio in which to share earnings:
The ratio in which the earnings are to be shared (4/5 and 1/5) between the two equity share types is
Let X = the portion of the earnings belonging to the ordinary shareholders
Then ¼ X = the portion of the earnings belonging to the participating preference shareholders
And therefore:
X + ¼ X = total earnings to be shared
X + ¼ X = 98 000
5
/4 X = 98 000
X = 98 000 x 4/5
X = 78 400 (share belonging to ordinary shareholders)
Therefore:
¼ X = ¼ x 78 400 = 19 600 (share belonging to participating preference shares)
please note that the C19 600 may also be calculated as 98 000 x 1/5 or
98 000 – 78 400 = 19 600
W4: Earnings per ordinary share – this is disclosable:

= = = C7,84 per ordinary share
1134 Chapter 24
Solution 4: continued
W5: Earnings per participating preference share – this is not disclosable:
Earnings belonging to participating preference shareholders
=
Number of participating preference shares
C2 000 + C19 600
= = C2,16 per participating preference share
10 000
Comment:
x Please note that the earnings belonging to the participating preference shareholders are made up of
both the fixed component (dividend based on the coupon rate: 10 000 x C2 x 10%) and the variable
component (share of the ‘after preference dividend profits’: 19 600 (W2)).
x Please also note that this ‘earnings per share’ of C2.16 is not disclosable because these earnings
belong to preference shareholders – the financial statements are produced for general users.
Also note that, as with the total earnings to be shared, the participating preference shareholders
participate in 1/5 of the ‘total variable’ dividends declared:
W6: Total dividends belonging to preference shareholders: C
Fixed dividend (10 000 x C2 x 10%) 2 000
Variable dividend (C4 000 x ¼) 1 000
Total dividend belonging to the participating preference shareholder 3 000
W7: Total variable dividends: C
Variable dividend declared to ordinary shareholders (given) 4 000
Variable dividend to participating preference shareholders: (C4 000 x ¼ or C5 000 x 1/5) 1 000
Total variable dividends declared 5 000
3.3 Basic number of shares (the denominator) (IAS 33.19 - .29 and .64)
3.3.1 Overview
Thus far, we have dealt with the earnings figure in the earnings per share calculation (the
numerator). We will now move on to discussing the denominator of the earnings per share
calculation, being the number of shares. The number of shares used could be the actual
number, an adjusted number or a weighted average number of shares (as discussed below).
In the event that there was no movement of shares during the year, (i.e. the balance of shares
at the beginning of the year equals the balance of shares at year-end, say 10 000), then the
denominator in the earnings per share calculation is 10 000 shares.
If, however, there was movement in the number of shares during the year, then the number of
shares to be used in the calculation will need to be adjusted or weighted. The movement could
entail an increase (issue of shares) or a decrease in the number of shares.
There are five distinct types of issues that may have taken place during the year:
x issue for value (e.g. shares issued at their market price);
x issue for no value (e.g. shares given away);
x combination issue (e.g. shares issued at less than their market value);
x contingently issuable shares (e.g. shares issued on satisfaction of an event); and
x deferred shares (e.g. shares issued after a period of time elapses and where time is the
only condition that must be satisfied).
Decreases in the number of shares could come in the form of:
x share buy-backs: a for-value reduction; and
x reverse share split (i.e. share consolidations): a not-for-value reduction.
Each of these types of movements will now be dealt with separately.
See the diagram that follows for a summary of what we have covered thus far (earnings) and
the main considerations that will be covered in this section (number of shares).
Chapter 24 1135
Basic earnings per share: calculation
Basic earnings No. of shares
Ordinary shares
Issues Issues
Ordinary shares only and participating
for value for no value
preference shares
Profit for the period Profit for the period Weight the current Adjust the number
Less Less year’s number of of shares so that
Fixed coupon pref div* Fixed coupon pref div* shares based on the the ratio of ‘CY
Variable pref div* time elapsed since shares: PY shares’
*: If the div is recognised as an equity distribution the share issue remains unchanged
Combination issues
3.3.2 Issue for value (IAS 33.19 - .23)
When shares are issued for value, we calculate the number of shares to include in the
denominator by weighting the number of shares from the date consideration is receivable. The
date on which consideration is receivable is generally the date of issue of the shares (although
some exceptions do apply). See IAS 33.21
3.3.2.1 Issues at the beginning of the current year
When shares are issued for value, it means that there is no free (bonus) element in the share
issue: the shares are sold at their full market value. Since such an issue raises extra capital for
the entity, there is every chance that the increased capital has caused an increase in profits.
Since the increase in the denominator (shares) is expected to lead to a similar increase in the
numerator (earnings), the number of shares needs no adjustment.
Example 5: Issue for value at the beginning of the year
A company has 10 000 ordinary shares in issue during the previous year.
There was a share issue of 10 000 ordinary shares at market price on the first day of the
current year. The earnings in the previous year were C20 000, and thus the earnings per share in the
previous year was C2 per share (C20 000/ 10 000 shares).
Required: Assuming absolutely no change in circumstances have occurred since the previous year,
explain what the user would expect the profits and earnings per share to be in the current year.
Solution 5: Issue for value at the beginning of the year

Since the capital base doubled, the user would expect the profits to double too. If the profits in the
current year did, in fact, double to C40 000, this would then mean that the earnings per share would
remain comparable at C2 per ordinary share (C40 000/ 20 000 shares).
Number of shares Actual Current year Prior year
(weighted)
(1)
Opening balance 10 000 10 000 10 000
(2)
Issue for value 10 000 10 000 0
Closing balance 20 000 20 000 10 000
(1)
Opening balance: 10 000 shares for 12 months (10 000 x 12/12) 10 000
(2)
New shares issued: 10 000 shares for 12 months (10 000 x 12/12) 10 000
Earnings per share: Current year Prior year
Earnings C40 000 C20 000

=
Number of shares 20 000 shares 10 000 shares
= C2 per share C2 per share
The earnings per share for the current year would then remain comparable at C2 per ordinary share.
1136 Chapter 24
3.3.2.2 Issues at the end of the year or during the year

When a company issues shares on a day other than at the beginning of the year, it must be
remembered that the earnings potential of the entity will only increase in the period after the
proceeds from the share issue have been received (the period in which the shares are in issue).
In order to ensure that the earnings per share in the current year is comparable to that of the
previous year, the number of shares is weighted based on time.
This weighting should ideally be performed based on the ‘number of days since the share
issue’ as a proportion of the ‘total number of days in the period’ (i.e. usually 365) although
months may also be used if considered a reasonable estimation. See IAS 33.20
Example 6: Issue for value at the end of the year
A company had 10 000 ordinary shares in issue during the previous year. There was a share
issue of 10 000 ordinary shares at market price on the last day of the current year.
The earnings in the previous year were C20 000, and thus the earnings per share in the previous year
was C2 per share (C20 000/ 10 000 shares).
Required: Assuming absolutely no change in circumstances since the previous year, explain what the
user would expect the profits and the earnings per share to be in the current year.
Solution 6: Issue for value at the end of the year

Although the capital base doubled in the current year, the user would not expect the current year’s
profits to double since the extra capital was only received on the last day of the current year with the
result that this would not yet have had an effect on the entity’s earning potential (profits).
Thus, assume the profits in the current year remained constant at C20 000 (i.e. equal to the prior year):
x unless the number of shares (in the earnings per share calculation) is adjusted,
x the current year’s earnings per share would incorrectly indicate that the efficiency of earnings halved
to C1 per share during the year (C20 000/ 20 000 shares),
x when the reality is the company earned C2 for every one of the 10 000 shares in issue during the year.
Therefore, in order to ensure the comparability of the earnings per share calculation, the number of
shares in the current year should be weighted as follows:
Current year
Number of shares Actual Prior year
(weighted)
(1)
Opening balance 10 000 10 000 10 000
(2)
Issue for value 10 000 0 0
Closing balance 20 000 10 000 10 000
(1)
(2)
New shares issued: 10 000 shares for 0 months (10 000 x 0/12) 0
=
Number of shares 10 000 10 000
Example 7: Issue for value during the year

A company had 10 000 ordinary shares in issue during the previous year. There was a share
issue of 10 000 ordinary shares (at market price) 60 days before the end of the current year.
In the previous year:
x earnings were C20 000, and
x earnings per share was C2 per share (C20 000/ 10 000 shares).
Chapter 24 1137
Solution 7: Issue for value during the year

Although the capital base doubled, the user could not expect the annual profits to double since the extra
capital was only received 60 days before the end of the year with the result that this extra injection of
capital could only have had an effect on the profits earned during the last 60 days of the period.
x The shareholder could only reasonably expect the earnings in the last 60 days to double.
x He would thus hope that the earnings for the current year totals C23 288 (C20 000 + C20 000 x
60/365).
Assume that the profits in the current year did total the C23 288 that the shareholders hoped for:
x Unless an adjustment is made to the earnings per share calculation, the current year’s earnings per
share would indicate that the efficiency of earnings decreased during the year (C23 288/ 20 000
shares) to 116,44c per share,
x despite the reality that the company earned C2 for every one share in issue during the period, as
was achieved in the previous year.

(weighted)
(1)
Opening balance 10 000 10 000 10 000
(2)
Closing balance 20 000 11 644 10 000
(1)
Opening balance: 10 000 shares for 365 days (10 000 x 365/365) 10 000
(2)
New shares issued: 10 000 shares for 60 days (10 000 x 60/365) 1 644

=
3.3.3 Issue for no value (IAS 33.26 - .28 and .64)

Issues for no value involve an entity effectively giving away shares. Examples of this include
capitalisation issues (bonus issues or stock dividends) and share splits. Capitalisation issues
frequently occur when a company has a shortage of cash with the result that shares are issued
instead of paying cash dividends to the shareholders.
Since there has been no increase in capital resources (there is no cash injection), a
corresponding increase in profits cannot be expected. If the earnings in the current year are
the same as the earnings in the prior year and there is an increase in the number of shares in
the current year, the earnings per share in the current year will, when compared with the
earnings per share in the prior year, indicate deterioration in the efficiency of earnings relative
to the available capital resources. Comparability would thus be jeopardised unless an
adjustment is made.
The adjustment made for an ‘issue for no value’ is made to the prior year and current year,
(note: an ‘issue for value’ is adjusted for in the current year only). This adjustment has the
effect that it appears that the shares issued in the current year had already been in issue in the
prior year. This adjustment is thus a retrospective adjustment.
Example 8: Issue for no value

A company had 10 000 ordinary shares in issue during the previous year.
There was a capitalisation issue of 10 000 ordinary shares during the current year.
The earnings in the previous year were C20 000, and thus the earnings per share in the previous year
was C2/ share (C20 000/ 10 000 shares).
1138 Chapter 24
Solution 8: Issue for no value

The number of shares doubled in the current year due to the capitalisation issue but there has been no
increase in resources and so the shareholders could not reasonably expect an increase in profits.
By way of explanation:
x Assume that the profits in the current year did, in fact, remain constant at C20 000.
x Without an adjustment to the earnings per share calculation, the earnings per share in the current
year would appear to halve to C1/ share (C20 000/ 20 000 shares), indicating to the user that the
entity was in financial difficulty.
x The reality, of course, is that the profitability has neither improved nor deteriorated since the
previous year and thus the earnings per share should reflect this stability.
The need for comparability between the earnings per share for the current year and the prior year
requires that the number of shares be adjusted. This is done by making an adjustment to the prior year’s
number of shares in such a way that it seems as if the share issue took place in the prior year.
x This means that the prior year’s earnings per share has to be restated; and
x the fact that the prior year’s earnings per share figure has been changed (restated) must be made
quite clear in the notes.
The earnings per share in the current year will be disclosed at C1 (C20 000/ 20 000 shares) and the
earnings per share in all prior periods presented will be restated: the prior period will be disclosed at
C1 (C20 000/ 20 000 shares).
Comment:
x Please notice that the adjustment is not time-weighted.
x Therefore ‘issues for no value’ made during the year, (as opposed to at the beginning or end of the
year), are all dealt with in the same way (by adjusting the prior year number of shares).
Example 9: Issue for no value after an issue for value

A company had 10 000 ordinary shares in issue during 20X1. On 1 April 20X2, 12 000
shares were issued at market value of C5 per share. On 1 June 20X2, there was a share split
where every 2 shares became 5 shares. The basic earnings were C150 000 (20X1) & C261 250 (20X2).
Required: Calculate the basic earnings per share for the years ended 31 December 20X1 and 20X2.
Solution 9: Issue for no value after an issue for value

Basic earnings per share (W1&W2): 20X1: C6 per share 20X2: C5,50 per share
W1: Number of shares Current year Prior year
Actual
(weighted) (adjusted)
(4)
Opening balance 10 000 10 000 10 000
(1)
(5) (5)
22 000 19 000 10 000
(3) (6) (7)
Issue for no value 33 000 28 500 15 000
(2) (8) (8)
Closing balance 55 000 47 500 25 000
P.S. Always start with the ‘actual’ column. The calculations thereafter are then:
(1)
New shares issued: 12 000 shares for 9 months (12 000 x 9/12) 9 000
(2)
Total shares after share split: 22 000 / 2 shares x 5 shares 55 000
(3)
Shares issued in terms of share split: 55 000 – 22 000 33 000
(4)
(5)
The ratio between the current and prior year is currently 19 000: 10 000 1,9: 1
(6)
Current year share split adjustment: 19 000 / 22 000 x 33 000 28 500
(7)
Prior year share split adjustment: 10 000 / 22 000 x 33 000 15 000
(8)
Check ratio the same: 47 500: 25 000 1,9: 1
W2: Earnings per share: 20X2 20X1
Earnings C261 250 C150 000
=
= C5,50 per share C6 per share
Comment: Where there is more than one movement during the year, it must be handled in chronological order
(i.e. in date order).
Chapter 24 1139
3.3.4 Combination issues

A combination issue is:
A combination issue occurs when shares are
offered at less than market value: we treat part of x an issue of shares at less than market
the issue as an issue for value and part as an issue value, in effect combining an:
not for value. An example of a combination issue is x issue for value (i.e. some shares are
a rights issue. A rights issue is an issue where assumed to have been sold at full market
value), and
shares are offered to existing shareholders at a
x issue for no value (i.e. some of the shares
specified price that is less than the market price. are assumed to have been given away).
There are two methods of calculating the number of shares: one involves the use of a table
(where the principles are those used in the previous examples) and the other involves the use
of formulae. Both give you the same final answer.
Take Note: Although share issues are always dealt with chronologically, when a combination issue
(or 2 issues on the same date) takes place, the share issue ‘for value’ is dealt with first.
Example 10: Rights issue

A company had 10 000 shares in issue at the beginning of the current year (20X2).
3 months before year-end, the company had a rights issue of 1 share for every 5 shares held.
The exercise (issue) price was C4 when the fair value immediately before the rights issue was C5 (i.e.
market value cum rights). All the shares offered in terms of this rights issue were taken up.
Required: Calculate the number of shares to be used as the denominator when calculating earnings per
share in the financial statements for the year ended 31 December 20X2.
Solution 10: Rights issue - using the ‘table approach’

The number of shares to be used in the calculation of EPS for 20X2 is 10 759 and for 20X1 is 10 345.
Workings:
x The number of shares issued in terms of the rights issue: 10 000/5 x 1 share = 2 000 shares
x The cash received from the rights issue: 2 000 shares x C4 = C8 000
x The number of shares that are issued may be split into those shares that are effectively sold and
those that are effectively given away: Number
Shares sold (issue for value): proceeds/ market price cum rights = C8 000/ C5 1 600
Shares given away (issue for no value): total shares issued – shares sold = 400
2 000 shares – 1 600 shares or (2 000 x C5 – C8 000)/ C5
2 000
x The weighted and adjusted average number of shares may then be calculated:
(weighted & adjusted) (weighted) (adjusted)
Balance: 1/1/20X2 10 000 10 000 10 000
Issue for value Note 1 (1 600 x 3/12) 1 600 400 0
11 600 10 400 10 000
Issue for no value Note 2 400 359 345
(CY: 400/ 11 600 x 10 400);
(PY: 400/ 11 600 x 10 000)
Balance: 31/12/20X2 12 000 10 759 10 345
Note 1: Please remember that issues for value during the year require weighting of the number of
shares to take into account how long the extra capital was available to the entity.
Note 2: Please note that an issue for no value will not cause an increase in the profits and therefore,
in order to ensure comparability, the prior year shares are adjusted as if the issue for no value had
occurred in the prior year. Please also note that the adjustment made should not change the ratio
between the number of shares in the current year and the prior year.
Note 3: The adjustment made should not change the ratio between the number of shares in the
current and prior year: to be sure you have not changed this ratio, check the ratios as follows:
Ratio between the number of shares in the current year and prior year:
Before issue for no value: 10 400/ 10 000 1,04
The issue for no value: 359/ 345 1,04
After the issue for no value: 10 759/ 10 345 1,04
It can therefore be seen that at no stage was this ratio altered .
1140 Chapter 24
Solution 10: Rights issue - using the ‘formula approach’ (IAS 33 Appendix A.2)
Theoretical ex-rights value per share:

(Fair value of all issued shares before the rights issue) + (the resources received from the rights issue)
Number of shares in issue after the rights issue
10 000 shares x C5 + 2 000 shares x C4 C58 000

= = = C4,833 per share
10 000 + 2 000 12 000
Adjustment factor:
Fair value per share prior to the exercise of the right C5
= = 1,0345
Theoretical ex-right value per share C4,833
Number of shares (rounded up):

= Current year (10 000 shares x 1,0345 x 9/12 + 12 000 x 3/12) 10 759
= Prior year (10 000 shares x 1,0345) 10 345
Comment: Notice that the current year calculation of the number of shares is weighted for the number of months
before the issue and after the issue, whereas the prior year is not weighted at all.
Example 11: Various issues over three years

Numbers Ltd has a profit of C100 000 for each of the years 20X3, 20X4 and 20X5.
There are no preference shares.
On 1 January 20X3, there were 1 000 ordinary shares in issue, all of which had been issued at C2 each,
after which, the following issues took place:
x 30 June 20X4: 1 000 ordinary shares were sold for C3,50 (their market price);
x 30 September 20X4: there was a capitalisation issue of 1 share for every 2 shares in issue on this
date, utilising the retained earnings account;
x 30 June 20X5: 2 000 ordinary shares were sold for C4,00 (their market price); and
x 31 August 20X5: there was a share split whereby every share in issue became 3 shares.
Required:
A Journalise the issues for the years ended 31 December 20X4 and 20X5.
B Calculate the basic earnings per share to be disclosed in the financial statements of Numbers for the
year ended 31 December 20X5.
C Calculate the basic earnings per share as disclosed in the financial statements of Numbers Limited
for the year ended 31 December 20X4.

Bank (A) 3 500
Issue of 1 000 ordinary shares at C3,50 (market price)
30/9/20X4
Retained earnings (Eq) (2 000/ 2 x 1) x Value per share [(SC:(C2 000 2 750
Stated capital (Eq) + C3 500)/ (number of shares in issue: 2 000)] 2 750
Capitalisation issue: 1 for 2 shares in issue: Transfer from RE
30/6/20X5
Bank (A) 2 000 x 4 8 000
Issue of 2 000 ordinary shares at C4 (market price)
31/8/20X5
There is no journal for a share split (the authorised and issued number of shares are simply increased
accordingly)
Chapter 24 1141
Solution 11B: Calculations – 20X5 financial statements
W1: Numerator: earnings 20X5 20X4 20X3

C C C
Profit for the year 100 000 100 000 100 000
Preference dividends (not applicable: no preference shares) 0 0 0
Basic earnings per share 100 000 100 000 100 000
W2: Denominator: number of shares Actual 20X5 20X4 20X3

Balance: 1/1/20X3 1 000 N/A 1 000 1 000
Movement: none 0 0 0 0
Balance: 1/1/20X4 1 000 N/A 1 000 1 000
Issue for value: 30/6/20X4 1 000 N/A 500 0
(20X4: 1 000 x 6/12);
(20X3: 1 000 x 0/12)
Issue for no value: 30/9/20X4 2 000 N/A 1 500 1 000
(2 000 / 2 x 1); 1 000 N/A 750 500
(20X4: 1 000 x 1 500/ 2 000);
(20X3: 1 000 x 1 000/ 2 000)
Balance: 31/12/20X4 3 000 3 000 2 250 1 500
Issue for value: 30/6/20X5 2 000 1 000 0 0
(20X5: 2 000 x 6/12);
(20X4 & 20X3: 2 000 x 0/12)
Issue for no value: 31/8/20X5 5 000 4 000 2 250 1 500
(5 000 x 3 – 5 000); 10 000 8 000 4 500 3 000
(20X5: 10 000 x 4 000/ 5 000);
(20X4: 10 000 x 2 250/ 5 000);
(20X3: 10 000 x 1 500/ 5 000)
Balance: 31/12/20X5 15 000 12 000 6 750 4 500
W3: Earnings per share for the 20X5 financial statements

20X5 20X4 20X3
C C C
Restated Restated
Basic earnings C100 000 C100 000 C100 000
Weighted average number of shares 12 000 6 750 4 500
= Basic earnings per share in 20X5 financials C8.33 C14.81 C22.22
Solution 11C: Calculations – 20X4 financial statements
W1: Earnings per share for the 20X4 financial statements 20X4 20X3
C C
Restated
Basic earnings C100 000 C100 000
Weighted average number of shares 2 250 1 500
= Basic earnings per share in the 20X4 financial statements = C44.44 C66.67
Comment:
x Look at 11C: When preparing the 20X4 financial statements, the denominators used (for the 20X4
and 20X3 years) are the number of shares calculated as at 31 December 20X4 (in W2). This is
because the share movements in 20X5 had not yet occurred.
x Look at 11B: When preparing the 20X5 financial statements, the denominators used (for the 20X4
and 20X3 years) are not the same as those used for 20X4 and 20X3 to be presented in the 20X4
financial statements (in 11C) since these must now be adjusted for any issues for no value
occurring during 20X5.
1142 Chapter 24
3.3.5 Contingently issuable shares (IAS 33.24)

These shares are included in the calculation of basic Contingently issuable
earnings per share when all the necessary conditions are shares are defined as
satisfied. See IAS 33.57 (b) and IAS 33.19 & .24
x shares that are issuable
x for little or no consideration, &
The type of conditions that may be included in a contingent
x only upon the satisfaction of
share agreement include, for example: specified conditions. IAS 33.5 Reworded
x the maintenance of a specified level of earnings;
x opening of specific number of retail stores; or
x the future market price of an ordinary share.
The denominators in the comparative years are not restated for contingent shares.
Please note that shares that will be issued upon the expiry
Deferred shares are:
of a period of time (deferred shares) are not considered to
be contingently issuable shares since the passage of time is x shares that will be issued
considered to be a certainty and not a condition that may or x after a certain period of time.
may not be met. Deferred shares are considered issued from the date on which the decision is
taken to issue these shares – even though they are not yet in issue. An example of a deferred
share is a compulsorily convertible debenture/ preference share.
Example 12: Contingently issuable shares
Jamnas Ltd had 10 000 ordinary shares in issue during 20X2.
At the beginning of 20X3 it issued 1 000 shares to each of its 3 directors, conditional upon
the company earnings being maintained at a minimum of C100 000 in each of 20X3 and 20X4.
If the conditions are met, the shares will be issued on 31 March 20X5.
Consider the two following scenarios: Scenario A Scenario B
Earnings Earnings
20X3 C100 000 C50 000
20X4 C110 000 C200 000
Required:
For each of the scenarios A and B, calculate the number of shares to be used when calculating BEPS
for disclosure in the year ended 31 December 20X5, and where two comparative years are to be
provided (i.e. 20X4 and 20X3).
Solution 12A: Contingently issuable shares
The condition upon which the issue is contingent was met in full (other than for a time delay) from
31 December 20X4 as the earnings in both 20X3 and 20X4 exceed the C100 000 minimum.
The denominator for the purposes basic earnings per share between 20X3 & 20X5 is therefore:
Denominator: number of shares Actual 20X5 20X4 20X3
Balance: 1 January 20X3 10 000 N/A N/A 10 000

20X3: contingent shares issued: 3 000 (1 000 x 3 directors) 3 000 N/A 0
N/A
contingent share issue: ignored note 1
Denominator: 31 December 20X3 13 000 N/A N/A 10 000
Balance: 1 January 20X4 10 000 N/A 10 000 10 000

20X4: contingent share issue (now deferred shares): note 2 3 000 N/A 3 000 0
conditions are satisfied (despite time delay)
Denominators: 31 December 20X4 13 000 N/A 13 000 10 000
Balance: 1 January 20X5 13 000 13 000 13 000 10 000

20X5: contingent/ deferred shares: reversed: (3 000) (3 000)
shares actually issued: 3 000 x 12/12 note 3 3 000 3 000 0 0
Denominators: 31 December 20X5 note 4 13 000 13 000 13 000 10 000
Chapter 24 1143

Notes:
1) At 31 December 20X3: Contingent shares ignored since conditions are not met.
2) At 31 December 20X4: Contingent shares are assumed to be actually issued since all conditions
(apart from time – the shares are only to be issued on a date in 20X5) are met, but the effect of
these shares is weighted based on the time from the date on which the conditions are met: since the
conditions are met on the last day of the year with the only remaining condition being a delay in
time, the contingent shares are no longer contingent but rather deferred shares (only condition
remaining is time). Deferred shares are taken into consideration in the basic earnings per share
calculation from the date that a decision was made to issue the shares. This ‘decision’ is
effectively made on 31 December 20X4 when the conditions (excluding time) were met. So,
although the shares are technically issued on 31 March 20X5, they are taken into consideration in
the basic earnings per share calculation at 31 December 20X4. See IAS 33.24
3) At 31 December 20X5: From 31 December 20X4, all conditions were met with the exception of
time. The shares that were deferred shares in the first three months of the year are then issued on
31 December 20X5. The table above shows the deferred shares being reversed and replaced with
an actual issue. This detail in the table is not necessary since it does not change the answer in any
way but is shown for completeness.
4) The denominator in the basic earnings per share calculation for 20X5 is adjusted for the contingent
share issue (i.e. they are treated as already in issue from the date that the conditions are met) but
the denominator for the basic earnings per share for 20X3 remains 10 000 (i.e. it is not restated).
Solution 12B: Contingently issuable shares

Although the earnings in 20X4 (C200 000) exceed the C100 000 sub-minimum, the earnings in 20X3
(C50 000) failed to meet the sub-minimum and so the conditions fail to be met and the contingently
issuable shares will never be issued.
The number of shares to be used when calculating basic earnings per share in the financial statements
for the year ended 31 December 20X5 and for its 20X4 and 20X3 comparatives is 10 000 shares.
Example 13: Deferred shares

Balloon had 10 000 ordinary shares in issue at 31 December 20X2. On 1 January 20X3,
Balloon decides that it will issue 1 000 shares to each of its 3 directors at the end of 20X4.
Required: Calculate the number of shares to be used when calculating BEPS for disclosure in the year
ended 31 December 20X5, where 2 comparative years are to be provided (i.e. 20X4 & 20X3).
Solution 13: Deferred shares

This is not a contingent share issue but rather a deferred share issue as the passage of time (which is a
certainty) is the only condition that needs to be met. These 3 000 deferred shares will be included in
the calculation of the ‘weighted average number of shares in issue’ from the date that the decision has
been taken to issue these shares i.e. 1 January 20X3.
W1: Denominator: number of shares Actual 20X5 20X4 20X3
10 000 N/A N/A 10 000
Balance: 1 January 20X3
20X3: Deferred shares ‘issued’ (see note 1) 3 000 N/A N/A 3 000
(1 000 x 3 directors): 3 000 x 12/12
Denominator: 31 December 20X3 13 000 N/A 13 000 13 000
0 N/A 0 0
20X4: Further issues
x Deferred shares reversed (3 000)
x Shares actually issued 3 000
Denominator: 31 December 20X4 13 000 13 000 13 000 13 000
0 N/A 0 0
20X5: Further issues
Denominator: 31 December 20X5 13 000 13 000 13 000 13 000
Note 1: For the purposes of the BEPS calculation, deferred shares are assumed to be in issue from the
date the decision was taken to issue the deferred shares and is thus weighted for 12/12 months.
1144 Chapter 24
3.3.6 Contingently returnable shares
Contingently returnable shares which are in issue are not treated as outstanding in the
calculation of the weighted average number of shares. These shares will only be included in
the weighted average number of shares from the date on which they are no longer
contingently returnable to the entity. See IAS 33.24
3.3.7 Share buy-back

A buy-back involves a reduction of the capital
A share buy-back is:
base (i.e. fewer issued shares will exist after
the buy-back) and a reduction in the money/ x a decrease in the entity’s capital base,
resources of the entity (this is because the x caused by
entity will be required to pay the shareholders - the entity repurchasing shares
for the shares). - from its own shareholders.
Since the entity pays the shareholders for their shares, the share buy-back is a for-value
reduction. The treatment of a for-value reduction is very similar to that of a for-value issue
with the exception that the number of shares involved is subtracted rather than added.
Example 14: Share buy-back
Bell Ltd had 10 000 ordinary shares in issue during 20X2 and had a share buy-back in 20X3:
x of 5 000 ordinary shares (at market price)
x 60 days before the end of the current year (year-end: 31 December 20X3).
The basic earnings in 20X2 were C20 000 and were C17 000 in 20X3.
Required: Calculate the earnings per share in 20X3 and 20X2.
Solution 14: Share buy-back

Basic earnings per share (W1&W2): 20X3: C1,85 per share 20X2: C2,00 per share
W1: Denominator: number of shares Actual 20X3 20X2
Opening balance: 1/1/20X2 10 000 10 000 10 000
Reduction for value: 1/11/20X3 (5 000) (822) 0
(20X3: 5 000 x 60/ 365);
(20X2: 5 000 x 0/12)
Denominator for 20X3 financials 5 000 9 178 10 000
W2: Earnings per share for inclusion in 20X3 financial statements
Basic earnings per share: 20X3 20X2
C1.85 C2.00
3.3.8 Reverse share split (share consolidation) (IAS 33.29)
An entity might perform a share split if they

believe that their share price is too low (by A reverse share split:
reducing the number of shares, the demand for
the share should push the market price up). x is the combining of 2 or more shares into 1 share.
x causes a reduction in shares.
As it can be seen, this transaction requires x does not bring in cash and is thus treated as a
none of the entity’s resources and thus it is not-for-value reduction.
treated as a not-for-value reduction.
The treatment of a not-for-value reduction is very similar to that of a not-for-value issue with
the exception that the number of shares involved is subtracted rather than added.
There is no journal entry to record a share consolidation.
Chapter 24 1145
Example 15: Reverse share split (share consolidation)

A company had 10 000 issued ordinary shares during 20X2. It then consolidated its shares in
20X3 such that every 2 shares were consolidated into 1 share, 60 days before the end of the
current year (year-end: 31 December 20X3). Basic earnings were C20 000 (20X2) & C17 000 (20X3).
Required: Calculate the earnings per share in the 20X3 financial statements.
Solution 15: Reverse share split (share consolidation)

Earnings per share (W1&W2): 20X3: C3,40 20X2: C4,00
W1: Denominator: number of shares Actual 20X3 20X2
Opening balance: 1/1/20X2 10 000 10 000 10 000
Reduction for no value: 1/11/20X3 (5 000) (5 000) (5 000)
(20X3: 5 000 x 10 000/ 10 000);
(20X2: 5 000 x 10 000/ 10 000)
Denominators for the 20X3 financials 5 000 5 000 5 000
W2: Earnings per share for inclusion in 20X3 financial statements
Basic earnings per share: 20X3 20X2
C3,40 C4,00*
* The 20X2 financial statements would have reflected earnings per share of C2 (C20 000/ 10 000) for 20X2.
Comment: Since the share consolidation is not for value, the reduction is not weighted but is rather
retrospectively adjusted.
3.3.9 Retrospective adjustments (IAS 33.64)

The adjustment made for an issue or decrease of outstanding shares for no value is made to
the prior year and current year. This adjustment has the effect that it appears that the shares
issued in the current year had already been in issue in the prior year. This adjustment is thus a
retrospective adjustment.
If ordinary shares outstanding increase or decrease for no value (i.e. a capitalisation issue,
rights issue, share split or reverse share split) between the end of the reporting period and the
date when the financial statements are authorised for issue, it will be treated as if the share
movement occurred just before the end of the reporting period. Thus, the number of shares
used in the calculation of the basic earnings per share (and thus also in the calculation of
diluted earnings per share) will be based on the new number of outstanding ordinary shares.
4. Headline Earnings Per Share (Circular 04/2018)
4.1 Overview
Headline earnings per share is not a requirement of IAS 33 but is a requirement for companies
wishing to be/remain listed on the South African Johannesburg Securities Exchange (JSE).
The story behind the development of headline earnings per share, stems largely from:
x the source of the basic earnings per share figure; and
x the price-earnings ratio as a tool for analysing financial statements.
Since basic earnings are derived from the profit for the year, it may include the re-
measurement of assets and liabilities, some of which:
x may relate to capital platform-related items (e.g. capital transactions), and some of which
x may relate to operating activities (e.g. inventories).
The price-earnings ratio is a frequently used tool in the analysis of financial statements. The
need for a headline earnings developed largely from the belief that the share price is:
x more likely to be driven by earnings from operations; and
x less likely to be driven by earnings from re-measurements of certain non-current assets
making up the company’s capital-platform (e.g. property, plant and equipment).
1146 Chapter 24
The headline earnings per share therefore simply separates the basic earnings into:
x The earnings that relates to operating/ trading activities (included in HEPS); and
x The earnings that relates to the capital platform of the business (excluded from HEPS).
In short, South Africa felt it was necessary to develop an alternative earnings figure (headline
earnings) that reflects the entity’s operating performance.
Please remember that the headline earnings per share is not intended to represent maintainable
earnings, nor is it a means to depart from IAS 33 or to correct what may be considered
inappropriate accounting for the business. It is an additional disclosure and not a replacement
for the disclosure of basic earnings per share and diluted earnings per share.
The following are some of the core definitions essential to your understanding of headline
earnings per share. All of these have been extracted from Circular 4/2018 and are found in
paragraph 14 thereof.
Headline earnings is defined as: NOTE 1
x an additional earnings number which is permitted by IAS 33. It is the basic earnings:
x Adjusted for separately identifiable re-measurements, as defined (net of related tax and related
non-controlling interests), but
x Not adjusted for included re-measurements, as defined.
NOTE 1: (Please see Circular 04/2018.14 for exact definition).
A re-measurement is defined as:
x an amount recognised in profit or loss relating to any change (whether realised or unrealised) in the
carrying amount of an asset or liability that arose after the initial recognition of such asset or
liability…)
x A re-measurement can, by definition, never be:
i) the initial recognition of an asset or liability at fair value; or
ii) the expensing of a cost which fails to meet the definition of an asset; or
iii) a gain recognised directly in other comprehensive income, such as a revaluation surplus on PPE.
Included re-measurements are defined as:
x re-measurements identified in circular 04/2018 (in the table in paragraph .21 of Section C) and
x are to be included in headline earnings because:
i) they have been determined as normally relating to the operating/trading activities of the entity;
ii) they relate to the usage (as reflected by depreciation) of a non-current asset, which is an
operating/trading activity of the entity;
iii) they relate to current assets or current liabilities, and thus relate to the operating/trading
activities of the entity (other than current assets or liabilities as part of a disposal group) within
the measurement scope of IFRS 5 − Non-current Assets Held for Sale and Discontinued
Operations);
iv) they are foreign exchange movements on monetary assets and liabilities and thus relate to the
operating/trading activities of the entity, except for those relating to foreign operations that
were previously recognised in other comprehensive income and subsequently reclassified to
profit and loss. This exception also applies to the translation differences of loans or receivables
that form part of such net investment in a foreign operation;
v) they are financial instrument adjustments arising from the application of IAS 39 (whether the
result of revaluation, impairment or amortisation), except for all reclassified gains and losses
other than those detailed in (vi) below. For example, gains or losses on available-for-sale
financial assets which are reclassified to profit or loss on disposal or impairment of the financial
asset are excluded from headline earnings because the reclassified fair value gains and losses do
not only reflect performance in the current period; or
vi) they are reclassified items relating to IAS 39 cash flow hedges because these amounts are
matched with those relating to the hedged item.
vii) they are financial instrument adjustments arising from the application of IFRS 9 (whether as
the result of revaluation, impairment or amortisation), except for all reclassified gains and losses
for a hedge of a net investment in a foreign operation.
Chapter 24 1147
A reclassification (or reclassification adjustments) is defined as:
x when re-measurements are initially recorded in other comprehensive income (in terms of IFRS)
x and are subsequently recycled or reclassified to profit and loss.
x This is referred to as a “reclassified gain or loss item.”
Separately identifiable re-measurements are defined as:
x those where the applicable IFRS explicitly requires separate disclosure of

x the operating/trading and/or the platform re-measurement
x in the separate or individual financial statements of the entity/company/subsidiary/associate/joint
venture or in the consolidated financial statements.
x No adjustments would be permitted based on voluntary disclosure of gains or losses (or components
of these). For example, in the case of biological assets, even if the operating/trading portion and the
platform portion of the fair value gain on an apple orchard were voluntarily disclosed, no adjustments
to headline earnings would be permitted because this disclosure is not required by IFRS.
The platform is defined as: Operating/trading activities are

defined as:
x the capital base of the entity. Capital x those activities that are carried out using the
transactions reflect and affect the resources ‘platform’,
committed in producing operating/trading x including the cost associated with financing
performance and not the performance itself. those activities.
4.2 Measurement of the headline earnings per share

4.2.1 Headline earnings (the numerator)
Headline earnings reflect the entity’s operating performance. We calculate basic headline
earnings by taking the basic earnings figure (as per IAS 33) and adjusting it. See Circular 04/2018.17
This basic earnings figure (calculated in terms of IAS 33) is:
x Adjusted for any re-measurement of an asset or liability that constitutes part of the
platform of the business (e.g. re-measurement of property, plant and equipment): these are
excluded from the earnings figure; and conversely,
x Not adjusted for any re-measurements of assets and liabilities related to the business
operations (e.g. re-measurement of inventories): these are included in headline earnings.
When calculating diluted headline earnings, we start with the basic diluted earnings figure
(per IAS 33), and adjust it for the same headline earnings adjustments as above. Circular 04/2018.23
The following are examples of some items that would be excluded from earnings when
calculating ‘headline earnings’ per share:
x Profits or losses on the sale of non-current assets NOTE 1
x Profits or losses on the full or partial sale of a business (i.e. sale of disposal groups) NOTE 1
x Impairments (and reversals thereof) of non-current assets or businesses NOTE 1
x Foreign exchange loss on the translation of a net investment in a foreign operation NOTE 1
x Gain on an available for sale financial asset that is reclassified on disposal (this type of
financial asset will not exist if the company has adopted IFRS 9). NOTE 2
The following are examples of some items that would not be excluded from earnings (i.e.
would be included in earnings) when calculating ‘headline earnings per share’:
x Depreciation of plant NOTE 3
x Amortisation of intangible assets NOTE 3
x Write-down of inventory (remember that this relates to a current asset) NOTE 4
x Increase in a deferred tax expense due to the effect of an increase in the tax rate on a
deferred tax liability NOTE 5
x Foreign exchange loss due to the effect of the weakening of the local currency on an
amount payable by the entity NOTE 6
x Gain on the initial recognition of a deferred tax asset NOTE 7
1148 Chapter 24
Note 1. excluded: re-measurement of an asset or liability that constitutes the business platform.
Note 2. excluded: re-measurement that falls outside of the definition of included re-measurements (v)
– this is a gain that does not only reflect the performance in the current year.
Note 3. included: relates to usage: see definition of included re-measurements (ii).
Note 4. included: relates to a current asset: see definition of included re-measurements (i) and (iii.)
Note 5. included: relates to operations: see definition of included re-measurements (i).
Note 6. included: relates to foreign exchange movements on a monetary liability: see definition of
included re-measurements (iv).
Note 7. included: this is not a re-measurement: see the definition of headline earnings where it is clear
that it is only re-measurements that are excluded.
Quick summary: Headline earnings per share (Circular 04/2018)
HE = BE that are:
x Adjusted for: ‘separately identifiable re-measurements’ as defined
x Not adjusted for: ‘included re-measurements’ as defined
HEPS: Disclosed in the notes (never on the face!)
Example 16: Conversion: basic earnings to headline earnings

Would we adjust basic earnings for the following? Explain.
1. Depreciation or amortisation
2. Inventory write-down
3. Reversal of an impairment of property, plant and equipment
4. An impairment of goodwill
5. Increase in a doubtful debt allowance
6. Increase in deferred tax expense due to a rate change
7. Increase in deferred tax expense due to initial recognition of a deferred tax liability
8. Gain on financial asset at fair value through profit or loss
9. Gain on cash flow hedge in OCI reclassified to P/L
10. Increase in deferred tax liability due to an increase in revaluation surplus on plant
11. Foreign exchange loss caused by increase in foreign creditor
12. Profit on sale of property, plant and equipment
13. Impairment of property, plant and equipment
14. Revaluation of property, plant and equipment
15. Fair value adjustment of investment property
Solution 16: Conversion: basic earnings to headline earnings
1. Depreciation or amortisation No IR (ii): usage of NCA
2. Inventory write-down No IR (i): operating and IR (iii): current
3. Reversal of an impairment of property, plant and Yes Re-measurement of A
equipment
4. An impairment of goodwill Yes Re-measurement of A
5. Increase in a doubtful debt allowance No IR (i): operating and IR (iii): current
6. Increase in deferred tax expense due to rate No IR (i): operating
change
7. Increase in deferred tax expense due to initial No Not a re-measurement
recognition of a deferred tax liability
8. Gain on financial asset at fair value through P/L No IR (vii): IFRS 9 adj
9. Gain on cash flow hedge in OCI reclassified to P/L No IR (vii): IFRS 9 adj
10. Increase in deferred tax liability due to an No Not included in profit
increase in revaluation surplus on plant
11. Foreign exchange loss on foreign creditor No IR (iv): forex and IR: (iii) current liability
12. Profit on sale of property, plant and equipment Yes Re-measurement of A
13. Impairment of property, plant and equipment Yes Re-measurement of A
14. Revaluation of property, plant and equipment No If reval surplus: Not included in profit; &
Yes If reval income: Re-measurement of A
15. Fair value adjustment of investment property Yes Re-measurement of A
4.2.2 Number of shares (the denominator) (Circular 04/2018.24)

The number of shares to be used in calculating the headline earnings per share must be the
same as the number of shares used to calculate basic earnings per share. Similarly, the
number used to calculate the diluted headline earnings per share must be the same as that used
to calculate diluted earnings per share. See Circular 04/2018.24 & IAS 33.73
Chapter 24 1149
Example 17: Headline earnings per share

The following information relates to Kin Limited’s year-ended 31 December 20X2:
The statement of comprehensive income shows profit for the year of C100 000. The calculation of this
profit included the following income and expenses:
x Impairment of building: C35 000 (before tax: C50 000)
x Profit on sale of plant: C22 400 (before tax: C32 000)
x Inventory write-down: C10 000 (before tax: C15 000)
The statement of changes in equity reflected preference dividends of C2 000.
Required: Calculate the basic earnings and the headline earnings.
Solution 17: Headline earnings per share

Basic earnings C
Preference dividends (2 000)
Basic earnings 98 000
Headline earnings
Adjusted as follows:
Add impairment of building 35 000
Less profit on sale of plant (22 400)
Headline earnings 110 600
4.3 Disclosure of the headline earnings per share

If an entity presents headline earnings per share in its financial statements, IAS 33 requires
that both the basic headline earnings per share and the diluted headline earnings per share are
calculated and presented and where these two variations of the headline earnings per share
and presented with equal prominence.
An ‘earnings per share note’ must be included in the financial statements and must include:
x the headline earnings per share
x a reconciliation between the basic earnings and headline earnings
x comparatives for all such disclosures. Circular 04/2018.25 & .27 & IAS 33.73
This reconciliation must be provided in a long-form, meaning that the amounts that have been
excluded from the basic earnings must be shown:
x gross (before tax) and
x net (after tax and after non-controlling interests). Circular 04/2018.28
The gross and net must be provided in two columns.
Example 18: Headline earnings per share - disclosure
Use the same information as was provided in example 17 and that there were 10 000 shares
in issue throughout the year.
Required: Disclose headline earnings per share for the year-ended 31 December 20X2.
Solution 18: Headline earnings per share - disclosure
Company name
Notes to the financial statements (extract)
25. Earnings per share 20X2 20X1
Headline earnings per share HE: 110 600/ Shares: 10 000 C11,06 per share xxx
Headline earnings per share
The calculation of headline earnings per share is based on earnings of C 110 600 (20X4 C XXX)
and 10 000 (20X4 xxx) ordinary shares outstanding during the year.
1150 Chapter 24

Reconciliation of earnings: Profit – basic earnings – headline earnings
20X2 20X1
Gross Net Gross Net
C C C C
Profit/(loss) for the period 100 000 xx
x Preference dividend (2 000) (xx)
Basic earnings 98 000 xx
x Add: back: Impairment of building 50 000 35 000 xx xx
x Less: Profit on sale of plant (32 000) (22 400) xx xx
Headline earnings 110 600 xx
5. Diluted Earnings Per Share (IAS 33.30 - .63)
5.1 Overview
A dilution is defined as:
Dilution means to make thinner or less concentrated. IAS 33.5
With respect to earnings per share, dilution would occur x A reduction in earnings per share, or
if the same earnings have to be shared amongst more x An increase in loss per share
shareholders than are currently in existence. x Resulting from the assumption that:
- convertible instruments are
Many entities at year-end have potential shares converted, or
- options/ warrants are exercised, or
outstanding, which, if converted into shares, may or may
that
not dilute the earnings per share. Diluted earnings per
- ordinary shares are issued upon the
share shows the lowest earnings per share possible satisfaction of specified conditions.
assuming that all dilutive potential ordinary shares were
no longer potential but had resulted in the issue of ordinary shares. In other words, the diluted
earnings per share shows users the maximum potential dilution of their earnings in the future
(i.e. the worst-case scenario) assuming the dilutive potential shares currently in existence are
converted into ordinary shares in the future. It logically follows that diluted earnings per share
can never be higher than basic earnings per share. Diluted earnings per share is calculated for
both basic and headline earnings per share.
Example 19: Diluted earnings per share: simple example

Family Limited had basic earnings for 20X5 of C500 000. This basic earnings figure was
equal to its profit for the year. It had no components of other comprehensive income.
Family Limited had 1 200 000 ordinary shares in issue throughout 20X5. There were 300 000 options
in issue at 31 December 20X5 (granted to the directors for no value).
Required:
A Calculate basic and diluted earnings per share for the year ended 31 December 20X5.
B Disclose basic and diluted earnings per share for the year ended 31 December 20X5.
Solution 19A: Diluted earnings per share - calculations

Basic earnings per share (W1): C0, 4167
Diluted earnings per share (W2): C0, 3333
W1: Basic earnings per share: 20X5
Basic earnings C500 000
Weighted average number of shares = 1 200 000
Basic earnings per share = C0,4167

W2: Diluted earnings per share: 20X5
Diluted earnings C500 000
=
Weighted average number of shares outstanding + potential shares (1 200 000 + 300 000)
Diluted earnings per share = C0,3333
Chapter 24 1151
Solution 19B: Diluted earnings per share - disclosure

Family Limited
20X5 20X4
Note C C
Other comprehensive income 0 xxx
Total comprehensive income 500 000 xxx
Basic earnings per share 15 0,4167 x
Diluted earnings per share 15 0,3333 x
Family Limited
15. Earnings per Share
Basic earnings per share Basic earnings per share is based on earnings of C500 000
(20X4: CX) and a weighted average of 1 200 000 (20X4: X)
ordinary shares in issue during the year.
Dilutive earnings per share Dilutive earnings per share is based on dilutive earnings of
C500 000 (20X4 C X) and a weighted average of 1 500 000
(20X4 X) ordinary shares during the year.
5.2 Potential shares (IAS 33.36 - .63) A potential ordinary

share is defined as:
Potential shares are contracts that could potentially x a financial instrument or
increase the number of shares in issue and thus lead to a x other contract
dilution (i.e. reduction) in the earnings per share. x that may entitle its holder to
ordinary shares. IAS 33.5
There are many types of potential shares (dilutive Potential shares may cause a dilution in
instruments). Each has a different effect on diluted the EPS.
earnings (the numerator) and/ or the weighted number of shares outstanding (the
denominator). Examples include options, convertible instruments and contingently issuable
shares.
Potential ordinary shares are weighted for the period they are outstanding, meaning that:
x those that are cancelled or allowed to lapse during the period are included in diluted
earnings per share only for the part of the period during which they were outstanding; and
x those that are converted into ordinary shares during the period are included in diluted
earnings per share only up to the date of conversion.
Potential ordinary shares that are included in the calculation of diluted earnings per share are:
x weighted from the beginning of the year, or
x if the potential ordinary share was issued during the year, then from the date of the issue.
The basic number of shares is then increased from the date the potential shares are exercised.
Diluted EPS: how potential shares affect the diluted EPS formula
Effect on EPS Convertible

Options Convertible Debentures
formula: Preference Shares
+ Finance costs saved + Dividends saved

Earnings: No effect: always zero
(net of tax) (if treated as finance costs)
+ number of possible
Number of + Number of possible + Number of possible
bonus/ not for value
shares: extra/new shares extra/new shares
shares
1152 Chapter 24
5.2.1 Options (IAS 33.45 - .48)

Options are granted to individuals allowing them to acquire a certain number of shares in the
company at a specified price per share (the strike price or
exercise price) in the future. Options, warrants and
their equivalents are
These options are referred to as ‘call options’ as they defined as:
grant the option holder a right (but not an obligation) to x financial instruments
purchase the underlying equity instrument. ‘Call’ is x that give the holder the right to
purchase ordinary shares IAS 33.5
investment jargon for the right to purchase a financial
instrument by an option holder. This right to purchase is usually at a price lower than the
market price (fair value) of the share. If the strike price is greater than the market price (on
the exercise date or during an exercise period), the option is referred to as ‘out of the money’
and the option-holder would not purchase the shares and the option would eventually lapse.
The holder would only consider exercising the option (i.e. buy shares) if the strike price is
below the market price on the exercise date i.e. the option will only be exercised if it is ‘in the
money’. When the date has been reached that the holder is entitled to exercise the option, we
say that the option has vested. It does not matter whether the option has vested or not: the
option is included in the calculation of diluted earnings per share from the beginning of the
year or, if later, from the date of issue of the option.
Options will affect the denominator for diluted earnings per share from the date of issue of
such options till the earlier of the date on which the options lapse or are exercised. The
notional shares to be included in the denominator for diluted earnings per share:
intrinsic value *
= Number of options X
average market price per share
* where intrinsic value= average market price per share – strike price per share
When the option is exercised it will result in both:

x a ‘for value issue’ (relating to the cash received) and
x a ‘not for value issue’ (relating to the bonus element, being the difference between what
should have been received based on the market price and what was received).
The two portions (for value and not for value) can be calculated as follows:
x the total proceeds received when the options are exercised are divided by the market price
per share and the resultant number of shares is seen as a for value issue. This for value
issue requires no adjustment in diluted earnings per share; and
x the total number of share options less the number of ‘for value’ shares calculated, is the
‘not for value’ portion. This ‘not for value’ portion has no effect on the numerator
(earnings) but the denominator must be increased accordingly.
Example 20: Options to acquire shares
20X5
There are 200 000 ordinary shares in issue (all issued at C2 each).
The company’s directors hold 100 000 options, at a strike price of C2 each.
Of these options, 100% vested on 1 July 20X5.
During 20X5 the company’s shares had an average market value of C6.
Required: Calculate the earnings per share figures for 20X5 ascertainable from the information given.
Solution 20: Options to acquire shares

W1: Basic earnings per share 20X5
Basic earnings = C410 000 Given
Weighted number of shares outstanding 200 000 Given
Basic earnings per share = C2,05
Chapter 24 1153
Solution 20: continued

W2: Diluted earnings per share (20X5):
Diluted earnings C410 000 Given (dilution has no effect on earnings)
=
Weighted number of ordinary shares 266 667 W3
= C1,5375
W3: Weighted number of shares:

Basic number of shares 200 000
Notionally exercised options See W4 or calculate as follows: 66 667
(not for value portion): Bonus element: (market price – strike price):
(C6 – C2) ÷ Market price: C6 x Options: 100 000
Diluted number of shares 266 667
W4: Effect of options on number of shares:

Total proceeds
= Effective number of shares that would be sold
Market price
100 000 x C2
= 33 333 effectively sold (for value)
C6
100 000 – 33 333 = 66 667 effectively given away (not for value)
5.2.2 Purchased options and written put options

When an entity purchases ‘put options’ (a right to sell) on its own equity instruments, the
weighted average number of shares used in the diluted earnings per share calculation will not
increase. This right will be anti-dilutive, as the put option will only be exercised if the
exercise price exceeds the market price – thus, there are no shares which are issued for ‘no
consideration’. See IAS 33.62
Similarly, when an entity purchases ‘call options’ (a right to buy) on its own equity
instruments, the effect is also anti-dilutive since the right will result in a decrease in the
weighted average number of shares issued. Think of it like this: the entity will repurchase its
shares below market price, thus, in effect, a portion of shares are purchased at market price,
and another portion of its shares will be purchased for no consideration, effectively decreasing
the weighted average number of shares by the shares purchased for ‘free’ – no corresponding
decrease in funding. This reduces the denominator, thus having anti-dilutive potential.
Selling an option is referred to as ‘writing an option’. Written put options are options that an entity
sells, and which give the purchaser the right to sell a financial asset to the entity. In other words,
written put options would require the entity to repurchase its own shares. When an entity writes put
options on its own equity instruments, the purchaser will only exercise it when the exercise price
exceeds the market price, as they will not want to sell the asset below market price. If we assume the
entity issues shares at market price to obtain funds to buy-back the shares, the entity will need to
issue more shares than the number of shares to be purchased from the option-holder. Thus, the
weighted average number of shares after the assumed buy-back and exercise of the put options will
increase as follows:
Number of shares purchased x Exercise price per option

– Number of shares purchased
Market price per share
5.2.3 Convertible instruments (IAS 33.49 - .51)

Convertible instruments are instruments that may be converted into ordinary shares (known as
potential ordinary shares) at some time in the future (either on a specific date or at any time).
Examples of convertible instruments include:
x convertible debentures; and
x convertible preference shares.
1154 Chapter 24
Instruments may be convertible at the option of the holder or the issuer. It does not matter
who it is that decides whether to convert the instruments into ordinary shares or not: we
always assume the worst-case scenario i.e. that the decision is made to convert the instrument
into ordinary shares.
The effect of a conversion will be:
x an increase in the expected earnings (the numerator): increased by the after-tax interest or
dividends saved by a conversion; and
x an increase in the number of shares (the denominator): increased by the extra shares that
may be created by a conversion.
From a tax perspective: please note that when we expect to save an interest expense, we will
also expect our tax expense to increase. This is because interest expense is tax deductible and
thus by saving an interest expense, we lose a tax deduction (thus taxable profits and tax
expense increase). Thus, when we adjust the earnings for an expected reduction in interest
expense, we adjust it for these savings after tax. Conversely, however, when we expect to
avoid a dividend distribution that is recognised as an interest expense, we do not expect our
tax expense to change. This is because, although it appears as an expected reduction in
interest, it is really a reduction in dividends and dividends would not have been tax-deductible
in the first place.
If the holder of the instrument is faced with more than one conversion option, the entity
(being the issuer of the instrument) must assume the most dilutive option in the diluted
earnings per share calculation. For example, if the holder of a debenture has the option to
convert the debenture into an ordinary share or to redeem it for cash, the entity must assume
that the holder will choose the ordinary shares since this will increase the number of shares
and therefore decrease dilutive earnings per share.
Example 21: Convertible debentures
Profit for the year ended 20X5 was C279 000, including finance costs on convertible
debentures of C30 000 (before tax). Tax is levied at 30%. There are:
z 100 000 ordinary shares in issue (all issued at C2 each)
z 200 000 convertible debentures in issue (the conversion rate is: 1 ordinary share for
each debenture; all were issued at C2 each).
Required: Calculate basic earnings and diluted earnings per share to be included in the statement of
comprehensive income for the year ended 31 December 20X5. Comparatives are not required.
Solution 21: Convertible debentures

W1: Basic earnings per share:
Basic earnings C279 000
= = C2,79
Weighted number of ordinary shares in issue 100 000
W2: Diluted earnings: C
Preference dividend 0
Adjustments:
Finance costs avoided 30 000
Tax saving due to finance costs lost (30 000 x 30%) (9 000)
Diluted earnings 300 000
W3: Weighted number of ordinary shares:
Notionally converted ordinary shares 200 000
Diluted number of shares 300 000
W4: Diluted earnings per share:
Diluted earnings C300 000 (W2)
=
Weighted number of ordinary shares outstanding 300 000 (W3)
= C1,00
Chapter 24 1155
Example 22: Convertible preference shares

Engine Limited has provided the following extract from its statement of
comprehensive income for the year ended 31 December 20X5: 20X5
Profit from operations 465 000
Finance costs (60 000)
Engine Limited has the following shares in issue, all of which have been in issue for many years:
z 200 000 ordinary shares in issue (all issued at C2 each)
z 100 000 convertible, 20% preference shares in issue:
The preference shares are convertible on 31 December 20X8 at the option of the preference
shareholders into ordinary shares at a rate of 1 ordinary share for every preference share.
A mandatory preference dividend of C40 000 was declared for 20X5.
Tax is levied at 30% on taxable profits. The preference dividend is not allowed as a tax deduction.
Required: Calculate basic earnings and diluted earnings per share for presentation in the statement of
comprehensive income for the year ended 31 December 20X5 assuming the following 2 scenarios:
A The preference shares are correctly recognised as a pure liability and the dividend of C40 000 is
recognised as a finance cost of C45 000 using the effective interest rate method (i.e. the finance
costs of C60 000 refer to interest on a bank loan and interest on the preference shares).
B The preference shares are correctly recognised as pure equity (the C60 000 finance costs shown in
the extract from the statement of comprehensive income relate to a bank loan).
Comparatives are not required.
Solution 22: Convertible preference shares

Ex 22A Ex 22B
W1: Basic and diluted earnings: (liability) (equity)
Preference dividend (1) (2) 0 (40 000)
Basic earnings 283 500 243 500
Adjustments due to dilutions from potential shares:
Part A: Finance costs saved; or Interest: 45 000
Part B: Dividends saved (3) Dividends: 40 000 45 000 40 000
Diluted earnings 328 500 283 500
(1) Ex 22A: If the shares are recognised as a pure liability, the preference dividend would be recognised
as an interest expense using the effective interest rate method (and would thus have already been
deducted in the calculation of profit for the year). Please note that the amount of the finance costs is
not necessarily the same as the actual dividend declared in any year.
(2) Ex 22B: If the shares are recognised as pure equity, the dividends to which the preference
shareholders are entitled have not been taken into account in determining the profit belonging to the
ordinary shareholders. These preference dividends must therefore still be deducted.
(3) Ex 22A and Ex 22B: The adjustment made to calculate the diluted earnings is the gross amount (i.e.
not net of tax) because preference shares do not qualify for tax deductions.
W2: Weighted number of ordinary shares:
Basic number of shares 200 000 200 000
Notionally converted ordinary shares 100 000 100 000
Diluted number of shares 300 000 300 000
W3: Basic earnings per share:
Basic earnings = C283 500 C243 500
Weighted number of ordinary shares in issue 200 000 200 000
Basic earnings per share = C1,4175 C1,2175
W4: Diluted earnings per share:
Diluted earnings C328 500 C283 500
=
Diluted number of shares 300 000 300 000
Diluted earnings per share = C1,095 C0,945
1156 Chapter 24
5.2.4 Contingent shares (IAS 33.52 - .57 and .24)

As already explained in section 3.3.5, contingent shares are those that will be issued in the
future if certain conditions (which are laid down in the share agreement) are met and these
shares will then be issued for little or no consideration (e.g. little or no cash).
5.2.4.1 Where time is the only condition
If the passage of time is the only condition that must be met, the issue is not treated as 'contingent
shares' but rather as 'deferred shares' because the passage of time is considered a certainty. The
condition is thus satisfied, and the shares are treated as outstanding from the date the decision was
made that these shares would be issued (see Section 3.3.5 and example 13).
5.2.4.2 Where there are multiple conditions including time
x Basic earnings per share
Only adjust the denominator when all the conditions, including time, are met.
x Diluted earnings per share
If at the end of the reporting period all the conditions stated in the contingent share
agreement are satisfied (even if the time condition has not yet been met), then treat the
end of the reporting period as if it were the end of the contingency period and adjust the
denominator as if the contingent shares had already been issued.
Example 23: Contingent shares
At 1 January 20X5, Airways Limited had 1 million ordinary shares in issue, all having been
issued at C1 in 20X4.
On 2 January 20X5, Airways Limited bought 100% of Radio Limited, which it paid for through an
issue of a further 1 million ordinary shares.
Another 500 000 ordinary shares are contingently issuable upon Radio Limited generating total profits
of C100 million over 3 years.
Airways Limited’s profit for 20X5 is C500 million (20X4: C400 million).
Radio Limited earned C200 million in 20X5.
Required: Calculate Airway Limited’s basic and diluted earnings per share for 20X4 and 20X5.
Solution 23: Contingent shares

20X5 20X4
C C
Basic earnings per share 20X5: C500 million ÷ 2 million shares 250,00 400,00
20X4: C400 million ÷ 1 million shares
Diluted earnings per share 20X5: C500 million ÷ 2,5 million shares 200,00 400,00
20X4 C400 million ÷ 1 million shares
Comment: The same rules do not apply to basic and diluted shares:
x Basic shares are not adjusted to include the contingent shares since the contingency period is not yet complete
and it is not yet certain that the shares will be issued (a profit of C100 million must be made over a 3-year
period). Although a large profit in excess of the minimum C100 million has already been made, this may
reverse before the 3-year period is up (e.g. if a large loss is made in 20X6 and 20X7, a net profit of C100
million may not necessarily be made over the 3 years).
x Diluted shares must include the contingent shares that would be issued (500 000 shares) assuming the
earnings at the end of the reporting period (20X5) were the amount of earnings at the end of the contingency
period (20X7). In other words, we pretend that 20X5 (the current reporting period) is the end of the term
stipulated in the agreement: that the time is up. (P.S. The prior year diluted earnings per share is not restated
for the contingent shares since the contingent shares are only taken into account from the date that the
contingent share agreement was signed). See IAS33.53
x If the passage of 3 years had been the only condition before issuing the 500 000 shares, then the denominator
for basic earnings per share would have been increased by 500 000 shares from the date that the decision was
made to issue these shares, being the 2 January 20X5.
Chapter 24 1157
5.3 Multiple dilutive instruments (IAS 33.44)

Many companies have more than one type of potential ordinary shares in issue. Some of these
instruments will be more dilutive than others – and some may even be anti-dilutive.
If you recall, the objective of diluted earnings per share is to show the most dilutive option or
‘worst case scenario’. In order to achieve this, all potentially dilutive instruments must be
ranked (most dilutive to least dilutive).
The instrument that has the lowest incremental earnings per share is the most dilutive and is
ranked first. Options, which have no effect on earnings (numerator) but do have an effect on
the number of shares (denominator), will thus have zero incremental earnings per share and
will thus always be dilutive. Options will also generally be the most dilutive because other
dilutive instruments generally result in cost savings which offset the dilutive effect of the
potential increase in the number of shares (e.g. if convertible debentures are converted into
ordinary shares, interest will no longer have to be paid to the debenture-holder and thus
profits will increase).
After ranking the dilutive instruments, we test whether the instruments will actually reduce
the earnings per share if they are issued. This is done on a cumulative basis, where we start
by asking ‘what if our most dilutive instrument is issued?’ If the earnings per share drops, the
effect is dilutive. The earnings per share can increase, in which case it is called ‘anti-dilutive’.
If the most dilutive instrument did in fact reduce earnings per share, we then ask ourselves
‘now what would happen if not only that instrument were to be issued, but also our next most
dilutive instrument were to be issued’. We continue with this process to see how small our
earnings per share could become. If at any stage, the cumulative effect increases our earnings
per share, we stop the process and our diluted earnings per share will be the last earnings per
share figure that decreased (i.e. the lowest earnings per share). Thus, the effect of anti-dilutive
instruments are not considered in calculating diluted earnings per share.
When we calculate whether an instrument is dilutive or not we must always be sure to use the
basic earnings from continuing operations. See IAS 33.41
Example 24: Multiple dilutive instruments
The following information relates to ABC Limited for the year ended 31 December 20X5:
x Basic earnings: C1 000 000
x Headline earnings: C979 250
x Basic number of shares: 995 500
The following potential shares are applicable on 31 December 20X5:
x Convertible debentures (convertible at the option of the debenture holders) into 20 000 ABC Ltd
ordinary shares on 31 December 20X9. If the debentures are not converted into ordinary shares
they will be redeemed on 31 December 20X9. Finance costs of C10 000 (after tax) were expensed
in arriving at the profit for 20X5;
x Convertible preference shares (convertible at the option of the shareholders) into 40 000 ABC
Limited ordinary shares on 31 December 20X9. If the shares are not converted into ordinary shares
they will be redeemed on 31 December 20X9. C50 000 finance cost (after tax) were expensed in
arriving at the profit for 20X5; and
x Options to acquire 100 000 ordinary shares in ABC Ltd on or after 31 December 20X6 at a strike
price of C7, 50 per share. During 20X5 the average market price of the shares was C10 per share.
Required: Disclose earnings per share in ABC Limited’s statement of comprehensive income for the
year ended 31 December 20X5. Comparatives and notes are not required.
Solution 24: Multiple dilutive instruments

Ranking in order of dilution: Change in EPS for each potential share Dilutive Ranking:
Convertible debentures Increase in earnings C10 000 0,50 2
Increase in shares 20 000
Convertible preference shares Increase in earnings C50 000 1,25 3

Increase in shares 40 000
1158 Chapter 24

Options 100 000 x (10 – 7,5) ÷ C10 C0 0,00 * 1
(bonus element only) 25 000
* this will always be zero
Testing whether dilutive or not: Cumulative change in EPS for each incremental share C
Basic earnings C1 000 000 1,0045
Adjust for:
1. notionally exercised options C1 000 000 + C0 options C1 000 000 0,9799
995 500 basic + 25 000 options 1 020 500 Dilutive
2. notionally exercised options C1 000 000 + C0 options + C10 000 finance cost C1 010 000 0,9707
& convertible debentures 995 500 + 25 000 options + 20 000 debentures 1 040 500 Dilutive
3. notionally exercised options, C1 010 000 above + C50 000 finance cost (divs) C1 060 000 0,9810
convertible debentures & 1 040 500 above + 40 000 pref shares 1 080 500 Anti-
convertible preference shares dilutive (*)
(*) This is anti-dilutive since the issue of the convertible preference shares would increase the EPS (increased
from 0.9707 to 0.9810).
ABC Limited
20X5
C
Basic earnings per share C1 000 000 ÷ 995 500 1,0045
Headline earnings per share C979 250 ÷ 995 500 0,9837
Diluted basic earnings per share C1 010 000 ÷ 1 040500 0,9707
Diluted headline earnings per share (C979 250 headline + C10 000 debentures) ÷ 1 040 500 0,9507
6. Presentation and Disclosure (IAS 33.66 - .73A)
6.1 Overview
Basic and diluted earnings per share should be disclosed for each class of ordinary share.
Both the basic and diluted earnings per share figures should be presented:
x on the face of the statement of comprehensive income. See IAS 33.66
Where an entity’s profit for the year involves a discontinued operation, the entity must
calculate the earnings per share (basic and diluted) based on
the profit or loss from the continuing operations separately to Earnings from
the profit or loss from the discontinued operation. continuing operations
are sometimes called
x The earnings per share for the continuing operation and ‘control earnings’
the earnings per share in total (i.e. including both the
continuing and discontinued operation) must be presented on the face of the statement of
comprehensive income.
x The earnings per share for the discontinued operation may be presented either on the face
of the statement of comprehensive income or in the notes. See IAS 33.68
Where earnings per share figures must be presented on the face of the statement of
comprehensive income but the entity presents two statements making up the statement of
comprehensive income (i.e. an income statement/ statement of profit or loss and a statement
of comprehensive income), these earnings per share figures must be presented in the
statement that shows the calculation of profit or loss (i.e. in the income statement/ statement
of profit or loss). See IAS 33.67A
Chapter 24 1159
Details of the calculation thereof should be disclosed by way of a note.

As mentioned earlier, headline earnings per share is not prescribed by the IFRSs. Instead, it is
a JSE listing requirement that is accounted for in terms of a SAICA circular. Headline
earnings per share is thus only presented in the earnings per share note, together with the
details of the calculation thereof: it may never be presented on the face of the statement of
comprehensive income. See IAS 33.73
Disclosure of dividends per share is required only by IAS 1 Presentation of financial
statements. IAS 1 requires that we present dividends per share in either the statement of
changes in equity or in the notes. See IAS 1.107
Interestingly, unlike earnings per share, when we calculate dividends per share, the number of
shares used as the denominator is generally the actual number of shares issued. However,
this is simply the general approach to calculating dividends per share because the calculation
of dividends per share is actually not stipulated anywhere in the IFRSs. There is a strong
argument that suggests that dividends per share should actually be calculated using same
denominator used when calculating earnings per share (i.e. the weighted number of shares)
because this would then enable the dividend payout ratio to be calculated without the user
having to first adjust the dividends per share figure (for your interest: the dividend payout
ratio is calculated as: dividends per share ÷ earnings per share).
6.1.1 Statement of comprehensive income
A suggested layout of the statement of comprehensive income disclosure is shown below.
Company name
20X2 20X1
C C
Other comprehensive income xxx xxx
Basic earnings per ordinary share 25 xxx xxx
x continuing operations xxx xxx
x discontinuing operations (*) xxx xxx
Diluted basic earnings per ordinary share 25 xxx xxx
x continuing operations xxx xxx
x discontinuing operations (*) xxx xxx
(*) These per share figures could be included in the notes instead of being disclosed on the face of the Statement
of Comprehensive Income.
6.1.2 Notes to the financial statements

The earnings per share figures disclosed in the statement of comprehensive income should be
referenced to a note. The information in this note should include (for basic, headline, diluted
basic and diluted headline earnings per share, where applicable):
x the earnings amount used in each of the calculations; See IAS 33.70(a)
x a reconciliation between each ‘earnings’ figure used and the ‘profit for the period’
attributable to the parent entity per the statement of comprehensive income (for headline
earnings, before and after-tax amounts must be disclosed); See IAS 33.70(a); .73 & Circular 04/2018.29
x the weighted average number of shares used in each of the calculations;
x a reconciliation between the weighted average number of shares used in calculating:
basic (and headline) earnings per share; and
diluted (and diluted headline) earnings per share (if applicable); See IAS 33.70(b)
x any dilutive instrument that was not included but could in the future still cause dilution
(potentially dilutive instruments); See IAS 33.70(c)
x any significant share transactions (other than those accounted for in terms of IAS 33.64)
after the end of the reporting period. See IAS 33.70(d)
1160 Chapter 24
6.1.3 Sample note disclosure involving earnings per share
Company name
Notes to the financial statements (extract)
25. Earnings per Share
Basic earnings per share
The calculation of basic earnings per share is based on earnings of C XXX (20X4 C XXX) and a weighted
average of xxx (20X4 xxx) ordinary shares outstanding during the year.
Diluted basic earnings per share
The calculation of dilutive basic earnings per share is based on dilutive earnings of C YYY (20X4 C YYY) and
a weighted average of yyy (20X4 yyy) shares during the year.
Headline earnings per share
The calculation of headline earnings per share is based on earnings of C XXX (20X4 C XXX) and a weighted
average of xxx (20X4 xxx) ordinary shares outstanding during the year.
Diluted headline earnings per share
The calculation of dilutive headline earnings per share is based on dilutive earnings of C YYY (20X4 C YYY)
and a weighted average of yyy (20X4 yyy) shares during the year.
Reconciliation of number of shares: Basic number of shares to diluted number of shares
20X5 20X4
Number Number
Basic number of shares xx xx
x Notionally exercised options xx xx
x Notionally converted debentures xx xx
x Notionally converted preference shares xx xx
Diluted number of shares xx xx
Reconciliation of earnings: Profit – basic earnings – diluted earnings
20X5 20X4
C C
Profit/(loss) for the period xx xx
x Preference dividend (xx) (xx)
Basic earnings xx xx
x Potential savings:
x Debenture interest xx xx
x Preference share dividend avoided xx xx
Diluted basic earnings xx xx
Reconciliation of earnings: Basic earnings – headline earnings – diluted headline earnings
20X5 20X4
Gross Net Gross Net
C C C C
Basic earnings xx xx
x Items needing reversing for headline purposes xx xx xx xx
Headline earnings xx xx
x Potential savings:
x Debenture interest xx xx
x Notional preference share dividend xx xx
x Finance costs avoided xx xx
Diluted headline earnings xx xx
20X5 20X4
Headline earnings per share Cxx/ share Cxx/ share
Diluted headline earnings per share Cxx/ share Cxx/ share
Potentially dilutive instruments: There are xxx convertible debentures in issue, which had the effect of
being anti-dilutive and were thus not included in the diluted earnings per share calculation.
Significant changes to the number of shares after the end of the reporting period: xxx ordinary shares
were issued at Cxxx after …. (date: last day of the reporting period).
Chapter 24 1161
6.2 Disclosure of further variations of earnings per share (IAS 33.73)
An entity may wish to calculate and disclose a further variation on earnings per share by
using a different earnings figure (note: the number of shares may never vary).
If the entity does disclose a further variation of earnings per share and the earnings used is not
a reported line item in the statement of comprehensive income, then a reconciliation should be
provided reconciling the following two amounts:
x the earnings used in the calculation, and
x a line item that is reported in the statement of comprehensive income.
Example 25: Disclosure of a rights issue; basic and headline earnings per share
The following information applies to company A for the year-ended 31 December 20X2:
x Per the statement of comprehensive income: profit for the year of C100 000 (there are
no components of other comprehensive income);
x Per the statement of changes in equity: preference dividends of C2 000.
Included in the calculation of profit for the year are the following income and expenses:
x Revaluation expense on plant: C35 000 (C50 000 before tax)
x Profit on sale of plant: C21 000 (C30 000 before tax)
The basic earnings and the headline earnings for the prior year (20X1) were correctly calculated as:
x basic earnings: C150 000
x headline earnings: C100 000
Details of the shares are as follows:
x There were 10 000 shares in issue at 1 January 20X1.
x There was no movement in shares during 20X1.
x There was a rights issue of 1 share for every 5 shares held on 1 October 20X2. The exercise (issue)
price was C4 when the fair value immediately before the rights issue was C5 (i.e. market value
cum rights). All the shares offered in terms of this rights issue were taken up.
Required:
Calculate and disclose the basic and headline earnings per share for 20X2.
Solution 25: Disclosure - rights issue; basic and headline earnings per share
Company A
Note 20X2 20X1
C C
Other comprehensive income for the year 0 xxx
Total comprehensive income for the year 100 000 xxx
Basic earnings per ordinary share (W4) 35 C9,11 C14,50
Company A
35. Earnings per share

Basic earnings per share: Basic earnings per ordinary share is calculated based on earnings of
C98 000 (20X1: C150 000) and a weighted average number of
ordinary shares of 10 759 (20X1: 10 345).
Headline earnings per share: Headline earnings per ordinary share is calculated based on earnings
of C112 000 (20X1: C100 000).
Headline earnings per share: (W5 and comment below) 20X2: C10.41/ share 20X1: C9.67/ share
1162 Chapter 24
Solution 25: Continued

20X2 20X1
Reconciliation of earnings Gross Net Gross Net
C C C C
Less preference dividends (2 000) xxx
Basic earnings 98 000 150 000
Adjusted for:
Revaluation expense on plant 50 000 35 000 xxx xxx
Profit on sale of plant 30 000 (21 000) xxx xxx
Headline earnings 112 000 100 000
Comment: Remember that headline EPS must be shown in the note and never on the face of the SOCI.
Workings:
W1: Basic Earnings C

Less Preference dividends (2 000)
W2: Headline Earnings C

Adjusted as follows:
Add revaluation expense on plant 35 000
Less profit on sale of plant (21 000)
Headline earnings 112 000
W3: Number of shares Current year Prior year

Actual (weighted) (adjusted)
Balance: 01/01/20X1 10 000 10 000 10 000
Movement: 20X1 Given 0 0 0
Balance: 01/01/20X2 10 000 10 000 10 000
(1)
Rights issue for value: 01/10/X2 1 600 400 0
10 000/ 5 x 1 x C4/ C5
(2)
11 600 10 400 (2)10 000
(3) (4)
Rights issue for no value: 01/10/X2 400 359 345
(10 000/ 5 x 1) – 1 600
(5) (5)
Balance: 31/12/20X2 12 000 10 759 10 345
P.S. Always start with the ‘actual’ column. The calculations thereafter are then:
(1)
Shares effectively ‘issued’ for 3 months (1 600 x 3/ 12) 400
(2)
The ratio between the current and prior year is currently 10 400: 10 000 1,04: 1
(3)
Current year no value adjustment: 400 x 10 400 / 11 600 359
(4)
Prior year no value adjustment: 400 x 10 000 / 11 600 345
(5)
Check ratio the same: 10 759/ 10 345 1,04: 1
W4: Basic earnings per share 20X2 20X1

Basic earnings (W1) C98 000 C150 000
Weighted average number of shares (W3) 10 759 10 345
= C9,11 = C14,50
W5: Headline earnings per share 20X2 20X1

Headline earnings (W2) C112 000 C100 000
Weighted average number of shares (W3) 10 759 10 345
= C10,41 = C9,67
Chapter 24 1163
Example 26: Disclosure involving multiple dilutive instruments

The following information relates to ABC Limited for the year ended 31 December 20X5:
x Profit for the year: C1 000 000
x Other comprehensive income: nil
x Basic earnings: C1 000 000
x Profit on sale of plant: C25 000 (tax thereon: C4 250)
x Basic number of shares: 995 500
The following potential shares are applicable on 31 December 20X5:
x Convertible debentures (convertible at the option of the debenture holders) into 20 000 ABC Ltd
ordinary shares on 31 December 20X9. If the debentures are not converted into ordinary shares,
they will be redeemed on 31 December 20X9. Finance costs of C10 000 (after tax) were expensed
in arriving at the profit for 20X5.
x Options to acquire 100 000 ordinary shares in ABC Ltd on or after 31 December 20X6 at a strike
price of C7, 50 per share. During 20X5 the average market price of the shares was C10 per share.
x Convertible preference shares (convertible at the option of the shareholders) into 40 000 ABC
Limited ordinary shares on 31 December 20X9. If the shares are not converted into ordinary
shares, they will be redeemed on 31 December 20X9. Finance costs of C50 000 (after tax) were
expensed in arriving at the profit for 20X5.
Required: Disclose the earnings per share figures for inclusion in ABC Limited’s statement of
comprehensive income for the year ended 31 December 20X5.
Solution 26: Disclosure including multiple dilutive instruments

Please see example 24 for the workings.
ABC Limited
20X5 20X4
Note C C
Profit for the year 1 000 000 xxx
Other comprehensive income for the year 0 xxx
Total comprehensive income for the year 1 000 000 xxx
Basic earnings per ordinary share C1 000 000/ 995 500 35 1,0045 xxx
Diluted basic earnings per ordinary share C1 010 000/ 1 040 500 35 0,9707 xxx
ABC Limited
35. Earnings per share

x Basic earnings per share
The calculation of basic earnings per share is based on earnings of C1 000 000 (20X4 C.….) and
a weighted average of 995 500 (20X4 xxx) ordinary shares in issue during the year.
x Diluted basic earnings per share
The calculation of diluted basic earnings per share is based on diluted earnings of C1 010 000
(20X4 C…..) and a weighted average of 1 040 500 (20X4 yyy) shares during the year.
x Headline earnings per share
The calculation of headline earnings per share is based on earnings of C979 250 (20X4 C...…)
and a weighted average of 995 500 (20X4 xxx) ordinary shares in issue during the year.
x Diluted headline earnings per share
The calculation of diluted headline earnings per share is based on diluted earnings of C989 250
(20X4 C…...) and a weighted average of 1 040 500 (20X4 yyy) shares during the year.
1164 Chapter 24

20X5 20X4
Reconciliation of basic number of shares to diluted number of shares Number Number
Basic number of shares 995 500 xx
x Notionally exercised options 25 000 xx
x Notionally converted debentures 20 000 xx
Diluted number of shares * 1 040 500 xx
*Note: remember not to include anti-dilutive instruments
ABC Limited
Notes to the financial statements (extract) continued ...
35. Earnings per share continued ...
20X5 20X4
Reconciliation of earnings: Profit – basic – diluted basic: C C
Profit for the period Given 1 000 000 xx
Preference dividend Balancing 0 xx
Basic earnings Given 1 000 000 xx
Potential savings:
x Debenture interest Given 10 000 xx
Diluted basic earnings 1 010 000 xx
Potentially dilutive instruments

Preference shares exist that are convertible, at the shareholders request, into 40 000 ordinary
shares. These convertible preference shares could potentially dilute earnings per share further.
These have been excluded from the diluted earnings per share calculation since they are currently
anti-dilutive.
Reconciliation of earnings: Basic – headline – diluted headline:

20X5 20X4
Gross Net Gross Net
C C C C
Basic earnings 1 000 000 xx
Profit on sale of plant (25 000 – 4 250) 25 000 (20 750) xx xx
Headline earnings 979 250 xx
Potential savings:
x Debenture interest 10 000 xx
Diluted headline earnings 989 250 xx
20X5 20X4
C C
Headline earnings per ordinary share C0,9837 xxx
C979 250 / 995 500
Diluted headline earnings per ordinary share C0,9507 xxx
(C979 250 + C10 000 debentures)/ 1 040 500
Chapter 24 1165
7. Summary
Earnings per share: Types
Basic Diluted Headline Other variations

(IAS 33) (IAS 33) (Circular 04/2018) (IAS 33)
Required by IFRS Required by IFRS if the Not required by IFRSs; Allowed if given in
entity had dilutive but is required for all SA addition to the
potential ordinary companies wishing to list BEPS and DEPS
shares on the JSE (a JSE Listing (where applicable)
Requirement)
Headline earnings per share (Circular 04/2018)

HE = BE that are:
x Adjusted for: ‘separately identifiable re-measurements’ as defined
x Not adjusted for: ‘included re-measurements’ as defined
x HEPS: Disclosed in notes (not on the face!)
Earnings per share: Calculation
Basic earnings Number of shares
Ordinary shares and

Issues for Issues for
Ordinary shares only participating
value no value
preference shares
Profit for the period Profit for the period Weight the current Adjust the number of
shares so that the
Less fixed preference Less fixed & variable year’s number of ratio of ‘CY shares: PY
dividends preference dividends shares based on the shares’ remains
(if equity distribution) (if equity distributions) time elapsed since the unchanged.
share was issued. Adjust PY and CY for
movements after
reporting period
before authorisation
of financial
statements for issue
Combination issue
Diluted EPS: how potential shares affect the diluted EPS formula
Effect on EPS Convertible

Options Convertible Debentures
formula: Preference Shares
+ Finance costs saved

Earnings: No effect + Dividends saved
(net of tax)
+ Not for value possible
number of extra shares
+ Purchased options:
Number of anti-dilutive + Number of possible + Number of possible
shares: +Written put options: extra shares extra shares
Not for value possible
extra shares
Earnings per share: Disclosure
Per share Reconciliation: Reconciliation: Potential dilutive After the

amounts Earnings Shares instruments reporting
period
Basic and diluted: Profit → BE →DBE Basic → Diluted Existence of Significant
x in SOCI other potentially changes to
Headline: BE → HE → DHE dilutive number of
x in notes instruments shares
1166 Chapter 24
Gripping GAAP Fair value measurement
Chapter 25
Fair Value Measurement
Contents: Page
1.1 Background 1168
1.2 Scope of IFRS 13 1168
1.3 An overview of IFRS 13 1168
2. Measurement of fair value 1169
2.1 Overview 1169
2.2 The asset or liability (or group thereof) 1169
Example 1: Characteristics to include in the measurement of fair value 1170
2.3 The market participants, market and orderly transactions 1170
Example 2: Markets and the fair value 1172
Example 3: Markets and the fair value 1172
2.4 Market participants in relation to non-financial assets 1173
Example 4: Fair value of non-financial assets 1174
2.5 Market participants relating to liabilities and an entity’s own equity instruments 1174
2.5.1 Overview 1174
Example 5: Transfer values versus extinguishment values 1175
2.5.2 Liabilities and equity instruments that may be held by others as assets 1175
2.5.3 Liabilities and equity instruments that would not be held by others as assets 1175
Example 6: Fair value of a liability that is not held by third parties as an asset 1176
2.6 Measurement date 1176
2.7 The price 1177
2.8 Fair value at initial recognition 1177
2.9 Valuation techniques 1178
2.9.1 Overview 1178
2.9.2 A change in valuation technique is a change in estimate 1179
2.9.3 Fair value hierarchy and inputs 1179
2.9.4 Present value technique (an example of the income approach) 1181
3. Disclosure 1182
4. Summary 1183
Chapter 25 1167
1. Introduction
1.1 Background
IFRS 13:
Fair value is not a new accounting concept: many standards
already require or permit the use of fair value either for x Does not require further measurements
of fair value (FV),
purposes of measuring an element or for disclosure purposes. x Simply clarifies how the FVs referred
Until the issue of IFRS 13 Fair value measurement (2011), to in other standards should be
each and every standard that required or permitted fair values measured and disclosed.
for measurement or disclosure purposes also explained how x Does not deal with the measurement
and disclosure of all FVs: certain FVs
to measure fair value. This was clearly cumbersome and, referred to in some standards are
having the measurement of fair value referred to in so many excluded from the scope of IFRS 13.
See IFRS 13.IN4.
different standards, also led to contradicting guidance on how
it should be measured. Furthermore, discussions aimed at converging IFRSs with US GAAP
required that certain measurement and disclosure requirements involving fair value had to be revised
and standardised. One single standard explaining the concept of ‘fair value’ became essential. IFRS
13 Fair value measurement was thus developed to:
a) Define the meaning of the term ‘fair value’;
b) Provide a single framework explaining how to measure it; and
c) Explain what needs to be disclosed regarding its measurement. See IFRS 13.1
IFRS 13 only applies when another IFRS requires or permits either fair value measurement or
disclosure. Some of these situations are listed in the table below. See IFRS 13.IN5-IN7 and IFRS 13.5
Standards currently permitting or requiring the use of fair value for measurement of items:
Fair value as a measurement is permitted in the following standards:
x IAS 16: Property, plant and equipment under the revaluation model is measured at depreciated fair value
x IAS 38: Intangible assets under the revaluation model are measured at amortised fair value
x IAS 40: Investment properties under the fair value model are measured at fair value
Fair value as a measurement is required by the following standards:
x IAS 19: Defined benefit plan assets must be measured at fair value.
x IAS 36: Testing assets for impairment, involves calculating the ‘recoverable amount’, which is measured at
the higher of ‘fair value less costs of disposal’ and ‘value in use’
x IFRS 3: Business combinations involve measuring:
assets and liabilities on acquisition at fair value
the consideration paid (i.e. to calculate goodwill/ bargain purchase gain) at fair value
x IFRS 5: Non-current assets held for sale must be measured at the lower of ‘carrying amount’ and ‘fair value
less costs to sell’
x IFRS 9: Certain financial instruments must be measured at fair value
x IFRS 15: The non-cash consideration component of a contract must be measured at fair value
1.2 Scope of IFRS 13 (IFRS 13.5-7)

IFRS 13 measurement and disclosure requirements do not apply to:
x Share-based payment transactions within the scope of IFRS 2 Share-based payments
x Leasing transactions within the scope of IFRS 16 Leases
x Measurements that have some similarities to fair value but are not fair value, such as net
realisable value in IAS 2 Inventories or value in use in IAS 36 Impairment of assets IFRS 13.6
IFRS 13 disclosure requirements do not apply to:
x Plan assets measured at fair value in accordance with IAS 19 Employee Benefits
x Retirement benefit plan investments measured at fair value in terms of IAS 26 Accounting
and Reporting by Retirement Benefit Plans, and
x Assets for which the recoverable amount is fair value less cost of disposal in terms of
IAS 36 Impairment of assets. IFRS 13.7
1.3 An overview of IFRS 13 (IFRS 13.2-.4) Fair value is:
a market-based measurement, not
A principal that is central to the measurement of fair value is an entity-specific measurement
that fair value must reflect the market conditions at IFRS 13.2
measurement date. Thus, it is a market-based measurement and not an entity-specific measurement.
1168 Chapter 25
Management intentions regarding the items being measured are thus ignored (e.g. whether
management intends to keep or sell the asset is irrelevant). See IFRS 13.2-3
Directly observable inputs are the most accurate source of information to use when measuring
fair value, (e.g. a quoted price for an identical asset, such as the price of a share on a stock
exchange), but these directly observable inputs may not always be available. See IFRS 13.2
If directly observable inputs are not available, other valuation techniques (e.g. a market approach,
cost approach or income approach) may be used instead. When a valuation technique is used, we
aim to maximise the use of observable inputs in performing these calculations. See IFRS 13.3
Although IFRS 13 refers mainly to assets and liabilities, it should also be applied when measuring and
disclosing the fair value of its own equity instruments, if these are measured at fair value. See IFRS 13.4
2. Measurement of Fair Value
2.1 Overview
Fair value is defined as:
The most important aspect coming from the definition of
x The price that would be:
fair value (see the grey box alongside) is that: received to sell an asset or
x it refers to market participants, which means that it paid to transfer a liability
is a market-based measurement and x between market participants
x it refers to the sale of an asset (not the acquisition of an x at the measurement date. IFRS 13.9
asset or the use thereof) and the transfer of a liability (not the acquisition of a liability or the
settlement thereof) which means that it is based on an exit price.
FV is an exit price.
There are also some other core factors in this definition i.e. the price to
that we must consider: x sell an A (e.g. not to acquire it)
x tfr a L (e.g. not to settle it)
x we must identify what the asset or liability is;
x we must decide who our ‘market participants’ are, and whether their transactions are
‘orderly’ or not – and we must also decide which ‘market’ we should use when measuring
our fair value;
x we must decide what is meant by ‘price’; and
x we must to decide when the ‘measurement date’ is.
The measurement date is actually not determined by IFRS 13 but by the specific IFRS that
requires or permits the measurement or disclosure of an item at fair value. For example,
IAS 40 Investment property requires that investment property be measured at reporting date
whereas IFRS 5 Non-current assets held for sale requires that fair value be measured when a
non-current asset is classified to the category ‘he

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Acknowledgements and thanks:

Chief editing and technical review of prior editions done by:

The author: Cathrynne Service Via Facebook:

The publisher: LexisNexis Web address: www.myacademic.co.za

Writing it would simply not have been possible without

Too numerous to mention, are the rest of my family and friends,

(‘counting mutants’ is a reference to accountants in the quirky comedy:

My own lifelong – and appalling – inability to distinguish accurately between debits

1 IASB, Companies The reporting environment 1

2 Conceptual The conceptual framework for financial reporting 34

3 IAS 1 Presentation of financial statements 77

21 IFRS 9, IFRS 7, & Financial instruments – general principles 976

22 IFRS 9, IFRS 7, & Financial instruments – hedge accounting 1067

24 IAS 33; Circ 2/15 Earnings per share 1127

The Reporting Environment

2. A Brief History of Accounting

2.1 Accounting is a language

2.4 The difference between GAAP and IFRS

3. GAAP and IFRSs – The Process of Internationalisation

3.1 A brief history of the internationalisation of GAAP into IFRSs

3.2.2 The meaning of the term: IFRSs

3.2.3 The meaning of the term: Standards

3.2.4 The meaning of the term: Interpretations

3.3 Conceptual Framework for Financial Reporting

3.4 Compliance with IFRSs (adoption) Compliance with

When a set of financial statements is prepared in terms of IFRSs, a declaration of this

3.4.2 Why would one comply with IFRS? Compliance could

3.4.3 The extent of compliance with IFRS around the world

3.6 Adoption versus Convergence

3.7 Development of IFRSs (standard-setting)

3.7.4.3 The Basic Development Cycle Discussion Paper (optional)

Diagram: Summary of who develops what:

IFRS: Previously developed by Now developed by

Exposure Drafts & IASC IASB

Improvements & SIC IFRSIC

3.7.4.4 Developing Exposure Drafts

A published Exposure Draft includes:

• are developed by the IASB.

The draft Standard is normally reviewed by the Interpretations Committee (IFRSIC).

3.7.4.6 Developing Interpretations Interpretations are

These amendments are limited to changes that either:

The objectives of the IFRS Foundation are:

3.8.3 The IFRS Foundation: an organogram

IFRS Foundation Monitoring Board 1: 1. Public accountability

2. Governance and oversight

IFRS Foundation Trustees2

Trustees appoint members to IFRSAC, IASB

22 trustees) ensure financing. They meet at least twice a

3. Independent standard-setting &

International Accounting The IASB develop & publish exposure drafts

IFRS Interpretations Committee The IFRSIC develop interpretations after

Adapted from: http://www.ifrs.org/about-us/our-structure/

3.8.4 The Trustees

The trustees are accountable to the Monitoring Board.

3.8.5 The Monitoring Board

3.8.6 The International Accounting Standards Board (IASB)

The International Accounting Standards Board (IASB) is the The IASB:

3.8.7 The IFRS Interpretations Committee (IFRSIC) The IFRSIC develop

The IFRSIC is essentially responsible for developing interpretations.

3.8.8 The IFRS Advisory Council (IFRSAC) The IFRSAC act as

4. The Companies Act and the Related Regulations

4.2 The Companies Act, 2008: Some of the big changes

4.3 The different categories of companies (Companies Act: s8 and s11)