Gripping GAAP

Twenty-second Edition

Cathrynne Service CA (SA)

BCompt (Hons) (C.T.A.) (UNISA) CA (SA)

Special thanks must go to:

Professor Dave Kolitz (University of Exeter)
Dr Steven Firer (Nexia SABT)
Gordon Adams CA (SA) (University of the Western Cape)
Aarthi Algu, Vanessa Gregory and Kerry-Lee Gurr (University of KwaZulu-Natal)
Súne Diedericks and Suzette Snyders (Nelson Mandela University)
Mulala Sadiki (SAICA Project Director)
Yusuf Hassan (KPMG Technical)
Yusuf Seedat (PWC Technical)
Thank you for your valuable advice, suggestions and interpretations over the years.

Special thanks to the assistant authors of all editions to date:

Steffen Wies, Sahil Bhaanprakash, Sohil Singh, Alyssa Sewsunker (from University of KwaZulu-Natal).
Steffen Wies, Sahil Bhaanprakash, Sohil Singh, Sian Mudaly (from University of KwaZulu-Natal),
Georgina Patten-Service (from Nelson Mandela University) and Gordon Adams (from University of Western Cape).
Steffen Wies, Sian Mudaly, Jyoti Maharaj, Thabiso Mtshali and Farnaaz Shaikjee (from University of KwaZulu-Natal),
and 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
Twenty-first edition: 2020
Twenty-second edition: 2022

© 2022
ISBN softcover 978 0 6390 0958 2
e-book 978 0 6390 0959 9

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 accur-
ate, 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:

x Accounting 911 by Kolitz and Service
Via LexisNexis:
x 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 dear parents, Roger and Jillianne,
who have provided endless love and support, on every level,
during the decades of writing that have gone into this book;
my dear sons, Roger and Guy,
who have been in the front line, providing love, patience, understanding and
endless cups of tea and coffee; and
my dear friend, Dave Kolitz,
for providing the humour and encouragement during ZULWHU¶V block, deadlines and other
crises, which, as a co-author, only he can understand.

Too numerous to mention are the rest of my family and friends,

who have all been subjected to the same excuse:
µSorry ± ,FDQ¶W± ,¶P writing «¶.

And to my team of guardian angels who not only inspired this book but have provided
me with the guidance and superhuman strength
needed to update it each year.

And finally I wish to dedicate this book to those for whom I wrote it: you!
I sincerely hope that my book sheds the necessary light
as you fervently study towards your ultimate goal
of joining our country¶s ranks of µcounting 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
Yet another µFour Words¶ to Gripping GAAP

Forewords are an interesting genre usually penned by someone completely adrift

from the subject matter ± EXWVRPHRQHKDVWRGRLW«So permit me to suggest most
SHRSOH¶Vtwo most favourite words: µTax Free¶! %XWLIZH¶UHWRIRFXVRQfour (I
RULJLQDOO\PLVXQGHUVWRRGµIRUHZRUG¶DVµIRXUZRUGV¶ WKHQ\RX¶re likely to agree that
the most agreeable might be µ\RXUVDODU\¶VEHHQGRXEOHG¶ RND\WKDW¶VUHDOO\five, but
ZKR¶VFRXQWLQJ" +RZHYHUPRUHVHULRXVO\ there are indeed four fundamentals your
troubled generation (IRUZKLFKPLQHEHJV\RXULQGXOJHQFHIRUWKHWXUEXOHQFHZH¶YH
caused) must contend with: life, death, health and wealth.

The first three are of no concern to you here, but the fourth (wealth) most certainly is.

As we enter probably the most troubled epoch ever known to humanity ± on many
levels ± your accounting for it all may be the most challenging facet of all - but
fascinating too.

This book will guide you across troubled waters to reach level playing fields while
avoiding the slings and arrows of outrageous fortune when skating on thin ice!

Are you counting? 7KDW¶Vfour PHWDSKRUVLQRQHVHQWHQFH« now turn to page 1 and

begin to bravely face the challenges ahead.

Woody Allen once said, µMoney is better than poverty if only for financial reasons!¶
Your task will be to make sense of it all ± for everyone concerned.

My thoughts are sincerely with you!

Roger Service Ph.D.

iv
 Gripping GAAP
A notee too youu from
m thee authorr
To all you dear students,
South African accountants can be proud to say they are world
South Africa was ranked the class, having been ranked as THE WORLD LEADERS in financial
WORLD LEADER in auditing reporting and auditing for seven years in a row! This amazing feat
and financial reporting for was due to the highly prestigious accolade given by the World Eco-
SEVEN years in a row! nomic Forum, most recently in the 2016±2017 Global Competitive-
World Economic Forum¶s ness Report. Unfortunately, this winning streak was lost in 2018,
2016±2017 Global not because of a lack of technical prowess, I hasten to add, but
Competitiveness Report purely because of corruption in certain top echelons of an other-
wise beautiful country. So, I want to start by congratulating you on
choosing to follow a career in which you can only flourish, given
that South Africa¶s education and training in this field are clearly the very best there is!
Having read the WEF assessment, the PDLQ UHDVRQVIRU 6RXWK $IULFD¶V IDOO IURP JUDFH were declining
investor protection, deteriorating ethical behaviour and efficacy of corporate boards and increasing cor-
ruption. But as a previous IRBA CEO, Bernard Agulhas, pointed out, we all need to µwork 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 you should aim to get
50% in ± it is imperative you grasp as much as you can and aim at full understanding of all principles.
Our economy is desperate for growth, more so now than ever before,
and for this to happen, investor confidence is essential. Accountants
play a pivotal role in generating confidence, together, of course, with Please visit our Facebook!
clear and sound economic policies. (See page ii for details)
So, to the subject at hand: accounting. It is a discipline that is most
misunderstood, with the general public¶s perception being that it is dull
and easy since it is simply about µdebits and credits¶. How hard can the principle of µdebit-credit¶ really
be? Well, it is safe to say that accounting is one of the fastest changing and most complex subjects and
is very interesting to those µin the thick of it¶. The International Financial Reporting Standards are cur-
rently 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, ZKLFK , FDOO µpop-ups¶,
throughout the chapters. These pop-ups are designed to help
you quickly identify core definitions (look for pop-ups with a
Support lectures and tutorials picture of an apple core) and to help you find mini-summaries,
are available ± please contact me showing the essence of a section, important tips or interesting
for details via Facebook facts (look for pop-ups with the picture of a happy face).
(see page ii for web addresses) To see how you are progressing, please access the LexisNexis
portal for free online questions. For teamwork and a com-
munity of students, 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!
As an optional extra, I offer online lectures for those who All you need is a positive
would prefer extra assistance. Please contact me if you have attitude, enthusiasm,
requests or queries in this regard by using the same Facebook commitment, perseverance ...
page. and Gripping GAAP!
In closing, please avoid complacency. 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 are right.
So, as you embark upon your journey into the world of µGAAP¶, it is imperative that you maintain a
positive attitude and keep your wits about you «and 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 result in a proliferation of
revised and re-revised standards, interpretations and exposure drafts. This edition has been
updated to account for the numerous amendments over the past two years, up to 10 Decem-
ber 2021, made to issued standards and interpretations (e.g. amendments have been made
to IAS 1, IAS 8, IAS 12, IAS 16, IAS 28, IAS 37, IFRS 3, IFRS 7, IFRS 9, IFRS 10, IFRS 16
and IFRS 17) and South African Circulars, legislation and regulations (e.g. Circular 1/2021
and JSE Listing Requirements).
The international standards and their interpretations are subject to a continuous process of
improvements, amendments, withdrawals and new publications. Please watch the Facebook
page for details of the changes as they happen (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 otherwise 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 µC¶ to denote an entity¶s currency but uses the symbol µLC¶
for an entity¶s µlocal currency¶ in any chapter dealing with foreign currencies.
Some chapters (e.g. chapters 1 & 23) include unavoidable reference to South African legis-
lation. Aspects of these chapters may not be relevant to some of the countries using this
book. All principles are, however, international principles.
Pedagogical philosophy
Gripping GAAP is designed for those who wish to:
z understand fully 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,
making it ideal for students studying on a distance basis.
Students must be able to see the µbig picture¶ and therefore flowchart summaries are pro-
vided at the end of each chapter. These summaries are actually a good place to start before
reading any chapter or in preparation for lectures and are also good to read over after read-
ing a chapter or attending 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 highlight the relevant
core definitions and the essence. These pop-ups have been provided in a bulleted format to
enable quick assimilation of µfast facts¶. The pop-ups with a graphic of an apple-core gener-
ally identify core definitions whereas those with the graphic of a smiling face provide sum-
maries of core facts, principles and tips.

vi
 Gripping GAAP
Pedagogical philosophy
x Chapter 1 explains the environment within which a µreporting accountant¶ finds himself or herself (i.e.
where an accountant is affected by the IASB and various related legislation).
x Chapter 2 explains the Conceptual Framework (CF), which is the basic logic underpinning the design
of the IFRSs. Chapter 2 covers the CF issued in 2018, highlighting key changes from the prior CF.
The IASB has not updated all 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 focus on the relevant IFRS and
simply identify any conflict with the 2018 CF.
x Chapter 3 explains how financial statements should be presented.
x Chapters 4±6 deal with revenue from customer contracts and taxes. Since tax is integral to all topics,
the chapters on tax are included early 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).
x Chapters 7±13 deal with various assets. These chapters are covered after deferred tax since the
assets concerned 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 and the second explains the revaluation model. The first part of this second chapter is
designed to explain the very basics of revaluations, focusing on revaluing non-depreciable assets. It
then progresses to revaluations of depreciable assets. The deferred tax and disclosure consequences
for both revalued non-depreciable and revalued 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 of these topics as they can affect
the measurement of various other assets (e.g. borrowing costs can affect the measurement of property,
plant and equipment). For this reason, these topics are included at a basic level in the affected asset
chapters (e.g. the basics of borrowing costs are covered in the chapter on property, plant and
equipment). For a more detailed understanding of these topics, see chapters 14 and 15.
x Chapters 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.
x Chapters 18±19 cover provisions, contingencies and events after the reporting period, and employee
benefits. Both chapters focus largely (but not entirely) on obligations (liabilities).
x Chapters 20±24: Chapter 20 deals with foreign currency transactions, explaining how transacting in a
foreign currency can affect the measurement of items.
Since foreign currency transactions frequently require hedging, chapter 22 explains hedge accounting
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 thus covered in the
immediately preceding chapter 21.
Share capital involves either equity instruments or financial liabilities and is therefore best covered
after having grasped the various concepts in the financial instruments chapter. The concept of share
capital and liabilities is therefore contained in chapter 23. Chapter 24 covers earnings per share,
which is best covered after having studied share capital.
x Chapter 25: Fair value measurement affects numerous prior chapters affected by fair value measure-
ments. You may refer to this chapter whilst studying these other affected chapters.
x 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.
x Chapter 27: This chapter, on cash flow statements, is distinct from all prior chapters in that it applies
the cash concept rather than the accrual concept and is therefore the penultimate chapter.
x Chapter 28: The final chapter deals with financial analysis and interpretation. 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 35

Framework
3 IAS 1 Presentation of financial statements 76
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 365
8 IAS 16 Property, plant and equipment: the revaluation model 417
9 IAS 38 & IFRS 3 Intangible assets and purchased goodwill 472
10 IAS 40 Investment properties 513
11 IAS 36 Impairment of assets 552
12 IFRS 5 Non-current assets held for sale and discontinued operations 602
13 IAS 2 Inventories 659
14 IAS 23 Borrowing costs 722
15 IAS 20 Government grants and government assistance 747
16 IFRS 16 Leases: lessee accounting 780
17 IFRS 16 Leases: lessor accounting 839
18 IAS 37; IAS 10 Provisions, contingencies and events after the reporting period 898
19 IAS 19 Employee benefits 936
20 IAS 21, IFRS 9, & Foreign currency transactions 958
IFRS 7
21 IFRS 9, IFRS 7, & Financial instruments ± general principles 983
IAS 32
22 IFRS 9, IFRS 7, & Financial instruments ± hedge accounting 1077
IAS 32
23 IFRS 9 & IFRS 7, Share capital: equity instruments and financial liabilities 1117
,$6 &R¶V$FW
24 IAS 33; Circ 1/21 Earnings per share 1142
25 IFRS 13 Fair value measurement 1182
26 IAS 8 Accounting policies, estimates and errors 1199
27 IAS 7 Statement of cash flows 1230
28 N/A Financial analysis and interpretation 1263

viii
Gripping GAAP The reporting environment

Chapter 1
The Reporting Environment
Main references: IFRS Foundation Constitution (2021); Due Process Handbook (2020); 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 2021

Contents: Page
1. Introduction 3
2. Skillsets and continuing professional development 3
2.1 Skillsets 3
Diagram 1: Skillset required of a South African Chartered Accountant 3
2.2 Continuing professional development 4
3. History of accounting: before internationalisation 4
3.1 Ancient history: the early evolution of accounting 4
3.2 The double-entry system 4
3.3 Modern history: further evolution due to corporations and credit 5
4. History of accounting: the process of internationalisation 6
4.1 Accounting is just a language 6
4.2 Generally Accepted Accounting Practice (GAAP) 6
4.3 The difference between GAAP and IFRS 6
4.4 A brief history of the harmonisation of National GAAPs into IFRSs 7
5. International Financial Reporting Standards (IFRSs) 8
5.1 Overview 8
5.2 The meaning of the term: µIFRSs¶RUµ,)566WDQGDUGV¶ 8
5.3 Standards 8
5.4 Interpretations 8
5.5 Conceptual Framework for Financial Reporting 9
6. Compliance, convergence and harmonisation 9
6.1 Compliance with IFRSs (adoption) 9
6.1.1. What does compliance with IFRS involve? 9
6.1.2. Why would one comply with IFRS? 9
6.1.3. The extent of compliance with IFRS around the world 10
6.2 Harmonisation versus Convergence 10
6.3 Compliance (adoption) versus Convergence 11
7. Development of IFRSs (standard-setting) 12
7.1 Overview 12
7.2 Standards developed to date 13
7.3 Interpretations developed to date 13
7.4 Due process 13
7.4.1 Overview 13
7.4.2 Principles of due process 13
7.4.3 The basic standard-setting cycle 14
Diagram 2: Basic standard-setting cycle 14
Diagram 3: Summary of who develops what 15
7.4.4 More about exposure drafts 15
7.4.5 More about annual improvements 16

Chapter 1 1
Gripping GAAP The reporting environment

&RQWHQWVFRQWLQXHG«
8. The IASB and the IFRS Foundation: a look at the structure 17
8.1 Overview 17
8.2 The IFRS Foundation 17
8.3 The IFRS Foundation: an organogram 18
8.4 The Monitoring Board 18
8.5 The Trustees 19
8.6 The International Accounting Standards Board (IASB) 19
8.7 The IFRS Interpretations Committee (IFRSIC) 20
8.8 The International Sustainability Standards Board (ISSB) 20
8.9 The IFRS Advisory Council (IFRSAC) 20
9. The Companies Act and the related Regulations 20
9.1 Overview 20
9.2 The different categories of companies 21
9.3 Legal backing for financial reporting standards 22
9.4 Which financial reporting standards must we use? 23
9.5 Legal backing for differential reporting 24
9.5.1 An overview 24
9.5.2 What is a small and medium-sized entity (SME)? 24
9.5.3 The history of differential reporting in South Africa 25
9.5.4 How do the IFRSs for SMEs help? 25
9.6 Does our company need an audit or independent review? 25
9.7 Company records 26
9.8 Accounting records 26
9.9 Financial year 27
9.10 Financial statements 27
9.11 Annual financial statements 28
9.11.1 Timing 28
9.11.2 Audit or independent review 28
9.11.3 Other documents included in the annual financial statements 28
9.11.4 Extra disclosure relating to directors or prescribed officers 28
9.11.5 Approval and presentation 30
10. JSE Listing Requirements 30
10.1 Overview 30
10.2 JSE RQµFontinuing obligations¶ 30
10.3 -6(RQµILnancial information¶ 30
11. King IV Report 31
11.1 Overview 31
11.2 King IV Report on remuneration 32
11.3 King IV Report on sustainability and integrated reporting 32
12. Summary 34

2 Chapter 1
Gripping GAAP The reporting environment

1. Introduction

This chapter describes the environment within which businesses and accountants operate and
report to the public. In this regard, it provides:
x an overview of the most important skills that an accountant needs, including the concept of
continuing professional development (see section 2)
x a brief and interesting history of accounting before internationalisation, the impact thereof, the
processes and the bodies behind the development of international standards and an
overview of what these standards consist of (sections 3 - 8);
x an overview of some of the more important aspects of the relevant regulatory framework,
such as the Companies Act, JSE Listing Requirements and the King Code (sections 9 - 11).

The term µregulatory framework¶ refers to a wide array of legislation, standards, guides,
handbooks, policies and other requirements and recommendations with which accountants and
businesses are expected to comply. Unsurprisingly, this regulatory framework is constantly
changing, which means we need to constantly remain up-to-date and vigilant to the changes.

In this regard, significant changes have been made to the regulatory framework since the
previous edition of this book, including, for example, an updated IFRS Foundation Constitution
as well as an updated IFRS Handbook.

2. Skillsets and continuing professional development

2.1 Skillsets
After reading this chapter, you will no doubt realise that the modern accountant does not only
need to have an affinity for numbers, but must also have a good command of language so as to
be able to study all aspects of the regulatory framework, including some complex legislation. In
fact, modern accountants are a far cry from the accountants of old, who were generally fairly
easily identifiable as the chap in the dusty back-office, pouring over numbers with a pocket-
protector and pen behind his ears. Instead, the modern accountant is an integral part of the
business, and someone who is expected to be able to contribute to the effective functioning of
all facets thereof. Today¶s accountants are front and centre and need a wide range of skills.

Diagram 1: Skillset required of a South African Chartered Accountant

Compulsory skills: Elective and residual skills:

1. Accounting and external 1. Auditing and assurance;
reporting; 2. Financial management;
2. Professional conduct; 3. Management decision-
3. Management and leadership; making and control;
4. Personal attributes; 4. Taxation;
5. Information technology 5. Risk management and governance

Source: CA(SA) Training programme: Prescribed Competencies

Gripping GAAP focuses on the main compulsory VNLOORIµaccounting and external reporting¶
x ‘Accounting¶UHIHUVWRUHFRUG-keeping, in other words, the process of documenting the results
of the business activities; and
x ‘External reporting¶ UHIHrs to how we convert these records into tKH µVWRU\ RI WKH EXVLQHVV¶
where this story is then told in the financial statements to those interested parties (external
users) in a way that will help them understand what occurred in the business during the period.

Chapter 1 3
Gripping GAAP The reporting environment

Having the specific VNLOORIµaccounting and external reporting¶UHTXLUHVDWKRURXJKXQGHUVWDQGLQJ

of many related theories, principles, rules and trends, including, for example:
x the basic theory and rules behind the double-entry system;
x the accounting and reporting rules and principles referred to as International Financial
Reporting Standards (IFRSs);
x the difference between IFRSs and generally accepted accounting practice (GAAP), where
the latter is simply an umbrella term referring to the accounting and reporting rules and
principles applicable in a country or region; for example:
 South African GAAP involves the application of IFRSs, whereas
 another country¶s GAAP may involve applying its own unique rules, instead of IFRSs, in
which case we would describe that country as applying its own national GAAP;
x the current trend involving the harmonisation of all various forms of national GAAP, and the
ultimate replacement thereof with IFRSs.

This chapter focuses on the wider reporting environment whereas the rest of the textbook focuses
on only one aspect thereof, being the application of IFRSs. In this regard, each of the remaining
chapters in this textbook is dedicated to a specific IFRS (or group of related IFRSs).

2.2 Continuing professional development

Continuing professional development (CPD) is recommended for all accountants but is
mandatory for those belonging to professional bodies. These CPD requirements will vary from
one professional body to another. For example:
x Some professional bodies require accountants to spend a minimum number of hours on
further study each year, referred to as an µinput model¶.
e.g. Chartered accountants in Australian and New Zealand must put in 120 hours of
relevant study over a 3-year period.
x Other professional bodies require accountants to design and follow their own individualised
CPD programme, referred to as an µoutput model¶.
e.g. Chartered accountants in South Africa have recently been transitioned from the µinput
model¶ to what is possibly a more onerous µoutput model¶. In this mode, the onus is placed
on the accountant to not only put in the necessary study-hours but to also create and
maintain an individualised rolling µCPD reflective plan¶, covering a 3-year period, which sets
out a learning plan designed to develop a skill-set relevant to their current specific position.

3. History of Accounting: Before Internationalisation

3.1 Ancient history: the early evolution of accounting

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). The early evolution largely
resulted from the changing nature of business. The evolution so far:
x Accounting first started as a basic record of items such as cattle and stores of grain, using
notches in clay tablets and sticks.
x Over time, this became more detailed where it then involved a written record of business
transactions (i.e. using words and numbers rather than notches).
x And then came the double-entry system (i.e. using debits and credits).

3.2 The double-entry system

The double-entry system is an accounting language that is centuries old, and as relevant today as it
was back then. It involves recording a transaction with both a debit and a corresponding credit entry:
x debit entries, being those on the left-hand side, represent assets and expenses; whereas
x credit entries, being those on the right-hand side, represent liabilities, income and equity.

4 Chapter 1
Gripping GAAP The reporting environment

Since equity is increased by income and decreased by expenses, this logic can be summarised as:

Assets = Liabilities + Equity Or Assets – Liabilities = Equity

Evidence of the first double-entry system exists in the form of 2 Evidence

ledgers, both of which are dated around the end of the 13th century: suggests the
x a ledger created by Amatino Manucci, a Florentine (Italian) double-entry
system began:
merchant, dated around the end of the 13th century; and
x in Italy
x a ledger created by Giovanino Farolfi & Company, a firm x in the 13th century!
of Florentine (Italian) merchants and moneylenders, dated 1299-
 FDOOHGWKHµ)DUROIL/HGJHU¶ 
Pacioli is called:
Roughly 200 years later, an Italian called Luca Pacioli, (who
worked closely with the artist and genius, Leonardo da Vinci), x the ‘father of
documented how the double-entry system worked, explaining it accounting’, but
in his mathematics textbook (Summa de arithmetica, geometria, x he did not design the
proportioni et proportionalità, published in Venice in 1494). double-entry system, …
x he simply wrote about it!
Interestingly, there is evidence of other books on the double-
entry system, published before Pacioli¶s book. However, Pacioli¶s books were more widely
distributed than the others, with the result that he became known as the µfather of accounting¶.

3.3 Modern history: further evolution due to corporations and credit

The double-entry
As explained, the evolution of accounting has come about due system came
largely to the evolution of business. Obviously there have about because it:
countless stages in the evolution of business, but if we keep it x gives the detail and
simple, we can probably agree on two fairly significant changes checks & balances
since the very early µcattle and grain businesses¶: x needed for those users
x the introduction of corporations, and x who are not involved in
x the introduction of credit. ‘day-to-day
management’.
Let us look how the arrival of corporations and credit have affected businesses and the
resultant impact on financial reporting:
x Introduction of corporations:
Initially businesses involved sole proprietors and family-run businesses, where record-
keeping was a relatively simple affair because the owners also managed the business and
were thus intimate with the EXVLQHVV¶V transactions. However, as businesses grew larger
and corporations began appearing on the scene, record-keeping had to become more
detailed because the owners of these corporations were shareholders and these
shareholders were generally not involved in the day-to-day management of the business.
Furthermore, this separation between owner and manager introduced what is known as
WKH µDJHQF\ SUREOHP¶: the risk that the interests of the owner and the interests of the
manager are not always perfectly aligned. To reduce the effects of the µagency problem¶,
more detailed financial reporting became necessary to enable the shareholders to more
easily assess the performance of management.
x Introduction of credit (finance):
Initially businesses worked purely on a cash basis. However, ZKHQ µcredit’ was
introduced, moneylenders wanted information that would help assess whether it was safe
to continue providing credit. Since moneylenders were not involved in the day-to-day
management of the business, they too needed detailed record-keeping.

In summary, the gradual evolution of business meant that there could be users of financial
information who were not necessarily involved in the management process (e.g. shareholders
and moneylenders) and who thus needed far more detailed financial information in order to
make business decisions.

Chapter 1 5
Gripping GAAP The reporting environment

The double-entry system was a magnificent development in this regard because it offered a
system of checks and balances that:
x gave assurances to the accountant that he had not overlooked an aspect of a transaction, and
x enabled the objective assessment of the financial health of a business by people who
were not involved in the management thereof (e.g. shareholders and moneylenders).

4. History of Accounting: The process of internationalisation

4.1 Accounting is just a language

Although accounting involves numbers, it is
actually a language, one that is used by accountants
to µWDON¶with other accountants and interested parties,
who we call µXVHUV¶ (see grey box alongside).
These users want to hear the EXVLQHVV¶Vµstory¶7KXV
accountants need to be able to document the story
(which they do with the use of the double-entry system)
and be able to describe the story (which they do
through the process of detailed reporting).
Examples of typical users:
Shareholders: who may consider
increasing or decreasing their
investments,
Lenders: need to assess the risk of continuing
to provide credit,
Suppliers: who may want to assess whether or
not to continue supplying goods and services,
Customers: need to decide who best to give
their business to.

4.2 Generally Accepted Accounting Practice (GAAP)

Over time, more detailed rules and principles have sprung up around the double-entry system
and the elements thereof: assets, liabilities, equity, income and expenses.

These rules and principles are known as generally accepted accounting practice (GAAP).

These rules and principles guide the accountant regarding the various elements:
x when to recognise them (i.e. when to process a journal entry),
x how to measure them,
x where they should be presented, and
x how much detail should be disclosed.

Before globalisation, countries operated very separately, each developing their own unique
form of GAAP (i.e. their own accounting language) (DFK FRXQWU\¶V *$$3 LV UHIHUUHG WR DV
WKDWFRXQWU\¶V national GAAP.

4.3 The difference between GAAP and IFRS

Pursuant to the industrial revolution, businesses began to grow and expand across borders.
Then, relatively recent µJOREH-VKULQNLQJ WHFKQRORJ\¶, such as cell phones, computers, email,
jet engines and the internet, made it possible to communicate instantly. All of this has resulted
in business and accountants from various countries needing to communicate financial
information with one another.

Over time, communication between accountants has led to the realisation that, although we
were all µtalking GAAP¶, we were not actually talking the same language. In fact, the National
GAAP used by businesses in one country is sometimes so different to the National GAAP
used by businesses in another country, that it is like comparing French and Chinese. In other
cases, the differences are minor such that it is more like comparing American English with
British English, where the words are the same, but generally it is just the accents that differ.

However, all differences, no matter how small, will still result in a level of 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.

6 Chapter 1
Gripping GAAP The reporting environment

The international communication amongst accountants had 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-Benz Story:

Once upon a time, back in 1993, WKH*HUPDQFRPSDQ\µ'DLPOHU-%HQ]¶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! ,WGHSHQGHGRQZKHWKHU\RXµVSRNH¶*HUPDQ*$$3RU86*$$3

At this stage, the attempt to develop a single accounting language, had been slowly underway
for many years, but the surge in globalisation, which resulted in exampleVVXFKDVWKLVµ
Daimler-%HQ] H[SHULHQFH¶, led to increased support for the idea and soon a new single
accounting language was born.

The process of developing this single accounting language, essentially involved the gradual
harmonisation of various forms of µNational GAAP¶ into a single µGlobal GAAP¶. This µGlobal
GAAP¶ is what we refer to as the International Financial Reporting Standards (IFRSs). Although
these IFRSs are now already being used by many countries, it should be noted that they will
probably always be a work-in-progress, and thus are continually being revised.

More on the development of the IFRSs, and the countries using them, can be found in section 6.

4.4 A brief history of the harmonisation of National GAAPs into IFRSs

As explained, global investors realised they needed a International Financial
single global accounting language, a global GAAP, Reporting Standards
without which comparability of financial results of global (IFRSs) - the history
companies was impossible. The development of this behind their development:
Global GAAP, called International Financial Reporting Late 1950’s: calls for global GAAP
1967: AISG was formed
Standards, began in the 1950¶s and involved
1973: IASC was formed
harmonising the various national GAAPs (see section 6.2 2001: IASB replaced IASC
for more on the µharmonisation project¶):
x 7KH¶V: In the lDWH ¶V FDOOV IRU JOREDO*$$3 EHJDQ GXH ODUJHO\ WR WKH LQFUHDVLQJ
economic integration after World War II and the resultant cross-border flow of capital.
x The ¶V: In 1966, it was proposed that a group be formed to focus on the idea of a global
GAAP. And so, 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.
x 7KH ¶V 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 (SUHIL[HGZLWKµ,$6¶).
x 7KH ¶V 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 (prefi[HGZLWKµ,)56¶ 

Chapter 1 7
Gripping GAAP The reporting environment

5. International Financial Reporting Standards (IFRSs) ± in a nutshell

5.1 Overview
International Financial Reporting Standards (IFRSs) contain the principles that are applied by
an accountant when:
x recording transactions and other financial information (accounting); and when
x preparing financial statements for external users (external reporting).

IFRSs are issued by the International Accounting Standards Board (IASB). The development
of IFRSs is explained in section 7.

5.2 The meaning of the term µIFRSs¶ or µIFRS Standards¶

It is important to know that the term µIFRSs¶ or IFRS IFRS Standards are
Standards¶ is actually a defined term, which technically (and defined as:
perhaps confusingly), refers to not only µstandards¶ but is a x standards &
term that refers to both Standards and Interpretations. x interpretations
issued by the board.
Occasionally, however, it may be used in a narrow sense to refer
They comprise:
only to standards and only those that were published by the
x IFRSs and IASs
International Accounting Standards Board. In other words, it may
x IFRIC and SIC
be used to refer only to those standards that are prefixed with interpretations.
µ,)56¶ (i.e. as opposed to those standards published by the Due Process Handbook: Glossary of terms

previous International Accounting Standards Committee, which

are SUHIL[HGZLWKµ,$6¶).
Thus, the term ‘IFRSs’
However, when reading a declaration in a set of financial technically includes:
statements that states the financial statements comply with x Standards; AND
x Interpretations.
IFRSs (or IFRS Standards), it is being used as defined, and
However, we sometimes use
thus it means that the financial statements comply with all the
it to refer only to those
standards and interpretations. ‘standards prefixed with IFRS’

5.3 µStandards¶
Standards:
Standards contain the principles to be applied by accountants.
x show us how to
The International Accounting Standards Board (IASB) is recognise, measure,
responsible for both developing and issuing the standards. present and disclose the
elements of accounting;
However, the development process follows strict due process
x will be prefixed with
procedures that require collaboration with national standard- either IAS or IFRS.
setters from around the world and other interested parties.

As explained previously, the IAS Board adopted all the work done by the previous
IAS Committee and thus some of the standards are still prefixed with IAS while those issued
by the IASB are prefixed with IFRS.

5.4 µInterpretations¶
Interpretations:
It can happen that a standard has confusing principles, the x explain how to apply
application of which needs some explanation. In this case, the standards;
IASB issues a document called an interpretation. x have the same authority
as standards.
Interpretations are given the same authority as the standards. x will be prefixed with
Thus, if a standard comes with an interpretation, this standard either SIC or IFRIC.
must be read together with its interpretation.

Although interpretations are issued by the IASB, they are actually developed E\ WKH ,$6%¶V
IFRS Interpretations Committee (IFRSIC).

8 Chapter 1
Gripping GAAP The reporting environment

As with the development of standards, the development of interpretations follows strict due
process procedures that require much collaboration with national Interpretations are
standard-setters from around the world and other interested parties. defined as:
x ‘developed by the
Since the IAS Board (IASB) adopted all the work done by the Interpretations
previous IAS Committee (IASC), some interpretations are Committee before being
x ratified & issued by the
prefixed with SIC and some are prefixed with IFRIC:
IASB.
x The old IASC prefixed their interpretations with SIC (being x Interpretations are part
the acronym for the committee responsible for their of IFRS Standards.’
development: Standing Interpretations Committee). Due Process Handbook: Glossary of terms

x The new IASB prefixes interpretations with IFRIC (the acronym for the committee that develops
them: International Financial Reporting Interpretations Committee).

5.5 Conceptual Framework for Financial Reporting

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

6. Compliance, convergence and harmonisation

6.1 Compliance with IFRSs (adoption) Compliance with

IFRSs means
6.1.1 What does compliance with IFRS involve? compliance with:
x Standards (IAS/ IFRS); &
x Interpretations (SIC/IFRIC).
To comply with IFRSs means to have adopted IFRSs. To be
able to state in the financial report that the financial statements comply with IFRS, they must:
x comply with all IFRSs, and
x comply without any modifications (i.e. adaptations).

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
stDWHPHQWVµFRPSO\ZLWKWKH,)56V¶we are actually saying they comply with both the:
x Standards, whether prefixed with IAS or IFRS; and
x 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).

6.1.2 Why would one comply with IFRS? Compliance could

be:
There is no international body forcing compliance with IFRSs. A x Legislated: due to the
relevant national
FRXQWU\¶V VSHFLILF national legislation may, however, require
legislation requiring
compliance with IFRSs. On the other hand, the national legislation of compliance; OR
some countries neither requires nor disallows compliance. On the x Voluntary: due to the
other end of the spectrum, there are some countries whose national international credibility
legislation actually disallows compliance (see section 6.1.3). that compliance gives.

Where the national legislation requires compliancHWKHDQVZHUWRµZK\ZRXOGRQHFRPSO\ZLWK

,)56¶ LV REYLRXV 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.

Chapter 1 9
Gripping GAAP The reporting environment

For example: For many years, 6RXWK $IULFD¶V OHJLVODWLRQ 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 9].

$SDUW IURP D FRXQWU\¶V OHJLVODWLYH UHTXLUHPHQWV ,$6  Presentation of Financial Statements

(i.e. a standard) states that if a set of financial statements complies with IFRSs (i.e. the
standards and interpretations), the financial statements must declare this fact. 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.]

6.1.3 The extent of compliance with IFRS around the world

7KH WHUP µ,QWHrnational Financial ReportLQJ 6WDQGDUGV¶ FDQ be a bit misleading at present
since not all countries use them. In other words, these standards are technically not
µLQWHUQDWLRQDO¶XQWLODOOFRXQWULHVrequire the use thereof. The situation is currently as follows:
x At least 156 1 participating countries (as at 7 November 20211) 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
x There are some countries that actually do not permit the use of IFRSs. Examples of some of
these include: Thailand, Cuba, Iran, Mali, Senegal and Vietnam.2
x 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
1https://www.ifrs.org/content/dam/ifrs/around-the-world/adoption/use-of-ifrs-around-the-world-overview-sept-
2018.pdf (accessed 7 November 2021)
2https://www.iasplus.com/en/resources/ifrs-topics/use-of-ifrs (accessed 7 November 2021)

Some countries have adopted the IFRSs word-for-word as World-wide usage of IFRSs
their own national GAAP. Some countries:
x require compliance with IFRSs
Others have adopted IFRSs but with certain modifications x permit compliance with IFRSs
x prohibit compliance with IFRSs.
that they consider necessary due to reasons that are
Sometimes countries that state
peculiar to that jurisdiction and which they thus believe they support the use of IFRSs are
have not been dealt with in the IFRSs. using:
x pure IFRSs,
x modified IFRSs, or
However, there are other countries that are not adopting the x national GAAP that has been or
IFRSs but are choosing to converge their national GAAP with is being converged with IFRSs.
the IFRSs instead (e.g. China, Indonesia and India).

Although these three approaches are all moving in the same direction, research has found
that the difference between using pure IFRSs (i.e. word-for-word) versus modified IFRSs or a
national GAAP that has been converged with IFRSs can be significant.

Thus, 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 GA$3¶VLQWR a single global GAAP (IFRSs) still has a long way to go.

6.2 Harmonisation versus Convergence

Developing global standards requires close consultation between the IASB and the national
standard-setters and interested parties from all countries. Two terms are commonly referred to in
these consultations: harmonisation and convergence.

10 Chapter 1
Gripping GAAP The reporting environment

The purpose of both harmonisation and convergence is The IFRS Foundation’s

to create a single set of high quality, global GAAP to be Constitution
adopted world-wide. x refers only to convergence;
x does not refer to harmonisation!
However, wKHUHDV µharmonisation’ was previously the
EX]] ZRUG µconvergence’ is now the focus. In fact, the Constitution of the IFRS Foundation
(see section 8.2) refers only WRWKHWHUPµFRQYHUJHQFH¶ So, what do these terms mean?

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 to:
x identify differences/ problems, and try to eliminate them; and
x 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). The IFRS Foundation’s
objective:
Essentially, the purpose of convergence is to try to reduce the x is not convergence; but
differences between the IFRSs (international GAAP) and the x is adoption.
standards of that specific country (that counWU\¶V QDWLRQDO Convergence is simply a
GAAP). It involves discussion and collaboration between that means to achieve adoption.
See IFRS Foundation Constitution 2(d)
FRXQWU\¶VVWDQGDUG-setters and the IASB in order to assess the
differences and reach an agreement on how to minimise these differences.

The IFRS Foundation¶V constitution clarifies that the ultimate objective is adoption of IFRSs,
and that convergence is simply a means to achieve adoption. Convergence is simply a
stepping-stone due to the resistance from some countries to adopting IFRSs.

Although most countries (at least 156 countries at November 20211) 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:
x Some countries resist adoption of IFRSs because the GLIIHUHQFHVEHWZHHQWKDWFRXQWU\¶V
national GAAP and the IFRSs are so vast that the complications and related cost of
converting to IFRSs are expected to outweigh the benefits.
x Some countries resist because they believe their national standards are superior to the IFRSs.
x 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 µOHVVZLOOLQJWRVurrender standard-VHWWLQJDXWKRULW\WRDQLQWHUQDWLRQDOERG\¶2

Where a country believes that it is unable to adopt the IFRSs, convergence is an option.

1https://www.ifrs.org/content/dam/ifrs/around-the-world/adoption/use-of-ifrs-around-the-world-overview-sept-2018.pdf (accessed 7 Nov 2021)

2 Research: Why Do Countries Adopt International Financial Reporting Standards? (2009: Ramanna & Sletten)

6.3 Compliance (adoption) versus Convergence

Comply (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

Chapter 1 11
Gripping GAAP The reporting environment

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
UHIHUUHGWRDVµWKH&RQYHUJHQFH3URMHFW¶+RZHYHULt 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 convergencHSURMHFWEHWZHHQWKH,$6%DQGWKH86¶V)$6%
is µhigh 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 I$6%¶s IFRSs DQG)$6%¶V86*$$3KDYHDOUHDG\EHHQIHOWE\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 supposed 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 WKDW GXH WR µWKH 86 3UHVLGHQWLDO
Elections and other priorities in Washington, it was unlikely that the SEC would return to the
topic of dRPHVWLF XVH RI ,)56V XQWLO HDUO\ ¶2 However, tKH ODVW µMRLQW IASB and FASB
pURJUHVVUHSRUW¶was released in 20183 (correct as at November 2021), suggesting that although
further work is continuing, the issue of domestic use of IFRSs is not high on the agenda.

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 µinternational accounting
bodies to redouble their efforts¶ to achieve this objective µwithin 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 (accessed 7 November 2021)
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 7 November 2021);
3 https://www.aasb.gov.au/admin/file/content102/c3/14.3.3_IASB_joint_IASB_FASB_UpdateJune2018_M167.pdf (access 7 Nov 2021)
4 https://www.journalofaccountancy.com/issues/2010/aug/20103021.html (accessed 7 Nov 2021)

7. Development of IFRSs (standard-setting)

7.1 Overview

IFRSs (standards and interpretations) are issued by the IASB, but their development occurs
either within the International Accounting Standards Board (IASB) or the IFRS Interpretations
Committee (IFRSIC).

Although the IFRSs are said to be developed by either the IASB or the IFRSIC, the
development process actually involves consultation with the various national standard-setters,
regulators and other interested parties from around the world. This global consultation
process enables a careful analysis of the priQFLSOHV DQG SUDFWLFHV FRQWDLQHG LQ WKH ZRUOG¶V
various national GAAPs to ensure that the IFRSs issued by the IASB are of a high quality.

This development follows specific procedures referred to as due process. Due process is
explained in section 7.4. In the meantime, let¶s look at what IFRSs have been developed to
date (Please note: IFRS is an acronym referring to µstandards¶ and µinterpretations¶).

12 Chapter 1
Gripping GAAP The reporting environment

There are now 42

standards:
7.2 Standards developed to date
x 25 are referenced as
IAS 1 to IAS 41
Standards are prefixed with either IAS or IFRS depending on (developed by the old
whether they were developed by the original International IAS Committee) &
Accounting Standards Committee (IASC) or the current x 17 are referenced as
IFRS 1 to IFRS 17
International Accounting Standards Board (IASB): (developed by the new
x The original International Accounting Standards Committee IAS Board).
(IASC) developed 41 global accounting standards, which were called International Accounting
Standards (thus prefixed µIAS¶), only 25 of which remain, the rest having been withdrawn;
x The new International Accounting Standards Board (IASB) adopted thHVH UHPDLQLQJ,$6¶V
and began developing further standards. So far, the newly created IASB has developed
17 new standards, referred to as the International Financial Reporting Standards ,)56¶V 

7.3 Interpretations developed to date

Interpretations are prefixed with either SIC or IFRIC depending There are now 20
interpretations :
on whether it was developed by a committee of the original
IASC or the current IASB. x 5 are numbered SIC 1 –
34 (developed by the old
x Interpretations were previously developed by a committee sub-committee); &
of the IASC, called the Standing Interpretations Committee x 15 are numbered IFRIC 1
(SIC). This committee developed 34 interpretations (SIC1 ± – 23 developed by the
new sub-committee).
SIC34), only 5 of which remain, the rest have been withdrawn.
x 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.

7.4 Due Process

7.4.1 Overview

Due process, which is set out in the Due Process Handbook, refers to the strict procedures
followed when standard-setting. Standard-setting refers to developing IFRSs, which includes:
x New standards;
x New interpretations;
x Amendments that are considered to be µmajor¶, which lead to revised standards;
x Amendments WKDWDUHFRQVLGHUHGWREHµPLQRURr narrow in VFRSH¶, which are processed
as part of the Annual Improvements Cycle.

7.4.2 Principles of Due Process (Due Process Handbook, Section 3)

Due process when standard-setting IFRSs is based on the following principles:

1. Transparency: this is achieved by, for example,
x meetings of both the IASB and IFRSIC, which are open to the public and webcast;
x rigorous voting processes; and
x various education sessions offered by the IASB.
2. Full and fair consultation: the IASB and IFRSIC requests input from a variety of sources
including, for example:
x various national and regional networks including the Accounting Standards Advisory
Forum and the IFRS Advisory Council;
x the publiFWKURXJKµLQYLWDWiRQVWRFRPPHQW¶, as well as public hearings; and
x 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.

Chapter 1 13
Gripping GAAP The reporting environment

3. Accountability: in this regard, the IASB is required, for example:

x to formally consider the likHO\µHIIHFWV¶ FRVWDQGEHQHILWV RISURSRVHG new or revised
standards throughout the development process;
x to provide WKH%DVLVIRU&RQFOXVLRQV LHWKH,$6%¶VUHDVRQLQJEHKLnd developing or
changing a standard as well as thH,$6%¶VUesponses to the comments received when
the proposals were exposed); and
x to provide Dissenting Opinions (i.e. if IASB members disagree with a standard, they
are required to provide reasons).

7.4.3 The Basic Standard-setting Cycle Diagram 2: Basic standard-setting cycle:

The starting point is to identify accounting Agenda

problems to which solutions may need to be
Public consultation
found. These items are normally added to
the agenda by the IASB, but the IFRS Research
Interpretations Committee (IFRSIC) can also
request items to be added to the agenda. Public consultation

Once an item is added to the agenda, the Discussion Paper (optional)

research begins, during which the accounting
problems and their possible solutions are
investigated. These are normally documented
in a Discussion Paper (DP), which is then
publishing with an invitation to comment. The
publishing of the DP is not mandatory.
x As its name suggests, if a discussion
paper (DP) is published, a discussion
would then follow (public consultation):
comments received are then considered
before finalising the research phase.
x If a DP is not published, the research
phase is simply finalised without public
consultation.
x Although a DP is not mandatory, the
reasons for not publishing one would
need to be explained to the Due Process Oversight Committee.
Public consultation
Exposure Draft (mandatory)
Public consultation
Standard/ Interpretation/ Improvement
Public consultation (the post- implementation review
process may reveal problems)
Agenda:
The post-implementation review may
suggest that amendments are needed.
These would be added to the agenda and
then possibly dealt with by way of:
 a revised Standard
 an Interpretation, or
 an Annual Improvement

Where the outcome of the research indicates that the accounting problem is significant but
that we have a plausible solution, we would move into the actual standard-setting phase. This
phase involves attempting to formalise what we believe to be the µplausible solution¶ by
developing a new standard, interpretation or amending a standard or interpretation (which
document we are working on depends on the circumstances). However, before we do this, we
must first publish an Exposure Draft (ED), together with an invitation for public comment. The
publishing of the exposure draft is mandatory. [See section 7.4.4 for more on exposure drafts]

An exposure draft is presented in the same format as the proposed final standard,
interpretation, or amendment to the standard or interpretation.

Once the exposure draft has been published and public comments have been considered and
successfully incorporated, we then move to the next stage, which is either the re-issue of an
adjusted exposure draft for further comment, or the publishing of the final document
(standard, amendment or interpretation).

The development process does not end when the final document is published. Instead, this is
when the post-implementation review process begins. For example, when entities start
applying new or amended Standards, practical issues may arise in the implementation,
causing problems or concern for businesses, accountants and auditors.

14 Chapter 1
Gripping GAAP The reporting environment

The implementation issues (problems) that may arise can be roughly categorised as follows:
x Major issues: these amendments could require the issue of, for example:
 a revised Standard or an Interpretation; or
x Minor or narrow-scope issues: these amendments would be dealt with in:
 the Annual Improvements cycle.

If such problems are identified in the post-implementation review period, this would lead to
issues being added to the agenda and the whole development process beginning afresh.

As can be seen from the standard-setting cycle, described above, public feedback is integral
in the development cycle. The value of the public feedback is that, rather than preparing a
poor-quality final document (e.g. standard or interpretation), we instead rewrite the discussion
paper or exposure draft, and then re-issue this for further public comment before preparing
the final document.

It is important to note that the IASB is responsible for issuing everything IFRS-related but it
does not develop everything:
x Exposure Drafts and Standards are developed by the IASB.
x Interpretations are developed by the IFRS Interpretations Committee (IFRSIC), which is a
sub-committee of the IASB.
x Annual Improvements are normally developed by the IFRS Interpretations Committee but
may be developed by the IASB instead. Due Process Handbook, Para 5.18

Diagram 3: Summary of who develops what:

IFRS: Previously developed by Now developed by

Exposure Drafts & IASC IASB

Standards

Improvements & SIC IFRSIC

Interpretations

7.4.4 More about Exposure Drafts

Exposure Drafts (EDs)

As can be seen from the standard-setting cycle, two x are developed by the IASB.
key areas for public comment include the discussion x are developed before developing
paper (DP) and the exposure draft (ED). Whereas the Standards/ Interpretations/
DP is optional, the ED is mandatory, being Annual Improvements.
considered µWKH ,$6%¶V PDLQ YHKLFOH IRU FRQVXlting the x always include invitations to comment.
SXEOLF¶ and a critical tool in ensuring high quality x must be approved by a ‘super
majority’ of the IASB.
documents. For this reason, it is important to gain a
bit more understanding of an exposure draft, its purpose, and how they are developed.
Exposure Drafts (EDs) are
Exposure Drafts (EDs) are draft documents prepared, defined as follows:
largely for the purpose of obtaining public comment,
x A draft of a proposed Standard,
before issuing new Standards, Amendments to amendment to a Standard or
standards or Interpretations. IFRIC Interpretation.
x An Exposure Draft sets out a
An ED is presented in the form of the proposed new specific proposal and includes a
document. In other words, if it is a draft of a new Standard, draft Basis for Conclusions and,
it will be presented in the format of a Standard. if relevant, alternative views.
x An Exposure Draft is a
mandatory due process step.
EDs of Standards are prepared by the technical staff Due Process Handbook: Glossary of terms
of the IASB, whereas EDs of Interpretations (which
are referred to as Draft IFRIC Interpretations), are prepared by the Interpretations Committee
and simply ratified by the IASB. See Due Process Handbook Para 6.4 & 7.1

Chapter 1 15
Gripping GAAP The reporting environment

EDs are µWKH,$6%¶VPDLQYHKLFOHIRUFRQVXlting WKHSXEOLF¶, with the result that the published
Exposure Draft always includes an invitation to comment. The comment period is normally:
x a minimum of 120 days when it is a draft Standard and
x a minimum of 90 days when it is a draft Interpretation or a draft Annual Improvement.
See Due Process Handbook Para 6.7; 6.15 & 7.11

The comment period can be shortened in the following cases:

x If the draft is narrow in scope (and can thus be dealt with as part of the Annual
Improvement Cycle), is urgent, and approval has been obtained from the Due Process
Oversight Committee (DPOC), the comment period can be as short as 30 days, or
x If there are exceptional circumstances and special approval has been obtained from the
Trustees, it can be reduced to less than 30 days. See Due Process Handbook Para 6.7; 6.8 and 7.11
A supermajority (EDs) is
Public comments received are thoroughly investigated. defined as follows:
If the issues raised are considered significant enough,
the IASB may decide to issue a revised ED for further x at least:
comment (this is called re-exposure).  8, if there are 13 members or less, or
 9, if there are 14 members.
Alternatively, however, a decision may be made that
x Abstaining is treated as a vote
the ED does not require re-exposure. In this case, the against a proposal.
ED (perhaps with certain amendments) is then voted Due Process Handbook: Glossary of terms (reworded slightly)
on, requiring approval by a µsuper majority¶ of the
IASB. Once this is obtained, the final Standard or Interpretation may be published.

Please note: EDs of Interpretations are prepared by the Interpretations Committee (IFRSIC).
In other words, unlike other EDs, they are not prepared by the technical staff of the IASB but
are simply ratified by the IASB. As a result, there are a few extra steps before a draft
interpretation gets issued for public comment. Two important extra steps are as follows:
x When a draft Interpretation is 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).
x Once this draft Interpretation is passed by the IFRSIC, it is presented to the IASB for
voting. On condition that no more than 3 members of the IASB disagrees with the draft,
the draft Interpretation is then issued for public comment. See Due Process Handbook Para 7.8 and 7.10

7.4.5 More about Annual Improvements

Annual Improvements are
The concept of Annual Improvements needs a little defined as follows:
explanation since the Due Process is slightly less
onerous. So, what are µAnnual Improvements¶ and in x narrow-scope or minor
what way is the Due Process less onerous? amendments to IFRS Standards
(i.e. standards and
interpretations)
Annual Improvements (AIs) involve amendments
x that are packaged together and
made to standards and interpretations that are exposed in one document even
regarded as µnarrow-scope or minor¶. These though the amendments are
amendments are limited to changes that either: unrelated.
Due Process Handbook: Glossary of terms (slightly reworded)
x clarify the wording in a Standard; or
x correct relatively minor unintended consequences, oversights or conflicts between
existing requirements of Standards. Due Process Handbook, para 6.10-11

Since it is obviously more efficient, we combine multiple minor amendments, even though
they are unrelated, into a single document, which we refer to as an Annual Improvement.

Strangely enough, although we refer to these amendments as µAnnual Improvements¶, and

also issue them within what we refer to as an µAnnual Improvements Cycle¶, it does not mean
that they are actually issued annually. In fact, we sometimes combine improvements for
multiple years into a single µannual cycle¶. For example, the most recent Annual Improvements
Cycle, issued in May 2020, covered amendments during the periods 2018-2020.

16 Chapter 1
Gripping GAAP The reporting environment

Although due process applicable to Annual Improvements (µnarrow-scope or minor¶ amendments)

is roughly the same as that which applies to all other amendments to IFRS Standards, due
process for Annual Improvements is slightly less onerous in that the level of consultation and
community outreach may be limited to the request for comment letters.See DPH para 6.11

8. The IASB and the IFRS Foundation: a look at the structure

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 that was created purely for the purpose
of enabling the IASB to function. Recently, however, the IFRS Foundation has added another
standard-setting body, the International Sustainability Standards Board (ISSB). Thus, the
Foundation now exists for the purpose of enabling both the IASB and ISSB 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, an advisory body has been created: the IFRS Advisory Council (IFRSAC).

8.2 The IFRS Foundation

The IFRS Foundation exists as the legal entity under which the IASB operates. It is described
DVµDQLQGHSHQGHQWQRW-for-profit private organisation ZRUNLQJLQWKHSXEOLFLQWHUHVW¶

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 2021)

The Objectives of the IFRS Foundation
The objectives of the IFRS Foundation are:
(a) through the IASB and the ISSB, to develop, in the public interest, high quality,
understandable, enforceable and globally accepted standards (referred to as ‘IFRS
Standards’) for general purpose financial reporting based on clearly articulated
principles. The IASB is responsible for developing a set of accounting standards (referred
to as ‘IFRS Accounting Standards’) and the ISSB is responsible for developing a set of
sustainability disclosure standards (referred to as ‘IFRS Sustainability Disclosure
Standards’). These complementary sets of IFRS Standards are intended to result in the
provision of high-quality, transparent and comparable information in financial
statements and in sustainability disclosures that is useful to investors and other
participants in the world’s capital markets in making economic decisions.
(b) to promote the use and rigorous application of IFRS 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 the adoption of IFRS Standards through the convergence of
national and regional standards and IFRS Standards

Chapter 1 17
Gripping GAAP The reporting environment

8.3 The IFRS Foundation: an organogram

IFRS Foundation Monitoring Board

Should be at least 5 members (from 5 specific bodies) & Public
1 non-voting observer Accountability
Current membership is constituted by 8 bodies &
1 non-voting 1 observer

IFRS Foundation Trustees

Should be 22 trustees (there are currently 22 trustees) Governance,
Strategy &
Trustees are appointed by the Monitoring Board
Oversight
Appointed for 3-yr terms (renewable once)
IFRS Advisory Council: currently +- 50 people

Appointments are for a renewable term of 3

International International
Accounting Sustainability
Standards Board Standards Board
(IASB): (ISSB):
IFRSAC normally meets twice pa.

Produces: Produces:
IFRSAC members are unpaid.
years.

IFRS Accounting IFRS Sustainability

.

Standards Disclosure Standards

Should be 14 members Should be 14 members

(13 voting & 1 voting (13 voting & 1 voting
chairman) chairman)

Appointed by trustees Appointed by trustees Independent

for 5-yr terms for 5-yr terms standard-setting
(renewable for a (renewable for a & related
further 3 yrs) further 3 yrs) activities

IFRS Interpretations
Committee
(IFRSIC):
Should be 15 members
(14 voting members
and 1 non-voting
chairman)

Appointed by trustees
for 3-yr terms
(renewable)

Adapted from: http://www.ifrs.org/about-us/our-structure/ (accessed 10 November 2021)

8.4 The Monitoring Board

The IFRS Foundation has a Monitoring Board, which provides a µformal link between the
Trustees and public authorities to enhance public accountability of the IFRS Foundation¶. 1

According to IFRS Foundation Constitution, the Monitoring The Monitoring Board:

Board's main responsibilities include:
x ensuring the Trustees fulfil their duties as defined by x Members come from Europe,
the Constitution; the US, Japan, Brazil, Korea and
other emerging markets.
x approving the appointment of Trustees;
x The MB effectively monitors
x meeting with the Trustees at least once a year (or the functioning of the Trustees.
more often if appropriate). 2 IFRSF-C: para 20

18 Chapter 1
Gripping GAAP The reporting environment

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:
x European Commission,
x Japanese Financial Services Agency (JFSA),
x US Securities and Exchange Commission (SEC),
x Board of the International Organization of Securities Commissions (IOSCO),
x Growth and Emerging Markets Committee of IOSCO
x Ministry of Finance of 3HRSOH¶V5HSXElic of China,
x Brazilian Securities Commission (CVM), and
x Financial Services Commission of Korea (FSC). 1

The current chairman is Jean-Paul Servais. Selecting a new chairman and admitting further
members to the Monitoring Board require the consensus of the existing members.
1 http://www.ifrs.org/groups/ifrs-foundation-monitoring-board/#about & #members (Accessed 10 November 2021)
2 IFRS Foundation Constitution, 2021

8.5 The Trustees Trustees:

There should be 22 trustees, who are appointed by and x are selected so that they reflect
a mix of professions and
thus accountable to the Monitoring Board. geographic areas.
x govern the operations of the
The trustees are tasked with governing the operations IFRS Foundation, IASB and ISSB.
of the IFRS Foundation and both its International
Accounting Standards Board (IASB) and International Sustainability Standards Board (ISSB).

The Constitution sets out the responsibilities of the trustees, including for example:
x appointing members of the IASB, ISSB, the IFRS Interpretation Committee (IFRSIC) and
the IFRS Advisory Council (IFRSAC);
x establishing and amending µthe operating procedures, consultative arrangements and due
process¶ to be followed by the IASB, ISSB, IFRSIC and the IFRSAC;
x monitor µcompliance with the operating procedures, consultative arrangements and due process¶;
x annually review µthe strategy of the IFRS Foundation, IASB and ISSB and its effectiveness¶;
x ensure the IFRS Foundation has suitable finance and approve its annual budget.
IFRS Foundation Constitution Para 14 & 16

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 is currently represented by
Suresh Kana, who was appointed in December 2018.

8.6 The International Accounting Standards Board (IASB)

The International Accounting Standards Board (IASB) is the standard-setting body focussed
on accounting. Its main objectives include:
x developing µIFRS Accounting Standards¶ and
x promoting convergence of µnational accounting standards¶ with the µIFRS Accounting Standards¶.

The membership of this board will: The IASB is the:

x ideally include 14 members, but no fewer than 8 members, x standard-setting body

x be appointed by the Trustees. focussed on accounting.
x be a combination of full-time and part-time members, paid by the IFRS Foundation, where
although some may be part-time, these members will still be expected to spend most of
their time working for the IFRS Foundation.
x have a high degree of expertise and knowledge relevant to sustainability reporting such
that they are able to contribute to the preparation of global accounting standards that are
of a high standard. See IFRS Foundation Constitution Para 25-38

Chapter 1 19
Gripping GAAP The reporting environment

8.7 The IFRS Interpretations Committee (IFRSIC)

The IFRS Interpretations Committee (IFRSIC) ± or simply called The IFRSIC:
the Interpretations Committee ± is a committee within the IASB.
x provides assistance in the
application of standards; and
The IFRSIC assists in the application of IFRS Standards. It does x develops interpretations.
this by, for example, answering questions from the public
regarding the application of IFRS Standards. It is also responsible for developing interpretations. 1
1. https://www.ifrs.org/groups/ifrs-interpretations-committee/#about (Accessed 10 November 2021)

8.8 The International Sustainability Standards Board (ISSB)

Th International Sustainability Standards Board (ISSB) is a brand-new board that has been
introduced into the IFRS Foundation. This board is the standard-setting body focussed on
sustainability reporting. The main objectives of this board will be to:
x develop IFRS Sustainability Disclosure Standards and
x promote convergence of µnational and regional sustainability reporting standards¶ with
these IFRS Sustainability Disclosure Standards.
The ISSB:
The membership of this board will:
x is the standard-setting
x ideally include 14 members, but no fewer than 8 members, body focussed on
x be appointed by the Trustees. sustainability reporting.
x be a combination of full-time and part-time members, paid
by the IFRS Foundation, where although some may be part-time, these members will still
be expected to spend most of their time working for the ISSB.
x have a high degree of expertise and knowledge relevant to sustainability reporting such
that they are able to contribute to the preparation of global sustainability disclosure
standards that are of a high standard. See IFRS Foundation Constitution Para 45-59

8.9 The IFRS Advisory Council (IFRSAC)

A separate IFRS Advisory Council (IFRSAC) exists as the forum The IFRSAC acts as
for organisations and individuals interested in international advisor to the
corporate reporting. x IASB,
x ISSB and
Membership should include at least 30 persons, who are x the Trustees
expected to meet at least twice per year. It is currently represented by 51 organisations,
constituted by 50 individuals from diverse geographical and professional backgrounds.
See IFRS Foundation Constitution: 2021: para 63

The Constitution states that the purpose of the IFRSAC is to provide the following services to
the IASB, ISSB and Trustees:
x strategic advice; and
x views relevant µto other consultative processes¶. See IFRS Foundation Constitution: 2021: para 63

9. The Companies Act and the Related Regulations

9.1 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 FRPSDQ\¶s existence and conduct.
It is separated into nine chapters and five schedules, of which, Chapter 2 and Schedule 2 and
Schedule 5 are most important to accounting and financial reporting. Some of the sections
relevant to accounting from these chapters and schedules will now be discussed.

20 Chapter 1
Gripping GAAP The reporting environment

9.2 The different categories of companies (Companies Act: S8 and S11)

There are two main categories of companies:
x profit companies; and
x 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 and Description:

1. Profit companies Definition: A company incorporated for the purpose of financial

1.1 A state-owned company
1.2 A private company
1.3 A personal liability company
1.4 A public company
2. Non-profit companies
gain for its shareholders Companies Act: S1
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 namePXVWHQGZLWKµ62&/WG¶. Companies Act: 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
Definition: A company is a private company if:
(a) it is not a state-owned company; and
(b) its Memorandum of Incorporation (MOI):
 prevents it from offering its securities to the public; and
 restricts the transfer of its securities. &R¶V$FW6 (See note 1)
Company name: must end witK HLWKHU µ3URSULHWDU\ /LPLWHG¶ or µ 3W\ 
/WG¶Companies Act: S11
Other interesting facts: A private company is no longer restricted to
50 members (i.e. it may now have more than 50 members!).
Definition: A company is a personal liability company if:
(a) it is a private company; and
(b) its Memorandum of Incorporation (MOI) states that it is a
personal liability company. Companies Act: S8
Company namePXVWHQGZLWKµ,QFRUSRUDWHG¶RUµ,QF¶Co¶s Act: S11
Definition: A company is a public company if it is:
(a) A profit company that is
(b) not a state-owned company, a private company or a personal
liability company. Companies Act: S1
Company namePXVWHQGZLWKµ/LPLWHG¶RUµ/WG¶&R¶V$FW: S11
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 namePXVWHQGZLWKµ13&¶. 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 µone of the units into which the
proprietary interest in a profit company is divided¶. See Companies Act: S1

Chapter 1 21
Gripping GAAP The reporting environment

9.3 Legal backing for financial reporting standards (Companies Act: S29 and Reg. S27)

For many years, South Africa had both:

x a national standard-setter (called the Accounting Practices Board: APB Note 1
) which would
publish SA accounting standards (SA GAAP) Note 2; and
x 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
x any person involved in the
companies, depending on the nature of the company:
x preparation, approval,
x IFRSs: International Financial Reporting Standards; dissemination or publication
x IFRS for SMEs: IFRSs for Small and Medium-sized x of any financial statements
Entities; x will be guilty of an offence
x SA GAAP Note 2; and x if those f/statements do not
x Any financial reporting standard of the FRPSDQ\¶V comply with IFRSs when they
choosing (this is only allowed for certain companies should comply. See Co’s Act S29
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 IFRS Standards. 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 must be IFRS Standards, 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. The FRIP will also
pro-actively review 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:
x The Financial Reporting Standards Council (FRSC); and
x The Companies and Intellectual Property Commission (CIPC). Continued on next page…

22 Chapter 1
Gripping GAAP The reporting environment

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; &
(b) making recommendations to the Council for amendments to financial reporting
standards, to secure better reliability and compliance. See Companies Act: S187(3)

9.4 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 µFRSs¶ 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 4.5).

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 that hold assets (b) IFRS for SMEs Note 1
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 continued…

Chapter 1 23
Gripping GAAP The reporting environment

1.6 Profit companies other than a state owned or public One of ±

companies, the public interest score of which for the (a) IFRS; or
particular financial year is less than 100, and whose (b) IFRS for SMEs Note 1
statements are 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 if the IFRS conflicts with any
a fiduciary capacity OR are state or foreign controlled OR requirement per the Public Finance
perform a statutory or regulatory function Management Act, the latter prevails
2.2 Non-profit companies other than those contemplated in the One of ±
first row above whose PIS for the particular year is at least (a) IFRS; or
350 (b) IFRS for SMEs Note 1
2.3 Non-profit companies other than those contemplated in the One of ±
first row above whose PIS for the particular financial year is (a) IFRS; or
at least 100 but less than 350 (b) IFRS for SMEs Note 1
2.4 Non-profit companies other than those contemplated in the One of ±
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.

9.5 Legal backing for differential reporting Legal backing for

differential reporting
9.5.1 An overview means that whereas
x some companies must use
The Companies Act 2008 has effectively given legal IFRS,
backing for differential reporting by allowing the use of x other companies may choose
both IFRSs and IFRSs for SMEs. to use IFRS 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.

9.5.2 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
x with no public
The IFRS for SMEs (section 1) explains that an entity has public accountability, but that
accountability if: x produce general
(a) its debt or equity instruments are publicly traded (or it is in the purpose financial
process of issuing such instruments); or statements for
external users.
(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.

24 Chapter 1
Gripping GAAP The reporting environment

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:
x whose parent uses full IFRSs, or
x forms part of a consolidated group that uses full IFRSs on consolidation,
you can still choose to use IFRS for SMEs fRU\RXURZQHQWLW\¶VILQDQcial statements.

9.5.3 The history of differential reporting in South Africa

Although the Companies Act of 2008 allows differential reporting, the

South Africa was
South African Accounting Practices Board (APB) had already the first country in
approved differential reporting in 2007. the world to adopt
IFRS for SMEs!
Given the extreme pressure placed on smaller companies to comply with complex IFRSs, the APB
felt it necessary to authorise the use oIWKH,$6%¶Vexposure 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.
https://www.iasplus.com/en/binary/safrica/0710smepr.pdf - last accessed 4 November 2019

9.5.4 How do the IFRS for SMEs help?

Small and medium sized entities (SMEs) are smaller entities that do not have the capability or
cash resources required to comply wLWK µIXOO¶ ,)RSs. Furthermore, their users are generally
interested in financial informaWLRQWKDWIRFXVHVRQWKHHQWLW\¶VFDVKIORZOLTXLGLW\DQGVROYHQF\
Thus, the IFRS for SMEs is a selection of simplified IFRS Standards to be used by SMEs which:
x provides disclosure relief (i.e. less detail needs to be provided in the financial statements);
x simplifies many recognition and measurement criteria;
x removes choices for accounting treatments;
x eliminates certain topics that are generally not relevant to SMEs; and
x is not updated as often as IFRS Standards are.

9.6 Does our company need an audit or independent review? (CR¶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 compan\¶VSXEOLc 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 iIDFRPSDQ\¶VMemorandum of Incorporation
states that an audit is required.

Category of company: Audit? By who?

1. Profit companies
1.1 State-owned companies Audit RA
1.2 Public companies Audit RA
1.3 ProfLWFR¶VRWKHUWhan 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.

Chapter 1 25
Gripping GAAP The reporting environment

Category of company continued … Audit? By who?

1. Profit companies continued …
1.4 3URILWFR¶VRWKHUWKan 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 Independent review RA/ CA
owner-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
owner-managed companies AFS

1.5 Profit FR¶Vother 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-SURILWFR¶VRWKHUWhan 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-pURILWFR¶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: Registered auditor 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 compDQ\¶V 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.

9.7 Company records (Companies Act: S24)

Section 24 deals with company records in general. Company records include accounting-
related records. The requirements specific to accounting-related records include:
x all company records (including accounting records) must be in writing or in a form that is
convertible into writing within a reasonable period of time (e.g. electronic form); and
x all company records must be kept for a period of 7 years:
Company records
- annual financial statements: for 7 years after the date must:
of issue*;
x be in writing (or be able to
- accounting records: for the current year plus the be converted into writing)
previous 7 completed years*; and x be kept for at least 7 yrs.
- 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.

9.8 Accounting records (Companies Act: S1 and S28)

Section 1 defines accounting records as:
x Information in written or electronic form
x concerning the financial affairs as required in terms of this Act,
x 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.

26 Chapter 1
Gripping GAAP The reporting environment

Section 28 requires that accounting records:

x must be accurate and complete;
x may be produced in any one oIWKHFRXQWU\¶VRIILFLDl languages;
x must be kept in the prescribed manner and form;
x must be in a form that enables the financial statements to be prepared in accordance with
this Act or any other law; and
x must be kept at, or be available from, the company¶VUHJLVWHUHGRIILFH

9.9 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 comSDQ\¶V
Notice of Incorporation.

Although it is possible to subsequently change the reporting date set out in the comSDQ\¶V
Notice of Incorporation, it may not be changed:
x without filing a notice of that change;
x more than once during any financial year;
x to a date that precedes the date on which the notice is filed;
x 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.
x For example: in the first year of operation, a cRPSDQ\¶V A financial year ends
on the reporting
accounting period starts on the date of incorporation and
date (RD).
ends on the reporting date set out in the compan\¶VNotice
of Incorporation. ThusXQOHVVWKHFRPSDQ\¶Vincorporation x Each co must state its RD
in its Notice of Incorporation.
date is exactly 365 days prior to its reporting date, the
x RDs may be changed.
FRPSDQ\¶VILUVWILQDQFLDO\HDUZLOOQRWEHD perfect 12 months.
x A financial year is normally
x Another example of when a financial year will not be 12 months but may end up
12 months is if the reporting date is changed. longer or shorter, but may
never exceed 15 months.

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.

9.10 Financial statements (Companies Act: S29 and Reg. 27)

Financial statements must:
x satisfy the Financial Reporting Standards, where these have been prescribed;
Persons involved in the
x may be compiled internally or independently; Reg. 27
preparation, approval,
x fairly present the compan\¶VVtate of affairs and business; dissemination or
publication of any
x H[SODLQWKHFRPSDQ\¶VWUDnsactions & financial position; f/statements,
x VKRZ WKH FRPSDQ\¶V DVVHWV OLDELOLWLHV HTXLW\ income x will be guilty of an offence
and expenses and any other prescribed information; x if these financial statements
x include the date they were produced; (or summaries thereof)
- do not comply with S29 or
x include the accounting period to which they apply; - are materially
x include, on the first page: false/misleading.

- 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.

Chapter 1 27
Gripping GAAP The reporting environment

9.11 Annual financial statements &R¶V$FWS30 & Reg. 38)

9.11.1 Timing Annual financial

Annual financial statements must be prepared within 6 statements
months of the financial year-end (or a shorter period to x must be prepared within at
provide adequate notice for an annual general meeting). least 6 months after year-end;
x may need to be audited or
9.11.2 Audit or independent review independently reviewed;
x must contain an auditors’
The annual financial statements of: report (if applicable), a
x state-owned and public companies must be audited. directors’ report and details
relating to directors and
x other companies may need an audit, independent others holding a prescribed
review or neither (see section 9.6) office in the company.

9.11.3 Other documents included in the annual financial statements

Annual financial statements (as opposed to financial statements) must also include an
DXGLWRU¶V UHSRrt (where applicable), a directors¶ report and details relating to directors or
individuals holding any prescribed office in the company.

9.11.4 Extra disclosure relating to directors or prescribed officers

For audited financial statements, further particulars must be disclosed where they relate to:
x directors, or
x 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. 6HH&R¶VRegulation 38

The particulars to be disclosed: D & PO Note 1 Disclose the: Reference:

x remuneration Note 2 and Note 3
current Amounts S30(4)(a)

x benefits paid or payable Note 2

current Amounts S30(4)(a)

x pensions paid or payable current and past Amounts S30(4)(b)(i)

x payments to pension funds on behalf thereof current and past Amounts S30(4)(b)(ii)

x compensation for loss of office paid current and past Amounts S30(4)(c)

x securities issued current and Number issued; S30(4)(d)

their relatives Class issued;

Amt received by the co in
exchange for the securities
x service contracts current All details S30(4)(e)

Remuneration includes: D and PO Reference:

x directors¶ fees for services to or on behalf of the company: amount Current S30(6)(a)

x salary, bonuses and performance-related payments: amount Current S30(6)(b)

x expense allowances for which the director need not account: amount Current S30(6)(c)

x contributions to any pension scheme not otherwise needing separate Current and past S30(6)(d)

disclosure: amount
x options or rights given directly or indirectly: the value thereof Current, past, future S30(6)(e)

and all relatives

x financial assistance for the subscription of options or securities or the Current, past, future S30(6)(f)

purchase of securities: amount and all relatives

x any loans (including loans made by third parties where the company is a Current, past, future S30(6)(g)

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 interHVWLQDQDUP¶VOHQJWKWUansaction,
- 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 teUPµremuneration’ includes a variety of items ± these are detailed in the table above. S30(6)

28 Chapter 1
 Gripping GAAP The reporting environment

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:
x services as director of the reporting company;
x 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 compDQ\¶V
financials differs from the amount that is disclosed LQWKHFRPSDQ\¶VILnancials.

For example: a director of company A may also be involved as a director in a subsidiary company,
say company B. This would then mean that when preparing the financial statements for company A:
x the amount recognised as an expense in company $¶V VWDWHPHQW RI Fomprehensive income will
include only the amount incurred by company A; but
x the amount disclosed as directors¶ UHPXQHUDWLRQLQFRPSDQ\$¶VQRWHs 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:
x the Companies Act 2008: S30: explained above;
x the JSE Securities Exchange (JSE) Listing Requirements: see section 10 of this chapter;
x the King IV Report: see section 11 of this chapter; and
x 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:
x a member of the board of a company, as contemplated in S66 (of the Companies Act), or
x an alternate director of a company and
x 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 section 5 and section 6, respectively.
However, it is interesting to compare the disclosure requirements relating to directors at this point:
x the Companies Act 2008 requires that the disclosures relating to directors¶ remuneration be
provided per director; but
x 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) & section 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)]
x 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;
x 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 .LQJ ,9¶V
Glossary of Terms: µindependence¶), is a category that is not required for purposes of disclosing the
GLUHFWRUV¶remuneration, but simply relates to the composition of the Board of Directors. See King IV Principle 7

Chapter 1 29
Gripping GAAP The reporting environment

9.11.5 Approval and presentation (Companies Act: S30(3))

Financial statements must be:

x approved by the board and signed by an authorised director; and
x presented to the fLUVWVKDUHKROGHUV¶PHeting after approval thereof. There is an exemption,
however: it need not be presented at this ILUVWVKDUHKROGHUV¶PHeting 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.

10. JSE Listing Requirements

10.1 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 (last updated in 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 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.

10.2 -6(RQµFontinuing obligations¶ (Section 3 of the JSE Listing Requirements)

Section 3 of the JSE Listing Requirements sets out the continuing obligations that an issuer
has once any of its securities have been listed on the JSE. This section is divided into a
number of paragraphs dealing with a variety of areas. The continuing obligations that involve
µannual financial statements¶ are set out 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 compan\¶V DQQXDl general meeting, distribute to all holders of
securities and submit to the JSE both:
x a notice of the annual general meeting; and
x 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).

10.3 -6(RQµIinancial information¶ (Section 8 of the JSE Listing Requirements)

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 µcontinuing
obligations¶ relating to matters of a financial nature:
x reporting historical financial information,
x pro-forma financial information,
x profit forecasts and estimates,
x UHSRUWLQJDFFRXQWDQW¶VUHSRUW
x minimum content of interim reports,
x preliminary reports,
x provisional annual financial statements and abridged annual financial statements,
x minimum contents of annual financial statements, and
x Financial Reporting Investigations Panel (FRIP).

30 Chapter 1
Gripping GAAP The reporting environment

The minimum contents of annual financial statements is contained in paragraph 8.62:

x 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 terms of International Standards on Auditing (ISAs), or in the case of foreign
companies, in terms of national auditing standards that are acceptable to the JSE;
d) be in consolidated form if the listing company has subsidiaries, unless the JSE
otherwise agrees, although the listed comSDQ\¶VRZn financial statements must also
be published if they contain significant additional information; and
e) fairly present the group¶s financial position, changes in equity, results of operations and cash flows.
x 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.

11. King IV Report

11.1 Overview
King IV deals with:
The King IV Report on Corporate Governance (King IV) was
x Ethical culture
published on 1 November 2016, effective for all financial years x Good performance
commencing on or after 1 April 2017. This report serves as the x Effective control
benchmark for corporate governance in South Africa. While x Legitimacy
King IV replaces King III in its entirety, it is not based on a King IV:
completely new philosophy ± instead, it has simply developed x has no legal backing; but
x is a JSE Listing Requirement.
and refined 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 been used and 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 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. King IV also
includes recommended practices (King practices) to support each principle (King principles).
These King practices are intended to make the King IV Report easier to apply.

A further change is that King IV has now adoptHGDQµDSSly and expODLQ¶DSSURDFKZKHUHDV

King III previously used an µapply 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
GHFLVLRQVRQDQHQWLW\¶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, fRXUµJRYernance
outcRPHV¶HWKLFDOFXOWXUHJRRGSHUformance, effective control and legitimacy.
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
µUHPXQHUDWLRQUHSRUW¶DnGDQµLQWHJUDWHGUHSRUW¶. Each of these will now be briefly discussed.

Chapter 1 31
Gripping GAAP The reporting environment

11.2 King IV Report on Remuneration (Principle 14)

King IV on remuneration:
The King IV Report states that governing bodies should
ensure that the organisation remunerates all employees x Should be fair, responsible and
fairly, responsibly and transparently, so as to promote the transparent.
creation of value in a sustainable manner. x Remuneration report:
enhanced accountability on
remuneration
There is a call for increased accountability for remuneration
x Executive remuneration should
which is achieved through the increase in disclosure be responsible relative to other
requirements. With this in mind, a remuneration report is employees
now required which focuses on three specific areas:
x A background statement, which provides the FRQWH[WRIDQRUJDQLVDWLRQ¶VUHPXQHUDWLRQ;
x An overview of the main provisions of the organisation¶s remuneration policy; and
x 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.

11.3 King IV Report on Sustainability and Integrated Reporting (Principle 5)

International attention to sustainability has been growing King IV emphasizes the
with many entities voluntarily publishing µVustainability importance of
sustainability by:
reports¶. This led to the IFRS Foundation introducing a
new board, the ISSB, dedicated to preparing International x reiteratingthe importance of
the Integrated Report,
Sustainability Disclosure Standards (see section 8.8). x which involves the integration
of sustainability reporting with
A sustainability report involves the practice of measuring, its financial and other reports
disclosing and being accountable to both internal and
external stakeholders for organizational performance towards the goal RI µVXVWDLQDEOH
deveORSPHQW¶

According to the Brundtland Report, the goal of sustainable development is:

x µWRPHHt the needs of the present
x without compromising the ability of futXUHJHQHUDWLRQVWRPHHWWKHLURZQQHHGV¶

King IV emphasises the importance of sustainability

reporting but notes that a sustainability repoUW LV µFULWLFDO King IV defines integrated
reporting as:
but insuffiFLHQW¶. It thus recommenGV µWKH PRYH IURP
siloed reportLQJWRLQWHJUDWHGUHSRUWLQJ¶ x a process founded on
integrated thinking
Siloed reporting tends to result in a variety of lengthy x that results in a periodic
reports (e.g. financial reports, sustainability reports, integrated report by an
organisation
audit reports, directors¶ reports etc) that lack cohesion.
x about value creation over time.
Annual reports that contain µVLORHG¶ information make it x It includes related
difficult for users to bring all the relevant information communications
together in a way that enables them to make informed x regarding aspects of value
decisions, which are really only possible if one can view creation
the company in a holistic way. Financial information presents only part of the business story
whereas there are also other important forward-looking issues regarding strategies of
sustainability relating to social and environmental issues. Thus, an integrated report better
reflects WKH UHDOLW\ µWKDW WKH Uesources or capitals used by organisations constantly
interconnecWDQGLQWHUUHODWH¶
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).

32 Chapter 1
Gripping GAAP The reporting environment

A useful analogy used by SAICA in explaining the integrated report is an octopusµthe head is
the integrated report and each arm is a detailed report or detailed information set (e.g.
governancHLQIRUPDWLRQ ¶

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¶V DELOLW\ WR FUHDte value. There are
three concepWVZKLFKVWHPIURPµLQWHJUDWHG thinking’:
x the organisation operates as an integral part of society;
x stakeholder inclusivity: the interdependency between an entit\¶VDELOLty to create value for
itself and value creation for others; and
x 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:
x Strategic focus and future orientation: An integrated report should provide insight into the
RUJDQL]DWLRQ¶VVtrategy, and how it relates to the organisDWLRQ¶V DELOLW\ WR FUHDWH YDOXH LQ
the short, medium and long term, and to its use of and effects on the capitals
x Connectivity of information: An integrated report should show a holistic picture of the
combination, interrelatedness and dependencies between the factors that affect the
organisDWLRQ¶VDELOLW\WRFUHate value over time
x Stakeholder relationships: An integrated report should provide insight into the nature and
quality of the organisDWLRQ¶VUHODWLRQVKLSVZith its key stakeholders, including how and to
what extent the organisation understands, takes into account and responds to their
legitimate needs and interests
x Materiality: An integrated report should disclose information about matters that substantively
affect the organisDWLRQ¶VDELOLW\WRFUHDWHYDOXHRYHUWKHVKRUWPHGLXPDQGOong term
x Conciseness: An integrated report should be concise
x Reliability and completeness: An integrated report should include all material matters,
both positive and negative, in a balanced way and without material error
x 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 organisDWLRQ¶VRZQ
ability to create value over time.

An integrated report typically contains:

x Annual financial statements; x Risk disclosures;
x Directors’ report; x IT reporting;
x Directors’ statement of responsibility; x Remuneration report;
x Management and directors’ commentary; x Statement by the company secretary;
x Report from the audit committee; x Terms of reference of committees; and
x Sustainability report; x Ethics statement.
x 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
µQLFHWRKDYH¶.LQJIV mDNHVWKHVHDµQHHGWRKDYH¶IRUDOO6RXWK$IULFDQOLVWHGFRPSDQLHV

Chapter 1 33
Gripping GAAP The reporting environment

12. Summary

About IFRSs

x We’re moving slowly towards global IFRSs:

GAAP: IFRSs
x Some countries have adopted IFRSs
x Some countries are resisting the
adoption of IFRSs – some of these have
agreed to a process of convergence
(e.g. the US)
x Include: standards & interpretations.
x Are issued by the IASB (the IASB’s legal
body is the IFRS Foundation).
x Development follows strict due process.
 Standards: developed by the IASB.
 Interpretations: developed by IFRSIC.
 Annual improvements: developed by
either the IASB or its IFRSIC.

Other topics covered (i.e. in addition to the 2008 Companies Act)

x IFRSs for SMEs: an overview of differential reporting

x JSE Listing requirements: an overview of the paragraphs

affecting annual financial statements

x 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

x No further CC’s There are many sections, however, some of

x No further par value shares the main sections affecting financial
x New company categories reporting include:
x Legal backing for IFRS S8: Categories of companies
x Legal backing for differential reporting S24: Company records
x Fourth Schedule disclosure falls away S27: Financial year
S28: Accounting records
S29: Financial statements
S30: Annual financial statements

34 Chapter 1
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 2021)

Contents: Page

1. The Conceptual Framework: purpose, objective and concepts 37

2. Conflicts between the CF and IFRSs 37

3. General-purpose financial reporting 38

3.1. Objectives and limitations 38

3.2. Information to be provided in general-purpose financial reports 39
3.2.1 Overview 39
3.2.2 Users use this information to make two basic assessments 39
3.3. Information about resources, claims and changes: position, performance or other 39
3.3.1 Overview 39
3.3.2 Resources and claims: financial position 40
3.3.3 Changes in resources and claims: financial performance or other 40
3.3.4 Presenting financial performance: accrual accounting and cash flow accounting 41
4. General-purpose financial statements 41

4.1. Overview 41
4.2. Financial statements versus financial reports 41
4.3. Objective of financial statements 42
4.4. Structure of financial statements 42
4.4.1 Statement of financial position 42
4.4.2 Statement of financial performance 43
4.4.3 Other statements and notes 43
4.4.4 Summary of how information is structured in financial statements 43
4.5. Summary comparison: financial statements versus financial reports 44
4.6. The reporting entity 44
4.7. The reporting period 45
4.8. The going concern assumption 46
5. Qualitative characteristics and constraints 46
5.1. Overview 46
5.2. Fundamental qualitative characteristics 46
5.2.1 Relevance (which involves materiality) 46
Worked example 1: Materiality is entity-specific (quantitative materiality) 47
5.2.2 Faithful representation 47
5.2.2.1 Complete 47
5.2.2.2 Neutral (involves prudence) 48
5.2.2.3 Free from error 48
5.2.3 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
5.3. Enhancing qualitative characteristics 49
5.3.1 Comparability 49
5.3.2 Verifiability 50
5.3.3 Timeliness 50
5.3.4 Understandability 51
5.3.5 Applying the enhancing qualitative characteristics 51
5.4. The cost constraint on useful information 51

Chapter 2 35
Gripping GAAP The conceptual framework for financial reporting

&RQWHQWVFRQWLQXHG« Page
6. Elements 52

6.1. Overview 52
6.2. Asset definition 53
6.2.1 Overview 53
6.2.2 Asset definition discussed in more detail 54
Example 1: Asset ± rent prepaid 55
Example 2: Asset ± various 56
6.3. Liability definition 57
6.3.1 Overview 57
6.3.2 Liability definition discussed in more detail 58
Example 3: Liability ± rent payable 60
Example 4: Liability ± various 60
6.4. Equity definition 61
6.5. Income and expense definitions 62
Worked example 4: Income definition 63
Worked example 5: Expense definition 63
Example 5: Expense ± arising from a payable 64
Worked example 6: Income and expense ± part of equity reserves 64

7. Recognition and derecognition 64

7.1. Recognition 64
7.1.1 7KHPHDQLQJRIWKHWHUPµUHFRJQLWLRQ¶ 64
Worked example 7: Recognising an asset and a liability 65
7.1.2 Recognition criteria 65
7.1.2.1 Overview 65
7.1.2.2 Relevance 66
7.1.2.3 Faithful representation 66
7.1.2.4 The trade-off between relevance and faithful representation 66
7.1.3 When an element is not to be recognised 66
7.2. Derecognition 66

8. Measurement 67

8.1. Overview 67
8.2. Different measurement bases 67
8.2.1 Overview 67
8.2.2 Historical cost 68
8.2.3 Current value 69
8.3. Factors to consider when selecting a measurement basis 69
8.3.1 Overview 69
8.3.2 Relevance 70
8.3.3 Faithful representation 70
8.3.4 Other considerations 70

9. Unit of account 71

10. Presentation and disclosure principles 71

10.1. Recognition versus presentation and disclosure 71

10.2. The principles of presentation and disclosure 72

11. Concepts of capital and capital maintenance 73

11.1. Capital 73
11.2. Capital maintenance and determination of profit 73

12. Summary 74

36 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

1. The Conceptual Framework: Purpose, objective and concepts (CF: SP1.1)

The Conceptual Framework for Financial Reporting (CF), revised in 2018, is a document that
sets out various key concepts:
x the µobjective of general-purSRVHILQDQFLDOUHSRUWLQJ¶; and
x various other concepts that underpin financial reporting. See CF SP1.1

Essentially, the CF states that, when we prepare general-purpose financial reports, our main
objective is to provide useful information about the entity (see section 3.1). See CF SP1.1

The µother concepts’ that it lays out, such as how to correctly determine whether we have an
asset or an expense, are those that are designed to help us meet this objective. In other
words, applying the concepts should ensure that we provide useful information. A complete
summary of the core concepts is listed below. See CF SP1.1

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).

It is important to note that the CF is not an International Financial Reporting Standard (IFRS).
Instead, IFRSs are what we use to guide us when preparing our financial statements, and the
CF simply forms the bedrock of logic upon which the IFRSs are developed. See CF SP1.1

In fact, one of the stated purposes behind having a Status of the CF:
Conceptual Framework (CF) is to be a helpful resource x not an IFRS!
x forms the basis of IFRSs.
to the International Accounting Standards Board (IASB) x may not override an IFRS.
in their development of the IFRSs. See CF SP1.1

A second purpose of the CF is to help preparers of financial statements to create their own
accounting policies where necessary. This can happen when either a suitable IFRS does not exist
or an existing IFRS allows an alternative policy to be developed. See CF SP1.1

The third purpose behind having a CF is to help everyone The purpose of the CF is to
assist:
(e.g. the IASB, the preparers of the financial statements
and users of financial statements) to understand and x the IASB to develop IFRSs.
x preparers to create
interpret the IFRSs. In other words, if we read something in accounting policies (rare)
an IFRS that we don¶t understand, we need to go back to x all parties to understand and
the basics and study the logic laid out in the CF. See CF SP1.1 interpret IFRSs. See CF SP1.1

So, in summary:
x our ultimate objective is to produce useful financial reports, so we create concepts that we
believe will achieve this objective: the objective and other concepts are contained in the CF;
x we then use this CF to create IFRSs; and
x we then use these IFRSs to prepare the financial statements.

2. Conflicts between the CF and IFRSs (CF SP1.2-4)

The CF was revised in 2018 and included some significant changes. For example, tKHµ2018 CF¶
clarified certain concepts (e.g. prudence), included new concepts (e.g. derecognition) and
updated certain concepts (e.g. new element definitions and recognition criteria).

Chapter 2 37
Gripping GAAP The conceptual framework for financial reporting

Interestingly, IFRSs issued before 2018 have not been updated for the new 2018 CF. This
means the wording in the older IFRSs may conflict with the wording of the new CF (e.g. IAS 37
specifically quotes the old liability definition, thus it conflicts with the 2018 CF). In all cases, if an
IFRS conflicts with the new CF, we must use the wording of the IFRS rather than the wording of
the CF (i.e. the CF never overrides an IFRS). The IASB will gradually resolve all such conflicts.

3. General-Purpose Financial Reporting (CF: Chapter 1 & CF: Chapter 3)

3.1 Objectives and limitations

The objective of ‘general-
The µobjective of general-purpose financial reporting¶ is purpose financial reporting’
to give users information that they will find useful in their is:
decision making (see full definition in grey box x to provide financial information
alongside). However, this objective is not to provide all x about the ‘reporting entity’ (RE)
possible users with all possible kinds of information for x that is useful to existing and potential
‘investors, lenders & other creditors’
all possible kinds of decisions.
x in making decisions relating to
CF 1.2
providing resources to the entity.
Which users are they designed for? This chapter will simply refer to the:
‘entity’, ‘users’ and ‘financial reports’.
There are many users who may find our general-purpose
financial reports (financial reports) useful, but we only need to 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 WKH HQWLW\ µSURYLGH LQIRUPDWLRQ GLUHFWl\ WR WKHP¶
Examples of other users who we do not need to 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:
What information are they to provide? x Only provides financial information
x Not designed for all users
As the name suggests, financial reports need only include x Not designed for all decisions
financial information. Other information that our users x Not exact information
may need include, for example, information about the x Only provides historic information
industry in which the entity operates, the political stability x Not designed to show the entity’s value!
of the country in which it operates, general economic
conditions and even climatic conditions (especially useful for agricultural businesses). Users will need
to find this information elsewhere. See CF 1.2 & 1.6

What ‘user decisions’ are they to assist with?

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. Information around any other decision regarding
an entity that a user may be facing would not be provided.

The resources that users may consider providing the entity with 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
WKHHQWLW\¶Veconomic 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

What makes the information useful?

Usefulness is hinged upon whether the information is relevant and a faithful representation. Faithful
representation means µcomplete, neutral and free from error¶. However, µfree from error¶ does not mean
the information is an exact depiction of transactions and events. Instead, they are fillHGZLWKµHstimates,
judgements DQG PRGHOV¶, based on the concepts contained in the CF (i.e. compliance with these
concepts is our goal). See CF1.11

38 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

3.2 Information to be provided in general-purpose financial reports

3.2.1 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
based on the user’s assessment of
decisions about whether to provide the entity with the entity’s:
resources (section 3.1). However, the specific decision x Prospects of future net cash inflows
depends on who the user is (e.g. an investor or lender), x Management stewardship See CF 1.3
and what potential return he needs to predict. For For users to make this assessment,
example, an investor may need to predict potential future they need financial reports showing
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), and
claims (L and Eq) and
plus interest income. See CF 1.3 changes in these resources & claims
(I, E & other transactions & events)
To make these predictions (of a specific potential return), x management‘s efficiency &
effectiveness in using the entity’s
users need information. To meet these needs, financial resources See CF 1.3-1.4
reports must include two categories of information about
the entity; namely information about its:
x economic resources, claims against the entity, and changes in those resources and claims; See CF 1.4
x managHPHQW¶V efficiency and effectiveness in performing their responsibility to use the
entity¶VHFRQRPic resources. See CF 1.4

3.2.2 Users use this information to make two basic assessments

Users use the abovementioned categories of information in making two basic assessments:
x µWKHprospects for future net cash inflows to the entiW\¶ OHW¶V call this µDVVHVVPHQW¶ and
x µPDQDJHPHQW¶s stewardship of the entit\¶V HFRQRPLF UHVRXUFHV¶ (this is basically how
management has cared for and handled the resources) (let¶VFDOOWKLVµDVVHVVPHQW¶). See CF 1.3

Interestingly, one assessment may also give insight into the other assessment. For example,
information that leads a user to assess managHPHQW¶VVWHZDUGVKLSDVEHLQJpoor (assessment 2),
may lead the user to an unfavourable assessment of the prospects of future net cash inflows
(assessment 1).

Financial reports  Financial statements (See section 4.2)

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
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 6)
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) often result in income & expenses,
but, not all such changes will meet the income definition (I) or expense definition (E).

3.3 Information about µresources, claims and changes¶: position, performance

or other

3.3.1 Overview

As already mentioned (section 3.2), financial reports provide two types of information about an entity.
However, the information about the µresources, claims and changes¶ therein deserves a little
more explanation. Information about µresources, claims and other¶ will provide insight into:
x our financial position; and also
x our financial performance and other events or transactions unrelated to financial performance.

Chapter 2 39
Gripping GAAP The conceptual framework for financial reporting

3.3.2 Resources and claims: financial position (CF 1.12 – 1.14)

Considering DQHQWLW\¶Veconomic resources (assets) with the claims against it (liabilities and
equity), gives a user a good idea of what is referrHGWRDVWKHHQWLW\¶s financial position.

When one WDONV DERXW DQ HQWLW\¶V Iinancial position, one is not only looking at a net asset
amount, but also referring to a variety of strengths and weaknesses, such as the HQWLW\¶V:
x liquidity (the user can look at the nature of its assets to assess the entit\¶s ability to
convert its assets into cash if needed);
x solvency WKHHQWLW\¶VDELOLW\WRSD\LWs liabilities); and
x funding structure (e.g. the portion of assets funded by liabilities versus equity) and possible
need for financing.

Furthermore, 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:
For example: an analysis of the HQWLW\¶s resources may reveal that management has invested
in assets yielding high returns or, perhaps that it has invested in technologically obsolete
equipment or slow-moving inventory; and
x the nature of the specific claims against these resources:
For example: 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).

3.3.3 Changes in resources and claims: financial performance or other (CF 1.15 – 1.21)

The changes LQDQHQWLW\¶s µHFRQRPLFUesources and FODLPV¶ are caused by a combination of:
x WKHHQWLW\¶V 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 x financial performance (e.g. profits)
the prior reporting date. x other reasons (e.g. issue of shares)

Furthermore, the user will want to know what caused the changes in these amounts.

The transactions and events that caused these changes can be categorised into (a) those
that relate to the entLW\¶V financial performance and (b) 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). This is because, for example, an increase in resources (e.g.
bank) that was generated through performance (i.e. income exceeding expenses) is generally
a better indicator of the entit\¶V ability to generate future cash flows than an increase in
resources that was a result of securing financing (e.g. raising a loan).

40 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

Financial performance is thus an indicator of the return RQ DQ HQWLW\¶V 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 3.3.4).
Information about the transactions and events that changeGDQHQWLW\¶V 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).

3.3.4 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 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. See CF 1.17 ± 19
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 1.20

Assessing past financial performance is generally useful in predicting future returns, but it is believed
that financial performance that has been depicted using The cash basis gives additional
accrual accounting is the best indicator of both past and useful information, which
some argue is essential
future performance. On the other hand, depicting financial
because the accrual system is
performance using cash flow accounting continues to be inherently flawed in that it allows for
useful in that it assists in assessing liquidity and solvency the manipulation of profits through
and helps assess and understand the entity¶V RSHUDWLRQV using various accounting policies and
investing and financing activities. See CF 1.17-1.20 measurement methods.

4. General-Purpose Financial Statements (CF: Chapter 3)

4.1 Overview Financial statements (FS)

are a form of
Financial report (FR)
So far, we have discussed financial reports. However,
this section deals with financial statements. FR’s give info about ‘economic
phenomena’

The following sections explain the difference between FS’s give info about ‘elements’
financial reports and financial statements, the financial statement objective, the term
µreporting entity¶ and µreporting period¶, the basic structuring of the financial statements
(financial position, financial performance DQGµRWKHU¶ DQGWKHGLIIHUent methods of accounting
for financial performance.

4.2 Financial statements versus financial reports (CF: Chapter 1, 2 & 3)

General-purpose financial reports (financial reports) are not A ‘general-purpose financial

the same as general purpose financial statements (financial statement’ is defined as:
statements). x a particular form of general-purpose
financial report
Financial reports is an µXPEUHOODWHUP¶WKDWLQFOXGHVILQDQFLDO x that provides information about the
statements: financial statements are simpl\ D µSarticular reporting entity’s:
 assets, liabilities, equity,
IRUP¶ of financial reports.  income and expenses CF Defined terms

Chapter 2 41
Gripping GAAP The conceptual framework for financial reporting

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
µeconomic resources DQGFODLPV¶
x Changes in these resources & claims
(the three of these are referred to as information See CF 2.2

DERXWWKHHQWLW\¶Vµeconomic 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 µfinancial reports¶ give information about all economic phenomena as well as
management efficiency and effectivenessµfinancial statements¶ give information about only
those economic phenomena that meet the definition of the elements: assets, liabilities, equity,
income and expenses (see section 6). 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 6).
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 7).
If useful, financial statements must provide information about all elements, whether they were recognised or not.

4.3 Objective of financial statements (CF 3.2) The objective of financial

statements (FSs) is:
The objective of financial statements is to provide users
x to provide financial information
with useful financial information about the reporting HQWLW\¶V
x about the reporting entity’s
elements: assets, liabilities, equity, income and expenses.
x assets, liabilities, equity, income &
expenses
4.4 Structure of financial statements (CF 3.3) x that is useful to users of FSs
-in assessing the prospects for
To provide information about these elements in a way that ‘future net cash inflows’ to the
will be useful to users, the financial statements are reporting entity, and
- in assessing ‘management’s
provided as a set of individual statements containing
stewardship’ of the entity’s
carefully categorised information about these elements. economic resources. CF 3.2

The CF does not dictate the title that must be used for
each or the detail to be contained in each, but the CF A set of FSs includes a:
refers to them as the:
x statement of financial position, x Statement of financial position
x statement of financial performance, x Statement of financial
x other statements and notes. See CF 3.3 performance
x Other statements and notes
4.4.1 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 6.2)
x Liabilities are the claims against an entity that meet the liability definition. Examples
include borrowings, trade payables and bank overdrafts. (See section 6.3)
x Similarly, equity reflects the claims against an entity that meet the equity definition.
Examples include ordinary share capital. (See section 6.4)

42 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

As was explained previously, users analyse the economic resources and claims to gain
valuable insight into WKHHQWLW\¶V strengths and weaknesses such as its liquidity, solvency and
need for financing (see section 3.3). 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 only be presented in the notes to the
statement of financial position (see section 4.4.3).

4.4.2 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 6.5)
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 6.5)

Although the CF refeUV WR WKLVDV WKH µVWDWHPent of financial performancH¶, 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 WLWOHµVtatement of comprehensive incomH¶This is covered in more
detail in chapter 3.

4.4.3 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 to the financial statements
2. This information will be found in the statement of cash flows and in the notes to the financial statements
3. This information will be found in the statement of changes in equity and in the notes to the financial
statements

4.4.4 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 thHHQWLW\¶V
x financial position,
x change in financial position that arose due to:
± the entit\¶V performance; and
± other reasons.

Chapter 2 43
Gripping GAAP The conceptual framework for financial reporting

Element Description
Assets Economic resource that meets the definition of an asset Section 6.2 Position
Liabilities Claims that meet the definition of a liability Section 6.3 Position
Equity Claims that meet the definition of equity Section 6.4 Position
Income Changes in economic resources and claims that meet the Section 6.5 Performance
definition of income*
Expense Changes in economic resources and claims that meet the Section 6.5 Performance
definition of expense *
Other items Changes in economic resources and claims that do not meet Section 6.5 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 µFKDQJHVLQHFRQRPic resources and claims¶Ls presented in two separate categories ± those that
arose due to performance and those that arose due to other reasons.

4.5 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 a:
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 &  assets, liabilities, equity, income and expenses.
changes in those economic resources and claims CF Defined terms

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 in making decisions about  assets, liabilities, equity, income and expenses
providing resources to the entity See CF 1.2 x that is useful to users
To make these decisions, users will need to assess: x in assessing:
x prospects for future net cash inflows to the  prospects for future net cash inflows to the
entity; and entity; and
x management’s stewardship of the entity’s  management’s stewardship of the entity’s
economic resources See CF 1.3 economic resources See CF 3.2

To make these assessments, the financial reports

must contain information about the:
x economic resources, claims against the entity &
changes in these resources & claims; & the
x efficiency and effectiveness with which
See CF 1.4
management has used economic resources.

4.6 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.

44 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

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.

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 µVLQgle-
entiW\¶ILnancial 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.

4.7 The reporting period (CF 3.4 ± 3.7)

Financial statements provide information abouW DQ HQWLW\ IRU D µVSHFLILHG time-SHULRG¶ FDOOHG D
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 DVVHW¶V EDOance 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, mDQDJHPHQW¶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 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

Chapter 2 45
Gripping GAAP The conceptual framework for financial reporting

4.8 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 WKDW µis 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.

5. Qualitative Characteristics and Constraints (CF: Chapter 2)

5.1 Overview There are 2 types of QC

x Fundamental QCs
Qualitative characteristics and constraints affect all forms of these are essential for
financial information, whether contained in financial usefulness
x Enhancing QCs
statements or other financial reports. However, this textbook these improve usefulness
focuses on financial statements. See CF 2.3

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: these are essential for usefulness.
x Enhancing qualitative characteristics: these improve usefulness. See CF 2.4-2.5

Let¶s look at what these characteristics are, how to apply them and let¶s also give some thought to
the cost constraint we would face when trying to ensure that our financial statements have them.

5.2 Fundamental qualitative characteristics (CF 2.5)

There are only 2
For financial statements to be useful, the information they Fundamental QCs:
hold must be both relevant and a faithful representation. x Relevance; &
We always start by deciding 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.

5.2.1 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¶GHFLVLRQ-making. See CF 2.6 x in the decisions made by users.
CF 2.6

Financial information is capable of making a difference if it Relevant information must have:

has either of the following or both: x Predictive value; and/or
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¶Vrevenue 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.

46 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

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 XVHUV¶ 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

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 µsales
income¶ (C22 000) and µservice income¶ (C18 000) and aggregates all remaining income types (e.g.
interest, dividends, rental), whicKLWGLVFORVHVDVµother inFRPH¶ (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:
µsales incoPH¶ (C850 000) and µRWKHr 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 financial statements with immaterial information would also risk obscuring
material information. Thus, quantitative materiality (magnitude) is entity-specific. Please note, however,
that qualitative materiality (nature) would also be entity-specific.

5.2.2 Faithful representation (CF 2.12 – 2.19) Faithful representation

means information must:
Faithful representation refers to the depiction of substance faithfully represent the
over form. This means, if something¶V legal form differs from substance of the
its substance, then we must rather portray its substance«QRW phenomena that it purport
to represent. CF 2.12
its legal form.
To be a faithful representation,
the information will need to be:
For example: a legal contract may state that an entity is x complete,
leasing an item from someone (legal form = lease), but the x neutral and
See CF 2.13
entity may be leasing the item for its entire useful life, in which x free from error.
case, the essence of the transaction is that the entity has 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
Complete means depicting:
5.2.2.1 Complete (CF 2.14) x all information
x necessary for a user to
x understand the
Financial statements must be complete. Completeness means phenomenon being
giving all information (words and numbers) that a user needs depicted CF 2.14
to understand whatever phenomenon is being described. For
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).

Chapter 2 47
Gripping GAAP The conceptual framework for financial reporting

5.2.2.2 Neutral (involves prudence) (CF 2.15 – 2.17)

Neutral means:
For financial statements to be neutral, we must not select
x free from bias.CF 2.15
or present information in a way that is biased. When there
Bias means :
is bias in the financial statements, it means the information
x manipulation to get a
has been manipulated, whether consciously or unconsciously, response that is either
so that users interpret it in a favourable or unfavourable way x favourable/
(this could happen by merely over-emphasizing one piece of unfavourable.
information or de-emphasizing another!).
Prudence is the:
To help us remain neutral, we must exercise prudence. x exercise of caution when
x making judgements
Exercising prudence means that, wherever there is a level of x under conditions of
uncertainty.CF 2.16
uncertainty in the information, we must exercise caution. Being
prudent (cautious), means we are being careful not to:
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).

5.2.2.3 Free from error (CF 2.18 – 2.19) Free from error means:
x no errors/ ommissions in
x description of
To be useful, information must be a faithful representation, and phenomena and
to be a faithful representation meaQVLWPXVWEHµIUHHIURPHUURU¶ x selection & application
HoweverLQIRUPDWLRQWKDWLVµIUHHIURPHUURU¶GRHVQRt mean it of processes used to
must be 'accurate in all UHVSHFWV¶ produce the information.
CF 2.18 (reworded)

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
µmeasurement uncertainty¶%\LWVYHU\QDWXUH 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 µIUHHIURPHUURU¶

µFree 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 rel\LQJRQRXUODZ\HU¶VHVWLPDWLRQV , and
x there are no errors in the selection and application of the process used to develop them. See CF 2.18

5.2.3 Applying the fundamental qualitative characteristics (CF 2.21 ± 2.22)

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

48 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

There is often a trade-off between presenting relevant information that is also a faithful
representation of the phenomenon, and vice versa. What is important is that we can conclude that
both fundamental qualitative characteristics are met. 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.
x In some cases, we may still be able to conclude that it is a faithful representation by simply
highlighting that this information is an estimate and explaining all the related uncertainties.
x 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.

Worked example 2: Relevant information that is also a faithful representation

The government gives us land at no cost. Land is the phenomenon we need to depict.
We can faithfully represent land (the phenomenon) at its µcost¶ (nil), but we decide cost is
not the most relevant information. Instead, we decide the most relevant information is its µfair value¶.
We then establish that we can estimate fair value based on current market valuations of similar
properties and that the measurement uncertainty relating to this estimate is low enough for us to
conclude that the estimated fair value would be a faithful representation.
Conclusion: We decide to measure land at its fair value because it is relevant and would be a faithful
representation and thus would be useful information (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 µfair value¶. However, its
fair value is not directly observable and thus we need to estimate it.
Unfortunately, there are no similar properties or market valuations available and thus we need to
estimate it using other data. We also realise this estimate will have such a high degree of
measurement uncertainty that we will not be able to conclude that the estimate is a faithful
representation of the properW\¶V fair value.
In this case, we decide that the next most relevant information about this property is its µcost¶. We
conclude that, since it needs no estimate, cost is a faithful representation of the property.
Conclusion: We thus decide that the information we must provide is µcost¶, since it is both relevant and a
faithful representation, and thus it is useful.
This is an example of having to reduce the relevance of the information in order to achieve a faithful
representation i.e. we are forced to give information that is not as relevant as we would have liked).
This is because: relevance + unfaithful representation  useful information

5.3 Enhancing qualitative characteristics (CF 2.23 ± 2.38)

Enhancing QCs (4):
Once information is both µrelevant¶ and µfaithfully represented¶ x Comparability
(fundamental qualities), we have useful information. x Verifiability
x Timeliness
x Understandability. See CF 2.23
We then try to enhance this usefulness by ensuring that the
information is also µcomparable¶, µverifiable¶, µunderstandable¶ and produced on a µtimely¶ basis.
These are the 4 enhancing qualitative characteristics. See CF 2.23

5.3.1 Comparability (CF 2.24 – 2.29) Comparability enables

users to:
Comparability allows users to identify similarities and x ‘identify & understand
x similarities in items, &
differences among items. Being able to compare items x differences among items’.
helps users choose how to proceed with their decisions CF 2.25

(e.g. whether to invest in one entity or another entity).

Chapter 2 49
Gripping GAAP The conceptual framework for financial reporting

µConsistency¶ is not the same as µcomparability¶…it simply helps achieve comparability. See CF 2.26
x µComparisons¶ need at least two items whereas Comparability  Consistency
x µConsistency¶ refers to the same methods being applied to
one specific item, either: x Comparability is the goal;
x Consistency helps achieve
 in a single entity across multiple periods; or the goal. CF 2.26

 across multiple entities in a single period.

Consistency helps enable
In other words, users find information more useful if they comparisons:
can make comparisons: x across multiple entities; and
x across multiple periods.
x from one year to the next: Transactions of a similar See CF 2.26

nature should be recognised, measured and presented by

an entity in the same way that they were in prior years (consistently) (e.g. an entity should
ideally use the same methods to measure inventory every year). This consistency enables
comparisons across multiple periods, which may help identify trends (e.g. a trend in
liquidity may help creditors decide if they should increase or decrease credit limits).
x from one entity to the next: Transactions of a similar nature should, ideally, be recognised,
measured and presented by all entities in the same way. This consistency enables
comparisons across multiple entities (e.g. this would be useful to potential investors 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.
Verifiability means that:
5.3.2 Verifiability (CF 2.30 – 2.32)
x different knowledgeable
and independent
Verifiability helps assure users that the information has been observers
independently assessed by knowledgeable observers and x could reach consensus,
found to be faithfully represented. Thus, verifiability gives users although not necessarily
complete agreement,
a measure of confidence in the information presented.
x that a particular depiction
(e.g. description/ amount)
An amount need not be a ‘single point estimate’ to be verifiable. is a faithful representation.
CF 2.30
Instead, a range of possible amounts and their probabilities
could be verifiable. See CF 2.30

Some information may not be verifiable (e.g. predictions and certain explanations). If information is
not verifiable, it should be clearly identified as such so that users can decide if they 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 looking at 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

5.3.3 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 µ2016 financial statements¶ of a business are CF 2.33

not relevant to a user who is trying to decide, in 2020, 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).

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5.3.4 Understandability (CF 2.34 – 2.36) Understandable

information is:
Since our ultimate objective is usefulness, it makes sense x Classified, characterised
that information must be understandable. For information to & presented
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 CF 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

5.3.5 Applying the enhancing qualitative characteristics (CF 2.37 – 2.38)

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 try to maximise
the enhancing QCs but
We must maximise the enhancing qualitative characteristics also be careful because:
where possible. However, this process involves a balancing act, x maximising one QC
because to apply one enhancing qualitative characteristic may (e.g. understandability)
mean that another one (an EQC or even a FQC) is diminished. x may reduce another QC
(e.g. timeliness).
For example:
x for information to be a faithful representation (a FQC), it 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.

5.4 The cost constraint on useful information (CF 2.39 ± 2.43)

There are often large 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.

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6. Elements (CF: Chapter 4)

6.1 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 desFULEHDQHQWLW\¶V
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 HQWLW\¶V 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.

Whereas financial reports include all WKH HQWLW\¶V HFRQRPLF 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 7). 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

Asset Liability
CF 4.3 – 4.25 CF 4.26 - 4.47

x A present economic resource Note 1

x A present obligation Note 2

x Controlled by the entity x To transfer an economic resource Note 1

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 – 4.72 CF 4.68 & 4.71 – 4.72

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 holders of equity claims x Other than contributions from holders of equity claims

Please note! IFRSs that were developed before the publication of the 2018 CF (i.e. pre-existing IFRSs) have
not yet 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.
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
preparers must remember that the requirements of an IFRS must always override the principles in the CF.

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6.2 Asset definition (CF 4.3 ± 4.25)

6.2.1 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
x the potential to produce economic benefits See CF 4.4

For an asset to exist there must be a present economic resource (defined as µa 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:

that has the potential to produce economic benefits), x a right (not an object):
x whether the entity controls this right, and e.g. right to use an asset

x that the right exists at reporting date due to a past event. x that has the potential (even if
it is remote) to produce
economic benefits (EB):
The most significant change brought about by the new asset e.g. cash inflow or a
definition is that, when trying to decide whether an asset exists, reduced cash outflow

we must no longer focuVRQWKHµREMHFW¶EXWUDWKHUWKHµrights’ that it represents (because an asset is

DQµHFRQRPLFUHVRXUFH¶which LVDµULJKWWKDWKDVWKHpotential to produce ecoQRPLFEHQHILWV¶). For
example, when deciding if a particular machine is an asset, we don¶t look µat the object¶, but rather
we look µinto the object¶ to see whether we can identify any rights µfloating around¶ in it (e.g. our
machine may give us the right to make muffins) and whether any of these rights has the potential to
produce economic benefits (e.g. selling the muffins would produce a cash inflow).

A right could be many things, such as a right to receive cash (e.g. receivable), a right to receive
goods or services (e.g. prepaid electricity), a right to use an asset (e.g. a machine) or a right to sell
an asset (e.g. inventory) etc. See CF 4.6

However, for a right to be an µeconomic resource¶, it must have the potential to produce economic
benefits for the entity. Depending on what the right is, this µpotential 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 etc. For example, inventory represents:
x the right to sell the asset, and
x this µright to sell¶ has the potential to produce economic benefits, (e.g. in the form of cash), if the
entity is able to sell the inventory.
Control over the ER
Control exists if we can:
The potential to produce economic benefits does not have to be
x direct the use of the ER &
certain, probable or even likely. Thus, even if the aforesaid x obtain its benefits
inventory was unlikely to ever be sold, the entity would still Generally able to prove
conclude that it has an asset since the right has the potential, control through the ‘ability
however remote, to produce economic benefits. to enforce legal rights’

For a right to meet the definition of an asset, it must be controlled by the entity. The entity has
control over a right if it has the µability to enforce legal rights¶ (e.g. if the right arises through a
legal contract). However, if the entity cannot establish that it has µlegal enforceability¶ over its
right, then it will simply have to prove that it can both µdirect the use¶ of the resource (i.e. that it
has the ability to decide how it is used) and µcan obtain the benefits¶ from the resource.

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6.2.2 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 µa right that has the potential to produce economic benefitV¶

 The right:

The fact that an economic resource LVDµright¶PHDQVit 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
µeconomic 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 Intangible asset may represent a right to use a patent, or lease it or sell it etc
x Inventory represents a right to sell an object.
Interestingly, since an asset is no longer an µREMHFW¶but rather WKHµULJKW¶ 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 µbundle oIULJKWV¶RU µVHWRIULJKWV¶ 
may now need to be identified as multiple assets. For example, if an entity owns a vehicle
WKHµREMHFW¶ , the entity would probably have the right to use the vehicle, sell it or even lease
it to someone else. In this caVHWKHµREMHFW¶, which is the vehicle, could be identified as three
assets. However, the CF concedes that where a set of righWVDULVHVIURPµOegal oZQHUVKLS¶ of
an object, it will generally PDNHVHQVHWRDFFRXQWIRUWKHµVHWRIULJKWV¶DVRQHDVVHW Le. as
RQHVLQJOHµuniWRIDFFRXQW¶  Thus, in this case, it would not make sense to identify these
rights as separate assets but WRUDWKHULGHQWLI\WKHµVHWRIULJhtV¶DVWKHDVVHW6LPLODUO\WKH
CF also notes that deVFULELQJWKLVµVHWRIULJKWV¶DVWKH physical object (i.e. describing it as a
vehicle UDWKHUWKDQDVµWKHULJKWWRXVHDYHKLFOH¶) ZLOOµRIWHQSURYLGe a faithful representation
of those rights in the mosWFRQFLVHDQGXQGHUVWDQGDEOHZD\¶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
ULJKW HJFUHDWLQJDµVHFUHWUHFLSH¶WKDWWKHHQWLW\WKHQKDVthe 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 one circumstance, be able to produce
benefits for the entity (in excess of the benefits available to all other parties). See CF 4.14
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 µright to sell¶ could be µcash 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).

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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 7), and
x how it is to be measured (see section 8).
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). See CF 4.20
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 WKHµability 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.
 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 recipe that it has not patented (i.e. there is no legal document), but if the
entity can keep it secret and 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
Alpha rents office space from a landlord, at C10 000 per month. It uses this space to run
a business selling advice. At 31 December 20X4, it pays for the rent for January 20X5.
Required: )URP$OSKD¶VSHUVSHFWLYHprove 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 (a right)
 There is a right to occupy the office space in January 20X5
 This right has the potential to produce economic benefits: the right to occupy the office
can be used to produce cash (e.g. by using the space to meet clients and sell 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. if 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, WKHHQWLW\¶VDELOLW\WRboth µdirect the use¶ and µobtain the economic benefits¶
can be proved through its ability to enforce legal rights. This is because of the combined
existence (1) of:
 the rental agreement (note, this agreement need not be written) and
 the prepayment of the rent.
(1) Depending on the terms of the contract, the existence of one without the other, would not give us
this right (e.g. if the contract existed but we had not prepaid the 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).

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x This resource is a result of a past event

There are two events that have led to the economic resource ((1) the signing of the rental
agreement (though please note that an agreement need not be in writing ± what is
important is that consensus between the two parties has been reached), and (2) 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.
Required:
a) Briefly explain to the accountant whether his concerns are valid.
b) UsLQJWKHµQHZ¶DVVet definition per the 2018 CF, briefly explain whether the following items
will still be considered to be 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 accountanW¶V concerns are not valid. The application of the new asset definition is
expected to result, in most cases, in the same outcome had the µROG¶GHILQLWLRQSHUWKH2010 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 proves how the following items will continue to meet the new asset definition:
(i) Inventory
x The present economic resource is
Ͳ the right to sell the inventory
Ͳ 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, as the entity purchased the inventory
x The past event is the purchasing, of the inventory, whereby the entity gained control.
(ii) Trade receivable
x The present economic resource is
Ͳ the right to collect the amount owed
Ͳ where this right has the potential to produce economic benefits through receiving 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 a savings account
x The present economic resource is
Ͳ the right to receive the cash from the bank
Ͳ 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 etc)
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.

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(iv) Land
x The present economic resource is
Ͳ 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)
Ͳ 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 It is controlled through legal ownership
x The past event is the purchasing and obtaining control of the land.
(v) Equipment
x The present economic resource is
Ͳ 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)
Ͳ 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 It is controlled through legal ownership
x The past event is the purchasing and obtaining control of the equipment.
(vi) Investment in shares
x The present economic resource is
Ͳ the right to hold or sell these shares
Ͳ where the right has the potential to produce economic benefits through the inflow
of 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
x The present economic resource is
Ͳ the right to direct the use of the property
Ͳ where the right has the potential to produce economic benefits through the inflow
of cash when the lease rentals are paid
x It is controlled through legal ownership
x The past event is the purchasing and obtaining control of the property.

6.3 Liability definition (CF 4.26 ± 4.47)

6.3.1 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

OLD 2010 CF NEW 2018 CF

A liability was defined as: A liability is defined as:
x Present obligation of the entity x A present obligation of the entity Note 1

x As a result of past events x To transfer an economic resource

x From which future economic benefits are
expected to flow from the entity
x As a result of past events See CF 4.26
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

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Gripping GAAP The conceptual framework for financial reporting

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 µpresent obligation¶ is a duty or responsibility that the entity has no
practical ability of avoiding. See CF 4.26 & .29

The most significant change arising from the new liability definition is possibly the clarification of the
PHDQLQJRIµSUHVHQWREOLJDWLRQ¶. 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.

Furthermore, in terms of the liability definition, the obligation is only considered to be a present
obligation (i.e. an obligation that µSresently¶H[LVWVDV at reporting date) if there is a past event (i.e. 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 µFDXVH DQGHIIHFW¶ 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 that
x 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).

6.3.2 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 WKHHQWLW\¶V 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 µFXVWRPDry practices, publishHG SROLFLHV RU VSHFLILF VWDWHPHQWV¶ (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 HQWLW\¶V duty or responsibility to transfer an economic
resource is conditional on the entity¶V 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.

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Notice that the term µHFRQRPLFUHVRXUFH¶LVpart of the definition of an µasset¶ (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 µaccounts payable¶, there is an obligation to transfer cash;
 in the case of µincome 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 rigKWVLQKHUHQWLQWKHVHµREMHFWV¶ .

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.

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 7), and
x how it is to be measured (see section 8).

This is the same principle that we apply when identifying whether an item meets the asset
definition (see section 6.2).

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 µHFRQRPLFUHVRXUFH¶refers tRµa right that has the potential
to produce economic benefits¶ (i.e. it is part of the definition of an asset). Therefore, 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 DQµDVVHW¶.

Consider the following examples:

x An entity receives, before reporting date, cash in advance from a customer for the delivery
of inventory (i.Hµincome 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.gµSURYLVLRQIRUUHKDbilitatioQ¶):
 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.

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Gripping GAAP The conceptual framework for financial reporting

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 advice. At 31 December 20X4, it still owes the rent for December 20X4.
Required: From BHWD¶Vperspective, prove that the payable is a liability at 31 December 20X4.

Solution 3: Liability ± rent payable

At 31 December 20X4, Beta has not yet paid 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.
x The obligation involves transferring an economic resource:
The obligation requires a transfer of economic resources, by way of a cash payment 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 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: 8VLQJWKHµneZ¶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 it:
Ͳ has the duty to pay the pay the supplier (i.e. the creditor)
Ͳ 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
x The entity has a present obligation, because:
Ͳ the entity has the duty to pay the contracting lawyer/law firm
Ͳ 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)
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 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.

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c) Bank overdraft
x The entity has a present obligation, because:
Ͳ the entity has the duty to pay the bank
Ͳ the entity has no practical ability of avoiding the duty due to the legal nature of
overdrafts/credit granted
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 potential transfer of economic resources is because
the entity has obtained an economic benefit by using the overdraft facility.

6.4 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 an entity¶s financial position, 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 called the entLW\¶VµQHWZHDOWK¶
The entLW\¶VWRWDOHTXLW\, total assets and total liabilities all appear in the statement of financial
position, using the following two headings: µDVVHWV¶DQGµHTXLW\DQGOLDELOLWLHV¶.
Entity name
Statement of financial position 20X2 20X1
As at 31 December 20X2 &¶¶V &¶0¶V

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 positiRQ WKH HQWLW\¶V HTXLW\ ZDV & 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 HQWLW\¶V µnet assets¶, it also represents the total of the
HQWLW\¶V µissued 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
Statement of financial position 20X2 20X1
As at 31 December 20X2 &¶¶V &¶¶V

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

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Gripping GAAP The conceptual framework for financial reporting

Another way of looking at WKHHQWLW\¶VILQDQFLDOSRVLWLRQLVthat the entity¶s assets (economic resources),

have been funded:
x through liabilities (obligations); and
x through equity (which does not involve any obligations).

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 entLW\¶VHFRnomic 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 bank (asset) with C20 000, and credit loan liability (liability) with C20 000).

By contrast, the share capital of C50 000 that was issued during 20X1, does involve equity. This is
because entities have no obligation to repay cash that is received in exchange for ordinary shares. Since
this transaction increases tKH HQWLW\¶V HFRQRPLF UHVRXUFes (cash in bank) but does not increase its
liabilities, we say that the transaction has resulted in the recognition of equity (debit bank (asset) with
C50 000, and credit ordinary share capital (equity) with C50 000).

A transaction involving the issue of ordinary shares, is called an equity claim. These ordinary
shareholders (who have contributed C50 000 to the entity) are referred to as µholders of equity claims¶
The entit\¶s receipt of cash from the issue of ordinary shares is thus referred WRDVDµcontribution from
holders of equity claims¶ and dividends paid to them are called µdistributions to holders of equity claims¶.

An equity claim is not the same as equity: an equity claim is µD claim on the residual interest in the
HQWLW\¶V DVVHWV DIWHU GHGXFWLQJ Lts liabilities¶ whereas equity is the µresidual interest in the assets after
deducting its liabilities¶. The term µequity claims’ is also described DVµWKHFODLPVDJDinst the entity that do
not meet the definition of a liabilLW\¶ (i.e. a claim that does not involve an obligation). To illustrate the
difference, look at the above example:« At the end of 20X1, we have economic resources (assets) of
C90 000, of which C20 000 will eventually be transferred to third parties due to the obligations (liabilities).
x Thus, the equity is C70 000 (Equity = Assets: 90 000 ± Liabilities: 20 000)
x However, the equity claim at 31 December, based on the share issue transaction is C50 000.

Different classes of equity claims are possible, such as ordinary and preference shares, depending on
the rights attached to them (e.g. rights to dividends, profit-sharing and liquidation rights).

An entity can also generate economic resources by making its own profits. These profits are also
part of total equity. Whether we have made a profit depends on the definitions of income and
expenses (profit = income - expenses). This is explained in the next section.

6.5 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.
OLD 2010 CF NEW 2018 CF
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 contributions
 inflows or enhancements of assets or 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)

62 Chapter 2
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OLD 2010 CF NEW 2018 CF

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 distributions
 outflows or depletions of assets or 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 µKROGHUV
RIHTXLW\FODLPV¶LQVWHDG of µequity participants. The new definitions have simply become a lot clearer:
x Income arises from increases in equity (increases in assets or decreases in liabilities) that do
not result from contributions from holders of equity claims.
x 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 cash (an asset), but this transaction does not simultaneously increase liabilities (or
decrease another asset), then, by definition, it has increased equity (Equity = A ± L = 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 6.4)
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 rental of an asset (income!)

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 = A ± L = ±100 ± 0 = -100).
x If the decrease in equity represents a µdistribution to a holder of an equity claim¶ (e.g. if the cash
outflow is a dividend payment), then it is excluded from the expense definition and thus journalised
as follows (see section 6.4)
Debit Credit
Dividends declared (Equity distribution) xxx
Bank xxx
Payment of a dividend (equity distribution – not expense!)

x However, if this decrease in equity does not represent a µdistribution to a holder of an equity claim¶,
then the transaction will meet the definition of an expense. Examples of expenses include cost of
sales, interest incurred or rent incurred. If the cash outflow is for rent incurred, the journal would be:
Debit Credit
Rent expense (Expense) 100
Bank 100
Payment of rent incurred

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Gripping GAAP The conceptual framework for financial reporting

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 tKDW%HWD¶VSD\Dble results in an expense at 31 December 20X4.

Solution 5: Expense ± arising from a payable

Solution 3 proved that a liability exists at 31 December 20X4 (since Beta had 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¶VOLDbilities
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 IURP µSURILt or loVV¶ DQG DUH
included in µRWKHUFRPSUHKHnVLYHLQFRPH¶LQVWHad ± 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 µLVsued share capital¶ plus WKHµUHVHUYHV¶(see section 6.4).

Worked example 6: Income and expense ± part of equity reserves

An entity begins operations in 20X1. During this year, it earns one type of income (sales income: C85 000)
and incurs 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 this was the 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.
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)

7. Recognition and Derecognition (CF: Chapter 5)

Recognise = Journalise
7.1 Recognition (CF 5.1 ± 5.25)
An element may only be
7.1.1 The meaning of the term ‘recognition’ recognised if it meets both
the:
x Element definitions; and
To recognise an item involves the process of: x Recognition criteria.
x capturing in the financial statements, (specifically
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

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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 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 (debit the asset and credit 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).

7.1.2 Recognition criteria (CF 5.6-5.25)

7.1.2.1 Overview

Before recognising a transaction or event, we first identify the elements and check they meet the
definitions thereof (see section 6), 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 recognition criteria per the previous 2010 CF, is shown below.
OLD 2010 CF NEW 2018 CF
Recognition criteria were: Recognition criteria are:
At item that meets the definition of an Assets and liabilities, and any resulting income,
element 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
useful, i.e. we only recognise the elements if it
x The item has a cost or value that is
means we will be giving information that is:
reliably measurable.
x relevant; and
See CF 5.7
x a faithful representation.

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
UHIHUUHG WR DV D µSUobabLOLW\¶ WKUeshoOG RU µUHOLDEOH PHDVXUH¶ WKreshold. 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 5.2).

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 µRutcome XQFHUWDLQW\¶  The
uncertainties that we consider when deciding whether an element should be recognised, can be
summarised as follows:
x Outcome uncertainty
x Measurement uncertainty
x Existence uncertainty.

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Gripping GAAP The conceptual framework for financial reporting

7.1.2.2 Relevance
Recognition criteria:
The relevance of information is affected by: The information
recognised must be
x existence uncertainty (e.g. the existence of an x relevant; and
obligation may be the content of a legal dispute); and x a faithful
representation. See CF 5.7
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.

7.1.2.3 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.

7.1.2.4 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.

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¶V cost instead. In this case, although information
about thHODQG¶V 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 5.2 for more examples.

7.1.3 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 µusefuO¶ 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

µDFFounting mismatFK¶). If this occurs, explanatory information must be included in the notes to
explain the uncertainties that existed, which prevented it from being recognised. See CF 5.23 and .25

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.

7.2 Derecognition (CF 5.26 ± 5.33)

Derecognition refers to WKH µUHPRYDO RI DOO RU SDUW RI D UHFRJQLVHG DVVHW RU OLDELOLW\ IUom the
statement oIILQDQFLDOSRVLWLRQ¶7KLVQRUPDOly happens when the asset or liability subsequently
fails to meet the relevant definition.

66 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

In the case of an asset, WKLVQRUPDOO\KDSSHQVµZKHQWKHHQWLW\ORVHVFRQWURO¶RYHUWKHDVVHW

(or part thereof). In the case of a lLDELOLW\WKLVQRUPDOO\KDSSHQVµZhen 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 5.27

8. Measurement (CF: Chapter 6)

8.1 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 HOHPHQWV DUH µTXDQWLILHG LQ PRQHWDU\ WHUPV¶ 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).

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 (see section 8.3).

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.

8.2 Different measurement bases

8.2.1 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 historical cost and current value

The CF gives three examples of measurement bases that use the current value approach:
fair value, value in use and current cost.

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The µhistorical cost¶ and µcurrent cost¶ (the latter is a measurement basis using the current value
approach) both reflect what is referred as an µentry price¶ (the price to acquire the asset or liability).
x The µhistorical 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 µcurrent 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 µfair value¶ and µvalue in use¶ both reflect what is referred to as an µexit price’.

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

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 DWµFRVW¶Dnd subsequently measured at
WKHµOower 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 (e.g.
depreciation), and 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).

8.2.2 Historical cost

As mentioned earlier, the historical cost is based RQ µthe price of the transaction or other
event that gave rise to the asseWRUOLDELOLW\¶See CF 6.24

The historical cost is useful in the sense that, if the transactioQZDVµa recent transaction on
market tHUPV¶LWZLOOW\SLFDOO\UHIOHFW
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 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).

68 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

8.2.3 Current value

A measurement that is based on current values reflects thH µFXUrent cRQGLWLRQV¶ DW
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 µfair value model¶,
 property plant and equipment measured under the µrevaluation model¶, and
 certain financial assets and financial liabilities held for trading measured at µfair value
through SURILWRUORVV¶.
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 LHµIXOILOPHQWYDOXH¶Ls the
equivalent of WKHµYDOXHLQ XVH¶ 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. µEquivalent¶ means that, if our asset is 3 years old, we
would use the current cost of a 3-year-old asset ± not the current cost of a new asset. See CF 6.21
The current cost of a liability is the consideration that would be received for an equivalent liability
at 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 to buy a new plant is C250, whereas a three-year-old plant is
about 40% of the new price. Thus, the current cost is C100 (C250 x 40%).

8.3 Factors to consider when selecting a measurement basis

8.3.1 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 PXVWµFRQVLder 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

Chapter 2 69
Gripping GAAP The conceptual framework for financial reporting

8.3.2 Relevance

The CF states that µthe characteristics of the asset or liability¶ and how it µcontributes 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 thH HQWLW\¶V EXVLQHVV
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.

8.3.3 Faithful representation

The CF explains that, although information that iV D µperfectly faithful representation is free
IURPHUURU¶ZHDUHQRWDLPLQJDW DµSHUIHFWO\IDLWKIXOrepreseQWDWLRQ¶,WHPphasizes 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

It should be noted, however, that if an asset and liabilLW\ DUH µUHODWHG LQ sRPH ZD\¶ What
measuring the assets and liabilities using different measurement bases may result in a
µPHDsurement inconsLVWHQF\¶ DOVR FDOOHG DQ µaccounting mismatFK¶) that results in the
information not being a faithful representation. See CF 6.58

8.3.4 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 and
x Understandable. 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. This is because using different
measurement bases may cause an µaccounting mismatch¶. 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

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9. Unit of account (CF 4.48 ± 4.55)

The definition of µunit of account¶ (see pop-up) refers to µrights¶

and µobligations.¶. If you recall, these two words form the basis of Unit of account is
defined as:
the asset and liability definitions:
x The right, or group of rights,
x An asset is a present economic resource controlled by the
x The obligation, or group of
entity as a result of past events. An economic resource is a obligations, or
right that has the potential to produce economic benefits. x The group of rights and
x A liability is a present obligation of the entity to transfer an obligations
economic resource as a result of past events. In order for a x To which recognition
criteria and measurement
liability to exist, three criteria must be met, the first of which concepts are applied CF 4.48
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.

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 3). 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.

10. Presentation and Disclosure Principles (CF: Chapter 7)

10.1 Recognition versus presentation and disclosure

As mentioned earlier, the teUP µrecognition¶ PHDQV 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 &
 statement of changes in equity, or disclosure refers to the
 statement of financial position; as well as level of detail in the
information given about
x the financial statement presented on the cash basis: elements that are:
 statement of cash flows. x Recognised;
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.

Chapter 2 71
Gripping GAAP The conceptual framework for financial reporting

The term µdisclosure’ 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 µproperty, 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.

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 an IFRS or if it is considered to be
useful information)

Yes No

Disclose Ignore

10.2 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.

72 Chapter 2
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The main principle, as always, is to provide information that is relevant and a faithful representation
of the transactions and events (i.e. to give useful information). 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.

11. Concepts of Capital and Capital Maintenance (CF: Chapter 8)

11.1 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.

11.2 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 the reflection of how a particular
entity µGHILQHV WKHFDSLWDOWKDWLW VHHNVWR PDLQWDLQ¶ ThXV µSUofit is the residual amount that remains
after expenses, including any maintenance adjustments, have been deducted from inFRPH¶$ORVV
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.

Chapter 2 73
Gripping GAAP The conceptual framework for financial reporting

12. 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
financial reporting
General purpose
financial reporting:
x The objective of
general-purpose
financial reporting is
to provide
 financial info
 about the entity
 that is useful to
the users *
 in making
decisions about
providing resources
to the entity
* Users (primary) =
 existing & potential
investors,
 lenders, and
 other providers of
capital
characteristics and the
(QCs) Reporting entity
Fundamental QCs: Financial statements: Measurement:
x Relevance. x The objective of x historical cost
Something is relevant if financial statements x current cost
is to provide
it makes a difference to x value in use
 financial information
user’s decision-making, (assets)
 about the x fulfilment value
which will be the reporting entity’s:
case if it has: (liabilities)
Assets, Liabilities, Equity,
 predictive value, & x fair values
Income and Expenses
 confirmatory value
 that is useful to The last 3 are
Relevance is related ‘current values’
to materiality, which users of
financial statements
is entity-specific.
Measurement of an
 in assessing: element can involve
x Faithful representation the entity’s prospects a mixture of
 Complete of future cash inflows
measurement
 Neutral and
methods e.g.
 Free from error management’s
 initial
Enhancing QCs: stewardship of the
entity’s resosurces measurement at
x Comparability cost; and
A reporting entity:
x Verifiability  subsequent
x is an entity that is measurement at
x Timeliness
required, or chooses
fair value
x Understandability to, prepare financial
statements;
x is not necessarily a
legal entity

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

x Present separately and disclose extra Is information about the element

information (if required by a IFRS or if useful to the user?
it is considered necessary for fair
presentation)

Yes No

Disclose Ignore

74 Chapter 2
Gripping GAAP The conceptual framework for financial reporting

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 A resource x A present economic resource*
x Controlled by the entity x Controlled by the entity
See CF 4.3
x As a result of past events x Resulting from past events
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 A present obligation x A present obligation of the entity
x Of the entity x To transfer an economic resource*
See CF 4.26
x As a result of past events x As a result of past events
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
See CF 4.29
x has no practical ability to avoid

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: x Other than those relating to
 increases in assets or  Contributions from holders of equity claims.
See CF 4.68
 decreases in liabilities
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: x Other than those relating to
 decreases in assets or  Distributions to holders of equity claims.
See CF 4.68
 increases in liabilities
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 price/ 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

Chapter 2 75
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 2021)
Contents: Page
1. Introduction 78
2. Scope of IAS 1 78
3. Objective of IAS 1 79
4. Purpose of financial statements 79
5. Financial statements 79
6. General features 80
6.1 Overview 80
6.2 Fair presentation and compliance with IFRSs 80
6.2.1 Achieving fair presentation 80
6.2.2 Compliance with IFRSs 81
6.2.3 Departure from IFRSs 81
6.2.3.1 When departure from an IFRS is required and allowed 81
6.2.3.2 When departure from an IFRS is required but not allowed 82
6.3 Going concern 82
6.4 Accrual basis of accounting 83
6.5 Materiality and aggregation 83
6.5.1 Accountancy involves a process of logical summarisation 83
6.5.2 Deciding whether an item is material and needs to be segregated 83
6.5.2.1 Materiality 83
6.5.2.2 Materiality and aggregation versus segregation 84
Example 1: Items with different nature, but immaterial magnitude 84
Example 2: Items that are material in magnitude, but not in nature or function 84
6.5.3 What to do with immaterial items 85
Worked example 1: Aggregation of immaterial items 85
6.6 Offsetting 85
Example 3: Offsetting ± discussion 85
Example 4: Offsetting ± application 86
6.7 Frequency of reporting 86
6.8 Comparative information 87
6.8.1 Minimum comparative information 87
Worked example 2 87
6.8.2 Voluntary additional comparative information 87
6.8.3 Compulsory additional comparative information 88
Example 5: Reclassification of assets 88
6.9 Consistency of presentation 89
7. Structure and content: financial statements in general 89
8. Structure and content: statement of financial position 90
8.1 Overview 90
8.2 Current versus non-current 90
8.3 Assets 91
8.3.1 Current assets versus non-current assets 91
Example 6: Classification of assets 91
8.4 Liabilities 91
8.4.1 Current liabilities versus non-current liabilities 91
Example 7: Classification of liabilities 92
8.4.2 Deferring settlement of a liability 92
Example 8: Loan liability and a refinancing agreement 93
Example 9: Loan liability and the option to refinance 93
8.4.3 Breach of covenants and the effect on liabilities 94
Example 10: Loan liability and a breach of covenants 94

76 Chapter 3
Gripping GAAP Presentation of financial statements

Contents continued ...: Page

8.5 Disclosure: in the statement of financial position 95
Example 11: Presenting line-items 95
8.6 Disclosure: either in the statement of financial position or notes 96
8.6.1 Overview 96
8.6.2 Disclosure of possible extra sub-classifications 96
Example 12: Presenting further sub-classifications 96
8.6.3 Further disclosures for share capital and reserves 97
8.7 A typical statement of financial position 97
9. Structure and content: statement of comprehensive income 98
9.1 Total comprehensive income, profit or loss and other comprehensive income 98
9.2 Presentation: one statement or two statements 99
9.2.1 Overview 99
9.2.2 Single statement layout 99
9.2.3 Two-statement layout 100
Example 13: Statement of comprehensive income: two layouts compared 100
9.3 Line items, totals and sub-headings needed 101
9.3.1 Overview 101
9.3.2 Minimum line items for: P/L 102
9.3.3 Minimum line items for: OCI 102
9.4 Analysis of expenses 103
9.4.1 Overview 103
9.4.2 Nature method 103
9.4.3 Function method 104
9.5 Material income and expenses 104
9.6 Reclassification adjustments 105
9.6.1 Explanation of reclassification adjustments 105
Worked example 3: Reclassification adjustments 105
9.6.2 Disclosure of reclassification adjustments 106
Example 14: Statement of comprehensive income: reclassification adjustments 106
9.7 Adjustments to a prior year profit or loss 107
9.8 A sample statement of comprehensive income 107
9.9 A consolidated 62&,WKHµDOORFDWLRQVHFWLRQ¶ 108
10. Structure and content: statement of changes in equity 109
10.1 Overview 109
10.2 General presentation requirements 109
10.3 Dividend distributions 110
10.4 Retrospective adjustments 110
10.5 A sample statement of changes in equity 110
10.6 A consolidated statement of changes in equity 111
11. Structure and content: statement of cash flows 112
12. Structure and content: notes to the financial statements 112
12.1 Overview 112
12.2 Structure of the notes 112
12.3 Basis of preparation 113
12.4 Material accounting policy information 114
12.5 Judgements made in applying accounting policies 114
12.6 Judgements involving estimates: sources of estimation uncertainty 115
12.7 Capital management 116
12.8 Puttable financial instruments classified as equity instruments 117
12.9 Unrecognised dividends 117
12.9.1 Disclosure of unrecognised dividends 117
12.9.2 Why are some dividends not recognised? 118
12.10 Other disclosure required in the notes 118
13. Summary 119

Chapter 3 77
Gripping GAAP Presentation of financial statements

1. Introduction

IAS 1 Presentation of Financial Statements is the first standard in the set of IFRS Standards
(IFRSs). It focuses on how we present information in the financial statements. However,
IAS 1 simply covers general presentation requirements: as we go through the other chapters,
we will see that the other standards may stipulate further presentation requirements.

7KHWHUPµSUHVHQWDWLRQ¶LVRQHRIseveral important terms that IAS 1 sets out the:

you will soon become familiar with. Four key terms include:
x objective of IAS 1;
x Recognition (and derecognition)
x purpose of f/statements;
x Measurement
x statements that make up a
x Disclosure, and complete set of f/statements;
x Presentation. x structure & minimum content
of each of these statements;
Very roughly speaking: x general features of f/statements.

x Recognition (and derecognition) effectively refers to

whether to process journals. IAS 1 explains how to
present FSs in general
x Measurement refers to how to calculate the amounts to terms.
use in these journals (e.g. the initial measurement of a The remaining IFRSs explain:
purchased asset might be at cost and subsequent x more specific presentation
measurement of the asset may require depreciation). x recognition,
x measurement, &
x People often get FRQIXVHG EHWZHHQ µSUHVHQWDWLRQ¶ DQG x disclosure.
µGLVFORVXUH¶ and yet they are very different. Disclosure
refers to the detailed information that may need to be included in the financial statements,
whereas presentation refers to more structural issues such as:
 what fiQDQFLDOVWDWHPHQWVWRLQFOXGHLQDµVHWRIILQDQFLDOVWDWHPHQWV¶
 how each of these financial statements should be structured,
 what line-items should be presented at a minimum, and
 other general features that should be present.
 Since there are thousands of scenarios a business could face, it is not possible for all
presentation requirements to be addressed specifically in IAS 1. However, IAS 1 also
explains why we prepare financial statements (i.e. their purpose) and this understanding
is useful in guiding our professional judgement as to how and what to present.

IAS 1 is one pillar of what I call WKH µWZR SLOODUV RI DFFRXQWLQJ¶ WKH RWKHU µSLOODU¶ EHLQJ WKH
Conceptual Framework for Financial Reporting (CF) (see chapter 2). I think of each of these
two documents as µSLOODUV¶EHFDXVHWKH\DIIHFWDOORWKHU,)56V
x The CF explains concepts that are used in all other IFRSs; and
x IAS 1 gives the general presentation requirements that affect all other IFRSs.

P.S. Since the CF (chapter 2) explains the concepts that are used in the other IFRSs, you may
notice these concepts referred to again in this chapter (and all subsequent chapters).

2. Scope of IAS 1 (IAS 1.2 - .6)

IAS 1 is used for general-purpose financial statements General purpose financial

(see definition in pop-up alongside), and is ideally suited statements are defined
to (but not limited to) entities: as those intended to:
x meet the needs of users
x whose share capital is equity; and
x who are not in a position to
x that are profit-oriented. See IAS 1.5-6
require an entity to prepare
reports tailored to their
Some entities have financial instruments and share capital 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 would
still apply IAS 1 but may need to amend some of the descriptions used in IAS 1.

78 Chapter 3
Gripping GAAP Presentation of financial statements

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 Interim
Financial Reporting (this is not covered in this textbook).

3. Objective of IAS 1 (IAS 1.1)

The µobjective of IAS 1¶ is to help us present µgeneral-purpose financial statements¶ that are
successful in enabling comparability EHWZHHQWKHHQWLW\¶VILQDQFLDOVWDWHPHQWVDQG
x its own financial statements in prior periods, and
Interesting observation:
x other entities’ financial statements.
Comparability appears in both:
This objective is achieved by IAS 1 providing us with: x IAS 1, as being key to good
x overall requirements for their presentation; presentation; and
x guidelines for their structure; & x The CF, where it is called an
enhancing qualitative
x minimum requirements for their content. See IAS 1.1 characteristic.

4. Purpose of Financial Statements (IAS 1.9)

The purpose of financial statements is to be a:

x structured representation
x RI DQ HQWLW\¶V ILQDQFLDO SRVLWLRQ DQG SHUIRUPDQFH and that also shows the results of
PDQDJHPHQW¶VVWHZDUGVKLSRIWKHUHVRXUFHVHQWUXVWHGWRLW;
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

5. 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 UHIOHFWVWKHHQWLW\¶VILQDQFLDOposition 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. In this case, there would be 3 sets of
balances in the SOFP. This is covered in detail LQWKHFKDSWHURQµ$FFRXQWLQJSROLFLHVFKDQJHVLQ
DFFRXQWLQJHVWLPDWHVDQGHUURUV¶. IAS 1.10(f)
Note 2. 7KH62&,UHIOHFWVWKHHQWLW\¶VILQDQFLDOperformance. The Conceptual Framework actually refers
to a µVWDWHPHQWRIILQDQFLDOSHUIRUPDQFH¶EXWFODULILHVWKDWWKLVLVQRWWKHUHTXLUHGWLWOH,$6VWDWHV
that financial performance could, in fact, be presented either:
x in a single statement: the µstatement of comprehensive income¶; or
x in two separate statements, one called the µstatement of profit or loss¶ and the other called the
µstatement of comprehensive income¶. See IAS 1.10A
This textbook uses a single statement approach and calls it the µstatement of comprehensive
income¶ (SOCI). Please see section 9.2 for more detail regarding the two approaches.
Note 3. 7KHWLWOHVRIWKHVWDWHPHQWVPDNLQJXSDVHWRIILQDQFLDOVWDWHPHQWVDUHQRWµVHWLQVWRQH¶DQG
other titles such as balance sheet and income statement are still acceptable. See IAS 1.10

Chapter 3 79
 Gripping GAAP Presentation of financial statements

6. General Features (IAS 1.15 - .46)

6.1 Overview
The 8 general features:

Financial statements should have eight general features,

x fair presentation & compliance
which are that they should:
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 – LILWLVQ¶WWKHQDQRWKHUEDVLVSOXVH[WUD x frequency of reporting;
disclosure is required) x comparative information; and
x consistency of presentation.
x be prepared using accrual accounting (except when
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)
and where any immaterial classes and items are presented in aggregate LHµOXPSHGWRJHWKHU¶
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 we go through these general features, notice how they often involve concepts from the
CF (chapter 2). For example:

x IAS 1 explains that fair presentation, one of the general features, requires faithful representation
(see section 6.2), which is a qualitative characteristic in the CF (see chapter 2).
x IAS 1 calls the going concern a ‘general feature’, but the CF refers to a ‘going concern assumption’.

6.2 Fair presentation and compliance with IFRSs (IAS 1.15 - .24)
6.2.1 Achieving fair presentation (IAS 1.15 & .17) Fair presentation is
generally achieved by:

Financial statements must fairly present the financial x application of the IFRSs, with
x extra disclosure if needed. See IAS 1.15
(a) position, (b) performance and (c) cash flows of an entity.

IAS 1 states that fair presentation is presumed to be Fair presentation needs:

DFKLHYHG E\ µWKH DSSOLFDWLRQ RI ,)56V ZLWK DGGLWLRQDO compliance with IFRSs and
disclosure when necessary.' extra disclosure where
needed, but it also needs:
x Application of the CF’s definitions
Additional disclosure is necessary if, despite the IFRS and recognition criteria;
requirements, we think our users may still not be able to x Faithful representation (complete,
understand the financial position and performance. In neutral and free from error);
other words, compliance with the IFRSs may not x Relevance, comparability,
necessarily be enough. See IAS 1.15 & 17(b) understandability and reliability.
See IAS 1.15 & 1.17(b)

Since the term µZKHQ QHFHVVDU\¶ is so vague, it means that the burden of ensuring that the
financial statements are fairly presented sits VTXDUHO\ RQ WKH DFFRXQWDQW¶V VKRXOGHUV  If we are
unsure if we have achieved fair presentation, IAS 1 tells us that fair presentation will be achieved
WKURXJK WKH µfaithful representation of the effects of transactions, other events and conditions in
accordance with the definitions and recognition criteria for assets, liabilities, income and
H[SHQVHVVHWRXWLQWKHIUDPHZRUN¶ (i.e. the Conceptual Framework; CF). According to the CF, a
faithful representation is achieved if the information is complete, neutral and free from error (see
chapter 2). See IAS 1.15

80 Chapter 3
 Gripping GAAP Presentation of financial statements

Fair presentation (FP) т

Fair presentation and faithful representation look similar, but: Faithful representation (FR)
x fair presentation (a general feature listed in IAS 1) is
Instead:
x more than faithful representation (a qualitative
Fair presentation is more than
characteristic listed in the CF): Faithful representation.
µFair presentation¶ is a goal and µfaithful representation¶ is In mathematical terms, we would
one of the characteristics needed to achieve this goal. say: FP > FR

IAS 1 explains that to achieve fair presentation, in addition to IFRS compliance and giving extra
disclosure if needed, we must also present the information in a way that ensures we are giving
our users relevant, comparable, understandable and reliable information. See IAS 1.17(b)

Interestingly, three of these adjectives, are µqualitative characteristics¶ per the CF (see chapter 2):
x µrelevance¶ is a fundamental qualitative characteristic, whereas
x µcomparability¶ and µunderstandability¶ are enhancing qualitative characteristics.

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 Accounting Policies, Changes in Accounting Estimates, and Errors. In this regard, we are
told to use IAS 8 when selecting and applying accounting policies and to also use the hierarchy of
guidance in IAS 8 if there is no suitable IFRS for an item. (see chapter 26). See IAS 1.17(a)

6.2.2 Compliance with IFRSs (IAS 1.16)

Disclosure regarding compliance with the IFRS must be

Although rare, compliance with IFRS
made in the financial statements if absolutely all standards may actually lead to information that
and interpretations have been complied with in full. is so misleading that it conflicts with
the financial reporting objective (i.e.
6.2.3 Departure from IFRSs (IAS 1.19 - .24) the information is no longer useful)!

In very rare circumstances, management may believe that applying an IFRS will make the
financial statements so misleading that they will no longer meet the objective of financial reporting
(which, in essence, is to provide users with useful information - see chapter 2). In making this
decision, management must consider:
x why the objective of financial reporting LVQRWDFKLHYHGLQWKHHQWLW\¶VVLWXDWLRQDQG
x KRZ WKH HQWLW\¶V FLUFXPVWDQFHV GLIIHU IURP those of other entities that have successfully
FRPSOLHGZLWKWKH,)56¶VUHTXLUHPHQWVSee IAS 1.24 and see CF1.2 for the objective of financial reporting

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.

6.2.3.1 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 financial misleading that it conflicts with
statements that are so misleading that the objective of the objective of financial
financial reporting ZRQ¶W EH PHW essentially that the statements:
x depart from the IFRS; unless
ILQDQFLDOLQIRUPDWLRQZRQ¶WEHuseful), and
x the relevant regulatory framework
x if the relevant regulatory framework (e.g. the laws in the prohibits departure. See IAS 1.19 & 1.23

relevant country) requires or otherwise does not prohibit If we depart, extra disclosure will be needed
such a departure. See IAS 1.19 to explain the departure.

If we do not depart, extra disclosure will be

7KHIROORZLQJH[WUDGLVFORVXUHLVUHTXLUHGZKHQGHSDUWXUHIURP needed to explain why we felt we should
DQ,)56LVDOORZHG depart and the adjustments we would have
liked to make but didn’t.
x PDQDJHPHQW¶VFRQFOXVLRQWKDWWKHILQDQFLDOVWDWHPHQWVµSUHVHQW
IDLUO\WKHHQWLW\¶VILQDQFLDOSRVLWLRQILQDQFLDOSHUIRUPDQFHDQGFDVKIORZV¶
x DGHFODUDWLRQWKDWWKHHQWLW\µKDVFRPSOLHGZLWKDSSOLFDEOH,)56VH[FHSWWKDWLWKDVGHSDUWHGIURP
DSDUWLFXODUUHTXLUHPHQWVRDVWRDFKLHYHIDLUSUHVHQWDWLRQ¶

Chapter 3 81
Gripping GAAP Presentation of financial statements

x WKHWLWOHRIWKH,)56IURPZKLFKWKHHQWLW\KDVGHSDUWHG
x WKHQDWXUHRIWKHGHSDUWXUH
x WKHWUHDWPHQWWKDWZDVUHTXLUHGE\WKH,)56DQGWKHUHDVRQZK\WKDWWUHDWPHQWZDVFRQVLGHUHG
WREHVRPLVOHDGLQJWKDWWKHREMHFWLYHRIILQDQFLDOUHSRUWLQJZRXOGQRWKDYHEHHQPHW
x WKHDOWHUQDWLYHWUHDWPHQWDGRSWHGDQG
x WKH ILQDQFLDO LPSDFW RI WKH GHSDUWXUH RQ HDFK LWHP IRU HDFK SHULRG SUHVHQWHG WKDW ZRXOG
RWKHUZLVHKDYHKDGWREHUHSRUWHGKDGWKHHQWLW\FRPSOLHGZLWKWKHUHTXLUHPHQW6HH,$6

7KHVHGLVFORVXUHV ZLWKWKHH[FHSWLRQRIPDQDJHPHQW¶V 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

6.2.3.2 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 PDQDJHPHQW¶V UHDVRQV IRU EHOLHYLQJ WKDW WKH 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.

6.3 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 Going concern (GC):
x includes a review of the available information relating to, at Management must
the very least, one year from the end of the reporting date. assess whether:
x the entity is a going concern
If the entity has a history of profitable operations and ready x the entity is not a going concern
access to funds, management need not perform a detailed x there is significant doubt as to
analysis. See IAS 1.26 whether the entity will be able to
continue as a going concern or not

The entity is a going concern unless management:

x voluntarily or involuntarily (i.e. where there is no realistic alternative)
x plans to:
- liquidate the entity; or
- cease trading. See IAS 1.25

5HVXOWVRIPDQDJHPHQW¶VDVVHVVPHQW 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 basis. x are not prepared on the GC basis; x are prepared on the GC 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 not causing this doubt.
considered to be a GC;
 the basis used to prepare the
financial statements (e.g. the
use of liquidation values).

82 Chapter 3
Gripping GAAP Presentation of financial statements

6.4 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.

6.5 Materiality and aggregation (IAS 1.29 - 31)

6.5.1 Accountancy involves a process of logical summarisation

Accounting starts with a transaction or event that is recorded on To summarise

information, means to
a source document (e.g. a receipt). This document is recorded combine (aggregate)
in a journal (e.g. receipts journal). This journal is posted into the items that we believe
relevant accounts in the ledger (e.g. bank and income). Posting are not material
enough to show separately.
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 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 are presented separately, whereas those that are immaterial, are aggregated with other items.
Diagram: Summary of the accounting process:

Transaction/ event

Source document

Journal

Ledger

Trial balance

Financial statements

6.5.2 Deciding whether an item is material and needs to be segregated (IAS 1.7 & 1.29 - .31)

6.5.2.1 Materiality (IAS 1.7)

Information is material:
Materiality is a term that entities use when deciding what
information to include in their financial statements. In other x if omitting, misstating or obscuring it
words, the materiality of information helps us decide if it is x could reasonably be expected to
influence decisions
relevant. If you recall, relevance is one of the fundamental x that the primary users of general-
qualitative characteristics listed in the CF (see chapter 2, purpose financial statements make.
section 5.2.1). IAS 1.7 (extract)

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, 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 FRQVLGHUHGREVFXUHGLILWLVµFRPPXQLFDWHGLQDZD\WKDW
would have a similar effect for primary users of financial statements to omitting or misstating that
LQIRUPDWLRQ¶,QIRUPDWLRQFDQEHREVFXUHG 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

Chapter 3 83
Gripping GAAP Presentation of financial statements

6.5.2.2 Materiality and aggregation versus segregation (IAS 1.7)

We use materiality to decide if an item, or class of items, should be included with another class
(aggregated) or presented separately in the financial statements (segregated). Classes of items are
items grouped together based on their nature or function (e.g. plant and buildings are both assets,
but they are different classes of asset because each has a different nature and function and thus,
different classes are recorded separately). When preparing financial statements, we analyse these
classes, deciding which classes should be aggregated with other classes and which should be
segregated. Immaterial items, or classes of items, must be aggregated with other items or classes
whereas material items or classes are segregated (i.e. presented separately 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 each 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. µCurrent payables¶are a grouping of liabilities with similar nature and function
that is considered material enough to present as a separate class of liability on the face of the
statement of financial position) whereas another class of items, although material, might only require
separate disclosure in the notes to the financial statements (e.g. trade creditors is a separate class of
liability ZLWKLQWKHµcurrent payables¶FODVVRIliabilities, which would not be material enough to present
on the face of the statement of financial position, but would possibly be material enough to present
separately in the notes ).

As mentioned above, materiality is an entity-specific concept that considers bRWKDQLWHP¶Vnature and

magnitude. When considering whether the magnitude of a certain class of items means it is µPDWHULDO¶,
entities sometimes apply a materiality threshold to that class. Materiality thresholds 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 C5 000 000.

Information could be material µeither individually or in combination with other information¶DQG must
be considered µin the context of its financial statements taken as a whole¶ 'HFLGLQJ ZKHWKHU
information could reasonably be expected to influence the decisions of primary users requires us to
consider the characteristics of these users, and also the circumstances of the entity.

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 HQWLW\¶Vmateriality limit is C300 000 for both types of asset.
Required: Describe how to decide if 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
an office and the other in a 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 HQWLW\¶V materiality threshold of C300 000, suggesting the magnitude of the
information is immaterial 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 XVHU¶VGHFLVLRQs (bearing in
PLQGWKHHQWLW\¶VFLUFXPVWDQFHVVXFKDVWKHQDWXUHRILWVEXVLQHVV , then each class would be considered
material and require segregation (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.

84 Chapter 3
Gripping GAAP Presentation of financial statements

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 since their nature or functions do not differ. However,
whether to provide separate information about machine A depends on the materiality of the information, which
depends on the nature or magnitude thereof. Although machine A is material in magnitude, it should probably not be
presented separately from the other machines since the nature of machine A is not materially different. Describing
each machine would be technical information (not 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 (relative to the HQWLW\¶V
financial statements as a whole), office furniture and office equipment should probably be aggregated
because their natures are not materially different. The decision always requires professional judgment in
assessing materiality in context of WKHHQWLW\¶VRZQFLUFXPVWDQFHV
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 both 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, their different natures are immaterial. What
is more important on the face, is that different categories of assets, (e.g. µproperty, plant and equipment¶
and µinventory¶) are separated. The segregation of the material classes within the categories of property,
plant and equipment and inventory is provided in the notes.

6.5.3 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
µIXUQLWXUH¶ EHFDXVH WKHir 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. µIXUQLWXUHDQGHTXLSPHQW¶).

6.6 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 µdoubtful debt allowance¶) is not considered
to be offsetting. Valuation allowances are part of the measurement of 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.

Chapter 3 85
Gripping GAAP Presentation of financial statements

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 µrevenue¶), 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),
the payable and receivable may be offset if the tax legislation allows VAT and Income Tax to be paid on a net
basis. Since South African legislation does not allow this, offsetting 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 had 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

Comment:
Part A: Since the sale of machines is part of the HQWLW\¶V ordinary activities (i.e. the machine would be
µLQYHQWRU\¶ 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) WKH HQWLW\¶V ordinary activities, the
income may be disclosed net of the expense ± since this still represents the substance of the sale.

6.7 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.

However, an entity may need to change its reporting date, resulting in the reporting period being longer
or shorter than a year. In this case, the entity must disclose the period covered, as well as:
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

86 Chapter 3
Gripping GAAP Presentation of financial statements

Interestingly, if the reporting period is longer or shorter than a year, the amounts in the current
\HDU¶V statement of financial position ZRXOG VWLOO EH HQWLUHO\ FRPSDUDEOH ZLWK WKH SULRU \HDU¶V
statement because this statement is merely a listing of values on a specific day rather than
over a period of time. 2Q WKH RWKHU KDQG WKH DPRXQWV LQ WKH FXUUHQW \HDU¶V statement of
comprehensive income would not be comparable with the prior year since the amounts in
each of these statements would reflect amounts accumulated over different lengths of time.

6.8 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.

6.8.1 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
information (for numerical
required. Thus, there would be two columns of figures in, and narrative information).
for example, a statement of financial position: one for the
Prior year info for narrative
current year and one for the prior year. info is only needed if relevant.
Comparisons may be needed in reverse....
The need to present comparative information applies
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
GRHVQ¶WDOZD\VUHIHUWRWKHQHHGIRUprior period information to support current period information. In
other words, current year information may be needed to support prior year information. This happens
when prior year narrative information continues to be relevant in the current year.

Worked example 2:
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.

6.8.2 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.

Interestingly, the comparative information need not be Voluntary comparative

provided for each and every statement. In other words, information:
an entity may give extra comparative information in its
x Extra comparative years can be
statement of financial position but decide not to provide given if we wish e.g. 2 prior periods
comparatives in its statement of comprehensive income. (2 PPs) instead of just the
minimum (1 PP).
,I H[WUD FRPSDUDWLYH LQIRUPDWLRQ LV SUHVHQWHG LQ D VWDWHPHQW x We can give extra comparatives
HJLIDWKLUGFROXPQLVLQFOXGHGLQWKHVWDWHPHQWRIILQDQFLDO for:
SRVLWLRQWRVKRZWKHSHULRG prior WR WKH SULRU SHULRG  WKHQDOO - just 1 statement if we wish, but
WKH QRWHV VXSSRUWLQJ WKDW VWDWHPHQW PXVW DOVR LQFOXGH WKH - the notes supporting this
H[WUDFRPSDUDWLYHLQIRUPDWLRQIRUWKDWH[WUDSULRUSHULRG statement must include all PPs.
x All PPs must comply with IFRS.

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6.8.3 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 correct adjustment’ is made.
an error that occurred in a prior year; or x This extra comparative year
x retrospectively reclassifying an item/s. refers to the opening balances of
the PP (i.e. the closing balances
of the period prior to the PP).
If we find a material error in a prior year, we must correct
that prior year (i.e. retrospective adjustment). This extra comparative year:
x only applies to the SOFP; but
x does not apply to the notes.
Similarly, retrospective adjustments are needed for
changes in accounting policy and reclassification of items. These are 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;
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.

If there is a reclassification but reclassifying the prior periods¶ILJXUHVLVLPSUDFWLFDEOHIAS 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

0D\/LPLWHG¶VQDWXUHRIEXVLQHVVFKDQJHGLQ;VXFKWKDW vehicles that were previously
held for use became stock-in-trade (i.e. inventory). Its unadjusted balances were:
x Property, plant and equipment: 20X1: C120 000 (machinery: C70 000 + vehicles: C50 000)
x Property, plant and equipment: 20X2: C100 000 (machinery: C60 000 + vehicles: C40 0000
x Property, plant and equipment: 20X3: C150 000 (machinery: C80 000 + vehicles: C70 000
Required: Show the statement of financial position and reclassification note at 31 December 20X3.

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Solution 5: Reclassification of assets

May Limited
Statement of financial position
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
Notice:
x 7KH;DQG;FROXPQVDUHKHDGHGXSµUHVWDWHG¶EXWWKHFROXPQIRU;LVQRW7KLVLVEHFDXVHWKH
20X3 column is published for the first time: we FDQ¶WUHVWDWHVRPHWKLQJWKDWKDVQHYHUEHHQVWDWHGEHIRUH
x The note only gives detail for 20X2 and 20X1 because only 20X2 and 20X1 amounts were reclassified.

6.9 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 the current presentation/classification is no longer
the most appropriate (due either to a significant
change in the nature of the operations or due to a
review of its financial statements); or
x an IFRS requires a change in presentation;
and
x presentation/classification
of items being the same
x from one period to the next.
It is essential for comparability.
Thus, if presentation or classification must
change, it is accounted for as a
reclassification (see section 6.8.3 and 9.6).

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 6.8 on comparative information).

7. 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 5); 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.

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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
individual entity or a group of entities; thus they must be clearly identified!

x relevant dates: we use the date of the end of the IAS 1 gives the structure & content
reporting period for the statement of financial position for 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.

8. Structure and Content: Statement of Financial Position (IAS 1.54 - 80)

8.1 Overview Remember...

The CF explained that an
The statement of financial position summarises the entire trial entity’s financial position is
balance into the 3 elements of assets, liabilities and equity reflected by:
(remember that the income and expense items are closed off to x its economic resources; and the
equity accounts, such as retained earnings). These three x claims against the entity.See CF 1.12
elements are presented under two headings:
x assets;
x liabilities and equity.

8.2 Current versus non-current (IAS 1.60 - 65)

Current & non-current:
Distinguishing assets and liabilities between those that are
current and non-current gives users an indication of how We can separate As & Ls into:
long it will take: x current and non-current; or
x list them in order of liquidity (if
x for an asset to be used up or converted to cash; and this is reliable & more relevant).
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.
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.

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Where assets and liabilities are non-monetary, 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.

8.3 Assets (IAS 1.66 - 68) Non-current assets are those:

x that are not current assets.
8.3.1 Current assets versus non-current assets Current assets are those:
x we expect to realise within 1yr of RD;
An asset is classified as a current asset if it meets any
x we hold mainly to trade;
one of the following criteria: x we expect to use/realise/ sell
x It is expected to be realised within 12 months after within operating cycle; or
the reporting date; x that are cash/ CE (unless restricted).

x It is held mainly for the purpose of being traded; RD: reporting date; CE: cash equivalents

x It is expected to be sold, used or realised (converted into cash) as part of the normal
µoperating cycle¶ (operating cycle: the period between purchasing the asset and converting it
into cash or a cash equivalent); or
x 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, a cash donation received in
20X6, a condition of 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 it may be used).
Non-current assets are simply defined as those assets that are not current assets.

Example 6: Classification of assets

Era Limited has two assets at its financial year ended 31 December 20X4:
x Inventory: which is slow-moving in nature and is expected to be sold during 20X6 (the
normal operating cycle);
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. This is because:
 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 also fails to meet the other criteria to be classified as current (it is not expected to be realised
within 12 months of reporting date, not held mainly for the purpose of being traded and not held
within the normal operating cycle).

8.4 Liabilities (IAS 1.69 - 76)

8.4.1 Current liabilities versus non-current liabilities (IAS 1.69 - 73)
A non-current liability is one:
A liability is classified as a current liability if any one
x that is not current.
of the following criteria are met:
Current liabilities are those:
x It must be settled within 12 months of reporting date; x we expect to settle within 1 yr of RD;
x It is expected to be settled within the normal x we hold mainly to trade;
µoperating cycle¶ NOTE 1 x we expect to settle within the OC; or
x we don’t have an unconditional right to
x It is held mainly for trading purposes; or delay settlement beyond 1 yr from RD.
x The entity µdoes not have the right at the end of the RD: reporting date; OC: operating cycle
reporting period to defer settlement thereof µfor at least 12 months¶ after reporting date. NOTE 2

Non-current liabilities are simply defined as liabilities that are not current liabilities.

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Note 1 It is interesting to note that liabilities that are considered part of the normal operating cycle (e.g. trade
payables and wage accruals) are always 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). However, 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 the term µsettlement¶ refers to all manner of payments: cash, other resources (e.g.
goods or services) and even the entity¶s own equity instruments.
If the counterparty has the option to choose how we settle the liability and where this counterparty might
choose that we settle by way of an issue of our own equity instruments, then we would typically
recognise the counterparty¶s option as an equity component separately from the liability component (in
other words, this would be a compound instrument and the classification of the liability component as
current or non-current would follow the same 4 criteria referred to above).

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
EQUITY AND LIABILITIES
Bank loan Comment: This liquidity format means we must have a note to show the 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

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
EQUITY AND LIABILITIES
Non-current liabilities
Bank loan 250 000
Current liabilities
Current portion of bank loan 250 000

8.4.2 Deferring settlement of a liability (IAS 1.72 - 76)

Deferring settlement of a liability means postponing the due date for repayment. It is sometimes
referred to as µrefinancing a liability¶ or µrolling-over of a liability¶. If we have the right to defer
settlement, and this right mean that we could defer settlement to beyond a year from reporting
date and this right exists at reporting date, then we would continue to classify the liability as non-
current. This logic applies even if we have no intention to exercise our right to defer payment.

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For example: If we have a liability that was once non-current (e.g. a 5-year bank loan) that is
now falling due for repayment within 12 months after reporting date, it would need to be
reclassified as current. However, if our pre-existing loan agreement allows us the right to
defer settlement beyond a year from reporting date, we continue to classify it as non-current.

It is important that the right to defer settlement is at our discretion. For example, if our loan
agreement has an option whereby we could defer settlement but it is at the lender¶s
discretion, then this right is ignored and we would have to classify our liability as current.

It is important that the right to defer settlement exists at reporting date. For example: If our
existing loan agreement does not include an option to defer settlement, but we subsequently
obtain an agreement allowing us to delay repayment of the loan beyond the 12-month period
after the reporting date, then the liability would be classified as:
x Non-current, if this agreement was reached before reporting date;
x Current, if this agreement was reached after reporting date.
Where the agreement is reached after reporting date but before approval of the financial
statements, it is called D µQRQ-adjusting post-reporting period HYHQW¶ which is why the
liability remains classified as current. However, details of the agreement obtained after
reporting date would be disclosed in the notes.
Example 8: Loan liability and a refinancing agreement
A loan of C100 000 is raised in 20X1. This loan principal is to be repaid as follows:
x C40 000 in 20X5; and
x C60 000 in 20X6.
Subsequently, an agreement is reached, whereby payment of the C40 000 need only be
made in 20X6.
Required: Present the current and non-current liabilities 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
EQUITY AND LIABILITIES
Non-current liabilities 60 000 100 000
Current liabilities 40 000 -
Comment: Since the agreement is signed after reporting date, it is a non-adjusting event and thus the
instalment of C40 000 remains classified as current. However, a note will be included to explain that the
liability of C40 000 was refinanced during the post-reporting period and is now technically non-current.

Solution 8B: Loan liability is refinanced in time

Entity name
Statement of financial position 20X4 20X3
As at 31 December 20X4 C C

EQUITY AND LIABILITIES

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 current and non-current liabilities LQ 1HHG\¶V statement of financial position at
31 December 20X3 if the loan agreement includes an option to defer payment of the first instalment:
A. the option is at the entity¶s discretion, defers payment by 7 months and Needy intends exercising it.
B. the option is at the entity¶s discretion, defers payment by 4 months and Needy intends exercising it.

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C. the option is at the entity¶s discretion, defers payment by 7 months and Needy does not intend
exercising it.
D. the option is at the bank¶s discretion, defers payment by 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
Statement of financial position 20X3 20X3 20X3 20X3
As at 31 December 20X3 C C C C
Part A Part B Part C Part D
EQUITY AND LIABILITIES
Non-current liabilities 600 000 400 000 600 000 400 000
Current liabilities 0 200 000 0 200 000
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 thus the liability is non-current. The entity¶s intentions are irrelevant.
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 and thus the liability is non-current. The intention not to exercise this right is irrelevant.
x Part D: The option to allow a delay in the payment of the first instalment is at the bank¶s discretion and
thus the entity does not currently have the right at reporting date, and thus the liability remains current.

8.4.3 Breach of covenants and the effect on liabilities (IAS 1.74 - 76)

A loan agreement could include a covenant, which is, essentially a promise made by the borrower to the
lender. Breaching a covenant (breaking a promise) may enable the lender to demand repayment of part
or all the loan. For example: a loan could be granted on condition 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 before reporting date to grant a period of grace allowing 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.

If such an agreement is signed after reporting date but before the financial statements are authorised
for issue, it would be a µQRQ-adjusting post-UHSRUWLQJSHULRGHYHQW¶:
 this information would be disclosed in the notes but
 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: Show the current and non-current liabilities in the statement of financial position at 31 December
20X3 assuming the financial statements are not yet authorised for issue and the agreement 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.

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Solution 10: Loan liability and a breach of covenants

Entity name
Statement of financial position 20X3 20X3 20X3 20X3
As at 31 December 20X3 C C C C
Part A Part B Part C Part D
LIABILITIES AND EQUITY
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.

8.5 Disclosure: in the statement of financial position (IAS 1.54 - 55)

The following line items must be presented in the
statement of financial position:
x property, plant and equipment;
x investment property;
x intangible assets;
x financial assets;
x investments accounted for using the equity
Minimum disclosure on the
SOFP face:
IAS1.54: lists line items that must
always appear on the SOFP face.
Extra disclosure on the SOFP face:
IAS 1.55: judgement is needed to decide if
further line items, headings & totals are
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;
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 ZKHWKHURUQRWLWLVUHOHYDQWWRWKHXVHU¶VXQGHUVWDQGLQJ 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 with 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;

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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 if it must be presented as a separate line item 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 Reason:

separate
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 SD\DEOHLVDµGHILQLWH¶OLDELOLW\

Comment: 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.

8.6 Disclosure: either in the statement of financial position or notes (IAS 1.77 - 80)

8.6.1 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.

8.6.2 Disclosure of possible extra sub-classifications (IAS 1.77 - 78 & IAS 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 (can be shown on the
face/ in notes). These depend on:
These sub-classifications may either be shown as: x specific IFRS requirements;
x materiality, liquidity, nature &
x line items in the SOFP; or function of assets; and
x in the notes. See IAS 1.77
x materiality, timing & nature of liabilities.

Whether further sub-classifications are needed depends on the following factors:

x whether the IFRS disclosure requirements specify the need for sub-classifications;
x whether the materiality of the amounts, liquidity, nature and function of assets suggest
that a sub-classification is relevant;
x whether the materiality of the amounts, timing and nature of liabilities 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:
x µUHYHQXH¶line-item:
 separate into revenue from contracts with customers and other revenue;
x µproperty, plant and equipment¶ line-item:
 separate into its two parts, being factory equipment and the office equipment;

96 Chapter 3
Gripping GAAP Presentation of financial statements

x µFDVK¶OLQH-item:
 separate into the amount held in cash and the amount held in the 6-month fixed deposit;
x µWUDGHDQGRWKHUUHFHLYDEOHV¶OLQH-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 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.

8.6.3 Further disclosures for share capital and reserves (IAS 1.79 - 80)

IAS 1 requires disclosure of extra detail 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
similar disclosure is required for each category of x the notes.
its 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.

8.7 A typical statement of financial position

An example of a statement of financial position appears on the next page. However, the line-
items needed for an entity might be fewer or more than those shown in this example: it
depends entirely on what is relevant to that entity (e.g. if an entity does not have goodwill,
then it will not show this line-item).

Also, remember that if tKHµOLTXLGLW\IRUPDW¶SURYLGHVPRUHPHDQLQJIXOGLVFORVXUHIRU\RXUHQWLW\WKDQ

WKHµFXUUHQWYHUVXVQRQ-FXUUHQW¶FODVVLILFDWLRQWKHQWKHVWDWHPHQWRIILQDQFLDOSRVLWLRQZLOOORRNMXVWWKH
VDPHEXWVLPSO\ZLWKRXWWKHKHDGLQJVµFXUUHQW¶DQGµQRQ-FXUUHQW¶

Chapter 3 97
Gripping GAAP Presentation of financial statements

Sample presentation: statement of financial position of a simple entity (not a group)

Entity name
Statement of financial position
As at 31 December 20X2
20X2 20X1
&¶¶V &¶¶V
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 because this information is disclosed in
the SOCIE. Thus, if a question asks 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’.

9. Structure and Content: Statement of Comprehensive Income (IAS 1.10 & 81A-105)

9.1 µTotal comprehensive income¶, µprofit or loss¶ and µother comprehensive income¶

The statement of comprehensive income gives information regarding the HQWLW\¶V 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
Gripping GAAP Presentation of financial statements

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 resulting from transactions and
other events,
x other than those changes
resulting from transactions with
owners in their capacity as owners.
x income less expenses,
x excluding the components of
other comprehensive income.
(including reclassification
adjustments)
x that are either not required or
not permitted to be recognised
in profit or loss by other IFRSs.

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
IRUHLJQRSHUDWLRQ¶VILQDQFLDOVWDWHPHQWV
x IFRS 17 Insurance contracts ± insurance finance income and expenses 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
IDLUYDOXHWKDWLVDWWULEXWDEOHWRFKDQJHVLQWKHOLDELOLW\¶VFUHGLWULVN
- 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)

9.2 Presentation: one statement or two statements (IAS 1.10 - 10A & IAS 1.81A)
9.2.1 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 an

9.2.2 Single-statement layout 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
Must include 3 totals:
x then the OCI section, ending with the final total (TCI). 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 explains we can call it:
x statement of comprehensive income (SOCI), or
x statement of profit or loss and other comprehensive income (SOPLAOCI), or
x any other appropriate title even if such a title does not appear in IAS 1 e.g. income statement.

Chapter 3 99
Gripping GAAP Presentation of financial statements

This textbook uses:

x this single-statement approach and
x WKHWLWOHRIµVWDWHPHQWRIFRPSUHKHQVLYHLQFRPH¶

Sample presentation: single-statement approach

Entity name
Statement of comprehensive income Note 1 20X2 20X1
For the year ended 31 December 20X2 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

9.2.3 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 µprofit 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 µother comprehensive income¶ and µtotal comprehensive income¶ and must
always start with the total µprofit or loss¶.

As with all statements, different titles may be used.

Sample presentation: two- statement approach

Entity name
Statement of profit or loss 20X2 20X1
For the year ended 31 December 20X2 C C
Income items X X
Expense items (X) (X)
Profit (or loss) for the period X X

Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 C C
Profit (or loss) for the period X X
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: 3UHSDUHWKHIROORZLQJIRU2UDQJH/LPLWHG¶V\HDUHQGHG'HFHPEHU;
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
Gripping GAAP Presentation of financial statements

Solution 13A: Statement of comprehensive income: single statement

Orange Limited
Statement of comprehensive income 20X1 20X0
For the year ended 31 December 20X1 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: This subheading is compulsory disclosure and is explained in sections 9.3.3 and 9.6.

Solution 13B: Statement of comprehensive income: two statements

Orange Limited
Statement of profit or loss 20X1 20X0
For the year ended 31 December 20X1 C C

Revenue: sales 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

Orange Limited
Statement of comprehensive income 20X1 20X0
For the year ended 31 December 20X1 C C

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: This subheading is compulsory disclosure and is explained in sections 9.3.3 and 9.6.

9.3 Line items, totals and sub-headings needed (IAS 1.81 - 87)
9.3.1 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
Gripping GAAP Presentation of financial statements

9.3.2 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 (see details on page vi).

9.3.3 Minimum line items for: OCI (IAS 1.81A, 1.82A, 1.85, 1.87, 1.90 - .96)
SOCI: line items, totals
The minimum line items on the face of the statement that & sub-headings:
discloses other comprehensive income include:
Minimum line items: for
x each item of other comprehensive income, classified by x P/L and
nature; x OCI
x total comprehensive income. See IAS 1.81A & 1.82A Additional line items:
x if IFRS requires or
The other comprehensive income section must be grouped x if relevant.
under the following sub-headings: Totals needed for:
x Items that will not be reclassified* subsequently to profit x P/L,
or loss; and x OCI &
x TCI.
x Items that will be reclassified* subsequently to profit or
No line item to be called
loss (when specific conditions are met). See IAS 1.82A
extraordinary.

Each item of other comprehensive income (OCI) must be Line items specific to OCI:
presented in the statement of comprehensive income: x Items on face:
- 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 single x Split between 2 sub-headings:
amount for the tax effect of all the relevant items per sub- - will be reclassified to P/L &
heading e.g. if there is only one item of OCI, there will be two - will not be reclassified to P/L
single amounts presented (the pre-tax amount of the OCI x Tax effects on face or notes.
item and the tax effect thereof) whereas if there are two items x Reclassification adjustments:
of OCI, there will be three amounts (the pre-tax amount for - on face or
- notes.
each of the two OCI items and one amount showing the
combined tax effect thereof). See IAS 1.91 A reclassification
adjustment is
The tax effect of each item of OCI (including reclassification x the transfer of an
income or expense
adjustments ± see pop-up) may be presented either:
from OCI to P/L
x on the face of the statement; or
(i.e. the item was previously
x in the notes. See IAS 1.90 recognised in OCI but must now be
recognised in P/L instead).
Reclassification adjustments may be presented: Reclassifications are discussed in
x on the face of the statement; or more detail in section 9.6.
x in the notes. See IAS 1.94

102 Chapter 3
Gripping GAAP Presentation of financial statements

Sample presentation: other comprehensive income section

Entity name
Statement of comprehensive income
For the year ended 31 December 20X1
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

9.4 Analysis of expenses

9.4.1 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
7KH FKRLFH EHWZHHQ DQDO\VLQJ H[SHQVHV RQ WKH µQDWXUH x Nature: no allocation of expenses
PHWKRG¶RUµIXQFWLRQPHWKRG¶GHSHQGVRQZKLFKPHWKRG
provides reliable and more relevant information. 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.

9.4.2 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)

Entity name
Statement of comprehensive income
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
Gripping GAAP Presentation of financial statements

9.4.3 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
gives reliable and more
x administration, and
relevant information.
x other operations.
x Function method is normally more
relevant, but if cost allocations can
Using the function method requires the allocation of all only be done arbitrarily, then the
expenses to these different functions (i.e. based on the allocated amounts aren’t reliable &
purpose of the expense). Thus, the function method this information won’t be relevant.
effectively provides µWKH UHDVRQV¶ IRU WKH H[SHQVHV DQG WKXV SURYLGHV more relevant
information than the nature method. Another advantage of the function method is, for
instance, that it enables the calculation of the gross profit percentage, where this calculation
LVQ¶WSRVVLEOHLIWKHQDWXUHPHWKRGLVXVHG

However, the function method is designed for larger businesses that have the necessary
systems, can afford to do the allocation and can allocate the expenses on a reasonable basis.
Although this method has the potential to provide more relevant information, there is a risk of
arbitrary allocations. This might even lead to information that is less reliable and thus not relevant.

Information relating to the nature of expenses is crucial to those users attempting to predict
future cash flows. Thus, 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 µclassification by
QDWXUH¶LV 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
FKDQJHVGHSHQGLQJRQZKHWKHUWKHµIXQFWLRQ¶RUµQDWXUH¶PHWKRGLVXVHG

Sample presentation: Expenses analysed by function (see section in white)

Entity name
Statement of comprehensive income
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)
...

9.5 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,
x showing:
This additional separate disclosure could be given either:
- nature and
x as separate line items on the face of the statement - amount,
of comprehensive income; or x either:
x in the notes. - on face of SOCI; or
- in notes.

104 Chapter 3
Gripping GAAP Presentation of financial statements

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)

9.6 Reclassification adjustments (IAS 1.92 - 96)

9.6.1 Explanation of reclassification adjustments

A reclassification adjustment refers to a journal entry
processed to recognise an income or expense in profit
or loss (P/L) where this income or expense had
previously been recognised in other comprehensive
income (OCI).
Thus, the one side of the journal entry recognises the
item of income or expense in P/L while the contra entry
removes it from OCI (it is always a transfer from OCI
to P/L ± never the other way around).
Reclassification adjustments
are defined as:
x amounts reclassified to P/L in
the current period
x that were recognised in OCI in the
current or previous periods. IAS 1.7
A reclassification adjustment refers
to a journal that reverses an item out
of OCI and reclassifies it into P/L.
Reclassifications never occur with:
x Revaluation surpluses; or
x Defined benefit plans.

The relevant IFRSs dictate when reclassifications Reclassifications may be disallowed

from OCI to P/L occur. in terms of IFRS 9 when
accounting for:
x certain cash flow hedges;
However, the following two types of OCI may never be x the time value of an option;
reclassified to P/L: x the forward element of a
x changes in a revaluation surplus; forward contract; and
x remeasurements of defined benefit plans. 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).
The ledger accounts will look as follows:

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
Gripping GAAP Presentation of financial statements

9.6.2 Disclosure of reclassification adjustments (IAS 1.90 & IAS 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) to hedge a loan receivable
denominated in a foreign currency. Interest on the loan is earned over a 5-year period. 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 a
cash flow hedge, the gain was recognised in other comprehensive income (OCI) (see definition of OCI
given in IAS 1.7): debit FEC asset, credit FEC gain in OCI.
x Since the hedged item (i.e. the loan receivable) is a financial asset, the gain recognised in OCI must
be reclassified to P/L over the period that the hedged item affects P/L (i.e. in this case, Lemon uses
a period of 5 years, because interest income on the loan will be recognised over 5 years).
The following was extracted before any journals related to this FEC had been processed:
Trial Balance Extracts at 31 December 20X2 Debit Credit
Revenue 1 000 000
Cost of sales 450 000
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 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 period the hedged item affects P/L

Solution 14B: Statement of comprehensive income

Lemon Limited
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 C C
Revenue 1 000 000 X
Cost of sales (450 000) (X)
Other income: gain on cash flow hedge 100 000 / 5 x 1 year 20 000 X
Administration costs (80 000) (X)
Profit before tax 490 000
Tax expense (70 000) (X)
Profit for the year 420 000 X
Other comprehensive income for the year 50. (20 000) 100 000
x Items that may be reclassified to profit or loss:
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
Total comprehensive income for the year 400 000 X

106 Chapter 3
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Lemon Limited
Notes to the financial statements 20X2 20X1
For the year ended 31 December 20X2 C C
50. Other comprehensive income: cash flow hedge
Gains on cash flow hedge arising during the year 0 100 000
Less reclassification adjustment: gain now recognised in profit or loss (20 000) 0
(20 000) 100 000
Comment:
x The total gain on the cash flow hedge is C100 000. It is recognised in OCI but must be reclassified
from OCI to P/L over the period the hedged item will affect P/L. Since interest income on the loan will
be recognised in P/L over a 5-year period, we should reclassify the gain from OCI to P/L over 5 years:
20 000 in 20X2 (and 20 000 e over the remaining 4 years 20X3 to 20X6).
x 7KHµJDLQRQ&)+2&,¶DFFRXQWwill reflect a balance of C80 000 at the end of 20X2.
 The SOCIE and the SOFP will show this closing balance; whereas
 The SOCI shows the movement in this OCI account each year.
x Notice: Since C20 000 (1/5 of the gain) was reclassified to 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
OCI in 20X1: 100 000 + P/L in 20X2: 20 000 = TCI over both years:120 000
This would be wrong since the total income to date is only C100 000, which should be correctly
presented over the years as follows:
OCI: 80 000 (Gain recognised in OCI in 20X1 100 000 ± Gain reclassified out of OCI in 20X2: 20 000) +
P/L: 20 000 (Gain recognised in P/L in 20X1: nil + Gain reclassified from OCI into P/L in 20X2: 20 000) = TCI: 100 000

9.7 Adjustments to a prior year profit or loss (IAS 1.89)

2FFDVLRQDOO\ D SULRU \HDU¶V LQFRPH RU H[SHQVH LH 3/  Adjusting a prior year P/L
needs to be changed. This may occur when the entity:
x applies a new accounting policy; May involve a:
x corrects a prior period error. x prospective adjustment (adjust
the current year P/L); or
Depending on the circumstances, the change may need x retrospective adjustment (adjust
to be made prospectively or retrospectively: the opening RE).

x A prospective change means adjusting the prior \HDU¶V income or expense (P/L) by
processing a journal entry WKDWDGMXVWVWKHFXUUHQW\HDU¶Vincome or expense (P/L) instead.
x A retrospective change means DGMXVWLQJ D SULRU \HDU¶V income or expense (P/L) by
processing a journal that adjusts the prior year¶s income or expense (P/L).

When journalising a retrospective change, adjustments to prior year income or expenses will need
to be journalised directly to the retained earnings account (i.e. not to that income or expense account).
This is because WKHSULRU\HDU¶Vincome and expense accounts will have already been closed off to that
SULRU \HDU¶V µ3/ account¶ DQG WKDW SULRU \HDU¶V µ3/ account¶ will have been closed off to retained
HDUQLQJV RQO\WKHFXUUHQW\HDU¶Vincome and expense DFFRXQWVZLOOVWLOOEHµRSHQ¶ for adjustments).

After a retrospective change has been processed, the presentation in the statement of
comprehensive income must make it clear that the prior year income and expenses have been
changed (i.e. if the prior year that was adjusted is presented as a comparative). The statement
of changes in equity will also include a line item to show the effect of the change on opening
retained earnings caused by all retrospective changes to the prior year/s income and expenses.
For more information on these adjustments, please see chapter 26 Accounting policies, estimates and errors.

9.8 A sample statement of comprehensive income

A statement of comprehensive income that might apply to a single entity is shown on the next page. It
is simplified to show a very basic statement where there are no associates or discontinued operations.

Please note that the line-items in a statement of comprehensive income may need to be fewer
or greater than those shown below. It depends entirely on the line-items relevant to the entity
(e.g. if an entity does not revalue any assets, then the revaluation surplus movement shown in
other comprehensive income would not be presented).

Chapter 3 107
Gripping GAAP Presentation of financial statements

Sample presentation: Statement of comprehensive income for a single entity

Entity name
Statement of comprehensive income
For the year ended 31 December 20X2 (function method)
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
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 for the year X X

9.9 A consolidated SOCI: WKHµDOORFDWLRQVHFWLRQ¶ (IAS 1.81B)

The following information relates to a consolidated statement

Consolidated SOCI
of comprehensive income produced for a group.
If the SOCI relates to a
If an entity owns part or all of a subsidiary, the entity is consolidated group that includes
referred to as a parent and the two entities together are a partly-owned subsidiary, the
referred to as a group of entities. SOCI must show how the:
x consolidated P/L and
If the parent owns 100% of the subsidiary (called a x consolidated TCI
will be allocated between:
wholly-owned subsidiary), then 100% RIWKHVXEVLGLDU\¶V x the parent’s owners and
income would belong to the parent. x the non-controlling interests.
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% RIWKHVXEVLGLDU\¶VLQFRPHZRXOG
belong to the parent - WKHUHVWRILWZLOOEHORQJWRµWKHRWKHURZQHUV¶ QRQ-controlling interests).

Thus, if the group includes a partly-owned subsidiary, the JURXS¶Vconsolidated 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
Gripping GAAP Presentation of financial statements

Sample presentation: Consolidated statement of comprehensive income:

x WKHµDOORFDWLRQVHFWLRQ¶ shown right at the end of the statement

Group name
Consolidated statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 (function method) 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

10. Structure and Content: Statement of Changes in Equity (IAS 1.106 - 110)

10.1 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; there are currently 11 possible components, including for example:
- changes in a revaluation surplus;
- remeasurement of 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 liabilit\¶VFUHGLWULVN;
- the effective portion of gains and losses on hedging instruments in a cash flow hedge;
- gains and losses on investments in equity instruments designated at fair value through
other comprehensive income;
- gains and losses on financial assets measured at fair value through other comprehensive
income. See IAS 1.7 & 1.108
A statement of changes in equity essentially shows the
reconciliation between the opening and closing balance for The SOCIE must present:
each component of equity.
x changes in equity; thus it needs
Bearing in mind that equity represents the net assets, x reconciliations for each
(E = A ± L), a change in equity simply means an increase or component of equity:

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 11 components 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.

10.2 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 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
Gripping GAAP Presentation of financial statements

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)

10.3 Dividend distributions (IAS 1.107; IAS 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: The dividend amount and DPS may be
x in the statement of changes in equity, or 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 12.9.

10.4 Retrospective adjustments (IAS 1.109 - 110) Retrospective adj’s are:

x presented in the SOCIE,
If there has been a retrospective change in accounting x not ‘changes in equity’!
policy (or correction of a material prior period error), the Presentation of RAs must include:
journals we would process to effect the adjustments (or x whether they relate to a:
corrections) must be presented as retrospective adjustments - change in accounting policy; or
(or retrospective restatements) of the opening balance of the - correction of error
relevant component of equity (e.g. retained earnings). x the effect on each item of equity
Technically-speaking, although these are presented in the - for each prior period; and the
statement of changes in equity as part of the reconciliation - opening current period balances.
between the opening and closing balances, they are not µFKDQJHs LQHTXLW\¶. See IAS 1.109-110

If the reconciliation between the opening balance and closing balance of a component of
equity is affected by a retrospective adjustment (or retrospective restatement), the
presentation thereof must make it very clear whether it relates to:
x a change in accounting policy; or
x a correction of error. See IAS 1.110

If there has been a retrospective adjustment (or retrospective restatement), its effect on the
relevant component/s of equity must be disclosed:
x for each prior period; and
x the beginning of the current period. See IAS 1.110

10.5 A sample statement of changes in equity

A statement of changes in equity that might apply to a single entity is shown on the next page. 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).
One may need fewer or more columns 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
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Sample presentation: Statement of changes in equity

Entity name
Statement of changes in equity
For the year ended 31 December 20X2
Ordinary Retained Other Total
share earnings compreh. equity
capital 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

10.6 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

Entity name
Consolidated statement of changes in equity
For the year ended 31 December 20X2
Attributable to owners of the parent Non- Total
Ordinary 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
Gripping GAAP Presentation of financial statements

11. Structure and Content: Statement of Cash Flows (IAS 1.111)

IAS 1 covers the structure and content of all statements except the statement of cash flows as this is
dealt with in its own standard, IAS 7. The statement of cash flows is explained in detail in chapter 27.

12. Structure and Content: Notes to the Financial Statements (IAS 1.112-138)

12.1 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 where the information could be 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)

Notes give the following information: See IAS 1.7; 1.112 & 1.117
x the basis of preparation; See IAS 1.112 (a)
x the material accounting policy information:
- information about accounting policies is material if, together with other information in
the financial statements, we can reasonably expect it to affect the decisions made by
the primary users See IAS 1.117
x supporting information (i.e. regarding items recognised in the statements) which:
- is required by the IFRSs See IAS 1.112(b) and IAS 1.7
- LVUHTXLUHGEHFDXVHLW¶VUHOHYDQW See IAS 1.112(c) and IAS 1.7
x extra information (i.e. regarding items not recognised in the statements) which:
- is required by the IFRSs See IAS 1.112(b) and IAS 1.7
- LVUHTXLUHGEHFDXVHLW¶VUHOHYDQW. See IAS 1.112(c) and IAS 1.7

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 YDULRXVRWKHUGHWDLOVUHODWLQJWRWKHHQWLW\¶VLGHQWLW\DQGGHVFULSWLRQ See IAS 1.138

12.2 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. This means the order must be logical, taking
into account 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
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IAS 1 suggests that the following order could be used:

x Statement of compliance Note 1
x Material accounting policy information
x Supporting notes (i.e. supporting information contained in the other statements) Note 2
x Other notes. See IAS 1.114 (c) but also see Note 2 and Note 3 below
Note 1. TKH µVWDWHPHQW RI FRPSOLDQFH¶ could EH SUHVHQWHG DV SDUW RI WKH µEDVLV RI SUHSDUDWLRQ¶ note.
(Please see the discussion relating to WKHµbasis of preparation¶, in section 12.3).
Note 2. Both the supporting notes and other notes would contain information
- Required by IFRSs;
- Required simply EHFDXVHLWLVFRQVLGHUHGUHOHYDQWWRWKHXVHUV¶XQGHUVWDQGLQJ See IAS 1.112

Note 3. Other notes (i.e. those that do not support items recognised in other statements) could include:
- 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:
WKHHQWLW\¶VREMHFWLYHVDQGSROLFLHVUHODWLQJWRLWVcapital management. See IAS 1.114 (c)

12.3 Basis of preparation (IAS 1.112 & 116 & 64)

IAS 1 states that the basis of preparation must be disclosed (IAS 1.112) but does not define
what it means. As a result, there are many ways in which this has been interpreted, for example:
x 6RPHLQWHUSUHWµEDVLVRISUHSDUDWLRQ¶WREHDYDJXHWHUPZLWKWKHresult that it is not referred
to at all in the financial statements
(e.g. 'HORLWWH¶V0RGHOILQDQFLDOVWDWHPHQWVIRUWKH\HDUHQGHG'HFHPEHU:
file:///C:/Users/Cathy%20Service/Downloads/IFRS%20Model%20Financial%20Statements%202021.pdf )
x 6RPH KDYH D KHDGLQJ IRU µEDVLV RI SUHSDUDWLRQ¶ DQG KDYH interpreted it as referring to
LQIRUPDWLRQ DERXW WKH µUHSRUWLQJ HQWLW\¶ µEDVLV RI DFFRXQWLQJ¶ LQ ZKLFK WKH\ LQFOXGH D
VWDWHPHQW UHJDUGLQJ FRPSOLDQFH ZLWK ,)56V RU RWKHU QDWLRQDO *$$3  µMXGJHPHQWV DQG
HVWLPDWHV¶DQGµPDWHULDODFFRXQWLQJSROLF\LQIRUPDWLRQ¶
HJ.30*¶V0RGHOILQDQFLDOVWDWHPHQWVIRU6HSWHPEHU:
https://home.kpmg/content/dam/kpmg/xx/pdf/2021/09/2021-ifs.pdf )

As can be seen, there are a variety of interpretations. This textbook enjoys aspects of each of
the above, but suggests WKH µEDVLV RI SUHSDUDWLRQ¶ VKRXOG EH SUHVHQWHG separately from the
µmaterial accounting policy information¶DQGVKRXOGFRQWDLQWKHIROORZLQJGHWDLOV
x Reporting entity: information on the entity and identifying whether its 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.

Sample presentation: Basis of presentation

ABC Ltd
Notes to the Financial Statements
For the year ended 31 December 20X2
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
Gripping GAAP Presentation of financial statements

12.4 Material accounting policy information (IAS 1.116 ± 124)

We must give users information about our accounting policies if we think that the information is material.
We should consider information to be material if, together with other information in the financial
statements, we can reasonably expect it to affect the decisions made by the primary users. See IAS 1.117

We need not present accounting policy information (API) relating to transactions, events and
conditions that are immaterial. When we consider materiality of these transactions, events and
conditions, we must consider both the amount and the nature. So, if the amount and nature is
immaterial, then the API would not be disclosed. However, conversely, we do not simply assume
that if the amount or nature is material that we must disclose the API. Instead, we only treat API
as being material LHZHZLOORQO\GLVFORVHWKH$3, LIZHEHOLHYHLWZLOOKHOSRXUXVHUVµunderstand
RWKHUPDWHULDOLQIRUPDWLRQLQWKHILQDQFLDOVWDWHPHQWV¶7KLVZLOOEHWKHFDVHLIIRUH[DPSOH
a) we changed an accounting policy during the reporting period, causing a material change to
the financial information;
b) the accounting policy relates to an IFRS that allows a choice (e.g. IAS 38 allows us to
measure certain intangible assets under the cost model or revaluation model);
c) we developed our own accounting policy in terms of IAS 8 because there was no other IFRS
that we could use for our specific transaction, event or condition;
d) we needed to make significant judgements or assumptions in the actual application of the
accounting policy, and where these µjudgements or assumptions¶DOVRQHHGWREHGLVFORVHG
(see section 12.5 and 12.6); or
e) the method of accounting for a material transaction, event or condition is so complex that
users would not otherwise be able to understand (e.g. where multiple IFRSs need to be
applied when accounting for a single transaction). See IAS 1.117A-B

This process of deciding whether specific API is material and needs to be disclosed is shown in
an excellent flowchart in IFRS Practice Statement 2 Making Materiality Judgements (para 88C).

We can collate all the 'material accounting polic\LQIRUPDWLRQ¶DQGpresent it as one separate note,
or we could present it as an as an entirely separate statement (i.e. in which case there would then
be 6 statements making up a set of financial statements) or we could present this information on a
piecemeal basis in the specific notes to which they relate (e.g. the information about inventory
accounting policies could be presented within the inventory note). See IAS 1.116

Sample presentation: Material accounting policy information

ABC Ltd
Notes to the Financial Statements
For the year ended 31 December 20X2
1. Basis of preparation...
2. Material accounting policy information
The following is a list of the accounting policy information used by ABC that is considered material.
These accounting policies have all been consistently applied, except for a change in accounting
policy that involved investment property, described in note 50.
2.1 Property, plant and equipment: Land is measured at fair value under the revaluation model
whereas plant is measured at depreciated cost under the cost model.
2.2 …

12.5 Judgements made in applying accounting policies (IAS 1.122 - 124)

We must disclose the judgements that management made when applying accounting policies
(except for those involving estimations ± these are called assumptions regarding estimation
uncertainty: the disclosure of these is explained in section 12.6). However, not all such
judgements must be disclosed«we only need to disclose those µthat have had the most
significant effect on the amounts recognised in the financial statements¶. In other words, we
only disclose key/ significant judgements made in applying accounting policies. See IAS 1.122

114 Chapter 3
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Consider the following example:

When purchasing shares in a business, we may have acquired an associate or a subsidiary or
simply an investment in shares. The deciding factor revolves around the level of control that
we now have over that business. Deciding whether control has been acquired is often difficult,
requiring significant judgment and, depending on the conclusion, different IFRSs will be
applied. If reaching a conclusion was difficult, then the logic management used in making its
judgements must be disclosed. However, if the effect on the amounts in the financial
statements will not be significantly different if the share purchase is regarded as having
resulted in a subsidiary, associate or merely an investment in shares, then the logic
management used when making its judgements would not need to be disclosed.

Judgements made in applying accounting policies can be disclosed as a separate note, or

within the µPDWHULDO accounting polic\ LQIRUPDWLRQ¶ note or anywhere else in the notes (e.g. if
we decided that an investment in shares did not result in the acquisition of a subsidiary or an
associate, but that it simply resulted in DQ µLQYHVWPHQW LQ VKDUHV¶ the detail regarding the
judgements made could be explained in the µinvestment LQVKDUHV¶note). See IAS 1.122

Sample presentation: Judgements made in applying accounting policies

ABC Ltd
Notes to the Financial Statements
For the year ended 31 December 20X2
1. Basis of preparation...
2. Material accounting policy information...
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 as a subsidiary despite
ABC owning only 40% thereof. Management decided ABC 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 considered 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 ...

Another example of judgements made when applying an accounting policy PDQDJHPHQW¶V

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 had met the
requirements to be classified as held for sale, in which case it should be accounted for in
terms of IFRS 5 Non-current assets held for sale and Discontinued operations.

12.6 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 about 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 that involve a high degree RIVXEMHFWLYHDQGFRPSOH[µJXHVVZRUN¶
there is, of course, a risk of the estimate EHLQJ µZURQJ¶. For example, when measuring a
SURYLVLRQIRUUHKDELOLWDWLRQRIODQGLQ\HDUV¶WLPHZHQHHGWRHVWLPDWHWKHIXWXUHGDPDJHWKDW
will have occurred by then, the future cost to rehabilitate it, which also involves estimating
inflation over 20 years, and the selection of an appropriate discount rate to calculate a present
value.

Disclosure is required if 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.

Chapter 3 115
Gripping GAAP Presentation of financial statements

Sample presentation: Sources of estimation uncertainty

ABC Ltd
Notes to the Financial Statements
For the year ended 31 December 20X2
1. Basis of preparation...
2. Material accounting policy information...
3. Judgements in applying accounting policies ...
4. Sources of estimation uncertainty
The following assumptions and estimation uncertainties carry a significant risk of resulting in a
material adjustment during the year ended 31 December 20X3:
4.1 Impairment of plant Note 15 includes plant, the carrying amount of which was impaired
by C10 000 to its recoverable amount of C80 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 the assumption that ABC secures a certain
government contract. However, if this government contract is not awarded to ABC, the value
in use would decrease to C60 000 and thus the carrying amount of plant would be measured
at C60 000 and the impairment expense would be measured at C30 000.
4.2 ...

Where disclosures are required regarding an estimate that required management to make
MXGJHPHQWV LQYROYLQJ µDVVXPSWLRQV DERXW WKH IXWXUH DQG RWKHU PDMRU VRXUFHV RI HVWLPDWLRQ
XQFHUWDLQW\¶WKHGLVFORVXUHVVKRXOGLQFOXGHIRULQVWDQFH
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; See IAS 1.129 (a)
x the sensitivity of the carrying amounts to the methods, assumptions and estimates used in
their calculation; See IAS 1.129 (b)
x the reasons for the sensitivity; See IAS 1.129 (b)
x the range of reasonably possible carrying amounts within the next financial year and the
expected resolution of the uncertainty; See IAS 1.129 (c)
x the changes made (if any) to past assumptions if the past uncertainty still exists. See IAS 1.129 (d)

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

Disclosures are not requiredHYHQLIWKHUHLVDVLJQLILFDQWULVNRIDQLWHP¶VFDUU\LQJDPRXQW

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 be presented in its
own separate note (as shown above) or could be presented in the actual note dealing with the
affected estimate (e.g. assumptions involved in estimating the impairment of plant could be
included in the note involving plant).

12.7 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
HQWLW\¶VPDQDJHPHQWRIFDSLWDO;
- how it is meeting its objectives for managing capital;

116 Chapter 3
Gripping GAAP Presentation of financial statements

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
Notes to the Financial Statements
For the year ended 31 December 20X2
1. Basis of preparation
2. Material accounting policy information
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.

12.8 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

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

12.9 Unrecognised dividends (IAS 1.137; IFRIC 17.10 & IAS 10.13)
12.9.1 Disclosure of unrecognised dividends (IAS 1.137)

IAS 1 requires that the notes include certain disclosures Dividends are recognised as
relating to unrecognised dividends. equity distributions when:
x there is an obligation to pay.
x For dividends that have not been recognised, we
must disclose the following in the notes: An obligation to pay arises when it

- the amount in total; and x has been appropriately authorised &

- 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
x is no longer at the entity's discretion
The obligation date is normally the:
x declaration date unless
x the particular jurisdiction requires
further approval after the dividend
declaration. See IAS 10.13 & IFRIC 17.10

Chapter 3 117
Gripping GAAP Presentation of financial statements

12.9.2 Why are some dividends not recognised?

A dividend distribution is only recognised if it has been paid or if the entity has an obligation to pay.

A dividend distribution normally has the following life-cycle:

x proposal; then
x declaration; then
x payment.

Dividends are first proposed in a meeting. If the proposal is accepted, the entity will then formally
declare the dividend.

Declaring a dividend means publicly announcing that the dividend will be paid on a specific date in the
future. Since a declaration is a public announcement, it is normally the declaration of the dividend that
obligates the entity. However, a dividend only becomes an obligation once it is no longer at the
discretion of the entity. This is important because, 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. See IAS 10.13

In summary, dividend distributions would only be recognised at reporting date if, at reporting
date, the entity was obligated to pay them. In other words, we would recognise dividends at
reporting date if the dividend was:
x declared before reporting date where no further approval was required;
x declared before reporting date where further approval was required and this approval was
given before reporting date.

Examples of dividends that would not be recognised at reporting date are dividends that were:
x proposed before reporting date but declared or paid after reporting date; and
x declared before reporting date but within a jurisdiction where further approval is required
and where, at reporting date, this had not yet been obtained.

If at reporting date there is an obligation to pay the dividend, we process the following journal:
Debit Credit
Dividends declared (distribution of equity) xxx
Dividends payable (liability) xxx
Dividend declared

Notice: the 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 (see chapter 2).

12.10 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 DGHVFULSWLRQRIWKHQDWXUHRIWKHHQWLW\¶VRSHUDWLRQVDQGSULQFLSDODFWLYLWLHVDQG
x the name of the parent entity and the ultimate parent of the group (where applicable).

118 Chapter 3
Gripping GAAP Presentation of financial statements

13. 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 material accounting policy information
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
Gripping GAAP Presentation of financial statements

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 2021)

Contents: Page
1. Introduction 125

2. Income versus revenue 125

Diagram 1: Relationship between income and revenue, and the different types of revenue 125
3. Scope 126
3.1 IFRS 15 only applies to contracts that involve customers 126
3.2 IFRS 15 does not apply to all contracts with customers 126
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 127
4.4 Measurement 128
4.5 Presentation 129
4.5.1 Overview 129
4.5.2 Rights are presented as assets 130
Example 1: Contract asset versus a receivable 130
4.5.3 Obligations are presented as contract 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
Gripping GAAP Revenue from contracts with customers

&RQWHQWVFRQWLQXHG« 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
Estimating when the distribution is continuous 149
Example 11: Estimating variable consideration ± the two methods of estimation
Estimating when the distribution is discontinuous 149
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
on the transaction price 153
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
Diagram 3: The accounts we use when accounting for a right of return 157
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 exceeds their fair value 169
Worked example 4: Consideration payable ± FRXSRQVIRUFXVWRPHU¶VFXVWRPHUV 169
Worked example 5: Consideration payable ± FRXSRQVIRUFXVWRPHU¶VFXVWRPHUV 170

122 Chapter 4
Gripping GAAP Revenue from contracts with customers

Contents FRQWLQXHG« Page

8. Allocating the transaction price to the performance obligations (step 4) 170
8.1 Overview 170
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 (where one was estimated based on the residual approach) 173
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 ± WKHUHJXODUGLVFRXQWFRQWUDFWGLVFRXQW 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 4: Overview of the classification of performance obligations 183
9.4.2 Performance obligations satisfied over time 184
Diagram 5: 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 as the entity performs? 184
Diagram 6: 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
enhanced? 186
Diagram 7: Classifying performance obligations ± using criterion 2 187
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
enforceable right to payment? 188
Diagram 8: Classifying performance obligations ± using criterion 3 189
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 criterion 191
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 the
HQWLW\¶VSURJUHVV 195
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

Chapter 4 123
Gripping GAAP Revenue from contracts with customers

Contents continued « Page

9.5.5 If a reasonable measure of the outcome is not available 197
Example 41: Outcome not reasonably measured 197
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 212
13.2.5 Disclosure of the remaining unsatisfied performance obligations and how
much of the transaction price has been allocated to these 212
13.2.6 Sample disclosure relating to the line-LWHPµUHYHQXHIURPFXVWRPHUFRQWUDFWV¶ 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
Gripping GAAP Revenue from contracts with customers

1. Introduction

IFRS 15 Revenue from contracts with customers explains 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.
For all types of revenue that fall within the scope of this standard (see section 3), there is a five-
step approach to recognition and measurement (see section 4, and sections 5 ± 9).
Interestingly, this standard on revenue does not only explain how to recognise and measure
revenue, but it also the incremental costs incurred in obtaining and fulfilling a contract (to the extent
that they are not within the scope of another standard, such as IAS 2 Inventories) (see section 10).
Also interesting is that the standard does not bother to explain how to present µrevenue¶ but,
instead, explains how to present any µrelated assets and liabilities¶. The presentation of µrevenue¶ is
explained in IAS 1 Presentation of financial statements (see section 12).
The standard covers the copious detail that must be disclosed (see section 13).
Before we continue with the study of this standard, it is important to be aware of the difference
between the terms µincome¶ and µrevenue¶ (see section 2).

2. Income versus revenue

µ,QFRPH¶DQd µUHYHQXH¶DUHQRWWKHVDPH µincome¶ is an umbrella term that includes µrevenue¶, where

µrevenue¶ is income from µordinary DFWLYLWLHV¶. IFRS 15 defines both terms as follows:

Income is defined in IFRS 15 * as Revenue is defined in IFRS 15 as

x increases in economic benefits during x income
the accounting period x arising in the course of
x in the form of inflows or enhancements x an entity’s ordinary activities.
of assets or decreases of liabilities IFRS 15. Appendix A

x that result in an increase in equity,

other than those relating to
contributions from equity participants.
See IFRS 15 App A

*: The ‘income definitions’ in IFRS 15 & the Conceptual Framework differ slightly: the effects are identical.

The following two examples may also help understand the difference between revenue and income:
x 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.
x 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

The inter-relationship between these two definitions can be seen in the diagram below:

Diagram 1: Relationship between income and revenue, and the different types of revenue
Income

Revenue * Other income

Income from ordinary activities:
x Revenue from contracts with customers
covered by IFRS 15
x Revenue from contracts with customers
covered by other IFRSs e.g. IFRS 16 Leases
x Other revenue not covered by a specific IFRS
Income not from ordinary activities:
Other income = Income that is not ‘revenue’
Examples include:
x incidental rent income
x interest income on overdue customer accounts
x gain on sale of property, plant & equipment.

See IFRS 15.113(a)

* we disclose ‘revenue from contracts with customers’ separately from ‘other revenue’.

Chapter 4 125
Gripping GAAP Revenue from contracts with customers

3. Scope

3.1 Overview
Although IFRS 15 deals with µrevenue¶, it does not apply to all types of revenue ± it only applies
to revenue arising from:
x µcontracts with customers’
x where the contract does not fall within the scope of certain other standards (e.g. it won¶t
cover revenue from a lease since this is covered by IFRS 16 Leases).

3.2 IFRS 15 only applies to contracts that involve customers

As its name suggests, IFRS 15 only deals with contracts, and A contract is defined
only contracts that involve customers. The terms µcontract¶ as:
and µcustomer¶ are defined in IFRS 15 (see grey boxes):
x an agreement between two
x A contract is an agreement in which the parties have rights or more parties
and obligations that are enforceable. It does not need to be x that creates enforceable
rights and obligations.
in writing ± it can be verbal or simply implied by the way in IFRS 15 Appendix A
which an entity normally conducts its business. What is
important is that it is enforceable by law.
A customer is defined
x A customer is simply a party (e.g. a person) who has as:
come to an agreement with the entity, promising to give x a party that has contracted
some form of consideration (e.g. cash) in exchange for with an entity
goods or services (e.g. food) that the entity promises to x to obtain goods or services
x that are an output of the
provide as part of its ordinary activities. entity’s ordinary activities
Example: if I agree to pay an entity for goods or services x in exchange for consideration.
IFRS 15 Appendix A
tKDWDUHQRWSDUWRIWKHHQWLW\¶VRUGLQDU\DFWLYLWLHVI am not
a µcustomer¶, as defined, and thus, this contract would not be accounted for under IFRS 15.

3.3 IFRS 15 does not apply to all contracts with customers

Although IFRS 15 applies to µcontracts with customers¶, some contracts are not covered by IFRS 15.
x IFRS 15 does not apply to contracts falling within the Scope exclusions:
scope of certain other specified standards Note 1. IFRS 15 does not apply to:
In other words, we first decide if these other standards x contracts that do not
would apply to the contract: involve customers as defined
x contracts with customers that
 if one or more of these other standards apply, then are covered by other standards
IFRS 15 will not apply; but - lease contracts under IFRS 16
 if these standards don’t apply, then IFRS 15 will apply. - insurance contracts per IFRS 4
- financial instruments and ‘other
Note 1: For the list of specified standards, see the grey contractual rights/ obligations’
box showing µscope exclusions¶. covered by IFRS 9, IFRS 10,
IFRS 11, IAS 27 or IAS 28
For example: If we sign a contract to which the standard x exchanges of non-monetary
on lease contracts (IFRS 16) apply, then the standard items between entities in the
on revenue (IFS 15) will not apply. same line of business to
facilitate sales to customers or
x IFRS 15 does not apply to contracts involving the potential customers.
See IFRS 15.5-6
exchange of non-monetary items between entities that
are involved in the same type of business and where the contract is simply to assist each
other to secure sales to existing or possible future customers.
For example: Entities A and B are milk distributors, where A and B operate in different
locations. 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 DVVLVWHDFKRWKHUE\SURYLGLQJPLONWRHDFKRWKHU¶VFXVWRPHrs if the other entity is closer to
that customer (e.g. B provides milk WR RQH RI $¶V FXVWRPHUV VLQFH % LV FORVHU Wo that
customer, and A provides PLONWRRQHRI%¶Vcustomers, since A is closer to that customer).

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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 2, 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 performance transaction transaction revenue when/
with a obligations in price price to the as the entity
customer the contract performance satisfies a
obligations in performance
the contract obligation
Recognition Recognition Measurement Measurement Recognition

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 µELJSLFWXUH¶RIWKHUHFRJQLWLRQPHDVXUHPHQW, presentation and disclosure requirements.

4.3 Recognition (IFRS 15.9 ± 45) Revenue is recognised

when:
When deciding whether to recognise something, we are x we have identified the
effectively deciding whether we should journalise it. When contract with a customer
(step 1);
deciding whether to recognise (i.e. journalise) revenue, we
x we have identified the
consider three steps: steps 1, 2 and 5. The essence of these performance obligations
steps is that revenue will be recognised if we have a contract, (step 2); and
we can identify our obligations in this contract and as and x the performance obligations
when we have satisfied these obligations. are satisfied (step 5).
See IFRS 15.9; 15.22 & 15.31

We must be able to identify a contract with a customer:

(IFRS 15 calls this step 1)

Contracts may be written, verbal or even simply be implied! What is important, however, is that the
contract is enforceable by law. If we conclude we do not have a µcontract with a customer¶, then
IFRS 15 will not apply and thus we would not recognise µrevenue from contracts with customers¶.

We must be able to identify the performance obligations in this contract:

(IFRS 15 calls this step 2)

µPerformance obligations¶ refer to the promises to supply Performance

obligations (POs) are
distinct goods or services or bundles (baskets) thereof. 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 ± this means the good or service (A PO can include a promise to
must be able to benefit the customer, whether this is transfer a series of the above)
See IFRS 15 App A
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

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x distinct in the context of the contract ± this means the A good or service is
promise to transfer the good or service must be able to be ‘distinct’ if it is:
separately identifiable from other promises in the contract. x capable of being distinct:
For example: a contract promising a fridge motor and a  can benefit the customer; &
fridge body may be promises that are so highly inter- x distinct in context of the
related that they are not separately identifiable. In other contract:
words, instead of there being two promises, we might  it is separately identifiable
from other G/S in the
decide there is only one promise: a fridge. This would See IFRS 15.27
contract.
apply, for example, if the motor can only be used in that
specific body and the body cannot be used without that specific motor.
7KHFRQFHSWRIµGLVWLQFW¶LVH[SODLQHGLQPRUHGHWDLOLQsection 6.4.

We must be able to identify when/as performance obligations are satisfied:

(IFRS 15 calls this step 5)

This step is crucial since the related revenue will be recognised Note!
as and when the entity completes its performance obligations.
x For revenue to be recognised,
The entity has satisfied its obligations when it has transferred the IFRS 15 requires control to
goods and/ or services to its customer in a way that gives the have passed to the customer.
customer control. This could happen at a point in time (instantly) or x Risks & rewards of ownership
over a period of time (gradually). do not need to transfer for
revenue to be recognised.
If, after these three steps, we decide we must recognise x Instead, this simply suggests
revenue, we will need to process a journal. To do this, we will control may have passed.
obviously need to know the amount of the journal. This involves measurement (see section 4.4).

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 by first calculating the
transaction price (TP); and
 we first work out the transaction price, being the total x By then allocating this TP to
amount to which we expect to be entitled, and each performance obligation
 we then allocate this to each of our performance obligations. based on the relative stand-
alone selling prices of the
/HW¶VORRk at these two steps in more detail: underlying goods or services.
See IFRS 15.73 - .90

Determine the transaction price:

(IFRS 15 calls this step 3)

The µtransaction price¶ is µthe amount of consideration to which the entity expects to be entitled’
for having transferred the goods and/ or services to the customer. See IFRS 15.47
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).

Allocate the transaction price to each performance obligation:

(IFRS 15 calls this step 4)

,IWKHFRQWUDFWLQYROYHVRQO\RQHVLQJOHSHUIRUPDQFHREOLJDWLRQWKHFRQWUDFW¶VHntire transaction
price will apply to that single obligation.
However, if a contract involves more than one performance obligation (i.e. it has made more than
one promise), the transaction price will need to be allocated to each separate performance obligation.
The reason we must allocate a portion of the transaction price to each of the performance obligations is
because the revenue from each of the obligations must be recognised separately, as and when each
obligation is satisfied (i.e. completed). In other words, at any one time, the revenue recognised by an
entity should reflect the effort it has put into fulfilling its promises.

128 Chapter 4
Gripping GAAP Revenue from contracts with customers

For example: a contract requiring us to supply and install a µcomplex 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 RIWKHµGLVWLQFW¶JRRGs 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 µcomplex 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).

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:
x an entity’s right to consideration
x in exchange for goods or services
that the entity has transferred to a
customer
x when that right is conditional on
something other than the passage of
time
(e.g. the entity’s future performance).
IFRS 15 App A
A contract liability is defined as:
x an entity’s obligation to transfer goods
or services to a customer
x for which:
- the entity has received consideration
from the customer; or
- the amount of consideration is due
from the customer.
IFRS 15 App A (slightly reworded)

A receivable is defined as:

x an entity’s right to consideration
IFRS 15.108 (extract)
that is unconditional.
A right to consideration is unconditional if:
x
all we need do is wait for payment to
See IFRS 15.108 (reworded)
fall due.

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Gripping GAAP Revenue from contracts with customers

For us 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 perform our side of the contract).

The relationship between these µrights¶ and µobligations¶ will determine whether we have:
x a contract asset, if our remaining rights exceed our remaining obligations; or
x a contract liability, if our remaining obligations exceed our remaining rights. See IFRS 15.BC18

Please note that contract assets and receivables are different kinds of assets (see section 4.5.2).
This means that, when measuring a contract asset, we must be
careful to exclude any amounts included in the receivable. Rights are assets:

4.5.2 Rights are presented as assets (IFRS 15.107 – 108) A contract asset is a:
x conditional right
A receivable is an:
As mentiRQHG DERYH DQ HQWLW\¶V right to consideration is x unconditional right.
recognised as an asset. * Simply waiting for time to
pass is not considered to be a
Thus, when processing the revenue recognition journal, condition (because ‘time in an
See IFRS 15.107-.108
inevitability’)
where revenue is a credit entry, we will need to carefully
decide which asset to debit.
x If revenue is received in cash, the Debit Credit
debit entry will be to cash. Cash/ Receivable/ Contract asset? xxx
x However, if the revenue has not Revenue xxx
yet been received, we must decide Revenue recognition journal
whether the debit should be a
contract asset or a receivable asset. (See journal above).

Deciding which asset to debit depends on whether our right to receive consideration is
conditional or not. If our right to consideration:
x is conditional upon something happening, other than the passing of time* (e.g. if it is
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* - in other words, we have satisfied all our obligations and are
now simply waiting for the customer to pay), then we debit the receivable.

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.

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Gripping GAAP Revenue from contracts with customers

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.
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
Revenue from customer contract (I) 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)
Accounts receivable (A) Given 15 000
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)

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Gripping GAAP Revenue from contracts with customers

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 µDOORZDQFHIRUGRXEWIXOGHEW¶PRGHO(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 contract 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 be able to recognise revenue, we may need to recognise a contract
liability instead. This happens if either of the following applies:
x We have already received the Debit Credit
consideration from the customer Cash xxx
(i.e. we have debited bank but Contract liability xxx
cannot yet credit revenue since the Recognising cash received but no
performance obligation has not yet revenue yet (PO not complete)
been satisfied); or
x We have an unconditional right to Debit Credit
this consideration (i.e. we have Accounts receivable xxx
debited accounts receivable but Contract liability xxx
cannot yet credit revenue since the Recognising unconditional right but
performance obligation has not yet no revenue yet (PO not complete)
been satisfied).

This contract liability is recognised on the earliest of the following two dates:
x when the entity receives the consideration; or
x when the entity obtains the unconditional right to this consideration.

The contract liability reflects our obligation to the customer, which could be one of the following:
x to satisfy our performance obligations (i.e. do what we promised to do)
 if this happens, we will process the following journal to get rid of the contract liability:
Debit Contract Liability and Credit Revenue

x to return any amounts that we have received from the customer (i.e. give back the cash)
 if this happens, we will process the following journal to get rid of the contract liability:
Debit Contract Liability and Credit Cash

x to release our customer from the amount to which we had an unconditional right (i.e. reverse
the account receivable)
 if this happens, we will process the following journal to get rid of the contract liability:

Debit Contract Liability and Credit Accounts Receivable

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. If we sign a non-cancellable contract,
x the date on which the contract requires our customer to make payment is the date on which we
obtain an unconditional right to the consideration, even if we have not performed our obligations.

Please note: The due date for payment per the contract is normally irrelevant when accounting for
revenue. But, the date is very important if the contract is non-cancellable, since it is the date on which
the entity obtains an unconditional right to receive the consideration.

132 Chapter 4
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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 cancellable in the event of non-performance.
B. the contract is non-cancellable . Adaptation of IFRS 15.IE38 & 39

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 cancellable and thus the contractual 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).
Since we received the cash, on 30 April, we will need to debit the cash/bank account.
However, because we have not satisfied our performance obligations, we cannot credit revenue and thus we will
need to recognise a contract liability instead:
P.S. This journal will
Debit Bank be posted on 30 April
Credit Contract Liability.
x In part (b), 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 an unconditional right arises on 1 April, which is before the cash is received (30 April), we will need to
debit the receivables account before we get to debit bank.
However, on 1 April, because we have not satisfied our performance obligations, we cannot credit revenue and
thus we will need to recognise a contract liability instead:
P.S. This journal will
Debit Accounts Receivable be posted on 1 April
Credit Contract Liability.

Solution 2A: 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).
30 April 20X2 Debit Credit
Bank (A) Given 15 000
Contract liability (L) 15 000
Recognising the receipt of cash and the obligation to install the fireplace
(contract liability) Continued on next page

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Gripping GAAP Revenue from contracts with customers

10 May 20X2 Debit Credit

Contract liability (L) Given 15 000
Revenue from customer contract (I) 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 receivable

Comment on Part B:
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).

1 April 20X2 Debit Credit

Accounts receivable (A) Given 15 000
Contract liability (L) 15 000
Recognising the unconditional right to receive consideration (the receivable)
and the obligation to install the fireplace (contract liability)
30 April 20X2
Bank (A) Given 15 000
Accounts receivable (A) 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
Revenue from customer contract (I) 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 thHµQDWXUHDPRXQW, timing DQGXQFHUWDLQW\¶RIERWKWKHUHYHQXH
anGWKHFDVKIORZVWKDWVWHPIURPWKHHQWLW\¶VFXVWRPHUFRQWUDFWV See IFRS 15.110

IFRS 15 disclosure requirements:

In terms of the previous standard on revenue (IAS 18), we had to disclose revenue in
the categories of sales, services, interest, royalties or dividends. Now, however, revenue may
be disclosed based on a variety of other categories (e.g.
x revenue from different geographical areas,
x revenue from different products,
x revenue from long-term contracts versus short-term contracts,
x revenue from shop sales versus from online sales 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
HQWLW\¶VFRmmon 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
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5.2 The contract must meet certain criteria (IFRS 15.9)

A contract is said to exist if it meets all the following five criteria:

a) If it is approved by all parties, who are also committed to fulfilling their obligations;
b) ,IHDFKSDUW\¶Vrights 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 is Please note:
important is that these rights and obligations must be legally Even if all criteria are
enforceable. As already mentioned, to be legally enforceable met, the contract may
does not mean the contract must be in writing. be 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
HQWLW\¶V µFXVWRPDU\ EXsLQHVV SUDFWLFHV¶ 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 µcourtesy valet service¶ at
every µmaintenance service¶ZKHUHWKLVFRXUWHV\YDOHWVHUYLFH¶LVQRWVSHFLILHG in the maintenance
contract. Thus, when deciding whether an entity has entered into a legally enforceable contract,
we must consider that particular entit\¶VµSUDFWLces and SURFHVVHV¶. 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 WRGHOLYHUFUXGHRLOWR(QWLW\%¶VFXVWRPHUDQG(ntity B agreeing to deliver
crude oil to EntiW\$¶VFXVWRPHUSee 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 entLW\¶V IXWXUH FDVK IORZV 7R DVVHVV D WUDQVDFWLRQ¶V 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)

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Gripping GAAP Revenue from contracts with customers

When considering whether it is probable that the entity will collect the consideration, we consider
WKH FXVWRPHU¶V DELOLW\ WR SD\ DQG LQWHQWLRQ WR SD\ EXW RQO\ 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 criteria are Contracts are deemed
not to exist if:
met, the contract will be deemed not to exist if:
x each and every party to the contract all parties are equally entitled
x KDVDµXQLODWHUDOHQIRUFHDEOHULJKWto terminatH¶ to terminate a contract that is
x DµZholly unperIRUPHGFRQWUDFW¶ wholly unperformed, without
compensating the others.
x without providing any compensation to the other party/ies.
A wholly unperformed contract
is one where the entity:
A wholly unperformed contract is a contract where the entity
has not yet transferred any of the promised goods or services, x has not yet done anything
x has not yet been paid; and
has not yet received any consideration and is not yet entitled
x is not yet owed anything.
to any consideration. 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 repreVHQWVWKHHQWLW\¶VREOLJDWLRQWRHLWKHU
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 x entity has no further
obligations and the receipts
revenue) or will be refunded (i.e. debit liability and credit
are non-refundable; or the
bank). However, the entity may not recognise the contract
x contract is terminated and
liability as revenue until: the receipts are non-
x all five criteria (in para 9) are subsequently met; or refundable
x it has no further obligations in terms of the contraFW µDQG DOO RU VXEVWDQWLDOO\ DOO¶ RI WKH
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
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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
Bank (A) Given 5 000
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: $OWKRXJKFROOHFWLQJSHQDOWLHVLVQRW3XEOLFDWLRQ¶VRUGLQDU\DFWivities, 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
QHHGWRUHDVVHVVWKHVLWXDWLRQZKHQWKHUHLVDµsignificant change in facts and cLUFXPVWDQFHV¶ HJLIZH
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 custRPHU¶VODZ\HUWRVD\WKDWWKHFXVWRPHUZDVGLVSXWLQJWKe 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 XQWLO µVLJQLILFDQW FKDQJHV LQ IDFWV DQG circumstancHV¶
suggested otherwise: Debit Receivable and Credit Revenue. (See the first journal below.)

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Gripping GAAP Revenue from contracts with customers

On 5 May, a lawyHU¶V OHWWHU ZDV UHFHLYHG LQGLFDWLQJ WKDW WKHUH ZDV D µVLJQLILFDQW FKDQJH LQ IDFWV DQG
circumsWDQFHV¶DQGZKLFKVXJJHVWHGWKDWWKHFULteria 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 months 4 000
Revenue (I) 4 000
Recognising the receivable and revenue earned (we could process 4 jnls of
C1 000 instead)

May
Receivable (A) C1 000 x 1 1 000
Refund liability (L) 1 000
Recognising the receivable and refund liability (delaying revenue recognition)

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¶VUelated parties; and
c) if:
- WKH\ZHUHµQHJRWLDWHGDVDSDFNDJHZLWKDVLQJOHFommercial obMHFWLYH¶or
- the amount to EH SDLG LQ WHUPV RI RQH RI WKH FRQWUDFWV µGHSHQGV RQ Whe price or
SHUIRUPDQFHRI¶RQHRIWKH other contract/s; or
- all or some of the goods or services that are promised in these contracts are, together,
considered to IRUPµDVLngle performance obOLJDWLRQ¶ (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 the
x all parties agree
price (or both) is subsequently changed. Modifications are also
x to a change in the:
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. (VWLPDWLQJ D QHZ SULFH LQYROYHV µHVWLPDWLQJ YDULDEOH
consideraWLRQ¶ DQG WDNLQJ LQWR account WKH µFRQVWUDLQLQJ HVWLPDWHV RI YDULDEOH FRQVLGHUDWLRQ¶ VHH
section 7 RQµGHWHUPLQLQJWKHWUDQVDFWLRQSULFH¶ 

138 Chapter 4
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Before we account for a change, we must consider all terms and Modifications may be
conditions to be sure that the change is enforceable. Modifications accounted for as:
that are not considered enforceable are ignored.
1 an extra separate contract
2 a termination of the old and
Depending on the circumstances, if the extra goods or creation of a new contract
services are considered to be distinct from the original goods
3 part of the existing contract.
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 DPRXQWWKDWUHIOHFWVWKHµstand-alone selling prices¶Rf
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 µdiscounted 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 (in terms of IAS 8,
see chapter 26).

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6. Identifying the performance obligations (step 2)

6.1 Performance obligations are promises (IFRS 15.22 - 23 & .25)

A performance obligation (PO) 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
- a series of distinct goods or services that are:
- substantially the same; and
IFRS 15 Appendix A reworded
- have the same pattern of transfer to the customer.

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 (i.e. defined as being goods or
services delivered consecutively rather than concurrently; 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 µHQWLW\¶Vcustomary 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.

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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 µWKURZQ LQ IRU frHH¶  7Kis
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.

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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. We look at
whether the nature of the promise was to transfer individual goods/ services or a combined item
to which the individual goods and services were just inputs.

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 (separable) 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 separable and would thus not be distinct in the context of a contract. Goods or
services where:
x There is a significant service of integration: if the entity is using the good or service 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 D µcontract management¶VHUYLFH (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 and thus the µconstruction¶ and µmanagement¶ are one PO.
x There is a significant modification/customisation: if the entity is using a good or service as an
input to significantly modify or customise another good or service promised within the same
contract, then that good or service being used as an input is considered to be part of the output,
being 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 cXVWRPHU¶VVHUver, the software company
also agrees to modify this software. In this case, the modification service is simply an input to
modify the output (the software) and thus the µsoftware¶ plus µmodification¶ is one PO.
x There is a high level of interdependence/ interrelatedness: if a good or service is highly
dependent on another good or service promised within the same contract (e.g. if it is not
possible for the customer to buy the one without the other), they may be 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 manufactured. The µdesign¶ and µmanufacture¶ performance obligations are
considered highly interdependent and are thus one PO. 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 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.

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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 RIWKHFXVWRPHU¶VKRXVH

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 x the amount of consideration
in a contract. In other words, the transaction price does not x to which an entity expects
to be entitled
necessarily equal the contract price.
x in exchange for transferring
goods/services to a
Instead, the transaction price is the amount of consideration to customer,
which the entity expects to be entitled for satisfying the x excluding amounts collected
performance obligations contained in the contract. on behalf of third parties.
IFRS 15.App A (reworded slightly)

The µtransaction price¶ is the total amount we expect to recognise

The transaction price is:
as µrevenue¶ from the completed contract. Thus, when converting the amount we expect
the µcontract price¶ into the µtransaction price¶, we must remove to be entitled to
from the µcontract price¶ any amounts that are to be received on – it is not the amount
behalf of third parties. For example: if the µFRQWUDFWprice¶ includes we expect to collect!
VAT, which belongs to the tax authorities, we deduct VAT from the µcontract price¶ when calculating the
µtransaction price¶ (Contract Price ± VAT = 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

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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 determining the transaction transaction price (TP):
price. This is because collectability was considered as part of x variable consideration (we
step 1, when determining if a contract exists (step 1 says that need to estimate it and
constrain it)
the probability of collecting the transaction price is one of the x significant financing
5 criteria that must be met when deciding if a contract exists). components
x non-cash consideration
However, where credit risk exists, there is always a possibility x consideration payable to the
that the full transaction price might not get collected. Since customer. See IFRS 15.48
revenue is measured at the full transaction price, any losses Collectability:
expected due to selling on credit will be taken into account x is not a factor when
when measuring the related receivable or contract asset. determining TP (thus it does
not affect measurement of
revenue), but
In this regard, when we recognise the receivable (or contract
x is a factor when measuring
asset), we will recognise a loss allowance, reflecting the the receivable. See IFRS 15.9
expected credit losseV GHELWµLPSDLUPHQWH[SHQVH¶FUHGLWµORVV
DOORZDQFH¶  The loss DOORZDQFH LV DQ µDVVHW PHDVXUHPHQW DFFRXQW¶ LH WKH UHFHLYDEOH LV
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’).
Please note: This differs from the previous old 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). This
approach is now outdated.
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 probable but, 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 90%). We satisfy our performance obligation on
20 June 20X1. At 31 December 20X1, reporting date, the expected credit loss is reassessed at 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 the following:
x Revenue is measured at the full transaction price, (ie 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 µexpected 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 Continued on next page

144 Chapter 4
Gripping GAAP Revenue from contracts with customers

31 December 20X1 Debit Credit

Impairment - credit losses (E) LA to reflect ECLs at reporting date: C15 000 – 5 000
Receivable: loss allowance (-A) 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
Receivable: loss allowance (-A) 15 000
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).

15 January 20X2 Debit Credit

Receivable: loss allowance (-A) 15 000
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
Receivable (A) 100 000
Receipt from the customer: recognise the cash received and derecognise
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).

15 January 20X2 Debit Credit

Impairment - credit losses (E) 5 000
Receivable: loss allowance (-A) 5 000
Remeasuring the loss allowance to C20 000 on date of full and final receipt
from the customer
Bank Given 80 000
Receivable (A) 100 000
Receivable: loss allowance (-A) 20 000
Receipt from the customer: recognise the cash received and derecognise
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 custoPHU¶V ILnancial 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.

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Gripping GAAP Revenue from contracts with customers

Solution 8: Transaction price: collectability versus implied price concession

Comment:
x When price concessions (i.e. a reduction in the price: a discount) are offered or are possible, we are dealing
ZLWKµYDULDEOHFRQVLGHUDWLRQ¶ VHe 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.
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 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 WRWKHFXVWRPHU¶VFUHGLWULVNDQGWKDWWKHHQWLW\LVGealing 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).
20 January 20X1 Debit Credit
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.

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 is
consideration and then estimate how much of this the entity included in the
expects to be entitled to. transaction price.
It is measured by:
Since variable consideration involves significant estimation, there x estimating the amount to
is an increased risk that we might overstate revenue. In order to which the entity believes it
avoid this, we are further required to constrain (limit) our estimate will be entitled; and
of the variable consideration. x constraining (limiting) the
estimate to an amount
Thus, we will need to decide how much of this variable that has a high probability
consideration to include in the transaction price by: of there being no
x estimating the amount to which we think we will be significant reversal of
revenue in the future.
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.

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Consideration may be
7.2.2 When is consideration considered to be variable?
considered variable due
to:
Variations in the consideration can come in many forms.
x contractual terms; or
Examples include:
x discounts, rebates, refunds, performance bonuses (or x the customer having a valid
expectation of a price
penalties) and price concessions offered to customers; concession; or
x incentives and performance bonuses (or penalties)
x the entity having the
offered to the entity. See IFRS 15.51 intention, at inception, to
give a price concession.
Consideration is considered variable if any one of the following See IFRS 15.52

criteria are met:

x the contractual terms explicitly state how the consideration may vary;
x WKH µHQWLW\¶V Fustomary business practice, published policies or specific statemeQWV¶ 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

AnaPal Limited sold inventory to a customer, on credit, for C100 000, less a 10% trade discount.
x A further discount of 5% is offered to customers who pay within 30 days. Based on experience,
AnaPal expects most of its customers to pay within this time frame.
x This customer obtained control of the inventory on 1 February 20X2 and paid on 20 February 20X2.
Required: Provide the necessary journals to account for the above information.

Solution 9: Variable consideration ± discounts

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 (VC)
was excluded entirely from the transaction price (TP).
The contract price (CP) is C100 000, but we first consider all discounts in determining the transaction price.
x Trade discount (TD): 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%)
and thus our transaction price is reduced by the trade discount.
x Settlement discount (SD): It is not certain that the customer will qualify for the settlement discount and
thus the further discount of C5 000 is variable consideration (VC).
The existence of the potential settlement discount effectively means that our contract price includes:
x variable consideration (VC): C5 000 (C100 000 x 5%) and
x fixed consideration (FC): C85 000 (Contract price C100 000 ± TD: C10 000 ± VC: C5 000).
Since the entity expects the settlement discount to be granted, the transaction price is based on the
contract price reduced by not only the trade discount, but also the settlement discount.
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
20 February 20X2
Bank (A) 100 000 – trade discount: 10 000 – settlement discount: 5 000 85 000
Receivable: settlement discount allowance (-A) 5 000
Receivable (A) 90 000
Recognising the receipt from the customer
Note: A customer that did not pay on time would have had to pay C90 000. In this case the settlement
discount allowance account would be transferred to revenue, thus making revenue greater (C90 000):
x debit bank C90 000, credit receivable C90 000
x debit receivable: settlement discount C5 000, credit revenue C5 000

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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 VSHFLILF FXVWRPHU¶V
receivables account with this discount until the customer successfully qualifies for the discount.
Thus, as an interim measure, we use a settlement discount allowance account, being a µQHJDWLYH
DVVHW¶ (an asset account with a credit balance) until we know 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,
whereas 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 thHµH[SHFWHGYDOXH¶PHthod; and
x the siQJOHµPRVWOLNHO\DPRXQW¶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 7KH µH[SHFWHG vDOXH PHWKRG¶ is probably ideal for situations where there are many similar
contracts on which to base the estimates of the possible outcomes; whereas
x 7KHµPRst likel\DPRXQW¶Pethod 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:
x identifying the various possible
amounts of consideration;
x multiplying each of these by its
relative probability of occurring; &
x adding together each
‘probability-weighted amount’.
The most-likely amount method entails:
x identifying the various possible
amounts of consideration; and
x selecting the single amount that
is that contract’s most likely
outcome.
See IFRS 15.53 (b)

See IFRS 15.53 (a)

WKHQ XVLQJ WKH µH[SHFWHG YDOXH¶ PHWKRG DOWKRXJK ZH DUH UHquLUHG WR FRQVLGHU DOO µKLVWRULFDO,
FXUUHQW DQG IRUHFDVW¶ Lnformation that is reasonably available to us, we are not required to
include in the calculation of the µconsideration¶ each and every amount that is possible. Instead,
ZHQHHGRQO\LQFOXGHDµUHDVRQDEOHQumEHU¶RISRVVLEOHFRQVLGeration amounts. For example:
If we estimate there to be 100 different µconsideration amounts¶ possible, we need not calculate and
assess the probability of each of these 100 possible amounts when calculating our expected value.
Instead, we can base our expected value calculation on just a selection of possible amounts that we
feel will give us a reasonable estimate of the outcome (LHµDUHDVRQDEOHHVWLPDWHRIWKHdistribution
RISRVVLEOHRXWFRPHV¶IFRS 15.BC201).
Thus, if we think that 80 of the 100 possible outcomes are highly unlikely, we can base our expected
value calculation on the 20 outcomes that we feel are more likely to occur. Alternatively, we can base
our calculation on only those outcomes we feel are most likely to occur. Deciding what is considered
a µUHDVRQDEOHQXPEHU¶RISRVVible 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 types. 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

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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
WKDWFOLHQW¶VFDXVHfor 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 agUHHGWRDUUDQJHDQGPDUNHWDVHULHVRIFKLOGUHQ¶VSOD\VWR be held over the months
of September to December. The plays would take place in tents erected in and around the province and all
PRQH\ FROOHFWHGZRXOG JRWRZDUGV IXQGLQJ 'HVSHUDWH'DQ¶V µ'RQNeys iQ 'LVWUHVV¶ ,Q H[FKDQJH IRU WKLV
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 µPRVW OLNHO\
DPRXQW¶PHWhod is not the best predictor. InsteadWKHµH[SHFWHGYDOXH¶PHWKRd 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 µGLVFUHWHDPRunWV¶
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

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FFA prepared the following schedule of expected performance bonuses:

Performance bonus: Probability:
C %
0 30%
100 000 30%
200 000 35%
300 000 5%
100%
Required:
a) CalFXODWH WKH HVWLPDWHG YDULDEOH FRQVLGHUDWLRQ XVLQJ WKH µH[pected value¶ PHWKRd ± but before
considering the effects of constraining the estimate.
b) Calculate the estimated YDULDEOH FRQVLGHUDWLRQ XVLQJ WKH µPRVW OLNHO\ DPRXQW¶ PHWKRG ± 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) 8VLQJWKHµH[SHFWHGYDOXH¶method, the estimated variable consideration is C115 000. However, this
estimate is before considering the required µFRQVWUDLQLQJRIWKHHVWLPDWH¶

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 µPRVW likely amounW¶ PHWKRG WKH HVWLPDWHG YDULDEOH FRQVLGHUation is C200 000. This is
because C200 000 reflected the highest probability of occurring (35%). However, this estimate of
C200 000 is before FRQVLGHULQJWKHUHTXLUHGµFRQVWUDLQLQJRIWKHHVWLPDWH¶

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 faced with The transaction price may
significant uncertainties. only include the estimated
variable consideration to the
extent that:
These uncertainties increase the risk that we may misinterpret
x ‘it is highly probable
something, and a misinterpretation may result in revenue being
x that a significant reversal
overstated or understated. Since the revenue line-item is critical
x in the amount of cumulative
to many 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
To limit volatility in our revenue estimates, and also to avoid consideration is
significant overstatement of our revenue, we apply the principle subsequently resolved’.
IFRS 15.56
of including only that portion of the estimated variable
consideration that we believe KDVDµKLJKSUREDELOLW\¶RInot UHVXOWLQJLQDµVLJQLILFDQWUHYHUVDO¶LQWhe
future of tKHµFXPXODWLYHUHYHQXHUHFRJQLVHG¶WRGate. See IFRS 15.56

Simply put, we only recognise variable consideration to the extent that we can reliably measure
it without there being a high probability of a big reduction in our estimated revenue in the future.

Applying this principle is referred to as the process of constraining (limiting) the estimate.

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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 baseG RQ WKH µH[SHFWHG YDOXH¶ PHWKRG
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 the grey box on the process of
constraining variable consideration ± on the prior page), the calculation of the 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 The significance of a
potential reversal of
There are no criteria to determine either whether a potential revenue is determined by:
reversal is considered highly probable to occur or whether the x considering the reversal in
relation to the
amount of a particular reversal would be considered significant.
x total consideration recognised
Thus, professional judgment is required for both these aspects. to the date of this reversal.
See IFRS 15.56

A reversal is considered probable of occurring if it is more likely

than not to occur (using the definition of µprobable¶ from IFRS 5 Highly probable = Likely
Non-current Assets Held for Sale & Discontinued Operations). x is not defined, but it
x seems to suggest ‘likely’
The significance of the amount of a potential reversal of revenue
Reasons:
on the date that the uncertainty clears up must be considered in
x probable = defined in IFRS 5 as:
relation to the entire contract revenue recognised (i.e. including
more likely than not, and thus
both the fixed and variable consideration recognised). What is
considered to be significant to one entity will not necessarily be x highly probable =
significant to another entity. Professional judgement will be ‘significantly more’ than ‘more
likely than not’ =
needed in deciding what is significant.
which roughly = ‘likely’.
See IFRS 15.BC211
Although there are no criteria to determine whether a potential
reversal is highly probable to occur, there may be indicators that there is an increased risk that a
reversal is highly probable of occurring or that it may be significant.
Deciding whether a
Examples of such indicators (given in IFRS 15) include: significant reversal is
highly probable,
x the amount of the variable consideration will be highly entails considering:
affected by external factors (i.e. factors that the entity x the entity’s ability to
cannot influence, such as the weather, economic state of estimate (e.g. due to lack of
the country, market price of shares, actions of third experience on similar
contracts or the complexity
parties, technological advancements by competitors);
of the contract) and
x the amount of the variable consideration will only be x whether factors beyond the
decided after a long time; entity’s control may affect
x the entity is unable to reasonably predict the variable the variable consideration.
consideration because it has limited experience with similar contracts;

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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 from this contract 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 after which the reversal of C10 000 then became necessary, it would
represent 10% of the cumulative revenue recognised to date (Reversal: 10 000 ÷ Cumulative revenue: 100 000).
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.

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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:

Performance bonus: Probability:
C %
0 30%
100 000 30%
200 000 35%
300 000 5%
100%
Required:
a) Calculate the estimated variable consiGHUDWLRQ XVLQJ WKH µexpected value¶ PHWKRG DQG DSSO\ WKe
principle of constraining the estimate and then calculate the final estimated transaction price.
b) Calculate the estimated variable consideraWLRQ XVLQJ WKH µmost likely amount¶ PHWKRG DQG DSSO\ WKH
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) 8VLQJWKHµH[SHctHGYDOXH¶PHWKRGWKHHVWLPDWHGvariable consideration is C115 000 (see calculation
in part (a) of example 11). However, this estimate is before considering the required µFRQVWUDLQLQJRI
WKHHVWLPDWH¶
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 (EDVHG RQ WKH µH[SHFWHG YDOXH¶  PXVW EH FRQVWUDLQHG WR &100 000
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
consideration: C100 000).
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).

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b) Using tKH µPRVW likely amount¶ PHWKRG WKH HVWLPDWHG YDULDEOH 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 reqXLUHGµFRQVWUDLning of the estimatH¶
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 oI& EDVHGRQWKHµPRVWOLNHO\DPRXQW¶ PXVWEHFRQVWUDLQHGWR& 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
consideration: C100 000).
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 of x the amount received (or
caution: we carefully estimate the variable consideration and receivable)
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 lower See IFRS 15.55

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 tKH µULJKW RI
UHWXUQ¶+Rw to account for goods that are solGZLWKWKHµULJKWRIUHWXUQ¶DUHH[SODLQHGLQGHWDLOLQ
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.

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Example 15: Receipts exceeds constrained estimate of variable consideration

An entity signed a contract with a customer in 20X1, in which the promised consideration is
represented entirely by variable consideration, estimated at C90 000 (based on its expected
value) and which was constrained to C80 000.
By the end of 20X1, the entity had completed 80% of its performance obligation. The customer made its
first payment a few days before reporting date, in an amount of C72 000 cash.
In 20X2, the uncertainty resolves and C90 000 is due in total by the customer. The entity has now
completed 95% of the performance obligation. There were no further receipts from the customer.
Required: Prepare the journal entry to reflect the information provided.

Solution 15: Receipts exceeds constrained estimate of variable consideration

20X1 Debit Credit
Accounts receivable (A) 80% x TP: 80 000 64 000
Revenue from customer contracts (I) 64 000
Recording the revenue from the contract with customer X. Notice: the TP is
based on the constrained estimate of the variable consideration of C80 000
Bank (A) Given 72 000
Accounts receivable (A) The balance in this account 64 000
Refund liability (L) Balancing: 72 000 – 64 000 8 000
Recording the receipt from the customer
20X2
Refund liability (L) 80% x TP: 90 000 – 64 000 8 000
Revenue from customer contracts (I) 8 000
Adjustment to 20X1 revenue due to the changed TP
Accounts receivable (A) 13 500
Revenue from customer contracts (I) 95%x TP: 90 000 – (64 000 + 8 000) 13 500
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.

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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.

Required: Prepare the journal entry to reflect the information provided.

Solution 16: Variable consideration ± volume rebate

1 June 20X8 Debit Credit
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 with the right of
A sale of goods with a right of return occurs when our customer return involves variable
has the right to return the goods to us. This means it involves consideration:
variable consideration becaXVH ZH FDQ¶W EH certain how much x consideration for products
of the consideration we will get to keep and how much we may we expect will be returned is
not included in the TP (i.e. it
have to refund in the event the goods are returned.
must be recognised as a
refund liability – not revenue);
When accounting for a µright to return¶, we only consider the x consideration for products
possible return of goods that would have commercial we expect won’t be returned
substance. In other words, a sale of goods to a customer who is included in the TP (i.e. it is
may exchange goods for a different size or colour is not a right recognised as revenue)
of return that we would account for. This is because this – we must estimate this
exchange would have no effect on our net assets or profit (i.e. variable consideration &
constrain it with reference
no adjustment is made for these exchanges).
to the expected returns.

The ability to return defective goods is not Dµsale with a right

A sale with the right of
RIUHWXUQ¶. Instead, a return of defective goods is accounted for return does not refer to:
as a µUHWurn under ZDUUDQW\¶(see section 11.2).
x exchanges that have no
commercial substance
However, if we sell an item to a customer and, at the same time, (changing a shirt for a
we offer the customer a right to return it (i.e. even if it is not different colour/ size);
defective), we must exclude the consideration for these items x a return of defective goods
from the transaction price if the entity expects them to be (these are warranty returns).
returned. This makes sense because the transaction price is the
amount of consideration to which the entity expects to be entitled. The refund from a return
Thus, if an entity expects that certain goods will be returned, it need not be given in full
would not expect to be entitled to the consideration for these or be given in cash:
goods. Thus, since the consideration for these goods is excluded x it could be a full or partial
from the transaction price, it means we cannot recognise it as refund
revenue and must thus recognise it as a refund liability instead. x a refund could come in the
form of cash or credits for
the customer to use or as an
The remaining promised consideration (i.e. the consideration entirely different product.
to which the entity expects to be entitled ± or, in other words,
the consideration for the goods that the entity does not expect will be returned), is variable
consideration since we cannot be certain what will or will not be returned. Thus, when including
consideration in the transaction price (and thus in revenue), we estimate how much is variable
(TP less portion relating to goods we expect will be returned) and then constrain this estimate.
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.

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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 to reflect 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.

Diagram 3: The accounts we use 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. Surplus vests may be
returned before 15 January 20X1, if they are returned in good condition.
x Using expected values, the entity estimates the customer will return 100 vests. The 400 vests that are not
expected to be returned 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.
Required: Prepare the journal entry to reflect the information provided.

Solution 17: Variable consideration ± sale with right of return

5 January 20X1 Debit Credit
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
Accounts receivable (A) 4 200
Adjusting the refund liability by adjusting revenue for the goods that were
not returned, reducing the receivable by the remaining refund liability being
the goods that were returned & recognising the cash received

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12 January 20X1 continuHG« 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
ZRQ¶WNQRZKRZPDQ\ 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 the
must exclude the effects thereof from the transaction price. timing of
 the payment &
In other words, the transaction price should reflect the cash  the performance.
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 contrDFW¶VWUXHWUDQVaction price.

The related interest income 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

Incidentally, this interest income recognised due to the time-value of money should only be presented
as µrevenue¶ if the earning thereof is considered part of the entity¶s ordinary activities. For example:
x a financier would classify µinterest income¶ as arising from its ordinary activities, and would thus
present it as µinterest revenue¶, whereas
x a retailer would probably classify interest income as being incidental to its ordinary activities, and
would thus present it as µinterest income¶.

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Although interest income may be presented as part of the total revenue (e.g. in the case of a financier),
it is never presented as part of the µUHYHQXH IURPFRQWUDFWV ZLWKFXVWRPHUV¶ The reason for this 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.BC246-247

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

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, it was decided 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. Thus, the entity must 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)
The entity obtains the benefit of the financing. Thus, the entity must 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 (control transfers 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.

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Solution 19: Significant financing component ± arrears journals

Comment:
x Receipt 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 a 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 the cash sales price, 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. to the date when the customer
obtains control):
121 000 x (1 / 1.1)2 = 100 000
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.

1 January 20X1 Debit Credit

Accounts receivable (A) 100 000
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 12/12 11 000
Revenue from interest (I) 11 000
Recognising the interest income on the significant financing component
Bank (A) 100 000 + 10 000 + 11 000 121 000
Accounts receivable (A) 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 (control transfers 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.
x The payment terms are considered to constitute a significant financing component in terms of IFRS 15.
x 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.
x The transaction price for the contract to transfer goods must be measured at the cash sales price on
date of transfer. Although the customer pays cash of C100 000, this is before transfer date and is thuis
not the transaction price. The future value on date of transfer of the goods is given as C121 000. This
future amount (C121 000) is more than the amount actually received (C100 000) because the amount
actually received is effectively a net amount: it is the amount the customer owes us for the goods
(C121 000) less the amount we owe the customer for the interest (C21 000).

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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.

1 January 20X1 Debit Credit

Cash (A) Given 100 000
Contract liability (L) 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
Contract liability (L) 10 000
Recognising the interest expense on the significant financing component
31 December 20X2
Interest expense (100 000 + 10 000) x 10% x 12/12 11 000
Contract liability (L) 11 000
Recognising the interest expense on the significant financing component
Contract liability (L) 100 000 + 10 000 + 11 000 121 000
Revenue from contracts with customers 121 000
Recognising the revenue from the contract on transfer of the goods

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 we financing if:
would adjust the transaction price for the existence of the
x the timing difference is > 1yr
financing component is if: &
x the difference between the timing of the payment and the x the benefit is significant to
timing of the transfer of goods or services is more than the contract. See IFRS 15.61 & .63
one year; and
x 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.

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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
µLQWHUHVW iQFRPH¶¶. 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
FRQVLGHUHG SDUW RI WKH HQWLW\¶V RUGLnary 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.

1 April 20X2 Debit Credit

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) + 43
Revenue from interest (I) (400 x 1.1 x 10% x 9/12) 43
Recording the revenue from interest on the contract with the customer
31 March 20X4
Accounts receivable (A) 400 x 1.1 x 10% x 3/12 11
Revenue from interest (I) 11
Recording the revenue from interest on the contract with the customer
Bank (A) 400 + 30 + 43 + 11 484
Accounts receivable (A) 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.

1 April 20X2 Debit Credit

Accounts receivable (A) 484
Revenue from contracts with customers (I) 484
Recording the revenue from the contract with customer Ben
31 December 20X2
Bank (A) 484
Accounts receivable (A) 484
Recording the receipt of the promised consideration from the customer

162 Chapter 4
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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.

1 April 20X2 Debit Credit

Accounts receivable (A) 484
Revenue from contracts with customers (I) 484
Recording the revenue from the contract with customer Ben
31 March 20X4
Bank (A) 484
Accounts receivable (A) 484
Recording the receipt of the promised consideration from the customer

7.3.3 How do we decide whether a financing component is significant or not?

When assessing if a financing component is significant, we The significance of a

assess it in relation to the contract ± not to the individual financing component is
performance obligation/s which may be financed. determined:

x relative to the contract as a

Whether or not the benefit of a financing component is whole; &
VLJQLILFDQWWRWKHFRQWUDFWUHTXLUHVXVWRFRQVLGHUDOOµIDFWVDQG x involves assessing all facts &
FLUFXPVWDQFHV¶LQFOXGLQJ circumstances.
See IFRS 15.61
x any difference between the promised consideration and
the cash selling price; and
x WKHµFRPELQHGHIIHFW¶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 finDQFLQJFRPSRQHQWZRXOGQRWEHFRQVLGHUHGWRH[LVWLIDµVXEVWDQWLDODPRXQW¶
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
Gripping GAAP Revenue from contracts with customers

c) A significant financing component would not be conVLGHUHGWRH[LVWLIµWKHGLIIHUHQFHEHWZHHQ

the promised consideration and the cash selling price¶ LV 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 The discount rate to
and the customer would have agreed upon if they had entered use is:
into a separate financing agreement on inception of the
contract. This discount rate is based on the relevant x the rate the entity &
customer would have agreed
circumstances on the date of inception of the contracts and upon
must not be updated for any changes in circumstances. x had they entered into a
separate financing agreement
This discount rate takes into account the credit risk of the x on date of contract inception.
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 RUGHFUHDVHLQWKHFXVWRPHU¶VFUHGLWULVN). 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
Gripping GAAP Revenue from contracts with customers

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.
x The transaction price for the contract to transfer goods must be measured at the cash sales price on
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).

1 January 20X1 Debit Credit

Cash (A) Given 100 000
Contract liability (L) 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
Contract liability (L) 8 000
Recognising the interest expense on the significant financing component
31 December 20X2
Interest expense (100 000 + 8 000) x 8% x 12/12 8 640
Contract liability (L) 8 640
Recognising the interest expense on the significant financing component
Contract liability (L) 100 000 + 8 000 + 8 640 116 640
Revenue from contracts with customers 116 640
Recognising the revenue from the contract on transfer of the goods

7.3.5 How do we present interest from the significant financing component? (IFRS 15.65)
Interest contained in a
When accounting for interest on a significant financing contract is presented
component in a contract with a customer, we either recognise: separately from
x Interest income, earned as a result of having provided ‘revenue from contracts with
See IFRS 15.65
customers’.
financing to the customer¶; or
x Interest expense, incurred as a result of having received financing from the customer.
The interest recognised is presented as follows:
x Interest income may be presented as interest revenue if it was earned as part of the
HQWLW\¶VRUGLQDU\DFWLYLWies. However, 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-LWHPµUHYHQXHIURPFRQWUDFWVZLWKFXVWRPHUV¶.
x Interest expense is presented separately from the line-LWHP µUHYHQXH IURP FRQtracts with
FXVWRPHUV¶ LH a relateG µLQWHUHVW H[SHQVH¶ PD\ QRW EH RIIVHW DJDLQVW WKH µUHYHQXH IURP
contUDFWVZLWKFXVWRPHUV¶ See IFRS 15.65 & .BC247
Non-cash consideration
7.4 Non-cash consideration (IFRS 15.66 ± 69)
x is included in the TP if the
7.4.1 Overview entity gets control of the
non-cash items, and
If the contract price includes non-cash consideration, this will x is measured at its FV.
See IFRS 15.66
need to be included in the transaction price ± unless the entity
does not obtain control over the non-cash items. This non-cash consideration should be
measured at its fair value (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
Gripping GAAP Revenue from contracts with customers

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
µQRQ-cash consiGHUDWLRQ¶ 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 µQRQ-FDVK FRQVLGHUDWLRQ¶ DQG Whus 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 wKDW<HOORZ¶VWUDQVDFWLRQSULFHZRXOd 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.

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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 WR EH µYDULDEOH
FRQVLGHUDWLRQ¶IRUSXUSRVHVRI,)56,QRWKHUZRUGV 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).

1 January 20X1 Debit Credit

Accounts receivable (A) 150 000
Revenue from contracts with customers 150 000
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).

1 January 20X1 Debit Credit

Accounts receivable (A) 160 000
Revenue from contracts with customers 160 000
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 LQWKHVKDUH¶VIDLUYDOXH &± 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
Gripping GAAP Revenue from contracts with customers

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 payable the customer (or the
by the customer to the entity, but also consideration payable customer’s customers), unless
by the entity to the customer. If this happens, the transaction it is for the transfer of distinct
price must be reduced by: goods or services for which
FVs can be reliably estimated.
x the consideration (1) 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 thaW WKH HQWLW\ SD\V RU H[SHFWV WR SD\ WKH FXVWRPHU RU WKH FXVWRPHU¶V
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 to
µSDUWLHVWKDWSXUFKDVHWKHHQWLW\¶VJRRGVRUVHUYLFHVIURP a customer includes:
the customer¶(e.g. our cuVWRPHU¶V customers), we would x cash; and
account for this payment as if it was consideration x other items that may be
payable to the customer. used to reduce the amount
owed to the entity (e.g.
A reduction in the transaction price means a reduction in the coupons) and
amount recognised as revenue. x includes consideration
payable to customers and
also the customer’s
The reduction in revenue is recognised on the later of the
customers.
following two dates: See IFRS 15.70

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
Gripping GAAP Revenue from contracts with customers

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
Recognising payment to customer
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
Recognising payment to customer
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 payabOHWRWKHFXVWRPHU¶VFXVWRPHUs.

Worked example 4: Consideration payable ± FRXSRQVIRUFXVWRPHU¶VFXVWRPHUV

A manufacturer of shampoo (the entity) enters into a contract with a retailer (the customer) in
which the manufacturer agrees to sell 100 bottles of shampoo to the retailer in exchange for
consideration of C1 000 and the manufacturer further agrees to provide coupons ± not for use by the
retailer, but for uVHE\WKHUHWDLOHU¶VFXVWRPHUV WKHVKRSSHUV 
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 on the next page…

Chapter 4 169
Gripping GAAP Revenue from contracts with customers

In this case, the consideration payable is in the form of coupons that thH FXVWRPHU¶V FXVWRPHUV FDQ
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. Therefore, the
transaction price would be determined at C900 . Calculation:
Consideration payable by the customer: (100 bottles x C10) ± Consideration payable by the entity: (100 bottles x C1).

Worked example 5: Consideration payable ± coupons for customeU¶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 ZKLFKDUHIRUXVHE\WKHUHWDLOHU¶VFXVWRPHUV 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 thHUHWDLOHU¶VFXVWRPHUVDt 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
discounts that may arise due to the potential use of coupons) per 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 wide enough to include an
offer of coupons. IFRS 15 requires that we estimate 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 could
include 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
recognised when (or as) the performance obligation is to be entitled
satisfied, we will need to allocate the transaction price x in exchange for transferring
(revenue) to each of these performance obligations. the 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.

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Gripping GAAP Revenue from contracts with customers

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-alone are defined as
selling prices for each of the distinct goods and services that x ‘the price at which
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 the IFRS 15.77

date of inception of the contract. See IFRS 15.76-.77 The stand-alone selling price
is determined at:
The best evidence of the stand-alone selling price is an x contract inception. See IFRS 15.76
observable price.

An observable price is the price at which the good or service is

sold seSDUDWHO\ WR D µVLPLODU FXVWRPHU¶ XQGHU µVLPLODU Stand-alone selling prices
circumstanceV¶ can be:
x directly observable (ideal); or
It may happen, however, that an entity does not have access x estimated. See IFRS 15.77-8

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.

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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.

Even though 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:

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:

Based on estimated stand-alone selling prices
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.

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Since Green has estimated the cost of production for products X and Y and is able to suggest a suitable
PDUJLQWKHµH[SHFWed cost-plus margin approaFK¶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:
Estimated costs: C50 000 + required margin: C50 000 x 10%
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):
Stand-alone Allocation of
selling prices transaction price
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

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

Based on estimated stand-alone selling prices
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 µexpected cost-plus margin approaFK¶EHXVHGWRHVWLPDWH&¶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 tKDW WKH µUHVLGXDO DSSURDFK¶ PD\ EH DSSURSULDWe 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:
Estimated costs: C50 000 + required margin: C50 000 x 10%
C200 000

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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¶V RZQ FRVW VWUXFWXUH DQG H[SHFWHG PDUJLQV  RU ZH ZRXOG QHHG WR XVH D GLIIHUHQW PHthod 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

always stipulated in the contract. Conversely, a contract could A discount exists if:
state that the contract price is calculated after deducting
discounts on certain goods or services when in fact the goods x the promised
or services are not truly discounted and the statement to this consideration
effect is essentially a marketing ploy. x is less than
x the sum of the SASPs.
See IFRS 15.81
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.

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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
specific treatment of the C20 000 discount inherent in the when allocating the TP to the
contract ± it was simply allocated when allocating the POs based on their relative
stand-alone selling prices.
discounted transaction price. See IFRS 15.81

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

Discounts are allocated proportionately to all the performance A discount is allocated

to only one/ some of the
obligations unless there is observable evidence to suggest
POs in the contract if
that the discount does not apply to all performance obligations
x there is sufficient
in the contract. observable evidence (that
meets all 3 criteria in
If this observable evidence exists, we must not allocate the para 82) that
discount proportionately to all performance obligations in the x it relates to only one/some
See IFRS 15.81 -82
of the POs.
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
IFRS 15.82
performance 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.

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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 this case, the plant and installation
regularly sold as a bundle are identical to the supply and installation of the plant per 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 performance obligations in the
contract, the transaction price is not allocated based on the stand-alone selling prices of each of these
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.
This is done by allocating C220 000 of the transaction price (i.e. the discounted price for the stand-alone
bundle) to the 2 obligations and allocating the remaining C80 000 to the 3rd obligation, the plant maintenance.
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 TP Allocation of
selling prices 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

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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 dLVFRXQWFRQWUDFWGLVFRXQW

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 dLVFRXQWFRQWUDFWGLVFRXQW

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 discount
individual bundles price (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.

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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 ± WKHUHJXODUGLVFRXQWFRQWUDFWGLVFRXQW

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 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 µdiscounted 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.

Notice that there is a

8.4 Allocating variable consideration (IFRS 15.84 ± 86) difference between:
x a discount inherent in a contract
(since the contract price is less
As we know, the transaction price is normally allocated to the than the sum of the stand-alone
various performance obligations based on their relative stand- selling prices), see section 8.3; &
alone selling prices. x an unsecured discount, being one
that has not yet been secured –
this discount is treated as
However, if the transaction price includes variable consideration, variable consideration (e.g. an
the total transaction price may not always be allocated in this way. early settlement discount)

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A transaction price that includes variable consideration is constituted as follows:

TP = fixed consideration + variable consideration.

7KLVYDULDEOHFRQVLGHUDWLRQPD\DSSO\µDFURVVWKHERDUG¶WR 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 is
However, it can happen that the variable consideration applies allocated to only one/
to only one/some of the performance obligations or may even some of the POs (or to a
apply to only part of a single performance obligation. In this part of a PO) in the contract if:
case, the variable consideration will be allocated to these x the discount is specifically
certain specific performance obligations, but only on condition connected to this PO/s (or to
that certain criteria are met, and the remaining fixed part of a PO) and
consideration would be allocated based on stand-alone selling x both criteria in para 85 are
prices. met (see pop-up below),
indicating that it is
appropriate under the
For example: A contract includes the supply of product A (PO 1), circumstances to allocate it
the supply of product B (PO 2) and the supply of a service (PO 3). to this specific PO/s (or part
See IFRS 15.85
The transaction price includes fixed consideration in relation to the thereof) .
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
pop-up box below).

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 othHUZRUGVWKHVXPRIWKHµIL[HGFRQVLGHUDWLRQ¶
DQGWKHµYDULDEOHFRQVLGHUDtion 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 performance that does not meet both
obligation (criterion a), and that the variable consideration criteria in para 85 is:
allocation accurately reflects what the entity believes it should x added to the fixed
receive for rendering that specific performance obligation consideration and
(criterion b). x allocated based on relative
stand-alone selling prices.
See IFRS 15.86
The next example illustrates the allocation of variable
consideration to all or some of the performance obligations.

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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 two
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 30A: Allocating variable consideration to all the POs

The bonus is µvariable 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)
Stand-alone Allocation of
selling prices transaction price
(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
C190 000 200 000 + Bonus 10 000 Note 1
C210 000

Note 1: notice that the transaction price including the variable consideration was allocated (200 000 + 10 000).

Solution 30B: 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).

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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 UHODWHWRHLWKHUWKHHQWLW\¶VHIIRUWVWRVDWLVI\WKHPO 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 32¶V6$63 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 (see the calculation overleaf). Continued on the next page…

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Stand-alone Allocation of
selling prices transaction price
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) referred to 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 we performance obligation
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 over
performance obligations.
time) and some will be completed in an instant (i.e. satisfied at See IFRS 15.31
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.

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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 satisfied A performance
when the goods or services have been transferred to the obligation is satisfied
customer. See IFRS 15.31 when:
x the goods or services have
This transfer of goods or services occurs when the customer has transferred
obtained control over the goods or services. See IFRS 15.31 x which is when control has
See IFRS 15.31
passed.
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 considereGWREHDVVHWVµHYHQLIRQO\PRPHQWDULO\¶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 the Control over an asset is
asset will be used and the ability to obtain most of its remaining evidenced by the ability
benefits. Control can also be proved by the ability to prevent others to:
from obtaining most of its remaining benefits. x direct how the asset will be
used; and the ability to
In essence, benefits refer to direct or indirect: x obtain substantially all 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 services x satisfied over time; or
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 EH µsatisfied at a
point in time¶7KLVSURFHVVLVshown diagrammatically below: See IFRS 15.32

Diagram 4: 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 3 Yes PO satisfied

point in time criteria to be classified as a over time
PO satisfied over time?

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9.4.2 Performance obligations satisfied over time (IFRS 15.35 – 37)

A SHUIRUPDQFHREOLJDWLRQLVFODVVLILHGDVµVDWLVILed over tLPH¶LIDQ\RQHRIWKHthree 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 5: 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 PO Yes

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

Or

PO satisfied
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
FODVVLILHGDVµVDWLVILHGRYHUWLPH¶ 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.

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Diagram 6: 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 may
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 entity taking 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: 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.

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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.

Solution 32: Classifying performance obligations: the first criterion

a) 7KHQDWXUHRIWKHUHFHSWLRQLVW¶VWDVNVLVroutine, which typically suggestVWKDWµVXEVWDQWLDOUH-SHUIRUPDQFH¶RI
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
RWKHUHQWLW\ZRXOGQRWEHUHTXLUHGWRµsubstantively re-SHUIRUP¶WKHZRUNZHhad 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 obligatLRQZRXOGEHFRQVLGHUHGWREHµVDWLVILHGRYHUWLPH¶

b) The nature of the legal advice and representation is not routine, which typically suggests that µVXEVWDQtial re-
SHUIRUPDQFH¶RIWKHVHWDVNVwould 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 woulGQHHGWRµVXEVWDntively re-SHUIRUP¶WKHZRUN
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 woulGQHHGWRµsubstantively re-SHUIRUP¶WKHZRUNZHKDGGRQHZHFRQFOXGHWKDW

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
REOLJDWLRQZRXOGQRWEHFRQVLGHUHGWREHµVDWLVILHGRYHUWLPH¶

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 overleaf for some examples of indications of control passing, per IFRS 15.38).

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Diagram 7: Classifying performance obligations – using criterion 2

Using criterion 2 to classify a performance obligation (PO)

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
If we assess that these control criteria will be met during the period that the

over time
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
Note 3
c) When the customer will obtain physical possession of the asset
d) When the customer will obtain the significant risks and rewards of
Note 4
ownership
Note 5
e) When customer acceptance will occur.
Professional judgement is essential when assessing these indicators.

No
Consider criteria 1 and 3 before concluding that the PO is satisfied
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
See IFRS 15.38 (b)
from recognising the related revenue.

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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
See IFRS 15.38 (c)
- control can exist without physical possession e.g. in some bill-and-hold agreements.

4. If the transfer of risks and rewards is relevant to the asset in question, we must be careful when
See IFRS 15.38 (d)
the risks and rewards are expected to transfer on a piecemeal basis!
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
See IFRS 15.38 (e)
customer’s formal acceptance before concluding that the customer has obtained control.

Example 33: Classifying performance obligations: the second criterion

Consider the following two contracts:
a) Contract 1 involves providing a customer with onsite developers who will be tasked with
HQKDQFLQJWKHFXVWRPHU¶VH[LVWLQJOLYHDFFRXQWLQJV\VWHP
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
µVDWLVILHGRYHUWLPH¶

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 µVDWLVILHGDWDSRLQWLQWLPH¶.

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.

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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
KRZWRGHFLGHLIDFRQWUDFWXDOUHVWULFWLRQLVµVXEVWDQWLYH¶) 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.

Diagram 8: Classifying performance obligations – using criterion 3

Using criterion 3 to classify a performance obligation (PO)

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

PO satisfied
This is evidenced by either: This right to payment must:
x Substantive contractual x exist continually throughout over time
restrictions preventing the the period of the contract;
entity from being able to and
readily use the incomplete x be sufficient compensation for
asset for something else; or any performance completed to
x Practical limitations preventing date.
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

Consider criteria 1 and 3 before concluding that the PO is satisfied

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

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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 µLI D FXVWRPHU can enforce its rights to the
promised aVVHW¶LQWKHHYHQWWKDWWKHHQWLW\XVHGLWIRUVRPHRWKHUSXUSRVH
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
HQWLW\¶VQRUmal 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.

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Example 34: Classifying performance obligations: 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 2:

Although legal advice is an asset, the nature thereof means that the customer cannot obtain control over it
or the outcome of the court case.

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
x the contract-specific profit (30%) and
x the normal profit applied to similar contracts (10%).
Thus, we use the lower profit of 10% as our hurdle and since the required 20% payment is higher than this
hurdle, it is considered to be sufficient compensation.
Note: had 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 tKHSHUIRUPDQFHREOLJDWLRQLVFRQVLGHUHGµVDWLVILHG RYHUWLPH¶

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 (SAPIT), 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.

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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 enWLW\¶VHIIRUWVXVLQg costs incurred, labour hours,
machine hours or time elapsed. See example 36.

If tKH HQWLW\¶V HIIRUWV DUH FRQVLGHUHG WR 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 accHVV WR D SULYDWH OLEUDU\ ,W VHOOV µDQ\-time
DFFHVVIRUD\HDU¶IRUDQDQQXDOPHPEHUVKLSIHH 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)
7KHHQWLW\¶VHfforts are the same throughout the year ± access simply has to be JUDQWHG6LQFHWKHHQWLW\¶V
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.

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Solution 36A: Measure of progress ± input method: number of tasks completed

20X3 Debit Credit
Receivable (A) W2 48 000
Revenue from customer contract (I) 48 000
Revenue from PO satisfied over time: input method: tasks complete

20X4
Receivable (A) W2 32 000
Revenue from customer contract (I) 32 000
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
Receivable (A) W2 56 000
Revenue from customer contract (I) 56 000
Revenue from services satisfied over time: input method: costs

20X4
Receivable (A) W2 24 000
Revenue from customer contract (I) 24 000
Revenue from services satisfied over time: input method: costs
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%

W2. Revenue to be recognised based on estimated progress 20X3 20X4

Revenue recognised to date (80 000 x 70%) (80 000 x 100%) 56 000 80 000
Less revenue recognised in prior years (0) (56 000)
Revenue recognised in current year 56 000 24 000

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.

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Solution 37: Measure of progress ± input method: total costs changes

Journals: Debit Credit
20X3
Receivable (A) W2 56 000
Revenue from customer contract (I) 56 000
Revenue from services satisfied over time: input method: costs
20X4
Receivable (A) W2 10 667
Revenue from customer contract (I) 10 667
Revenue from services satisfied over time: input method: costs

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%

W2. Revenue to be recognised based on estimated progress 20X3 20X4

Revenue recognised to date (70% x 80 000) and (83.3% x 80 000) 56 000 66 667
Less revenue recognised in prior years (0) (56 000)
Revenue recognised in current year 56 000 10 667
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 LQSXW GRHV QRW FRQWULEXWH WR DQ HQWLW\¶V 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 proportionDWH WR WKH HQWLW\¶V SURJUHVV LQ VDWLVI\LQJ D PO (i.e. it
exaggerates WKHHQWLW\¶VSURJUHVV), 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 tRWKHHQWLW\¶VSURgress 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)

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Example 38: Measure of progress ± input method

± LQSXWGRHVQRWFRQWULEXWHWRHQWLW\¶VSURJUHVV
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 entLW\¶VIDFtory 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

± LQSXWLVQRWSURSRUWLRQDWHWRWKHHQWLW\¶VSrogress
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 ‘WKHHQWLW\¶V SURJUHVVLQVDWLVI\LQJD32¶
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
GHOLYHUHGWRWKHFXVWRPHU¶VSUHPLVHVDQGthe 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 enWLW\¶VSURJUHVV
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 HQWLW\¶VSURJUHVV
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.

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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
REMHFWLYH LV WR µIDLWKIXOO\ GHSLFW WKH HQWLW\¶V SHUIRUPDQFH WRZDUGs complete satisfaction of the
performance obliJDWLRQ¶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
HQWLW\¶V SHUIRUPDQFH LI 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 thHHQWLW\¶VSHUIRUmance 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.

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Solution 40: Measure of progress ± output method: work surveys

20X3 Debit Credit
Receivable (A) Given – or W2 50 000
Revenue from customer contract (I) 50 000
Revenue from services satisfied over time: output method
20X4
Receivable (A) W2 30 000
Revenue from customer contract (I) 30 000
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%

W2. Revenue to be recognised based on estimated progress 20X3 20X4

Revenue recognised to date (80 000 x 62.5%) (80 000 x 100%) 50 000 80 000
Less revenue recognised in prior years (0) (50 000)
Revenue recognised in current year 50 000 30 000

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

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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 µforward contract¶) or has a

right to repurchase an asset (referred to as a µcall 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 B66)
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.

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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
HQWLW\µVHOOV¶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.B76

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:
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 (the expected recovery could either be
directly from the customer or indirectly via the contract profit margin); 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 (i.e. those costs that would not have been
incurred if the contract had not been obtained). See IFRS 15.92

A commission paid on successfully obtaining a contract is an µincremental cost¶ because it would

not have been incurred if we had not obtained the contract. Thus, a commission paid due to
successful obtaining a contract would be capitalised if the entity expected this cost to be
recoverable. Conversely, the cost of preparing a tender is not an µincremental cost¶ of obtaining a
contract since this is a cost that is incurred even if the contract is not obtained. Since these µtender
costs¶ are not µincremental costs¶, they would not normally be capitalised. However, it is possible to
capitalise these if these are explicitly chargeable to the customer (i.e. in terms of the agreement,
the customer will refund these even if the contract is 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

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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 documents necessary to lodge the tender 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 7KH ODZ\HUV¶IHHV ZRXOG KDYH EHHQ SDLG HYHQ LIWKH FRQWUDFW KDG QRt been awarded and are thus not
incremental costs of obtaining the contract. Since these costs were not explicitly 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 explicitly
chargeable to the customer, they must be capitalised.
x The commission paid to the sales manager for securing the contract is an incremental cost of obtaining
the contract (because these are only incurred if the contract is obtained) and it is assumed the entity
expects to recover these indirectly through the contract profit. Thus, these costs must be capitalised.
x The discretionary bonus paid to the sales manager based on 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 since it is not chargeable to the customer, it is 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 all three of the
following criteria are met:
x the costs are directly related to a contract (or an expected contract) and where this contract can
be specifically identified (e.g. direct labour, direct materials, allocations of overhead costs such as
insurance and depreciation where they relate directly to the contract, costs that are explicitly
chargeable to the customer and other costs incurred purely due to entering the contract);
x the costs wLOO µJHQHUDWH RU HQKDQFH¶ WKH HQWLW\¶V UHVRXUFHV WKDW will be, or are being, used to
complete the contract; and
x the entity expects to recover these costs. See IFRS 15.95-96

If a cost does not meet all three 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).

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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 (the entity expects to renew):
Licence to manufacture patented products C10 000
Purchase of a machine to be used to manufacture the product C40 000
Cost of liaising with the customer regarding the quality of the 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 fulfilling a contract

x The cost of the licence must be accounted for in terms of IAS 38 Intangible assets. See IFRS 15.95

x The cost of the machine must be accounted for in terms of IAS 16 Property, plant and equipment. See IFRS 15.95
x The cost of liaising with the customer regarding quality levels will be accounted for in terms of IFRS 15
since there is no other standard covering it. It is a cost directly related to the contract (a cost incurred
only because the contract was entered into) and thus we would need to decide if this cost meets the
remaining two criteria laid out in IFRS 15.95. If the cost meet all three criteria, it will be capitalised.
x The wages to the employees allocated to the contract will be accounted for in terms of IFRS 15, since
although wages is covered by IAS 19 Employee benefits, that standard allows it to be capitalised if
another IFRS requires or permits it. Thus, in terms of IFRS 15, we conclude that wages is a cost directly
related to this contract and if the remaining 2 criteria in IFRS 15.95 are met, they will be capitalised.
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¶V
carrying amount above the carrying amount that it would have had had it never been impaired.

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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 the forms:
customer than the product will function as intended or that x assurance-type: account for
it meets the agreed-upon specifications. it in terms of IAS 37
x A service-type warranty offers the customer a service in x service-type: account for it
in terms of IFRS 15, as a
addition to the mere assurance that the product will separate PO
function as intended.

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.

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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 HQWLW\¶VFRQVLGHUDWLRQZLOOEHLQWKHIRUPRIFommission;
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

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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

5 January 20X1 Debit Credit
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.

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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
5RQGLO¶VJDrage 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 as follows (see next page):

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Gripping GAAP Revenue from contracts with customers

5 January 20X1 Debit Credit

Bank (A) Given 100 000
Revenue from customer contract (I) 100 000
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 customHUZLWKDµmaterial right that it would not receive without
HQWHULQJLQWRWKDWFRQWUDFW¶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¶V 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.

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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
WKHFXVWRPHUDµmaterial right that it wouOGQRWUHFHLYHZLWKRXWHQWHULQJLQWRWKDWFRQWUDFW¶DQGso 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:
Stand-alone Allocation of
selling prices transaction price
Vehicle C800 000 TP: C800 000 x 800 000 / 880 000 C727 272
(calculated below)
Option C80 000 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

5 January 20X1 Debit Credit

Bank (A) Given 800 000
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
Revenue from customer contract (I) 172 727
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 LQLWLDOFRQWUDFW¶VWUDQVDFWLRQSULFH

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.

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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
Revenue from customer contract (I) See allocation of TP above 196 000
Contract liability (L) Balancing 4 000
Receipt from customers; related revenue from the sale of the contracts for the 1st
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
Revenue from customer contract (I) See allocation of TP above 196 000
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%.

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Solution 49A: Customer loyalty programme (entity is a principal) ± first year

The CLP offers a discount on future goods or services and gives the customHUV D µmaterial right that it
would not receive ZLWKRXWHQWHULQJLQWRWKDWFRQWUDFW¶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:

Stand-alone Allocation of
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
Revenue from customer contract (I) See allocation of TP above 423 729
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
Revenue from customer contract (I) See allocation of TP above 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

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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)
For the year ending 31 December 20X2
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 tKH µQDWXUH DPRXQW WLPLQJ DQG XQFHUWDLQW\¶RI ERWK
the revenue and cash fORZVVWHPPLQJIURPWKHHQWLW\¶VFXVWRPHUFRQWUDFWV 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 µQDWXUH
amount, tiPLQJDQGXQFHUWDLQW\¶RIERWKWKHrevenue and cash flows).

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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
DIIHFW WKH µQDWXUH DPRXQW WLPLQJ DQG XQFHUWDLQW\¶ RI WKH 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 rHOHYDQW WR WKH HQWLW\ ZH PXVW FRQVLGHU WKH µIDFWV DQG
circuPVWDQFHV¶UHODWLQJWRWKHHQWLW\¶VFXVWRPHUFRQWUDFWV 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

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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.

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13.2.6 Sample disclosure relating to the line-item ‘revenue from customer contracts’

The following example uses hypothetical amounts.

Company name
Notes to the financial statements
For the year ending 31 December 20X2
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.
- 3URYLGH DQ H[SODQDWLRQ DV WR ZK\ WKLV PHWKRG XVHG LV FRQVLGHUHG WR EH µD IDLWKIXO
depiction of the transfer of goods or serviFHV¶. 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

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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
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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 are 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 (only reassess the 5 criteria if
significant change in facts and circumstances).

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 does not meet
criteria as a separate contract and the remaining G/S are distinct); or
- adjustment to the existing contract (if it is does not meet criteria as a separate 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 (under step 5)

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); AND
- 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).

Chapter 4 215
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- 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.

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. Since we only recognise as revenue the consideration to which we
expect to be entitled, we only recognise as revenue the sale of products that we expect will
not be returned (since this is VC, we must remember to constrain the estimate to avoid
overstating revenue). The balance of the consideration, relating to the sale of products that
we expect will be returned, is recognised as a refund liability. Thus the journal will involve
two credit entries: debit bank/receivable & credit revenue/ refund liability

This differs slightly from other forms of VC because we must not only remember to
constrain our estimate of the VC when determining the TP (thus constraining the amount
of revenue recognised), but we must also remember to recognise a right of return asset. In
other words, in addition to recognising the cost of sales expense (to reflect the cost of
inventory sold: debit cost of sales expense & credit inventory), we must also recognise a
right of return asset (to reflect the value of the goods sold that we think will be returned
into stock: debit right of return asset & credit inventory).

x 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 TP every year – (if TP changes, see last bullet point under Step 4)

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)

216 Chapter 4
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- 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).

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 to all POs based on SASPs 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 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).
§§
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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 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 is explicitly able to recover them by charging 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
following criteria are met:
- 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) (examples include revenue by product line or by
geographical location).

SOFP – presentation
x Contract asset (reflects 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 (reflects 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 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 received the cash already
e.g. debit bank and credit contract liability.
- 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

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 2021)

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 introduces you to the various 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 tax only) 230

PART A:
Various Types of Tax
Contents: Page
A: 1 Introduction 221
A: 2 Transaction tax (VAT) 221
A: 2.1 Overview 221
A: 2.2 VAT on the sale of goods 222
Example 1: VAT on sale of goods (output VAT) ± journals 223
Example 2: VAT on sale of goods ± vendor or non-vendor ± ledger accounts 223
A: 2.3 VAT on the purchase of goods 224
Example 3: VAT on purchase of goods (input VAT) ± journals 225
Example 4: VAT on purchase of goods ± vendor or non-vendor ± ledger accounts 225
A: 3 (PSOR\HHV¶WD[DWLRQ 226
([DPSOH(PSOR\HHV¶WD[ 226
A: 4 Dividend tax 227
A: 5.1 Overview 227
A: 5.2 Measuring dividend tax 228
A: 5.3 Recognition of dividend tax 228
Example 6: Income tax and dividend tax 228
A: 5 Income tax 229
PART B:
Income Tax (Current Tax Only)
Contents: Page
B: 1 Introduction 230
B: 2 Recognition of income tax 230
B: 2.1 Overview 230
B: 2.2 Tax recognised in profit or loss 230
B: 2.3 Presentation of tax recognised in profit or loss 231
B: 2.4 Tax recognised in other comprehensive income 231
B: 2.5 Presentation of tax recognised in other comprehensive income 231
B: 3 Measurement of income tax (current only) 231
B: 3.1 Overview 231
B: 3.2 Enacted and substantively enacted tax rates 232
Example 7: Enacted and substantively enacted tax rates 232
B: 3.3 Taxable profits versus accounting profits 233

Chapter 5 219
 Gripping GAAP Taxation: various types and current income taxation

&RQWHQWVFRQWLQXHG« Page
B: 3.4 Permanent differences 234
B: 3.4.1 Exempt income and non-deductible expenses ± a general overview 234
Example 8: Permanent differences: exempt income and non-deductible expense 235
B: 3.4.2 Capital profits versus taxable capital gains 236
B: 3.4.2.1 General 236
B: 3.4.2.2 IFRSs: capital profits 236
B: 3.4.2.3 Tax legislation: taxable capital gains 236
Example 9: Base cost  Cost price 236
B: 3.4.2.4 Difference: exempt capital profit 237
Example 10: Capital profits and taxable capital gains 237
Example 11: Exempt income and non-deductible expenses 238
B: 3.5 Temporary differences 239
B: 3.5.1 Overview 239
B: 3.5.2 Temporary differences caused by the system of accrual 240
Example 12: Income that is receivable 241
Example 13: Income that is received in advance 242
Example 14: Expenses that are payable 242
Example 15: Expenses that relate to provisions 243
Example 16: Expenses that are prepaid 244
B: 3.5.3 Temporary differences caused by depreciable assets 245
B: 3.5.3.1 Depreciation expense versus tax deduction 245
Example 17: Depreciation versus tax deductions 245
B: 3.5.3.2 Carrying amount versus tax base 246
Example 18: Depreciable assets - carrying amount versus tax base 246
B: 3.5.3.3 The effect of selling the asset ± at below the original cost 247
Example 19: Profit/loss on sale versus recoupment/scrapping allowance on sale 247
B: 3.5.3.4 The effect of selling the asset ± at above the original cost 248
Example 20: Capital profit vs. capital gains on sale (proceeds > original cost) 250
B: 3.5.4 Temporary differences caused by tax losses (also known as assessed losses) 251
Example 21: Tax losses (assessed losses) 251
B: 3.6 Permanent differences and temporary differences 252
Example 22: Temporary differences and permanent differences 252
B: 4 Payment of income tax 254
B: 4.1 Overview 254
B: 4.2 Income tax: provisional payments and estimates 254
B: 4.3 The first provisional payment (first estimate of current income tax) 255
B: 4.4 The second provisional payment (second estimate of current income tax) 256
B: 4.5 The final estimate of current income taxation (third estimate of current income tax) 256
Example 23: The provisional payments and tax estimate 256
B: 4.6 The formal tax assessment and resulting under / over provision of current tax 257
B: 4.7 The formal tax assessment and resulting under / over payment of current tax 258
Example 24A: First provisional tax payment in 20X1 258
Example 24B: Second provisional tax payment in 20X1 259
Example 24C: Current tax expense estimated for 20X1 259
Example 24D: Under/over provisions of 20X1 income tax 260
Example 24E: Income tax transactions in 20X2 260
Example 25: Under/over-payments and under/over-provisions of tax 261
B: 5 Disclosure of income tax ± a brief introduction 262
B: 5.1 Overview 262
B: 5.2 Statement of financial position disclosure 262
Example 26: Disclosure of current tax assets and liabilities (set-off) 262
B: 5.3 Statement of comprehensive income disclosure 263
Example 27: Disclosure involving exempt income and non-deductible expenses 264
Example 28: Disclosure involving an under-provision 265
Example 29: Disclosure involving other comprehensive income 266
C: Summary 268

220 Chapter 5
 Gripping GAAP Taxation: various types and current income taxation

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:
VAT (value-added taxation)
This is a tax on goods bought: the
purchaser of the goods will pay the
VAT and the seller, being the one to
receive the payment, pays the tax
over to the tax authority.
VAT is levied at 15% in South Africa
see Section A: 2
Employees’ tax
Employee’s tax is a tax on the
employee receiving the salary.
However, it is a withholding tax,
meaning the entity deducts the tax
from the employee’s salary and pays
it to the tax authority; the employee
is then paid his salary net of tax.
see Section A: 3

Income tax on companies:
This is also called company/corporate
tax. It is a tax on a company’s
taxable profits. Taxable profits may
also include taxable capital gains.
Income tax is paid to the tax
authority using a provisional tax
payment system.
The corporate income tax rate in
South Africa is 28%.
see Sections A: 4 and Part B
Dividends tax
Dividends tax is levied on the
shareholder receiving the dividends.
Various
However, it is a withholding tax,
taxes that
meaning the dividend is paid net of
could apply tax and the entity declaring the
dividend is responsible for paying the
tax to the revenue authorities.
Dividend tax is 20% in South Africa
see Section A: 5

Other taxes
Governments often levy many other
hidden taxes, such as property rates,
postage stamps, excise duty included
in the petrol price, unemployment
insurance funds & many more.

:H ZLOO FRQFHQWUDWH RQ VRPH RI WKHPDLQ WD[HV DIIHFWLQJ D EXVLQHVV HQWLW\ 9$7 HPSOR\HHV¶
taxes, income tax on profits and dividend 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% is withheld on payment of dividends.
Remember: Use the tax rates given in the question, but if none are given, it is generally
advisable to use the tax rates for the country in which the entity is operating.
E.g. Currently, in South Africa, VAT is 15%, corporate tax is 28% and dividends tax is 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; &
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
 Gripping GAAP Taxation: various types and current income taxation

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
9$7EDFNDQGLVWKHUHIRUHFRQVLGHUHGWREHWKHµILQDOFXVWRPHU¶IRUWD[SXUSRVHV

Worked example 1: The VAT process in the sale of goods

1. A is a manufacturer & VAT vendor. A 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 for the goods.
3. Of the C115 A has just received, C15 was VAT and thus A pays this C15 VAT to
the tax authority.
4. Let’s say B is a VAT vendor. In this case, he will receive the C15 VAT back from
the tax authorities.
5. B (the retailer) then sells the goods to C (the ‘man in the street’) for C230
(including C30 VAT).
6. C pays C230 to A for the goods.
7. Of the C230 B has just received, C30 was VAT and thus B pays this C30 VAT to
the tax authority.
8. C is not classified as a vendor for VAT purposes and thus may not claim the C30 back.
9. Notice how the tax authority received C15, but gave it back and then received C30
but did not have to give it back. Thus, the tax authority gets to keep the final C30.
The following picture shows the resultant flow of cash. 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
ends up paying the VAT. Mr C is normally the man in the street and not a business.
Can you also see that VAT is quite an onerous system in terms of the paperwork
that has to be sent to the tax authorities supporting amounts paid over to them
and then claimed back from them, instead of simply levying the C30 on Mr C.

A B C
1&2: 115 5&6: 230
3: 4: 7:
15 15 30

Tax authority

A: 2.2 VAT on the sale of goods VAT Vendors who sell

vatable supplies must:

Businesses that are registered as VAT vendors in terms of the x Charge VAT (this is
called output VAT)
tax legislation must charge VAT on the sale of all the goods and
VHUYLFHV VXSSOLHG DVVXPLQJ WKDW WKH VXSSOLHV DUH FODVVLILHG DV µYDWDEOH VXSSOLHV¶  7KH ODZ
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 µoutput VAT¶.

222 Chapter 5
Gripping GAAP Taxation: various types and current income taxation

Equation 1: Marked price = Selling price + VAT

Some useful equations:
This can be simplified as: MP = SP + VAT
Equation 2: If VAT is 15%, then: VAT = SP x 15%
Now substitute equation 2 (VAT) into equation 1 (MP): MP = SP + (SP x 15%)
Which simplifies to: MP = (SP x 1) + (SP x 15%) = SP x (1 + 0,15) = SP x 1,15
Thus, MP can be expressed as: Equation 3: MP = SP x 1,15
We can switch this around: i.e. ‘MP = SP x 1.15’ is the same as ‘SP x 1.15 = MP’
Then, SP can be expressed as: Equation 4: SP = MP ÷ 1,15
MP = SP + VAT Now substitute equation 4 into equation 2 to get equation
115% = 100% + 15% 4, being another way of expressing VAT:
1,15 = 1 + 0,15 Equation 4: VAT = MP ÷ 1,15 x 0,15

Example 1: VAT on sale of goods (output VAT) ± journals

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 C300 per item and thus the marked price is C345 (i.e. the
invoice will include 15% VAT on the C300: C300 x 115% = C345).
x Mr. Seller sells one item for cash, thus immediately receiving C345 from the customer.
x Mr. Seller then pays the C45 to the tax authorities.
Required: Record all related transactions in the journal of the seller.

Solution 1: VAT on sale of goods (output VAT) ± journals

Comment:
x Mr. Seller receives C345 but this includes C45 VAT, which belongs to the tax authorities.
 6LQFHWKH&GRHVQRWEHORQJWR0U6HOOHUKHUHFRJQLVHVLWDVDOLDELOLW\XQWLOLW¶VSDLG
 The remaining C300 belongs to Mr. Seller and is thus recognised as income.
x When the seller pays the tax authorities the C30 in VAT, the liability reduces to zero, and the net effect on the
VHOOHU¶VEDQNLVDQLQFUHDVHRIRQO\& &± C45), which was why only C300 was recognised as income

Debit Credit
Bank (A) Marked price 345
Sales (I) Selling price (ex VAT) 300
Current tax payable: VAT VAT 45
Sale of goods for cash (marked price is C345, including VAT)

Current tax payable: VAT VAT 45

Bank (A) 45
Payment of VAT to tax authorities

Example 2: VAT on sale of goods ± vendor or non-vendor: ledger accounts

Mr. A sells vatable goods to Mr. B for C230, cash (the marked price).
7KHFRXQWU\¶V9$7UDWHLV 15%.
Required:
a) 6KRZWKHUHOHYDQWMRXUQDOVSURFHVVHGLQ0U$¶VOHGJHUassuming:
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 vendor or non-vendor: journals

Comment: Before we record a sale, we need to know if we are a VAT vendor or not.
x If we are a VAT vendor, and the goods are vatable (i.e. not exempt or zero-rated), we charge our customer
VAT. Thus, a portion of the marked price will belong to the tax authorities (i.e. will be recognised as a liability)
and the balance will belong to us (i.e. will be recognised as income).
x If we are not a VAT vendor (or the goods are exempt or zero-rated), we do not charge the customer VAT and
thus the entire marked price will belong to us (i.e. will be recognised as income).

Chapter 5 223
 Gripping GAAP Taxation: various types and current income taxation

6ROXWLRQ$&RQWLQXHG«

i. Mr. A is not a VAT vendor:

In this case, Mr. A will not have included VAT in the marked price (i.e. the invoice price) of C230.
Since the marked price does not include VAT, all of it belongs to Mr. A & is thus income.
Calculations:
Marked price (MP) = Selling price (SP) + VAT
Since VAT = 0 , LWPHDQVWKDWµ03 63¶«DQGWKXVµ03 63¶

Bank (A) Sales (I)

Sales 230 Bank 230

ii. Mr. A is a VAT vendor:

In this case, Mr. A will have charged VAT. Thus, the marked price of C230 includes VAT (C30).
Thus, although a total of C230 is received, only C200 belongs to Mr. A and is thus recognised as income, and the
balance of C30, constituting VAT, is recognised as a liability.
Calculations
We are given the marked price and must use this to calculate the selling price (ex VAT) and VAT.
Since, MP = SP + VAT and since VAT = SP x 15%, we can also say that:
MP = SP + SP x 15% «or µMP = (SP x 1) + (SP x 0.15)¶ which simplifies to MP = SP x 1.15

1RZOHW¶VXVH these formulae to calculate the selling price (ex VAT) and the VAT:
x Selling price: MP = SP x 1.15 6XEVWLWXWH03 &«7KXV
C230 = SP x 1,15
SP = C230 / 1,15 = C200

x VAT: MP = SP + VAT 6XEVWLWXWH03 & 63 &«7KXV

C230 = C200 + VAT
VAT = C230 ± C200 = C30

Bank (A) Sales (I)

Sales & CTP: VAT 230 Bank 200

Current tax payable: VAT (L)

Bank 30

Solution 2B: VAT on sale of goods ± purchaser is vendor or non-vendor

If Mr. B is a VAT vendor, Mr. B would be able to claim back from tax authorities the VAT he paid. If he is
QRW D 9$7 YHQGRU LW PHDQV KH ZRQ¶W EH DEOH WR FODLP EDFN WKLV 9$7 +RZHYHU Where would be no
GLIIHUHQFHLQWKHZD\WKHMRXUQDOVDUHUHFRUGHGLQ0U$¶VERRNVVLQFHLWLVRIQRFRQVHTXHQFHWR0U$
whether or not Mr. B is able to claim back the VAT that Mr. B pays.

A: 2.3 VAT on the purchase of goods VAT Vendors who buy

vatable supplies may:
Before we can record a purchase, we need to know: x Claim back VAT paid
x LIZHWKHSXUFKDVHUDUHFODVVLILHGDVDµ9$7YHQGRU¶DQG x this is input VAT
x if the supplier (i.e. VHOOHU LVFODVVLILHGDVDµ9$7YHQGRU¶RUQRWDQG
x LIWKHVXSSO\RIJRRGVRUVHUYLFHVLVFRQVLGHUHGWREHDµYDWDEOHVXSSO\¶RUQRW

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.
x If our 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).
x However, if our 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.

224 Chapter 5
Gripping GAAP Taxation: various types and current income taxation

Example 3: VAT on purchase of goods (input VAT) ± journals

Continuation of example 2, where Mr. A was a VAT vendor.
Mr. A originally purchased these goods from Mr. Z, also a VAT vendor, for a marked price of C69,
cash. Mr A received his VAT refund shortly after purchasing the goods.
The country in which they operate levies VAT at 15%.

Required: Record the related journal entries in Mr. A's ledger.

Solution 3: VAT on purchase of goods (input VAT) ± journals

Comment: Since Mr. Z is a VAT vendor, it means the marked price of C69 included 15% VAT.
Thus, the total amount of C69 paid by Mr. A includes VAT of C9 (C69 x 15/115) and C60 for the goods
(C69 x 100/115).
Since Mr. A is a VAT vendor, he claims back this C9 VAT (input VAT) from the tax authority.
Notice that inventory is measured at C60 (not C69) since although Mr. A initially pays C69 for the
purchase, he receives C9 back from the tax authorities, with the result that 0U$¶V net cash outflow is
only C60 (see the bank account: C69 paid ± C9 received).

Debit Credit
Inventories (A) Purchase price (ex VAT) 60
Current tax receivable: VAT (A) VAT 9
Bank (A) Marked price 69
Purchase of goods for cash (marked price is C69, including VAT)

Bank (A) VAT 9

Current tax receivable: VAT (A) 9
Receipt of VAT from tax authorities

Example 4: VAT on purchase of goods ± vendor or non-vendor ± ledger accounts

Mr. B buys vatable goods from Mr. A for C115 (the marked price).
The country in which they operate levies VAT at 15%.
Required: 6KRZWKHMRXUQDOVSRVWHGLQ0U%¶VOHGJHUDVVXPLQJ
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 ± vendor or non-vendor ± ledger accounts

Comment: This example shows the impact of the various combinations that could exist involving whether
or not the seller and purchaser are VAT vendors. Notice that the only time the purchaser of goods claims
VAT back from the tax authorities is when both he and the supplier (i.e. the seller) are VAT vendors: see
example (ii) where the purchaser and seller are VAT vendors and the inventory is thus C100.

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, he bought from Mr. A who is not a VAT vendor and thus had not charged any VAT.

ii. Mr. B is a VAT vendor and Mr. A is a VAT vendor

Bank (A) Inventories (A)
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).

Chapter 5 225
 Gripping GAAP Taxation: various types and current income taxation

Solution 4: FRQWLQXHG«
iii. Mr. B is not a VAT vendor and Mr. A is not a VAT vendor
Bank (A) Inventories (A)
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

Bank (A) Inventories (A)
115 115
Explanation: Mr. A is a VAT vendor and has thus charged C15 VAT, included 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.

A: 3 (PSOR\HHV¶7D[DWLRQ

Employees’ tax is a tax that is incurred by the employee. The entity SD\LQJWKHHPSOR\HH¶VVDODU\,
however, is responsible for calculating the tax, deducting it from the salary of the employee and
paying this tax to the tax authorities within a specified period of time. Thus, HPSOR\HHV¶WD[LV
called D µZLWKKROGLQJ WD[¶ In other words, the entity 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, WKHHPSOR\HHV¶WD[LVQRWLQFOXGHGLQWKHHQWLW\¶V tax expense, but is
instead included in the entity¶Vsalaries and wages expense (i.e. this salaries and wage expense
is measured at the gross amount ± not net of the HPSOR\HHV¶ tax!). ,Q6RXWK$IULFDHPSOR\HHV¶
tax is also called PAYE (Pay As You Earn). The following journal shows how we recognise this
tax. Notice that it does not affect the HQWLW\¶VWD[H[SHQVH
Debit Credit
Salaries and wages (E) xxx
Salaries payable to employees (L) xxx
Current tax payable: employees tax (L)
Salaries and wages for the month

([DPSOH(PSOR\HHV¶WD[
AM Limited has one employee, hired with effect from 1 December 20X1.
x The employee earns a gross monthly salary of C20 000.
x 7KHHPSOR\HH¶VWD[RQKLVVDODU\KDVEHHQFDOFXODWHGWREHC4 000 per month.
x The employee was paid in cash on 30 December 20X1, but the HPSOR\HH¶VWD[ZDV
only paid to the tax authorities on 7 January 20X2.
Required:
a) Show the 20X1 transactions in AM /LPLWHG¶VOHGJHU
b) Prepare the statement of comprehensive income and statement of financial position at 31 December 20X1.
c) Show the 20X2 transactions in AM /LPLWHG¶VOHGJHU

Solution 5: (PSOR\HHV¶WD[
a) Ledger accounts ± 20X1 transactions (i.e. salary paid)
Salaries (E) Bank (A)
Bank & CTP (1) 20 000 Salaries (1) 16 000

Current tax payable: employees tax (L)

Salaries (1) 4 000

(1) Payment to the employee of C16 000 KLVVDODU\QHWRIHPSOR\HHV¶WD[ DQGWKHEDODQFHRI&4 000, being
HPSOR\HHV¶WD[GHGXFWHGIURPWKHHPSOR\HH¶VVDODU\UHFRUGHGDVRZLQJWRWKHWD[DXWKRULWLHV
Notice: The salaries account shows the gross amount of the salary (C20 000). Thus, it includes the
amount paid to the employee (C16 000) plus the amount that will be paid to the tax authorities (C4 000).

226 Chapter 5
 Gripping GAAP Taxation: various types and current income taxation

Solution 5: FRQWLQXHG«
b) Financial statements at year-HQG LHEHIRUHHPSOR\HHV¶Wax paid to the tax authority)
AM Limited
Statement of comprehensive income (extracts) 20X1
For the year ended 31 December 20X1 C

Administration expenses
- Salaries and wages 20 000

AM Limited
Statement of financial position (extracts) 20X1
As at 31 December 20X1 C

Current Liabilities
- &XUUHQWWD[SD\DEOHHPSOR\HHV¶WD[ 4 000

Comment: Note that the salaries expense is shown at the gross figure of C20 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 C20 000 (see the bank account after payment is made to the tax authorities), and
x HPSOR\HHV¶WD[LVDWD[LQFXUUHGE\WKHHPSOR\HHDQGLVQRWLQFXUUHGE\WKHFRPSDQ\ ± 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 SD\PHQWRIWKHHPSOR\HH¶VWD[)

Salary (E) Bank(A)
Bank & CTP(1) 20 000 Salaries (1) 16 000
CTP: ET (2) 4 000
20 000
Current tax payable: employees tax (L)
Bank (2) 4 000 Salaries (1) 4 000

(2) 3D\PHQWWRWKHWD[DXWKRULWLHVRIWKHHPSOR\HHV¶WD[ZLWKKHOGIURPWKHHPSOR\HH.
Comment: It is clear from the bank account that, although the employee only receives C16 000, the
entity has to pay a total of C20 000 to retain the services of this employee. Thus, the salaries expense
in the statement of comprehensive income is C20 000.

A: 4 Dividend Tax

A: 4.1 Overview
Dividend tax
Dividend tax is a tax on shareholders1 and is levied on their
cash dividends received. In other words, dividends tax is not x is levied at 20%
a tax on the company paying the cash dividend, and thus it x is a tax on the shareholder, but
does not form part of that FRPSDQ\¶Vtax expense2. Instead, is paid by the entity on behalf of
the shareholder, and thus
the company declaring this dividend is only responsible for:
x does not form part of the entity’s
x calculating the dividends tax that is owed by the tax expense.
shareholder,
x withholding this tax when paying the dividend to the shareholder, and then
x paying this tax to the relevant tax authority.
Note:
(1) Not all shareholders are liable for dividends tax. E.g. the tax applies to shareholders who are individuals (including business
entities run as sole traders and partnerships), but does not apply to shareholders that are South African companies.
(2) Although we say it is the shareholder who incurs the tax, there is an exception: if the company declares a
dividend that is not cash but is an asset in specie, then the tax will, instead, be incurred by the company that
declared the dividend. In this case, the declaring company includes it within its tax expense.

Chapter 5 227
 Gripping GAAP Taxation: various types and current income taxation

A: 4.2 Measuring dividend tax

Dividend tax is calculated as:

Dividend tax =
. Cash dividends received by the shareholder (gross) x Dividend tax rate

South Africa currently applies a dividends tax rate of 20%. Since the shareholder will be paid the
dividend net of this tax, it means that the shareholder will be paid 80%.
For example: If an entity declares a cash dividend of C100, then 20% of the dividend to be received
by the shareholder is withheld by the entity declaring the dividend, and thus the shareholder will
receive the net amount of C80.

A: 4.3 Recognition of dividend tax

The fact that this dividends tax is not a tax on the entity declaring the dividend is reflected in its journals.
x The entity is generally responsible for calculating and withholding the dividends tax and paying the
shareholder the dividend net of tax.
x the dividends tax is debited to the dividends payable account (reducing the amount owed to its
shareholders) and thus not to the HQWLW\¶V tax expense account.
Debit Credit
Dividend declared (Eq distribution) 100% of dividend xxx
Dividends payable to shareholders (L) 80% of dividend xxx
Current tax payable: dividends tax (L) 20% of dividend xxx
Dividends declared

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 Dividend tax is levied at 20% of the dividend that will be distributed to the
shareholders (this has not yet been recorded).
x There are no components of other comprehensive income.
Required:
A Show all the tax and dividends journals IURP%,/LPLWHG¶VSHUVSHFWLYH.
B Show the above in the %,/LPLWHG¶Vstatement of comprehensive income, statement of changes in
equity and statement of financial position for the year ended 31 December 20X1.
C Show the journal entries for a shareholder (a business running as a partnership) that owns 10%
shares in BI Limited for the year ended 20X2 assuming that the dividend has been paid.

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
Current income tax charge for the current year

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

228 Chapter 5
 Gripping GAAP Taxation: various types and current income taxation

Solution 6B: Disclosure: income tax and dividends tax

BI Limited
Statement of comprehensive income (extracts) 20X1
For the year ended 31 December 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)
For the year ended 31 December 20X1
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 (50 000) (50 000)
though 20% is withheld and paid to
the tax authorities as dividends tax
Balance at 31 December 20X1 1 375 000 xxx

BI Limited
Statement of financial position (extracts) 20X1
As at 31 December 20X1 C
LIABILITIES AND EQUITY
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

Solution 6C: Journals: Dividends tax from perspective of the shareholder

Debit Credit
Bank 50 000 x 10% x (100% - 20%) 4 000
Income tax (P/L: E) Balancing 1 000
Dividend income (P/L: I) 50 000 x 10% 5 000
Cash dividend received, net of dividends tax

A: 5 Income Tax

,QFRPH WD[ LV D WHUP FRPPRQO\ XVHG E\ WKH YDULRXV FRXQWULHV¶ WD[ DXWKRULWLHV WR UHIHU WR WKH
SULPDU\LQFRPHWD[OHYLHGRQDFRPSDQ\¶VSURILWV,Q6RXWK$IULFDWKHVWDQGDUGUDWHRILQFRPH
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%.

,W LV LPSRUWDQW WR XQGHUVWDQG WKDWWKH UHOHYDQW WD[ UDWHV LVQRW OHYLHG RQWKH FRPSDQ\¶V SURILW
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 shown below. Notice how the current tax owing for the year is
GHELWHGWRWKHFRPSDQ\¶VLQFRPHWD[H[SHQVHDFFRXQW
Debit Credit
Income tax (E) xxx
Current tax payable (L) xxx
Current income tax charge for the current year

Chapter 5 229
 Gripping GAAP Taxation: various types and current income taxation

PART B:
Income Tax (current only)

B: 1 Introduction

As 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 (for more on measurement, see B:3).

,GRQ¶WSODQWRWHDFK\RXWKHLQWULFDFLHVRIWKHWD[OHJLVODWLRQEHFDXVH\RXZLOOOHDUQWKLVZKHQ\RX
study tax. This chapter¶VREMHFWLYHLVWR 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 DQHQWLW\¶VLQFRPH, 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 HQWLW\¶Vtaxable 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
It is possible for there to be a variety of income taxes levied on not included in the
an entity¶V SURILWV 6RPH FRXQWULHV VLPSO\ OHY\ RQH WD[ RQ entity’s 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 currentO\OHYLHVRQO\RQHW\SHRIWD[RQDQHQWLW\¶VSURILWVZKLFKZHZLOO
simply UHIHUWRDVµLQFRPHWD[¶,QFRPHWD[ZDVLQWURGXFHGLQVHFWLRQ$, the calculation thereof
is explained in section B.3 and the method of payment is explained in section B.4.

230 Chapter 5
 Gripping GAAP Taxation: various types and current income taxation

B: 2.3 Presentation of tax recognised in profit or loss (IAS 1.82)

TKHWD[OHYLHGRQWKHHQWLW\¶VSURILWor loss must be reflected as a single line item in profit or loss,
called the µincome tax expense¶. 7KLVµLQFRPHWD[H[SHQVH¶OLQHLWHPPXVWEHVHSDUDWHO\GLVFORVHG
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 µother comprehensive income section¶, called µWD[on
RWKHUFRPSUHKHQVLYHLQFRPH¶. 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 29 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 taxable x Taxable profits
(or tax loss)
profits (or tax loss) for the current period. It is measured by
x
multiplying these taxable profits (or the tax loss) by the tax rate
x 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
OHJLVODWLRQ LH WKH UHOHYDQW FRXQWU\¶V 7D[ $FW  7KXV, the taxable profit and
accountant needs to convert his accounting profit (calculated in accounting profit includes
terms of IFRS) into the taxable profit (calculated in terms of tax x Temporary differences &
legislation). To be able to do this requires a sound knowledge of x Permanent differences
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
\HDU¶VWD[DEOHSURILWVZLOORQO\EHUHFHLYHGORQJDIWHUWKHUHSRUWLQJGDWH

Chapter 5 231
 Gripping GAAP Taxation: various types and current income taxation

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 µnew¶ rate has been enacted on or before reporting date, it Enacted or substantively
PHDQVWKDWWKHUHOHYDQWFRXQWU\¶V7D[$FWKDVEHHQFKDQJHGRQ enacted tax rates
or before this date, but if a new rate has been proposed but not Measure your current income tax using:
legally enacted on or before reporting date, deciding if it has been x the enacted tax rate, unless there is
µsubstantively enacted’ by reporting date may require professional x a substantively enacted tax rate that
judgement and a careful assessment of the circumstances.  existed at reporting date, &
 which will affect the measurement of
For example: 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, a new rate is generally considered to be substantively enacted on the date it is
announced LQWKH0LQLVWHURI)LQDQFH¶V%XGJHW6SHHFK%XWLIWKLVQHZUDWHLVLQH[WULFDEO\OLQNHGWR
other tax laws, it is only substantively enacted when it has not only been announced by the Minister
of Finance but also approved, evidenced by it having been signed into statute by the President.

Whilst current tax is to be measured using either the enacted or substantively enacted tax rate at
reporting date, the over-ULGLQJUXOHLVWKDWLWPXVWEHµPHDVXUHGDWWKHDPRXQWH[SHFWHGWREHSDLGWR
UHFRYHUHGIURP WKHWD[DWLRQDXWKRULWLHV¶Thus, we must 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. We must
thus also 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 do not make adjustments for this change. Instead, 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. See IAS 12.46

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. 7KHFRPSDQ\¶V\HDURIDVVHVVPHQWHQGVRQ'HFHPEHU;
B. 7KHFRPSDQ\¶V\HDURIDVVHVVPHQWHQGVRQ)HEUXDU\;
C. 7KHFRPSDQ\¶V\HDURIassessment ends on or after 31 March 20X1.

232 Chapter 5
 Gripping GAAP Taxation: various types and current income taxation

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 tax x profit or loss for a period
is not levied on the HQWLW\¶V µaccounting profit¶ (i.e. profit for x before deducting tax expense.
the period, before tax), but on its µtaxable profit¶. Taxable profits (or tax losses)
are defined as the:
Both these are terms that are defined in IAS 12 (see pop- up x profit (loss) for a period,
alongside). The essence of these two definitions is that x determined in accordance
¶Dccounting profits¶ are determined in accordance with the with the rules established
by the taxation authorities,
IFRSs (or other accounting standards) and µtaxable profits¶ x upon which income
are determined in accordance with the local tax legislation. taxes are payable
In other words: (recoverable).
IAS 12.5

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
 income that is taxable calculated in terms of IFRSs;
and
 less expenses that are deductible.
x Taxable profits are
calculated in terms of local
The differences that arise between the accounting profit and tax legislation.
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
 Gripping GAAP Taxation: various types and current income taxation

Permanent differences arise due to: Differences between

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

Worked example 2: 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.
x Year 1¶V accounting profit (AP) will be C100 and taxable profit (TP) will be C0 (i.e. AP > TP in yr 1).
x YHDU¶VDFFRXQWLQJSURILW(AP) will be C0 and taxable profit (TP) will be C100 (i.e. AP < TP in yr 2).
There is a difference between AP and TP in each of the years (yr 1 and yr 2), but over the 2-year period,
the AP is C100 (C100 + C0) and TP is also C100 (C0 + C100). Thus the difference that arose in each
of the years disappears over time (AP = TP over a 2-year period).

Thus, the summary of how to convert accounting profits into taxable profits is 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 movement in 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, which we make when converting
DFFRXQWLQJSURILWVLQWRWD[DEOHSURILWV ZLOOQRZEHH[SODLQHGRYHUWKHQH[WVHFWLRQV %DQG% 

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 (i.e. are:
the tax authorities will not charge tax on this income). Income
x the differences between
that is exempt from tax is called exempt income. Exempt taxable profit and accounting
income is income that will never be included in the calculation profit for a period
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 profit subsequent periods.
and the calculation of our accounting profit included exempt These differences are also
income, we would need to subtract the exempt income from referred to as:
accounting profit to calculate the taxable profit. non-temporary differences

Worked example 3: Exempt income

If we have accounting profit (AP) of C800 that included exempt income of C100, our taxable profit (TP)
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
 Gripping GAAP Taxation: various types and current income taxation

Thus, if we wanted to convert accounting profit into taxable profit and the calculation of our
accounting profit included the deduction of an expense that was non-deductible for tax purposes,
we would need to reverse this expense (i.e. add back the non-deductible expense to the
accounting profit) in order to calculate the taxable profit.
Worked example 4: Non-deductible expenses
If we calculated our accounting profit (AP) to be C800 after deducting an expense of C100 that is non-deductible
for tax purposes, our taxable profit (TP) would be calculated by adding back (reversing) this expense, as follows.
TP = AP: 800 + Non-deductible expense: 100 = C900

Thus, when converting accounting profits into taxable profits, where permanent differences
exist, we must deduct exempt income and add back the non-deductible expenses, as follows:

Converting accounting profit into taxable profit when permanent differences exist 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 movement in temporary differences xxx
Taxable profit (profit that will be taxed by the tax authorities in this year) xxx

Thus, if permanent differences exist: Permanent differences

include:
x the accounting profit and taxable profit will differ.
x exempt income: income per
x this difference will not reverse over time. the accountant that the tax
In other words, it does not matter over what period one authorities will never tax;
x non-deductible expenses: the
compares these profits ± the total accounting profit over expenses per the accountant
a 100-year period will still not equal the total taxable profit that the tax authorities will
over this 100-year period. never allow as a tax deduction.

x this difference will mean the effective rate of tax and

the applicable rate will differ. Since we must disclose relevant and useful information to
our users, this difference will mean we will need 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).
There were no temporary differences during the year and no components of other
comprehensive income. The income tax rate to be applied to taxable profits is 30%.
Required: Calculate the current income tax for the year ended 28 February 20X5.

Solution 8: Permanent differences ± Exempt income and non-deductible expenses

C
Profit before tax (accounting profit) 900 000
Adjust for permanent differences (20 000)
Less: Dividend income Exempt income is reversed (50 000)
Add: Donations expense Non-deductible expenses is reversed 30 000
Adjust for movement in temporary differences 0
Taxable profit 880 000

Current tax at 30% 880 000 x 30% 264 000

Notice: $OWKRXJKWKHµapplicable WD[UDWH¶LVLIZHFRPSDUHWKHWD[H[SHQVH of C264 000 ZLWKWKHµDFFRXQWLQJ
SURILW¶of C900 000 UDWKHUWKDQWKHµWD[DEOHSURILW¶ of C880 000 WKHµeffective WD[UDWH¶LVRQO\ & 000 /
C900 000). Example 27 shows the disclosure required due to the difference in rates.

Chapter 5 235
 Gripping GAAP Taxation: various types and current income taxation

Basic steps to converting µDFFRXQWLQJSURILW¶ LQWRµtaxable SURILW¶

Step 1: Figure out how the transactions affect 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 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 FRPSDQ\¶VFDSLWDOJDLQVis taxable, whilst 40RIDQDWXUDOSHUVRQ¶VFDSLWDO

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:
Proceeds on sale xxx
Less original cost (xxx)
Capital profit on sale 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:
Proceeds on sale xxx
Less base cost (xxx)
Capital gain on sale 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 at 1 October 2001
(called WKH µYDOXDWLRQ GDWH YDOXH¶  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.

Example 9%DVHFRVWCost price

An asset was purchased for C1 000 on 1 January 1999, LW¶V value at C10 000 was 1 October
2001 (i.e. its base cost) and was sold for C15 000 on 31 December 2016.

Required: Calculate the capital profit (accounting treatment) and capital gain on disposal (tax treatment).

Solution 9%DVHFRVW&RVWSULFH
Capital profit on disposal (accounting perspective) = Proceeds: 15 000 ± Cost: 1 000 = C14 000
Capital gain on disposal (tax treatment) = Proceeds: 15 000 ± Base cost: 10 000 = C5 000

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 Gripping GAAP Taxation: various types and current income taxation

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 10 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 10: 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 10A: 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 10B: 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 10C: Portion of the capital profit that is exempt from tax
C
Capital profit on sale Example 10A 10 000
Less taxable capital gain Example 10B (8 000)
Exempt capital profit 2 000

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Gripping GAAP Taxation: various types and current income taxation

Solution 10D: &DSLWDOJDLQDQGWD[DEOHFDSLWDOJDLQZKHUH%&&3

C
Proceeds on sale 120 000
Less base cost (115 000)
Capital gain 5 000
Inclusion rate @ 80%
Taxable capital gain 4 000

Solution 10E: Portion of the capital profit that is H[HPSWIURPWD[ZKHUH%&&3

C
Capital profit on sale Example 10A 10 000
Less taxable capital gain Example 10D (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 10F: Comparing the effects of differing base costs on exempt capital profit
C
([HPSWFDSLWDOSURILWZKHQµEDVHFRVW FRVW¶DW& 000: Example 10C 2 000
([HPSWFDSLWDOSURILWZKHQµEDVHFRVWFRVW¶DW& 000: Example 10E 6 000
Increase in exempt capital profit 4 000
Explanation:
3DUW(¶VEDVHFRVW  000) is higher than the base cost in Part C (100 000). The higher base cost results
in a smaller µcapital gain¶ (the CG decreased by C5 000: C10 000 - C5 000) and thus a smaller µtaxable
capital gain¶ (the TCG decreased by C4 000: C5 000 x 80%). If the µtaxable capital gain¶ gets smaller by
C4 000, it means that the portion of the µcapital profit¶ that is exempt from tax is bigger by C4 000.

Example 11: 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 11A: 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 movement in 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 11B: Journal

Debit Credit
Income tax (P/L: E) 22 800
Current tax payable: income tax (L) 22 800
Current income tax charge for the current year

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 Gripping GAAP Taxation: various types and current income taxation

Solution 11C: Disclosure

Retailer Limited
Statement of financial position
As at 31 December 20X2
Note 20X2
Current liabilities C
Current tax payable See journals 22 800

Retailer Limited
Statement of comprehensive income (extracts)
For the year ended 31 December 20X2
Note 20X2
C
Profit before tax 100 000
Income tax expense See journals (22 800)
Profit for the year 77 200

Other comprehensive income 0

Total comprehensive income 77 200

B: 3.5 Temporary differences Temporary differences

are caused by
B: 3.5.1 Overview differences in the
timing of when items of
income and expense are
It can happen that an item of income or expense is included in included in the accounting profit
the calculation of accounting profit in a different period to the and taxable profit.
period in which it is included in the calculation of taxable profit.
Temporary differences can be
In other words, we are talking about an item that will be included caused by:
in the calculation of both accounting profit and taxable profit, x The accrual system
but just not necessarily in the same period. x Depreciable assets
x Tax losses

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 accountaQW¶Vsystem 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.
7KHGLIIHUHQFHEHWZHHQWKHDFFRXQWDQW¶VV\VWHPRIDFFUXDODQGWKHWD[DXWKRULW\¶VK\EULGV\VWHPLV
discussed in section B: 3.5.2.
x TKHDFFRXQWDQW¶VPHDVXUHPHQWRIdepreciable 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.

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 Gripping GAAP Taxation: various types and current income taxation

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 woXOGQRWDOVREHLQFOXGHGLQWKDW\HDU¶Vcalculation 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 lead x Deferred income tax (next chapter)
to the recognition of deferred income tax. The WRWDO µtax expense¶ for the year is constituted by a
combination of µcurrent income tax¶ and µdeferred income tax adjustments¶. Deferred tax is explained in
the next chapter.

B: 3.5.2 Temporary differences caused by the system of accrual

7KHDFFRXQWDQW¶VV\VWHPRIDFFUXDOJRYHUQHGE\,)56VUHVXOWVLQ 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¶VV\VWHPLVHIIHFWLYHO\Dhybrid between the accrual basis and cash basis
and is governed by DFRXQWU\¶Vtax 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 GHWDLOIDOOVRXWVLGHWKHVFRSHRIµILQDQFLDOUHSRUWLQJ¶DQGis 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, ZKHQ LW¶V 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 \HDUZKHQLW¶Vreceived. 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.

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 Gripping GAAP Taxation: various types and current income taxation

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 RXWFRPHPD\GLIIHUIURPDµQRUPDO¶ payable. This is because, unlike a
µSD\DEOH¶DµSURYLVLRQ¶LVDOLDELOLW\RIXQFHUWDLQWLPLQJRUDPRXQW LHZHPD\QRWEHVXUHwhen it
will need to be paid or how much will need to be paid). Due to this uncertainty, tax authorities will
often µGLVDOORZ¶WKHGHGXFWLRQRIWKHUHODWHGH[SHQVHuntil 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 12: 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.

Solution 12A: Journals

Comment: This example shows how income receivable is journalised.

20X1 Debit Credit

Receivables (A) 80 000
Revenue from sales (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 12B: 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 movement in temporary 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
Gripping GAAP Taxation: various types and current income taxation

Solution 12B continued…

Note 1: 7KHµSRUWLRQRIWKHDFFRXQWLQJSURILWWKDWLVWD[DEOH¶ $ DQGWKHµWD[DEOHSURILW¶ % GRQRWGLIIHULQHLWKHU
20X1 or in 20X2. This is because 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 13: 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.
x 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.

Solution 13A: Journals

Comment: Part A shows how income in advance is journalised.

31 December 20X1 Debit Credit

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

Solution 13B: Calculation

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 profit that is taxable at some stage) (A) 12 000 (3) 12 000 (2) 0 (1)
Adjust for movement in temporary differences
x Add inc received in advance (c/bal): taxed in current year N/A 0 12 000 (1)
x 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 (AP = accounting profit and TP = taxable profit):
1) 20X1: The 20X1 AP includes no income as the income is not earned in 20X1 (accrual basis).
But the 20X1 TP includes rent income on the basis that it was received (cash basis).
Thus, to convert the AP into TP, we must add C12 000 (a temporary difference arises).
2) 20X2: The 20X2 AP includes rent income as the rent income is earned in 20X2 (accrual basis).
But the 20X2 TP does not include rent income as it was included in the 20X1 TP (cash basis).
Thus, to convert AP into TP, we must deduct the income of C12 000 (temporary difference reverses).
3) Total (Overall): The µSRUWLRQRIWKHDFFRXQWLQJSURILWWKDWLVWD[DEOHat some stage $ DQGWKHµWD[DEOH
SURILW¶(B) differ in each of the years 20X1 and 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 AP and total
TP are the same. Thus, the differences that arose in 20X1 and 20X2 were temporary.

Example 14: 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.

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Gripping GAAP Taxation: various types and current income taxation

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.

Solution 14A: Journals

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

Solution 14B: Calculation

Comment: Expenses payable did not cause a temporary difference.

Total 20X2 20X1
Calculation of current income tax: C C C
Profit before tax (accounting profit) 20X1: 100 000 – 10 000 190 000 100 000 90 000
Adjust for permanent differences 0 0 0
Subtotal (portion of accounting profit that is taxable) (A) 190 000 (1) 100 000 (1) 90 000 (1)
Adjust for movement in temporary 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 µportion of the accounting profit that is taxable¶ at some stage (A) and the µtaxable profit¶ (B) do
not differ in either 20X1 or in 20X2. This is 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 15: 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:
A. Show the journal entries in 20X1 and 20X2 relevant to the expense and payment above.
B. Calculate the income tax for each year.

Solution 15A: Journals

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

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Gripping GAAP Taxation: various types and current income taxation

Solution 15B: Calculation

Comment: The provision caused a temporary difference to arise in 20X1 and reverse in 20X2
Total 20X2 20X1
Calculation of current income tax: C C C
Profit before tax (accounting profit) 20X1: 500 000 – 150 000 650 000 300 000 350 000
Adjust for permanent differences 0 0 0
Subtotal (portion of accounting profit that is taxable) (A) 650 000 (3) 300 000 (2) 350 000 (1)
Adjust for movement in temporary differences
x Add provision (closing balance): not deductible in 20X1 N/A 0 150 000(1)
x Less provision (opening balance): deducted in 20X2 N/A (150 000) (2) 0
Taxable profits (B) 650 000 (3) 150 000 (2) 500 000 (1)
Current tax (B x 30%) [Dr: TE ; Cr: CTP] 195 000 45 000 150 000
Notes (AP = accounting profit and TP = taxable profit):
1) In 20X1: To calculate the 20X1 AP, we deduct the legal expense, as it was incurred in 20X1 (accrual basis).
But the tax authorities do not deduct this cost when calculating 20X1 TP as it is not yet paid (cash basis).
Thus, to convert the 20X1 AP into TP, we add back the C150 000 (reverse the expense).
2) In 20X2: In calculating 20X2 AP, we do not deduct a legal expense as it was expensed in 20X1 (accrual basis).
But the tax authorities deduct this cost when calculating 20X2 TP as it has now been paid (cash basis).
Thus, to convert the 20X2 AP into TP, we must deduct the C150 000.
3) Total (Overall): The µSRUWLRQRIWKHDFFRXQWLQJSURILWWKDWLVWD[DEOHat some stage $ DQGWKHµWD[DEOHSURILW¶(B)
differ in each of the years 20X1 and 20X2 (as the expense occurs in 20X1 but the tax deduction occurs 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 16: Expenses that are prepaid

Frame Limited paid C22 000 in December 20X1 as annual rental of its factory for 20X2.
x Profit before tax and before processing any journals for this payment is C100 000 in both 20X1 and 20X2.
x The tax authorities allowed the prepaid rent to be deducted in 20X1 when it is 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:
A. Show the journal entries in 20X1 and 20X2 relevant to the expense and payment above.
B. Calculate the income tax expense for 20X1 and 20X2 and briefly explain your answer.
Solution 16A: Journals
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)

Solution 16B: Calculation

Comment: Expenses prepaid cause a temporary difference to arise in 20X1 and reverse in 20X2.
Total 20X2 20X1
Calculation of current income tax: C C C
Profit before tax (accounting profit) 20X2: 100 000 – 22 000 178 000 78 000 100 000
Adjust for permanent differences 0 0 0
Subtotal (accounting profits that are taxable at some stage) (A) 178 000 (3) 78 000 (2) 100 000 (1)
Adjust for movement in temporary differences
x Less expense prepaid (c/bal): deductible in 20X1 N/A 0 (22 000) (1)
x Add expense prepaid (o/bal): already deducted in 20X1 N/A 22 000 (2) 0
Taxable profits (B) 178 000 (3) 100 000 (2) 78 000 (1)
Current tax (B x 30%) [Dr: TE ; Cr: CTP] 53 400 30 000 23 400

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Solution 16B continued …

Notes (AP = accounting profit and TP = taxable profit):
1) In 20X1: When calculating 20X1 AP we do not deduct rent expense as it is not yet incurred (accrual basis).
But the tax authorities deduct rent in calculating the 20X1 TP as it has been paid (cash basis).
Thus, to convert 20X1 AP into TP, we must deduct the C22 000 (deduct the payment).
2) In 20X2: When calculating 20X2 AP, we deduct the rent expense because it is now incurred (accrual basis).
But the tax authorities do not deduct it when calculating 20X2 TP as it was deducted in 20X1 (cash basis).
Thus, to convert 20X2 AP into TP, we must add back the C22 000 (i.e. reverse the expense).
3) Total (Overall): The µportion of the accounting profit that is taxable at some stage¶ $ DQGWKHµWD[DEOHSURILW¶(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 AP and total TP 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
UDWHWKDWUHIOHFWVWKHHQWLW\¶VHVWLPDWLRQof the manner in which the asset is expected to be used.
Tax legislation, however, requires an asset¶s cost to be
Depreciable assets may
deducted in the calculation of taxable profits using standard rates cause temporary
set out in the tax legislation, irrespective of how the entity plans differences because the:
to use its asset. This deduction, calculated by the tax authorities, accountant & tax authority might
is often called, for example, a capital allowance, wear and tear, expense the asset’s cost at different
depreciation for tax purposes or simply a tax deduction. speeds (e.g. 20% depreciation versus
10% wear & tear).
The amount expensed when calculating accounting profits (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 DLPWRµUHYHUVH¶LWHPVWKDWZHUHLQFOXGHG

in the calculation of accounting profits but which the tax authority would not use in the calculation of
taxabOHSURILWDQGµSURFHVV¶WKHLWHPVWKDWWKHWD[DXWKRULW\ZRXOGXVHZKHQFDOFXODWLQJWD[DEOHSURILWV
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 17: 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
Profit before tax (after deducting any depreciation on the vehicle) in each C100 000 pa
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. The income tax rate is 30%.
Required: Calculate the current income tax per the tax legislation for 20X1, 20X2 and 20X3.

Solution 17: 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
 Gripping GAAP Taxation: various types and current income taxation

Solution 17 continued …
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
DVVHW¶V 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 DVVHW¶Vµcarrying
amount¶ per the accounting records) and its µtax 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 18: Depreciable assets ± carrying amount versus tax base

Use the same information as that provided in the previous example (Example 17).
Required: Calculate the carrying amount and tax base at the end of 20X1, 20X2 and 20X3.

Solution 18: 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
 Gripping GAAP Taxation: various types and current income taxation

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
µprofit on sale¶, but refers to it as a µrecoupment¶. Conversely, if an asset is sold below original
FRVWDQGEHORZLWVWD[EDVHWKHWD[OHJLVODWLRQVHHVWKLVDVDµOoss on sale¶EXWUHIHUVWRWKLVas
a µscrapping allowance¶. 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 µUHYHUVH¶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 µprocess¶ the items that the tax authority would use
when calculating his taxable profits. Thus, 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:
x reverse the profit by subtracting it from the accounting profit and
x 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:
Proceeds on sale xxx
Less carrying amount (xxx)
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 19: 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:
Cost of vehicle purchased on 1 January 20X1 C150 000
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 19A: Calculation of profit or loss on sale (IFRS)

20X2
Calculation of profit or loss on sale (IFRSs) C
Proceeds on sale 110 000
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
 Gripping GAAP Taxation: various types and current income taxation

Solution 19B: Calculation of recoupment or scrapping allowance on sale (tax law)

20X2
Calculation of recoupment or scrapping allowance on sale C
Proceeds on sale 110 000
Less tax base Cost: 150 000 – Acc wear & tear: (150 000 ÷ 4 yrs x 2 yrs) (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 19C: 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 – 0) ÷ 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:
Proceeds on sale xxx
Less carrying amount (xxx)
Profit or (loss) on sale xxx

The capital profit included in this profit on sale of a non-current asset is as follows:
Proceeds on sale xxx
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
Less carrying amount (xxx)
Non-capital profit or (loss) xxx

248 Chapter 5
 Gripping GAAP Taxation: various types and current income taxation

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 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:
Proceeds on sale xxx
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
PD\DVVXPHWKDWWKHEDVHFRVWHTXDOVWKHDVVHW¶VFRVWXQOHVVWKHLQIRUPDWLRQgiven 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%
Taxable capital gain xxx

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 10.
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
Capital profit on sale Capital gain & Taxable capital gain 6 5. Arises if proceeds > cost
6. Arises if proceeds > base cost
Non-capital profit on sale 7 Recoupment 8 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
Gripping GAAP Taxation: various types and current income taxation

Example 20: 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
evident from the information provided.
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 20A: 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)
Profit on sale 125 000
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 20B: 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 20C: 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 20D: 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 appHDUDVUHFRQFLOLQJLWHPVLQWKHWD[H[SHQVHQRWH¶VUDWHUHFRQFLOLDWLRQ

250 Chapter 5
 Gripping GAAP Taxation: various types and current income taxation

Solution 20D: FRQWLQXHG«

Total 20X2 20X1
Current income tax C C C
Profit before tax (AP) 20X2 100 000 + PoS: 125 000 325 000 225 000 100 000
Add back depreciation 20X1: (150 000 – 0) ÷ 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 20A) (125 000) (125 000) 0
Add recoupment 20X2: (see Ex 20B) 50 000 50 000 0
Add taxable capital gain 20X2: (see Ex 20C) 40 000 40 000 0
Taxable profit (TP) 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 (AP) 20X2 100 000 + PoS: 125 000 325 000 225 000 100 000
Permanent differences:
Less capital profit 20X2 (see Ex 20A) (50 000) (50 000) 0
Add taxable capital gain 20X2: (see Ex 20C) 40 000 40 000 0
Temporary difference movements:
Less non-capital profit 20X2 (see Ex 20A) (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 20B) 50 000 50 000 0
Add taxable capital gain 20X2: (see Ex 20C) 40 000 40 000 0
Taxable profit (TP) 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 A deductible tax loss is
figure, it means that the entity has made a tax loss See IAS 12.5 Reworded

(assessed loss) « not a taxable profit. In other words, a x the loss for a period,
tax loss means that, in terms of the tax legislation, the x calculated in terms of tax
entity has made a loss. legislation,
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
when calculating taxable profits in a
there is a tax loss (i.e. there will be no current tax expense).
future period).

Sometimes tax losses may be µcarried 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
IROORZLQJ\HDUVWKXVUHGXFLQJWKDW\HDU¶VWD[DEOHSURILWDQGthus WKDW\HDU¶VFXUUHQWWD[FKDUJH LH
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 21: Tax losses (assessed losses)
Cost of vehicle purchased on 1 January 20X1 C120 000
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 evident from the information provided.

Chapter 5 251
 Gripping GAAP Taxation: various types and current income taxation

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 21A: 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 (AP) 100 000 30 000 (80 000)
Add back depreciation (120 000 – 0) ÷ 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) (TP/TL) 50 000 (10 000) (60 000)
Current tax at 30% [Dr: TE; Cr: CTP] 15 000 0 0

Solution 21B: 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 (AP) 100 000 30 000 (80 000)
Add back depreciation (120 000 – 0) ÷ 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) (TP/TL) 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) /HW¶VFRPSDUH3DUW$DQG3DUW%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 because, 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 22: 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
Gripping GAAP Taxation: various types and current income taxation

Solution 22: 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) (AP) 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
Taxable profit (TP) 125 200
Current tax at 30% [Dr: TE; Cr: CTP] 119 200 x 30% 37 560

The current tax journal will be: Debit Credit

Income tax (P/L: E) 37 560
Current tax payable (L) 37 560
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 µDJUHHV¶ 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 µtaxable 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 µprofit before tax¶ (accounting profits) because
DPRXQWVUHFHLYHGLQDGYDQFHDUHUHFRJQLVHGDVOLDELOLWLHV«QRWLQFRPH (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).
7KXVWRFRQYHUWµSURILWEHIRUHWD[¶LQWRµWD[DEOHSURILWV¶ZHQHHGWRDGGWKHincome received in advance.
(3) The prepaid water will not have been included in the µprofit before tax¶ (accounting profits) because
SUHSD\PHQWV DUH UHFRJQLVHG DV DVVHWV«QRW H[SHnses (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 µSURILWEHIRUHWD[¶LQWRµWD[DEOHSURILWV¶ZHQHHGWRGHGXFWWKHSUHSDLGH[SHQVH
(4) Depreciation will have been deducted in the calculation of the 20X1 µprofit 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 DFFRXQWDQW¶VGHSUHFLDWLRQPXVW EH
DGGHGEDFN UHYHUVHG DQGWKHQWKHWD[DXWKRULW\¶Vcapital allowance must be deducted.
Please note: Both the accountant and the tax authority µagree¶ that the full cost of C56 000 will be deducted
± the issue is simply how much to deduct each year.

Chapter 5 253
 Gripping GAAP Taxation: various types and current income taxation

Solution 22 &RQWLQXHG«
(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.
7KXVWRFRQYHUWµSURILWEHIRUHWD[¶LQWRµWD[DEOHSURILWV¶ZHDGGEDFN UHYHUVH WKHOHJal 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 WKHWRWDO\HDU¶VFXUUHQWincome 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 DµWD[UHWXUQ¶
and submitted to the tax authorities. The tax authorities assess WKLV µWD[UHWXUQ¶ DQG VHQG WKH
entity an official assessment thereofFRPPRQO\UHIHUUHGWRDVDµWD[DVVHVVPHQW¶. The receipt of
WKHµtax DVVHVVPHQW¶ZLOOW\SLFDOO\RFFXUDIWHUWKHILQDQFLDOVWDWHPHQWVIRUWKHFXUUHQW\HDUXQGHU
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 GRFXPHQWHGLQWKHµWD[UHWXUQ¶ , will equal the tax calculated by
the tax authorities GRFXPHQWHG LQ WKH µWD[ DVVHVVPHQW¶ . HRZHYHU ZH GRQ¶W OLYH LQ D SHUIHFW
world and thus differences may arise that will require an adjustment.

In this regard, iIWKHµtax DVVHVVPHQW¶LQGLFDWHVWKDWWKHWD[DXWKRULWLHVGLVDJUHHZLWKWKHWRWDOWD[

calculated per WKH µWD[UHWXUQ¶ WKDW ZDV VXEPLWWHG 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
 Gripping GAAP Taxation: various types and current income taxation

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 WRHDVHWKHFRPSDQ\¶VEXUGHQ
of paying an otherwise very large single sum at the end of the year.

In South Africa, two provisional payments are required to

Provisional tax
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: WD[OHJLVODWLRQDOORZVSURYLVLRQDOSD\PHQWVWREHEDVHGRQDµEDVHDPRXQW¶LQVWHDG
of profits, but this option will be best H[SODLQHGZKHQ\RXVWXG\WKHVXEMHFWµ7D[DWLRQ¶UDWKHUWKDQ
µ)LQDQFLDO$FFRXQWLQJ¶ . 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 WKHDFFRXQWDQW¶VWKLUGDQGILQDO

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, ZH GRQ¶W OLYH LQ D SHUIHFW ZRUOG 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 RIILFLDO µWD[ DVVHVVPHQW¶ ZKLFK W\SLFDOO\ RFFXUV 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 \HDU¶Vincome tax expense
will be made in the financial period in which the relevant assessment is received.

B: 4.3 The first provisional payment (first 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 tax payment

x Calculation:
(Estimated taxable profit for the year x Tax rate) ÷ 2
x Journal:
Debit Credit
Current tax payable/receivable: income tax (L/A) xxx
Bank (A) xxx
Payment of first provisional payment

Chapter 5 255
 Gripping GAAP Taxation: various types and current income taxation

B: 4.4 The second provisional payment (second 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 tax payment

x Calculation:
(Estimated taxable profit for the year x Tax rate) - First Provisional Payment.
x Journal:
Debit Credit
Current tax payable/receivable: income tax (L/A) xxx
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 (third estimate of current income tax)
The accountant makes the final estimate of current income taxation for the current year when preparing
the annual financial statements. This will be recognised as the current income tax expense for the year.

The final estimate of current tax for the year (i.e. current income tax expense),
x Calculation:
Actual taxable profits for the year x Tax rate.
x Journal:
Debit Credit
Income tax (P/L: E) xxx
Current tax payable/receivable: income tax (L/A) xxx
Recording estimated current tax in the current year

This estimate is shown as the current portion of the income taxation expense 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
(if the estimate exceeded the payments) or by the tax authority (if the payments exceed the estimate).
This is shown in the statement of financial position as a current tax asset or a current tax liability.

Example 23: 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
 Gripping GAAP Taxation: various types and current income taxation

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 23A: 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 23B: Ledger accounts

Income tax expense (E) Current tax payable/ receivable (L/A)

CTP: IT (3) 120 000 Bank (1) 60 000 Opening bal 0
Bank (2) 40 000 Inc. tax exp. (3) 120 000
Balance c/f 20 000
Bank (A) 120 000 120 000
CT P/R (1) 60 000 Balance b/f 20 000
CT P/R (2) 40 000

Solution 23C: Disclosure

Company name
Statement of comprehensive income (extracts) 20X1
For the year ended 31 December 20X1 C

Profit before taxation xxx

Income tax expense (120 000)
Profit for the year xxx

Company name
Statement of financial position (extracts) 20X1
As at 31 December 20X1 C

Current liabilities
Current tax payable 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 ta[DXWKRULW\¶V 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.

In South Africa, this estimate is then also submitted to the tax authorities (i.e. the entity submits its
µtax return¶). The tax authorities then assess this µtax UHWXUQ¶DQG send thHLUµWD[assessment¶ to the
entity. This official µWD[assessment¶ arrives after the financial statements have been finalised.

Chapter 5 257
 Gripping GAAP Taxation: various types and current income taxation

The assessment will show the tax charge for the whole year,
based on the tax authority¶V FDOFXODWLRQV, minus the Tax assessment
provisional payments made by the entity leaving either a The assessment should
balance owing or receivable. provide 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.
entity 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 entit\¶VILQDQFLDOVWDWHPHQWV

Since the assessment will be received by the entity after its financial statements have been finalised,
any adjustment relating to the SULRU\HDU¶V tax expense will have to be processed in the financial year
in which the assessment is received. The adjustment will either be:
x an under-provision adjustment (increasing the current income tax expense) or
x 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 RIDSULRU\HDU¶VFXUUHQWLQFRPHWD[H[SHQVHis as follows:

Debit Credit
Income tax (E) xxx
Current tax payable/receivable: income tax (L/A) xxx
The under-provision of tax in yr 1 is adjusted in yr 2

The journal adjusting for an over-provision RIDSULRU\HDU¶VFXUUHQWLQFRPHWD[H[SHQVHis as follows:

Debit Credit
Current tax payable/receivable: income tax (L/A) xxx
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 24A: 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).
The income tax rate is 30%
Required: Calculate the first provisional payment due and post the entries in t-account format assuming it was
paid on due date.

258 Chapter 5
Gripping GAAP Taxation: various types and current income taxation

Solution 24A: 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 24B: Second provisional payment of tax in 20X1

Example continued from Example 24A: 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 24B: Second provisional payment of tax in 20X1

The second provisional tax payment: (C112 000 x 30%) ± C15 000 = C18 600

Bank (A) Current tax payable/ receivable (L/A)

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 24C: Current income tax expense estimate for 20X1

Example continued from Example 24B: 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 24C: 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

Bank (A) Current tax payable/ receivable (L/A)

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
Balance b/d (4) 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
Gripping GAAP Taxation: various types and current income taxation

Example 24D: Under/over provisions of 20X1 income tax

Example continued from Example 24C:
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 24D: 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.

Bank (A) Current tax payable/ receivable (L/A)

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)(5)

Income tax expense (E)

20X1 year: 20X1 year:
CT P/R (3) 39 000 P/L 39 000
20X2 year:
CT P/R (5) 6 000

(5) The 20X2 tax expense is adjusted for the under-provision of the tax expense in 20X1.

Example 24E: Income tax transactions in 20X2

Example continued from Example 24D:
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 24E: Income tax transactions in 20X2

Bank (A) Current tax payable/ receivable (L/A)
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)
Inc tax exp (6) 50 000
Balance c/d 31 400
61 400 61 400
Balance b/d 31 400

260 Chapter 5
Gripping GAAP Taxation: various types and current income taxation

Solution 24(&RQWLQXHG«
Income tax expense (E)
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:
(6) Payment of the first (and only) provisional payment made in 20X2
(7) Recognising the accountant’s final estimate of current tax relating to the 20X2 taxable profits.

Example 25: Under/over-payments and under/ over-provisions of tax

An entity 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 25A: 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 25B: 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

Notice:
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 The under-provision of the 20X1 tax expense is processed in the 20X2 ledger accounts.

Solution 25C: 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)
EXWVLPSO\DµIXUWKHUSD\PHQW¶± provisional payments are the payments made before the tax assessment
is received).

Chapter 5 261
 Gripping GAAP Taxation: various types and current income taxation

Solution 25D: 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/A)

20X2 CT P/R(1) 2 000 Balance 10 000
20X2 Tax(1) 2 000
Balance 12 000

Solution 25E: Ledger accounts: if top-up payment made

Bank (A) Current tax payable/ receivable (L/A)

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 of current tax
x (PSOR\HHV¶WD[
liabilities/assets
x Dividends tax; and
Amounts owing for various
x Income tax.
types of taxes (discussed in
the beginning of the chapter) must be
If we have a current tax receivable (e.g. a VAT refund disclosed separately.
expected) and a current tax payable (e.g. income tax
payable), these balances must not be set-off against each other (i.e. the asset and liability
balances must be presented separately) unless we:
x are legally allowed to settle these taxes on a net basis; and
x either intend to settle the asset or liability on a net basis or intend to settle the liability and
realise the asset at the same time.

Example 26: Disclosure of current tax assets and liabilities (set-off)

The tax authority owes an entity an amount of C50 000 VAT.
This same entity 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 HQWLW\¶Vstatement of financial
position assuming that:
A. the tax authority allows the VAT and income tax to be settled on a net basis and the entity 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
 Gripping GAAP Taxation: various types and current income taxation

Solution 26: 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.

Entity name
Statement of financial position (extracts)
$VDW«
Part A Part B
Current assets : 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 entLW\¶V 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 rate of tax (also known as the standard rate of tax) (i.e. this chapter used 30% as the
applicable income tax rate). 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 before tax). x taxation expense in the SOCI
x expressed as a percentage of
accounting profit (e.g. the profit
The effective tax rate will differ from the applicable tax rate due
before tax in the SOCI). See IAS 12.86
to permanent differences (also referred to as non-temporary
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:

Entity name
Notes to the financial statements (extracts)
)RUWKH\HDUHQGHG«
20X2 20X1
25. Income tax expense C C
x Current income tax xxx xxx
 current tax: for the current year xxx xxx
 current tax: for the prior year - under/ (over) provided in prior year xxx xxx

x Deferred income tax (see chapter 6) xxx xxx

Income tax expense per the SOCI xxx xxx

Note continued on the next page

Chapter 5 263
 Gripping GAAP Taxation: various types and current income taxation

Entity name
Notes to the financial statements (extracts) continued …
)RUWKH\HDUHQGHG«
20X2 20X1
25. 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 (adjustment of prior yr CT) xxx xxx
Income tax expense per the SOCI Tax expense in the 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 UDWHZDVVXEVWDQWLYHO\HQDFWHGRQ« GDWH 

Example 27: Disclosure involving exempt income & non-deductible expenses

This example follows on from Example 11, 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, which was exempt from tax,
- donations incurred of C10 000, which were not tax-deductible
- 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 /LPLWHG¶Vstatement of comprehensive income and tax
expense note for the year ended 31 December 20X2. Ignore deferred tax.

Solution 27: 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
Notes to the financial statements (extracts)
For the year ended 31 December 20X2
20X2
4. Income tax expense C
Current income tax - for the current year 22 800

Income tax expense per the statement of comprehensive income 22 800

Tax rate reconciliation:

Applicable tax rate 30%
Tax effects of:
Profits before tax (PBT) 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)
Income tax expense per the statement of comprehensive income 22 800
Effective tax rate Tax expense: 22 800/ PBT: 100 000 22,8%

264 Chapter 5
Gripping GAAP Taxation: various types and current income taxation

Solution 27: &RQWLQXHG«

Retailer Limited
Statement of comprehensive income (extracts) 20X2
For the year ended 31 December 20X2 C
Note
Profit before taxation 100 000
Income tax expense 4 (22 800)
Profit for the year 77 200
Other comprehensive income 0
Total comprehensive income 77 200

Example 28: Disclosure involving an under-provision

This example follows on from Example 24 (A-E), which dealt with an entity called Carl. The
information from Example 24 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 LQWKHFRPSDQ\¶Vstatement of financial position; statement of
comprehensive income and the tax expense note for the year ended 31 December 20X2.

Solution 28: 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
Notes to the financial statements 20X2 20X1
For the year ended 31 Dec 20X2 C C

4. Income tax expense

Current income tax 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
Income tax expense per statement of comprehensive income 56 000 39 000
Reconciliation
Applicable tax rate 30% 30%
Tax effects of:
Profits before tax (PBT) 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
Income tax expense per statement of comprehensive income 56 000 39 000
Effective tax rate 20X2: Tax exp: 56 000 / PBT: 166 667 33,6% 30%
20X1: Tax exp: 39 000 / PBT: 130 000

A Limited
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 C C
Note
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
Total comprehensive income 110 667 91 000

Chapter 5 265
Gripping GAAP Taxation: various types and current income taxation

Solution 28: &RQWLQXHG«

A Limited
Statement of financial position 20X2 20X1
As at 31 December 20X2 C C
Note
Current Liabilities
Current tax payable 31 400 5 400

Example 29: 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 exempt income, non-deductible expenses or 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 29A: Disclosure of other comprehensive income after tax

Suri Limited
Statement of comprehensive income 20X1
For the year ended 31 December 20X1 C
Notes
Profit before taxation 200 000
Income tax expense 5 (60 000)
Profit for the period 140 000

Other comprehensive income (net of tax) 6 77 000

x Items that may not be reclassified to profit or loss:
Revaluation surplus increase, net of tax 42 000
x Items that may be reclassified to profit or loss:
Gain on a cash flow hedge, net of tax 35 000

Total comprehensive income 217 000

Suri Limited
Notes to the financial statements 20X1
For the year ended 31 December 20X1 C

5. Income tax expense

Current income tax - for the current year 60 000

Income tax expense per SOCI 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
Gripping GAAP Taxation: various types and current income taxation

Solution 29B: Disclosure of other comprehensive income before tax

Suri Limited
Statement of comprehensive income
For the year ended 31 December 20X1
20X1
Notes C
Profit before taxation 200 000
Income tax expense 5 (60 000)
Profit for the period 140 000
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)
x Items that may be reclassified to profit or loss:
Gain on a cash flow hedge 50 000
Deferred tax on the gain on the cash flow hedge (15 000)

Total comprehensive income 217 000

Suri Limited
Notes to the financial statements
For the year ended 31 December 20X1
20X1
5. Income tax expense C
Current income tax - for the current year 60 000
Income tax expense per the SOCI 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
Gripping GAAP Taxation: various types and current income taxation

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 30% tax rate. This is simply to make
x Charge VAT
the answers easier for you to calculate
x Claim VAT
in your head.

Non-vendors: Incurred:
x Don’t charge VAT x Current (charged)
x Can’t claim VAT x Deferred (next chapter)

VAT vendors must keep a record of VAT Current

x VAT on purchases (Input VAT) x Estimate of CY assessment
x VAT on sales (Output VAT) x Adjustments to PY estimates

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
x Depreciation (IFRS: Expense) (Tax Act: deductible
allowance – often a different amounts)
x Income received in advance (IFRS: Liability)
(Tax Act: income)
These cause reconciling items in the rate
reconciliation
x Capital profit (IFRS: Income) (Tax Act: part or
all of this may be a capital gain, 80% of which
is taxable – the rest is exempt, being the
permanent difference)

x Expenses prepaid (IFRS: Asset) (Tax Act: expense)
x Non-capital profit on sale of asset (IFRS:
Income) (Tax Act: Recoupment – often a
different amounts)
x Loss on sale of asset (IFRS: Expense) (Tax Act: a
deductible scrapping allowance - often a
different amounts)
x Dividend income (IFRS: Income) (Tax Act:
generally all exempt – i.e. not taxable)
x Fines (IFRS: Expense) (Tax Act: not deductible)
x Donations (IFRS: Expense) (Tax Act: generally
not deductible)

Dividends tax
x Dividend tax is levied on the shareholder as a percentage of the cash dividend received
(now 20%)
x Thus, dividend tax is a tax on the shareholder (see exceptions, below)
x The dividend tax is deducted from the dividend declared before it is paid to the shareholder
x The company withholds this tax and pays it over to the tax authorities
x Dividend tax is not a tax on the entity that declares the dividend and is thus not included in
that entity’s tax expense
x The individual or entity that receives the dividend (shareholder) would record the tax as
part of their tax expense line-item in the statement of profit and loss.
x Exceptions can arise e.g. if the company declares a dividend that will not be paid in cash
but as an asset in specie instead, then the dividend tax is a tax levied on the company
(not the shareholder) & thus will be included in the company’s own tax expense line-item

268 Chapter 5
Gripping GAAP Taxation: various types and current income taxation

C: 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):
x Less exempt dividend income (xxx)
x Less exempt capital profit
- Less capital profit SP - CP (xxx)
- Add taxable capital gain (SP – BC) x 80% xxx
x Add non-deductible fines xxx
x Add non-deductible donations xxx
Profit before tax that the accountant knows will be taxable at some stage xxx
Adjust for movement in temporary differences:
x Add depreciation xxx
x Less wear and tear (xxx)
x Less non-capital profit on sale; or SP (limited to CP) - CA (xxx) or
Add loss on sale xxx
x Add recoupment on sale; or SP (limited to CP) - TB xxx or
Less scrapping allowance on sale (xxx)
x Add income received in advance (c/balance) xxx
x Less income received in advance (o/balance) (xxx)
x Less expense prepaid (c/balance) (xxx)
x Add expense prepaid (o/balance) xxx
x Add provision (c/b) xxx
x 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 profiton 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 1 December 2021)

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 (a debit balance) 274
Example 2A: Creating a deferred tax asset 274
Example 2B: Reversing a deferred tax asset 275
1.3 Creating a deferred tax liability (a credit balance) 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 method 279
Example 4A: Income received in advance (income statement approach) 280
2.3 The balance sheet method 282
2.3.1 Overview 282
2.3.2 Tax base of an asset 284
2.3.3 Tax base of a liability 284
2.3.4 Deferred tax is calculated using tax bases and carrying amounts 285
Example 4B-D: Income received in advance (balance sheet approach, journals, disclosure) 285
3. Deferred tax caused by year-end accruals and provisions 288
3.1 Overview 288
3.2 Expenses prepaid 288
Example 5: Expenses prepaid 289
3.3 Expenses payable 292
Example 6: Expenses payable 293
3.4 Provisions 295
Example 7: Provisions 296
3.5 Income receivable 299
Example 8: Income receivable 299
4. Deferred tax caused by non-current assets 302
4.1 Overview 302
4.2 Deductible assets 303
Example 9: Cost model ± PPE ± Deductible and depreciable assets 304
4.3 Non-deductible assets and the related exemption 307
4.3.1 Overview 307
4.3.2 The exemption from recognising deferred tax liabilities 308
Example 10: Cost model ± PPE ± Non-deductible and depreciable assets 309
Example 11: Cost model ± PPE ± Non-deductible and non-depreciable assets 311
4.4 Non-current assets measured at fair value 313
4.4.1 Overview 313
4.4.2 Non-current assets measured at fair value and presumed intentions 315
4.4.2.1 Non-GHSUHFLDEOHDVVHWVPHDVXUHGXVLQJ,$6¶VUHYDOXDWLRQPRGHO 315
4.4.2.2 Investment property measured using IA6¶VIDLUYDlue model 315
Example 12: Non-current asset at fair value and presumed intentions 315
4.4.3 Measuring deferred tax based on management intentions 316
4.4.3.1 Intention to sell the asset (actual or presumed intention) 317
4.4.3.2 Intention to keep the asset 317
4.4.4 Measuring deferred tax if the fair valued asset is also non-deductible 317
Example 13: Revaluation above cost: PPE: Non-deductible; depreciable: keep 318
Example 14: Revaluation above cost: PPE: Non-deductible; depreciable: sell 320
Example 15: Revaluation above cost: PPE: Non-deductible; non-depreciable: keep 322

270 Chapter 6
Gripping GAAP Taxation: deferred taxation

&RQWHQWVFRQWLQXHG« Page
4.5 Sale of a non-current asset 324
Example 16: Non-current asset sold at a profit with a recoupment 325
Example 17: Non-current asset sold at a loss with a scrapping allowance 326
Example 18: Sale of a deductible, depreciable asset (plant): below cost 326
Example 19: Sale of a deductible, depreciable asset (plant): above cost 328
Example 20: Sale of a non-deductible, non-depreciable asset: below cost 330
Example 21: Sale of a non-deductible, non-depreciable asset: above cost 332
Example 22: Sale of a non-deductible, depreciable asset: below cost 334
Example 23: Sale of a non-deductible, depreciable asset: above cost 335
5. Exemption from deferred tax 337
6. Measurement: enacted tax rates versus substantively enacted tax rates 338
Example 24: Enacted and substantively enacted tax rates 339
7. Rate changes and deferred tax 340
Example 25: Rate changes: journals 341
Example 26: Rate changes: journals and disclosure 341
8. Deferred tax assets 343
8.1 What causes a deferred tax asset? 343
8.2 Deferred tax assets: recognition 344
Example 27: Recognising deferred tax assets: tax loss to expire: discussion 345
Example 28: Recognising deferred tax assets: deductible temporary differences 346
8.3 Deferred tax assets: measurement 347
8.4 Deferred tax assets: disclosure 347
Example 29: Tax losses: deferred tax asset recognised in full 348
Example 30: Tax losses: deferred tax asset recognised in full then written-down 350
Example 31: Tax losses: deferred tax asset recognised partially 351
9. Disclosure of income tax 354
9.1 Overview 354
9.2 Accounting policy note 354
9.3 Statement of financial position disclosure 355
9.3.1 Face of the statement of financial position 355
9.3.1.1 Non-current asset or liability 355
9.3.1.2 Setting-off of deferred tax assets and liabilities 355
Example 32: Set-off of deferred tax assets and liabilities 355
9.3.2 Deferred tax note (asset or liability) 356
9.3.2.1 The basic structure of the deferred tax note 356
9.3.2.2 A deferred tax reconciliation may be required 356
9.3.2.3 Extra detail needed on unrecognised deferred tax assets 357
9.3.2.4 Extra detail needed on recognised deferred tax assets 357
9.3.2.5 Extra detail needed on unrecognised deferred tax liabilities 357
9.4 Statement of comprehensive income disclosure 358
9.4.1 Face of the statement of comprehensive income 358
9.4.2 Tax on profit or loss ± the income tax expense note 358
9.4.2.1 Basic structure of the income tax expense note 358
9.4.2.2 Effect of deferred tax assets on the income tax expense note 359
9.4.2.3 Tax relating to changes in accounting policies and correction of errors 360
9.4.2.4 Extra detail required with regard to discontinuing operations 360
9.4.3 Tax on other comprehensive income 360

10. Summary 362

Chapter 6 271
 Gripping GAAP Taxation: deferred taxation

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:
Accounting profit and
x current tax; and Taxable profit definitions:
x deferred tax.
x Accounting profit is profit or loss
for the period before deducting
The total tax expense, presented on the face of the statement of tax expense. IAS12.5
comprehensive income, is the tax incurred on the accounting profits.
x Taxable profit is the profit or loss
These accounting profits are calculated based on the international for the period, determined in
financial reporting standards (IFRSs). The IFRSs involve the accordance with the rules
concept of accrual and thus the tax expense is based on the established by the taxation
concept of accrual. authorities, upon which income
taxes are payable (or recoverable).
IAS12.5

This current tax is the tax charged on the current periRG¶Vtaxable

profits. These taxable profits are calculated based on tax Tax expense is defined as:
legislation (discussed in chapter 5). The tax legislation is not
x the aggregate amount
focussed on the accrual concept, and thus, for example, income x included in the determination of
might be included in taxable profits before it is earned (i.e. before it P/L for the period in respect of
is included in accounting profits). x current tax and deferred tax. IAS12.5

Thus, the tax expense (tax incurred on accounting profits) and

Tax expense equals:
the current tax (tax charged on taxable profits) are generally
different amounts because: x Current tax expense (or income); &
x accounting profits are calculated in accordance with the x Deferred tax expense (or income).
international financial reporting standards (IFRSs), and
x taxable profits are calculated in accordance with tax legislation.

The current tax charged (the amount based on tax legislation) is Current tax is defined as:
debited to the tax expense account (debit tax expense; credit
x amount of income taxes
current tax payable). We then adjust this tax expense account
x payable/(recoverable) in respect of
upwards or downwards so that it shows the tax expense incurred x taxable profit/ (tax loss)
(the amount based on IFRSs). This adjustment is called a deferred x for the period. IAS12.5
tax adjustment and is thus simply an accrual of tax.

This deferred tax adjustment, results in the creation of a deferred tax asset or liability (e.g. a deferred tax
adjustment may involve debiting the tax expense and crediting the deferred tax liability).

Worked example: Imagine we have taxable profit of C100 on which the tax authorities charge us tax, at 30%, of C30
(current tax). The current tax journal would be: Debit tax expense and Credit current tax payable: C30
The following table shows the deferred tax adjustments needed depending on the accounting profit (assume there
are no permanent differences):
Scenario Accounting Tax expense Current tax Deferred tax Deferred tax adjustment:
profit (incurred) (charged) (adjustment) the journal
A C150 C45 (150 x 30%) C30 (given) +15 (45 ± 30) Debit tax expense; Credit DT liability
B C80 C24 (80 x 30%) C30 (given) -6 (24 ± 30) Credit tax expense; Debit DT asset

The logic described above, of why we process deferred tax Deferred tax is not defined but
adjustments, is often called the µincome statement PHWKRG¶. the logic of it is that it arises:
However, IAS 12 uses another method commonly called the x when income/expenses (or A/Ls)
µbalance sheet method¶. This chapter will first explain the logic are treated differently:
using the income statement method and then the balance  under IFRSs (accounting profit); &
 under tax legislation (taxable profit)
sheet method. /HW¶V now work through the following basic x and where these differences will
example (based on example 17 from chapter 5) to explain the reverse (i.e. they are temporary).
logic behind deferred tax.

272 Chapter 6
Gripping GAAP Taxation: deferred taxation

Example 1: Current and deferred tax interaction

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 or permanent differences other than those evident from the information provided.
Required:
A. Calculate the current tax charged (tax on taxable profits per the tax legislation) for 20X1 to 20X3.
B. Calculate the tax expense incurred (tax on accounting profits per IFRSs) for 20X1 to 20X3.
C. Calculate the difference between the current tax charged (A) and the tax expense incurred (B) and thus
whether an adjustment to the current tax recognised in the tax expense account (A) would be required in
order to disclose the tax expense incurred, as required by IAS 12 (B).

Solution 1: Current and deferred tax interaction:

Comments:
x In each of the years 20X1 and 20X2, the current tax µchargeG¶ per the tax legislation is more than the tax
expense µLQFXUUHG¶ SHU IFRSs). 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 smaller tax
incurred. This adjustment (of C7 500, in each of the first two years) is a deferred tax adjustment.
x In 20X3, the current tax charge per the tax legislation is less WKDQWKHWD[H[SHQVHWKDWLVµLQFXUUHG¶ SHU
IAS 12). 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 bigger tax incurred. This adjustment
(of C15 000) is a deferred tax adjustment.
A: 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
Movement in temporary differences
x Add back depreciation (150 000 / 2 years) 150 000 0 75 000 75 000
x 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
Debit: Tax expense; Credit: Current tax payable

B: Tax expense incurred

Profit before tax (accounting profit) (No PDs = 100% taxable) 300 000 100 000 100 000 100 000
Tax incurred (tax on accounting profit) at 30% 90 000 30 000 30 000 30 000

C: Comparison of Current tax & Tax expense

Current tax (on taxable profits, per tax legislation) 90 000 15 000 37 500 37 500
Tax incurred (on accounting profits, per IAS 12) 90 000 30 000 30 000 30 000
Deferred tax adjustment needed: increase/ (decrease) - 15 000 (7 500) (7 500)

20X1 & 20X2 journals: Current tax > Tax incurred 20X3 journals: Current tax < Tax incurred
Thus, DT adjustment = Thus, DT adjustment =
x Credit: Tax expense, x Debit: Tax expense;
x Debit: Deferred tax asset x Credit: Deferred tax asset (derecognising the DT asset)

Notice: The tax expense account in each year shows the tax expense incurred. Also notice that over 3 years, the total
current tax charged (90 000) equals the total tax expense incurred (90 000) and thus, that the deferred tax adjustments
net off to nil. This means that the differences in each year were just timing issues.
Tax expense account: debit/(credit) Total 20X3 20X2 20X1
Current tax (on taxable profits, per tax legislation) 90 000 15 000 37 500 37 500
Deferred tax adjustment needed: increase/ (decrease) - 15 000 (7 500) (7 500)
Tax incurred (on accounting profits, per IAS 12) 90 000 30 000 30 000 30 000

Chapter 6 273
Gripping GAAP Taxation: deferred taxation

1.2 Creating a deferred tax asset (a debit balance)

Deferred tax asset is defined as:
A debit balance on the deferred tax account reflects the IAS12.5

DFFRXQWDQW¶V EHOLHI WKDW WD[ KDV EHHQ charged but which x the amounts of taxes recoverable
has not yet been incurred. This µpremature¶ tax charge x in future periods in respect of:
must be deferred (postponed). In some ways, this - deductible temporary differences
treatment is similar to that of a prepaid expense. - unused tax losses carried forward;
- unused tax credits carried forward.

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 the tax incurred for 20X1 to be C24 000.
The C6 000 excess will be deferred to future years.
There are no other items affecting the deferred tax balance.

Required: Show the ledger accounts and disclose the deferred tax asset/ liability line-item (in the SOFP)
and tax expense line-item (in the SOCI) together with the tax expense note for 20X1.

Solution 2A: Creating a deferred tax asset (debit balance)

Comment:
The tax expense in the SOCI 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: 20X1

Income tax expense (E) Current tax payable (L)

CTP (1) 30 000 DTA (2) 6 000 Inc tax exp (1) 30 000
_____ P/L (3) 24 000
30 000 30 000

Deferred tax asset (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
Statement of financial position (extract) 20X1
$VDW«; C

Non-current assets
Deferred tax asset 6 000

Entity name
Statement of comprehensive income (extract) 20X1
)RUWKH\HDUHQGHG«; Note C

Profit before tax xxx

Income tax expense (current tax charge: 30 000 ± deferred tax adjustment: 6 000) 3. (24 000)
Profit for the period xxx

274 Chapter 6
Gripping GAAP Taxation: deferred taxation

Entity name
Notes to the financial statements (extract) 20X1
For thH\HDUHQGHG«; C

3. Income tax expense

x Current 30 000
x Deferred (6 000)
Income tax expense per statement of comprehensive income 24 000

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.
x There are no other items affecting the deferred tax balance.
Required: Show the ledger accounts and disclose the deferred tax asset/ liability line-item (in the SOFP)
and tax expense line-item (in the SOCI) together with the tax expense note for 20X2.

Solution 2B: Reversing a deferred tax asset

Comment: Notice, over the 2-years, the total current tax charged equals the total tax expense recognised:
x total current tax charged by the tax authorities = C72 000 (20X1: 30 000 + 20X2: 42 000),
x total tax expense recognised in the accounting records = C72 000 (20X1: 24 000 + 20X2: 48 000)

Ledger accounts: 20X2

Income tax expense (E) Current tax payable (L)
CTP (1) 42 000 Balance b/d xxx
DTA (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 asset (A) Profit or loss (closing account)
Balance b/d 6 000 Inc tax exp(3) 48 000
Inc tax exp (2) 6 000
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 LQ WKH FXUUHQW WD[ SD\DEOH LV UHIOHFWHG E\ µ[[[¶ (i.e. instead of at
C30 000, being the closing balance in this account in solution 2A), is because we are not given all the information
(e.g. we do not know how much was paid to the tax authorities or if any over/under-provision was processed).

Disclosure for 20X2:

Entity name
Statement of financial position (extract) 20X2 20X1
$VDW«;2 C C
Non-current assets
Deferred tax asset 0 6 000

Entity name
Statement of comprehensive income (extract) 20X2 20X1
)RUWKH\HDUHQGHG«; Note C C
Profit before tax xxx xxx
Income tax expense (20X2: CT charge: 42 000 + DT adjustment: 6 000) 3. (48 000) (24 000)
Profit for the year xxx xxx

Chapter 6 275
Gripping GAAP Taxation: deferred taxation

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year HQGHG««20X2 C C
3. Income tax expense
x Current 42 000 30 000
x Deferred 6 000 (6 000)
Tax expense per the statement of comprehensive income 48 000 24 000

1.3 Creating a deferred tax liability (credit balance)

A deferred tax liability is
A credit balance in the deferred tax account reflects the defined as:
accRXQWDQW¶V belief that tax has been incurred, but that it has x the income taxes payable
not yet been charged by the tax authority. It thus shows the x in future periods, in respect of
amount that the tax authority will charge in the future. This is x taxable temporary differences
IAS12.5 Reworded very slightly
similar to how we account for an expense payable. However, a
deferred tax liability is not yet payable ± it is just a prediction of what will be payable in the future.
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) is C22 000.
x There are no other items affecting the deferred tax balance.
Required: Show the ledger accounts and disclose the deferred tax asset/ liability line-item (in the SOFP)
and tax expense line-item (in the SOCI) together with the tax expense note for 20X1.

Solution 3A: Creating a deferred tax liability (credit balance)

Comment:
x The tax expense in the statement of comprehensive income must reflect the tax incurred for the year (22 000)
rather than the tax charged (15 000).
x We first record the tax charge of C15 000 (current tax) in the tax expense account. Then we increase this
account by C7 000 (deferred tax adjustment) so that the account reflects tax incurred of C22 000.
x When increasing tax expense with C7 000, we debit tax expense and credit deferred tax liability. Notice we do
not FUHGLWµFXUUHQWWD[ SD\DEOH¶. This is because wHGRQ¶W\HWRIIicially owe this to the tax authorities. This extra
tax of C7 000 has been incurred but will only be charged by the tax authorities in future years (i.e. it is tax that
will only become payable in the future)

Ledger accounts: 20X1

Income tax expense (E) Current tax payable (L)
CTP (1) 15 000 Inc tax exp (1) 15 000
DTL (2) 7 000 P/L (3) 22 000
22 000 22 000

Deferred tax liability (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 (estimated amount that will be charged by the tax authorities).
(2) Recording a deferred tax adjustment: Incurred C22 000 (tax expense) ± Charged C15 000 (current tax).
(3) The income tax expense account is closed off to profit or loss (DOOLQFRPHDQGH[SHQVHDFFRXQWVDUHµFORVHG-RII¶DW
year-end). (Please note: current tax payable is a liability and the deferred tax account is an asset).

Disclosure for 20X1:

Entity name
Statement of financial position (extract) 20X1
$VDW«20X1 C
Non-current liabilities
Deferred tax liability 7 000

276 Chapter 6
Gripping GAAP Taxation: deferred taxation

Entity name
Statement of comprehensive income (extract) 20X1
)RUWKH\HDUHQGHG«0X1 Note C
Profit before tax xxx
Income tax expense CT charge: 15 000 + DT adjustment: 7 000 3. (22 000)
Profit for the year xxx

Entity name
Notes to the financial statements (extract) 20X1
)RUWKH\HDUHQGHG«20X1 C

3. Income tax expense

x Current 15 000
x Deferred 7 000
Tax expense per the statement of comprehensive income 22 000

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 charged 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 charged 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.
There are no other items affecting deferred tax (i.e. no opening balance and no other temporary differences).
Required: Show the ledger accounts and disclose the deferred tax asset/ liability line-item (in the SOFP)
and tax expense line-item (in the SOCI) together with the tax expense note in 20X2.

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 because it now forms part of the current tax payable liability instead (a current liability).
x Notice that, over the 2-years, the total current tax charged equals the total tax expense recognised:
- total current tax charged by the tax authorities = C34 000 (20X1: 15 000 + 20X2: 19 000),
- total tax expense recognised in the accounting records = C34 000 (20X1: 22 000 + 20X2: 12 000)

Ledger accounts: 20X2

Income tax (E) Current tax payable (L)

CTP (1) 19 000 DTL (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 liability (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 of C19 000 for 20X2 (amount we estimate will be charged by the tax authority).
(2) Recording the deferred tax adjustment for 20X2: Incurred C12 000 (tax expense) ± Charged C19 000 (current tax).
This adjustment reverses the 20X1 deferred tax liability of C7 000.
(3) The tax expense account is closed off to profit or loss (income and expenses are closed-off at year-end).
(4) Please note: the reason the opening balance in the current tax payable is reflected b\µ[[[¶ LHQRW& 000 as
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
Gripping GAAP Taxation: deferred taxation

Disclosure for 20X2:

Entity name
Statement of financial position (extract) 20X2 20X1
$VDW««; C C
Non-current liabilities
Deferred tax liability 0 7 000

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year endeG«; Note C C
Profit before tax xxx xxx
Income tax expense (CT charge and DT adjustment) 3. (12 000) (22 000)
Profit for the year xxx xxx

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended «; C C
3. Income tax expense
x Current 19 000 15 000
x Deferred (7 000) 7 000
Tax expense per the statement of comprehensive income 12 000 22 000

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, deferred tax must always be presented as a non-current liability or asset.

1.5 Recognition of deferred tax adjustments (IAS 12.57 ± 68C)

Deferred tax adjustments, like current tax adjustments, are Recognition of deferred tax
recognised in profit or loss, other comprehensive income or adjustments:
equity, depending on where the underlying transaction or x If the TD arose due to something in
event was recognised. For example: P/L then the DT adj is recognised in
P/L.
x Depreciation is recognised in profit or loss, and thus
x If the TD arose due to something in
any deferred tax adjustment arising because the OCI, then the DT adj is recognised in
depreciation differs from the related tax deduction (e.g. OCI.
wear and tear), is also recognised in profit or loss. Thus, x If the TD arose due to something in
this deferred tax adjustment is included in the tax equity, then the DT adj is recognised
in equity.
expense line-item in profit or loss.
x A revaluation surplus arising when revaluing property, plant and equipment (chapter 8: section 4) is
recognised in other comprehensive income and thus the related deferred tax adjustment is also
recognised in other comprehensive income (i.e. it is not included in the tax expense in profit or loss).
x The adjustment to opening retained earnings due to the retrospective correction of a material
prior period error (chapter 26) is recognised directly in equity and thus the related deferred tax
adjustment is also recognised in equity (i.e. it is not included in the tax expense in profit or loss).

A deferred tax adjustment is only processed if the deferred tax asset or liability can be recognised. In this
regard, ZHPD\EHGHDOLQJZLWKDµGHIHUUHGWD[H[HPSWLRQ¶ (see section 5), in which case the deferred tax
asset or liability would not be recognised (i.e. thus we would not process the deferred tax adjustment).
Similarly, deferred tax assets might also not be recognised because the future tax saving is not probable
(i.e. the recognition criteria are not met) (see section 8).

278 Chapter 6
 Gripping GAAP Taxation: deferred taxation

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 presented as 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 method; and balance sheet approaches:
x the balance sheet method. x Income statement approach:
DT adj = (Accounting profits –
The previous version of IAS 12 referred to the income Taxable profits) x tax rate
statement method, which involves measuring deferred x Balance sheet approach:
tax based on the difference between the tax effects of: DTA/L bal = (CA – TB) x tax rate
x taxable 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 describes the measurement of deferred tax in terms of 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 these assets and liabilities.

Both methods will give the same answer, but you will generally be required to present your workings
and discussions using the µbalance sheet method¶. The µincome statement method¶ has been used in
prior examples and is explained in more detail below since it is very helpful in understanding the
concept of deferred tax (i.e. that it is rooted in the accrual concept). Furthermore, knowing how to use
the µincome statement methRG¶ enables us to check our µEDODQFHVKHHWPHWKRG¶calculations.

2.2 The income statement method

Remember what you learned in 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:

Profit before tax (accounting profits) A
Adjusted for differences that are permanent in nature: xxx
x less exempt income (e.g. certain capital profits and dividend income) (xxx)
x 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 [(C-B) x 30% = deferred tax adjustment] C-B
x add depreciation xxx
x less depreciation for tax purposes (e.g. wear and tear) (xxx)
x add income received in advance (closing balance): if taxed when received xxx
x less income received in advance (opening balance): if taxed when received (xxx)
x less expenses prepaid (closing balance): if deductible when paid (xxx)
x add expenses prepaid (opening balance): if deductible when paid xxx
x add provisions (closing balance): if deductible when paid xxx
x less provisions (opening balance): if deductible when paid (xxx)
Taxable profits (C x 30% = current tax charge) C

As we can see, there are two types of differences between accounting profits and taxable profits:
x permanent differences; and
x movement in temporary differences.

We can also see that this calculation can be used to calculate not only the current tax charge
(C x 30%), but also tax expense (B x 30%) and the deferred tax adjustment ((C-B) x 30%).

Chapter 6 279
Gripping GAAP Taxation: deferred taxation

Accounting profits (A) = Profit before tax, based on IFRS

+/- Permanent differences

Portion of the accounting profits

Taxable accounting profits (B) = that are taxable, although not X 30% = Tax expense
necessarily now

Deferred tax adjustment

+/- Movement in temporary differences X 30% =
(expense/ income)

= Profits that are taxable now, based

Taxable profits (C) X 30% = Current tax expense
on tax laws

The difference between µaccounting profits¶ (A) and µtaxable accounting profits¶ (B) includes
differences that will never reverse: income that is included in the accounting profit but which will
never be taxed and expenses that are included in accounting profit but which will never be tax-
deductible. These are called permanent differences (also known as non-temporary differences).

The difference between µtaxable accounting profits¶ (B above) and µtaxable profits¶ (C above) is
caused by the movement in temporary differences. This movement relates to issues of timing
e.g. when income is taxed versus when it is recognised in the accounting records.

Thus, deferred tax adjustments are only made if there is a movement in the temporary differences.

Example 4A: Income received in advance (income statement approach)

An entity receives rent of C120 000 in 20X1 that will only be earned in 20X2. The entity has no other
income or receipts in either year.
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: Using the income statement approach, calculate, for 20X1 and 20X2, the current tax expense, the
deferred tax adjustment and the total tax expense and show the related ledger accounts.

Solution 4A: Income received in advance (income statement approach)

Comment:
x Rent of C120 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 The tax authorities include the receipt of C120 000 in taxable profit in 20X1, so the current tax charge in 20X1
includes C36 000.
x In order to match the C36 000 tax charge in 20X1 to the period in which we recognise the income of C120 000
(20X2), we defer recognising the tax charge as an expense until 20X2. Thus, in 20X1, we initially record the
current tax charge of C36 000 in tax expense (current tax charge: Dr tax expense; Cr current tax payable) but
then immediately defer recognising it as an expense. Deferring it requires us to reduce the tax expense
(deferred tax adjustment: Dr deferred tax asset; Cr tax expense) and thus recognise a deferred tax asset.
x Then, in 20X2, when we recognise the income of C120 000, we reverse the deferred tax asset and recognise
the tax expense of C36 000 (deferred tax adjustment: Dr tax expense Cr deferred tax asset).
x The first deferred tax adjustment is an originating deferred tax adjustment and the second one is a reversing
deferred tax adjustment. Thus, the deferred tax asset in 20X1 disappears in 20X2. Similarly, the accountant and
tax authorities agree income is C120 000 and tax expense is C36 000 (recognised by the tax authorities in
20X1, but by the accountant in 20X2). Thus, the differences were just timing differences.
20X1 20X2
W1. Current income tax Profits Tax at 30% Profits Tax at 30%
Profit before tax (accounting profits) (1) (7) 0 120 000
Permanent differences (N/A) 0 0
Taxable accounting profits and tax expense (3) (9) 0 0 120 000 36 000
Movement in temporary differences and deferred tax adj.(3) (9) 120 000 36 000 (120 000) (36 000)
x Add income received in advance (c/balance): taxed now (2) 120 000 0
x Less income received in advance (o/bal): previously taxed (8) (0) (120 000)
Taxable profits and current tax (2) (8) 120 000 36 000 0 0

280 Chapter 6
Gripping GAAP Taxation: deferred taxation

Ledger accounts: 20X1

Bank (A) Rent received in advance (L)

RRIA (1) 120 000 Bank (1) 120 000

Income tax expense (E) Current tax payable (L)

CTP (2) 36 000 DTA (3) 36 000 Inc tax exp (2) 36 000
Balance c/d 0
36 000 36 000
Balance b/d (5) 0

Deferred tax asset (A)

(3 & 4)
Inc tax exp 36 000

Ledger accounts: 20X2

Bank Rent received in advance (L)

Rent income (6) 0 Balance b/d 120 000
Rent income (7) 120 000
120 000 120 000
Balance b/d 0

Income tax expense (E) Current tax payable (L)

CTP (8) 0 Balance b/d 36 000
DTA (9) 36 000 Balance c/d 36 000 Balance c/d 36 000 Inc tax exp (8) 0
36 000 36 000 36 000 36 000
Balance b/d (11) 36 000 Balance b/d 36 000

Deferred tax asset (A) Rent income (I)

Balance b/d 36 000 Bank (6) 0
Inc tax exp (9) 36 000 RRIA (7) 120 000
Balance c/d 0 Balance c/d 120 000
36 000 36 000 120 000 120 000
Balance b/d (10) 0 Balance b/d 120 000
Notes:
(1) 20X1: Rent received in 20X1 (120 000) is not yet earned and is thus not recognised as income but as a liability.
(2) 20X1: Current tax charged by the tax authority (36 000 ± W1): Debit tax expense and Credit current tax payable.
(3) 20X1: Deferred tax adjustment: Since we do not recognise income in 20X1, we must not recognise the related tax
expense in 20X1. Thus, we defer the tax of C36 000 to a future period: Credit tax expense & Debit deferred tax asset.
(4) 20X1: The deferred tax balance on the deferred tax account is a debit (36 000) at the end of 20X1 and is thus a
deferred tax asset. It 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 expense balance, which will appear on the face of the statement of comprehensive income in 20X1, is
zero since it reflects the tax incurred on income earned. Since no income has been earned, no tax is incurred.
(6) 20X2: Rent received in 20X2 is nil. No entry is actually processed (it is shown here purely for explanatory purposes).
(7) 20X2: Rent income in 20X2 (120 000) is recognised by reversing the income received in advance from 20X1:
Debit rent received in advance and Credit rent income.
(8) 20X2: Current tax charged by the tax authority in 20X2 is nil (W1), since the rent income was taxed in 20X1. No entry
would actually be processed (it is shown here purely for explanatory purposes).
(9) 20X2: Deferred tax adjustment: Since we recognise rent income of C120 000 in 20X2 (see note 7), we must recognise
the related tax expense of C36 000 (at 30%). However, the current tax charge for 20X2 is nil, thus we must increase
the tax expense by C36 000. Thus, we reverse the deferred tax asset created in 20X1 (the tax that was charged in
20X1 is now incurred in 20X2): Debit tax expense and Credit deferred tax asset.
(10) 20X2: The deferred tax balance on the deferred tax asset account is nil at the end of 20X2.
(11) 20X2: The tax expense balance, which will appear on the face of the statement of comprehensive income in 20X2, is
C36 000 since it reflects the tax incurred on income earned (C120 000).

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Gripping GAAP Taxation: deferred taxation

Temporary differences are

2.3 The balance sheet method defined as:
x differences between
2.3.1 Overview x an asset’s or a liability’s:
- carrying amount in the SOFP; and
The income statement method involves first calculating the - tax base. IAS 12.5 reworded
current tax expense, comparing this to the tax expense we
want to present, and in so doing, calculating the deferred tax adjustment we need to process. We then
process this adjustment, thus changing the deferred tax opening balance into a closing balance.

The balance sheet method, on the other hand, is the method whereby we first calculate the deferred tax
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 required closing deferred tax balance).
Taxable temporary differences
The idea behind the balance sheet method is that the are defined as:
deferred tax balance (liability or asset) represents the x those that will result in
expected future tax (payable or receivable) that will be x taxable amounts
levied on the expected future transactions that have x in determining taxable profit (tax loss)
already been recognised in the financial statements. x of future periods
x when the CA of the asset or liability
is recovered or settled. IAS 12.5
The expected future transactions that have already been
P.S Taxable temporary differences lead
recognised are reflected in our assets and liabilities (presented to deferred tax liabilities (TD x 30%)
in our statement of financial position). If you revisit the asset
and liability definitions per the Conceptual Framework (see chapter 2), you will see that:
x assets represent the expected future inflow of economic benefits, e.g. future income, and
x liabilities represent the expected future outflow of economic benefits, e.g. future expenses.
Deductible temporary
Let us consider a couple of examples: differences are defined as:
x The carrying amount of plant (an asset) reflects the x those that will result in
expected future inflow of economic benefits (future x amounts that are deductible
x in determining taxable profit (tax loss)
income from future transactions involving the plant). x of future periods
x The carrying amount of an expense payable reflects x when the CA of the asset or liability
is recovered or settled . IAS 12.5
the expected future outflow of economic benefits
P.S Deductible temporary differences
(future expenses involving the payable). lead to deferred tax assets (TD x 30%)

Let us now consider the logic behind why we recognise deferred tax on assets and liabilities. For the
purpose of this exercise, lHW¶V think about why we recognise deferred tax on an asset, such as a
plant (the logic is the same for why we recognise deIHUUHG WD[ RQ D OLDELOLW\« it is just easier and
quicker to understand the logic of deferred tax using an asset rather than using a liability ͧͪ).
ͩ
ͨ

The logic here is that, in the same way that our current year profits are shown after tax, any future
profits recognised should also be after tax. Thus, when we recognise future income (i.e. when we
recognise the asset), we should also recognise the expected future tax effect (i.e. deferred tax).
x This µfuture tax effect¶ could either be a future tax payable (deferred tax liability) or a future tax
saving (deferred tax asset). It depends on what the future tax deductions on this asset are.
The µfuture tax deductions¶ relating to an asset (e.g. plant) are referred to as its tax base. In
the case of plant, they include things like wear and tear or capital allowances (i.e. the tax
DXWKRULW\¶VHTXLYDOHQWRIGHSUHFLDWLRQ«µtax-depreciatiRQ¶).
x Thus, to work out whether the asset (plant) will lead to a future tax payable (deferred tax liability)
or a future tax saving (deferred tax asset), we need to compare its µfuture income¶ (i.e. the
DVVHW¶Vcarrying amount) with its related µIXWXUHWD[GHGXFWLRQV¶ (i.e. WKHDVVHW¶Vµtax base¶ .
 If an DVVHW¶V µfuture income¶ (carrying amount: CA) exceeds its µfuture tax deductions¶ (tax
base: TB), it means we expect a future taxable profit from the asset.
This difference (CA minus TB) is called a taxable temporary difference.
Expecting a µfuture taxable profit¶ (taxable temporary difference) means we expect a future
tax payable, which we recognise as a deferred tax liability.

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 ,I DQ DVVHW¶V µIXWXUH LQFRPH¶ FDUU\LQJ DPRXQW  LV less than LWV µIXWXUH WD[ GHGXFWLRQV¶ (tax
base), it means we expect a future tax loss/ net tax-deduction from the asset.
This difference (CA minus TB) is a deductible temporary difference.
ExpectiQJDµIXWXUHWD[loss/ net deduction¶ (deductible temporary difference) means we expect
a future tax saving (i.e. when we get to deduct this excess deduction, it will reduce our
taxable profit and thus reduce our current tax), which we recognise as a deferred tax asset.

Thus, when using the balance sheet method to calculate deferred tax, we compare the carrying
amount of each asset and liability with its tax base. For example, in the case of an asset:
x The carrying amount is its balance recognised in terms of IFRSs (future income);
x The tax base is effectively its balance calculated based on tax legislation (future tax deductions).

:HKDYHUHIHUUHGWRWKHWHUPµtax base¶DIHZWLPHVDOUHDG\SDUWLFXODUO\LQFRQWH[WRIDQDVVHW+RZHYHU
WKHFRQFHSWRIµWD[EDVH¶FDn be simply explained as the WD[DXWKRULW\¶VHTXLYDOHQWRI a carrying amount.
In other words, imagine if the tax authorities were to draw up our ledger based on the tax legislation, the
EDODQFHVLQWKHDVVHWDQGOLDELOLW\DFFRXQWVZRXOGEHFDOOHGµWD[EDVHs¶.

For example: We buy a plant for C100 000 and depreciate it over 10 years.
After one year the accountant will show WKHSODQW¶Vcarrying amount at C90 000 (cost 100 000 ± accumulated
depreciation 10 000).
However, if this plant is tax-deductible over 5 years and if the tax authorities were to draw up our ledger for us
(using tax legislation as the basis), after one year, the tax authority would show our SODQW¶Vtax base at C80 000
(cost 100 000 ± accumulated tax-depreciation 20 000).
P.S. Notice the tax base equals the future deductions on the plant: the tax authorities allow the cost of C100 000
to be deducted over 5 years: since C20 000 is deducted in year one, there are future tax deductions of C80 000.

Any difference between the carrying amount and tax base, Tax base is defined as:
is called a temporary difference.
x the amount attributed to that A or L
x for tax purposes. IAS 12.7
Generally, the existence of a temporary difference means we
must recognise a deferred tax balance (sometimes we dRQ¶W ± see section 5 and section 8). We
measure the deferred tax balance by multiplying the temporary difference by the relevant tax rate.

For example: The plant in the example above causes a taxable temporary difference, at the end of year 1, of
C10 000 [CA (future income): 90 000 ± TB (future tax-deductions): 80 000] and thus, if the tax rate is 30%,
a deferred tax liability of C3 000 must be recognised (temporary difference 10 000 x 30%).

Please note that the deferred tax balance is not the same thing as a deferred tax adjustment.
The µdeferred tax adjustment¶ that we process is calculated by comparing the required closing
µdeferred tax balance¶ (temporary differences at the current reporting date x tax rate) with the
opening µdeferred tax balance¶ (temporary differences at the prior reporting date x tax rate).

For example: If there were taxable temporary differences, at the end of year 2, of C50 000, and the tax
rate is 30%, then a deferred tax liability closing balance of C15 000 must be recognised (TD x 30%).
However, if there were taxable temporary differences, at the beginning of year 2, of C10 000 and the tax
rate was 30%, then the deferred tax liability opening balance was C3 000 (TD x 30%).
Thus, since our closing deferred tax balance must be C15 000 (liability), we must journalise a deferred
tax adjustment of C12 000 (DTL closing balance 15 000 ± DTL opening balance 3 000), as follows:
Debit Tax expense 12 000
Credit Deferred tax liability 12 000

Although we can visualise the µWD[EDVH¶ as the tax authorit\¶s equivalent of a carrying amount, the µtax
base of an asset¶ and the µtax base of a liability µare both defined in IAS 12, and so we need to know
these definitions and how to apply them when calculating a tax base. See sections 2.3.2 and 2.3.3.

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2.3.2 Tax base of an asset

The tax base of an asset is
defined as:
The definition of the tax base of an asset (see pop-up)
x the amount that will be
effectively refers to two types of assets: deductible for tax purposes
x an asset that represents a future inflow of economic x against any taxable economic
benefits that will be taxable and benefits that will flow to an
entity
x an asset that represents a future inflow of economic x when it recovers the CA of the asset.
benefits that will not be taxable.
If those economic benefits
x will not be taxable,
Simply speaking, the definition means: x the TB of the A is its CA. IAS 12.7
Reworded

x If the inflow will be taxable (e.g. a plant that will result in

us earning taxable profits):
the tax base will be the future deductions relating to the asset.
x If the inflow will not be taxable (e.g. dividend receivable where the dividend is exempt from tax):
the tax base will be the carrying amount of the asset.

This can be represented as follows:

Tax base of an asset e.g. Plant is one of the assets used by the
whose economic entity to generate sales. This inflow of sales
benefits
= Future tax deductions
will be taxed; thus, the tax base of the plant is
will be taxable the related future tax deductions

Tax base of an asset e.g. A loan receivable reflects the expected

whose economic receipt of the loan principle. This inflow will
benefits
= Carrying amount
not be taxed; thus, the tax base of the loan
will not be taxable receivable is its carrying amount

The tax base of a liability is

2.3.3 Tax base of a liability defined as:
x its carrying amount,
The definition of a tax base of a liability (see pop-up)
x less any amount that will be
refers to two types of liabilities: deductible for tax purposes
x liabilities that are income received in advance; and - in respect of that liability
x other liabilities (i.e. those that relate to expenses). - in future periods.
But if the L is income received in
Simply speaking, the definition means: advance, the tax base of this liability is:
x its carrying amount,
x if the liability is income received in advance: x less any of the revenue that will not be
the tax base will be its carrying amount less the portion taxable in future periods. IAS 12.8 Reworded
WKDWZRQ¶WEHtaxable in the future
(i.e. the tax base is the portion that will be taxed in the future);
x in the case of any other liability:
the tax base will be its carrying amount less any portion that represents future tax deductions
(i.e. the tax base is the portion that will not be allowed as a tax deduction in the future).

This can be represented as follows:

Tax base of a liability

Amount of revenue
that is
income received
= Carrying amount - that will not be
taxable in future
in advance

Tax base of a liability

that is
not income received
= Carrying amount - Future tax deductions
in advance

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2.3.4 Deferred tax is calculated using tax bases and carrying amounts

As can be seen from the above:

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 (SOFP) will give us our deferred tax journal adjustment (SOCI).

This can be show diagrammatically as follows:

A/L Carrying amount: Temporary difference (opening balance) A/L Tax base:
Temporary difference x 30% =
Opening balance Deferred tax (opening balance) Opening balance

Movement:

DT journal
adjustment

A/L Carrying amount: Temporary difference (closing balance) A/L Tax base:
Temporary difference x 30% =
Closing balance Deferred tax (closing balance) Closing balance

A useful format for calculating deferred tax (DT) using the balance sheet approach is as follows:
Deferred tax table Carrying Tax Temporary Deferred Details re the
amount base difference taxation DT bal/ adjust
(CA) (TB) (TD) (DT)
(per SOFP) (per IAS 12)
(a) (b) (b ± a) TD x 30%
Opening balances xxx xxx xxx xxx DT A/L
Dr DT A/L
Movement: DT adjustment xxx xxx xxx xxx Cr TE
Or vice versa
Closing balances xxx xxx xxx xxx DT A/L

Abbreviations: TE = tax expense DT A/L = deferred tax asset or liability

Note: When using this deferred tax table there are no rules as to how to use brackets. However, in this textbook,
an asset balance (or debit) is always shown without brackets and a liability balance (or credit) is always in brackets.
Also, the temporary difference (TD) is always FDOFXODWHGDVµWD[EDVH± caUU\LQJDPRXQW¶ QRWvice versa). If the TD is
positive, it means it is a deductible TD, leading to a deferred tax asset balance. Conversely, if the TD is negative, it
means it is a taxable TD, leading to a deferred tax liability balance. Although it is important to be able to explain if the
outcome is that we have a deductible TD and thus a deferred tax asset, or a taxable TD and thus a deferred tax
liability, by being consistent with brackets, we can quickly and easily identify these outcomes.

All the above principles are best explained by way of an example.

Example 4B-D: Income received in advance (balance sheet approach)

The following information is the same as example 4A, repeated below for your convenience:
x An entity receives rent of C120 000 in 20X1 that will only be earned in 20X2. The entity has no
other income or receipts in either year.
x The tax authority taxes income on the earlier of receipt or earning. The income tax rate is 30%.
x There are no other transactions affecting any of the related accounts.
Required: Please note: Part A can be found under section 2.2
B. Calculate the deferred income tax adjustment using the balance sheet approach for both years.
C. Show the current and deferred tax journals.
D. Disclose the above information in as much detail as possible for the year ended 31 December 20X2.

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Solution 4B: Income received in advance (balance sheet approach)

Comment:
x Calculating deferred tax using the balance sheet approach (see W1) involves comparing:
- WKHDFFRXQWDQW¶Vcarrying amount of an asset or liability (per the SOFP); and
- the equivalent balance from the perspective of a tax authority, which we call the tax base.
x 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 Carrying Tax Temporary Deferred Details

advance: IRIA (L) amount (1) Base (2) difference (3) Tax (4) DT bal/adj
Opening balance ± 20X1 0 0 0 0
Dr DT
Movement (balancing) ± 20X1 (120 000) 0 120 000 36 000 Cr TE (5)
Closing balance ± 20X1 (120 000) 0 120 000 36 000 Asset (4)
Cr DT
Movement (balancing) ± 20X2 120 000 0 (120 000) (36 000) Dr TE (5)
Closing balance ± 20X2 0 0 0 0 (4)

1) CA end 20X1: During 20X1, rent of C120 000 is received before it is earned. Thus, the accountant does
not recognise the receipt of an income but, instead, recognises it as a liability: IRIA. Thus, at the end of 20X1, the
accountant has an IRIA liability with a carrying amount of C120 000.
2) CA end 20X2: The IRIA OLDELOLW\¶V carrying amount is zero since the income was earned in 20X2 thus the
balance on this liability account was reversed out to income (Dr IRIA liability and Cr income).
3) TB end 20X1 & end 20X2: The tax authority treats the receipt as income in 20X1, when it is received (the rent is
taxed on the earlier of receipt or earning). Visualising DQµLPDJLQDU\WD[OHGJHU¶WKHWD[DXWKRULW\debits bank and
credits income, thus not recording an IRIA liability. Thus, the IRIA liability tax base is nil in 20X1 & 20X2. The tax
base can also be calculated using the relevant µWD[EDVHRIDOLDELOLW\¶definition (see W2).
4) TD end 20X1: Since the IRIA OLDELOLW\¶V carrying amount (CA) and tax base (TB) differ at the end of
20X1, there is a temporary difference (TD) at the end of 20X1, of 120 000.
/HW¶V WU\ WR XQGHUVWDQG WKLV TD: the IRIA CA UHIOHFWV µfuture income¶  000) and its TB reflects the
µportion of the future income that will be taxed in the future¶ QLO . This means the resultant TD equals the
µportion of the future income that will not be taxed in the future¶.
Thus, the TD of 120 000 is income that will not be taxed in the future, because it has already been taxed.
This means when we earn this income in the future, we will need to deduct it from the accounting profit to
calculate taxable profit. Thus, we call it a deductible TD.
TD end 20X2: The CA and TB of the IRIA liability are now both nil, and thus the TD is now nil (there is no
difference now since both the accountant and tax authority have recognised the receipt as income.
5) DT end 20X1: Since, at the end of 20X1, we have a deductible temporary difference of C120 000, it means we
have a future tax saving of C36 000 (i.e. when we recognise the rent as income in 20X2, we ZRQ¶WEHFKDUJHG
tax on it, because we were charged tax on it in 20X1). The future tax saving is an asset to the entity and is thus
recognised as a deferred tax asset (DTA) balance, similar to a tax tKDWKDVEHHQµSUHSDLG¶
DT end 20X2: At the end of 20X2, the temporary difference is nil. This means the deferred tax asset must be nil.
6) DT adjustment in 20X1: To get the DTA opening balance of nil to be a closing balance of C36 000.
DT adjustment in 20X2: To get the DTA opening balance of C36 000 to be a closing balance of nil.

W2. Tax base calculated using the definition of a TB of a L that is IRIA: 20X1 and 20X2

The TBs at the end of both 20X2 and 20X1 were nil (see W1). These can be calculated by applying
the definition of the ‘TB of a liability that is IRIA’: ‘the carrying amount of the liability less the portion
representing income that will not be taxable in future periods¶.

Tax base of a liability that is Amount of revenue that will

income received in advance
= Carrying amount - not be taxed in the future

TB: 20X1 = 120 000 - 120 000 Note 1 = 0

TB: 20X2 = 0 - 0 Note 2 = 0

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This tax base calculation can also be laid out as follows: 20X1 20X2
Carrying amount (income received in advance) 120 000 0
Less Portion that will not be taxed in the future (120 000) (0)
(20X1: 120 ZRQ¶WEHWD[HGLQIXWXUHEHFDXVHLWLVWD[HGLQ 20X1)
(20X2: Not applicable since there is no carrying amount to consider)
Tax base (Portion that will be taxed in the future) 0 0

Solution 4C: Income received in advance (journals)

20X1 Debit Credit
Income tax expense (P/L: E) 36 000
Current tax payable (L) 36 000
Current tax payable per tax law (see example 4A: W1)
Deferred tax asset (A) 36 000
Income tax expense (P/L: I) 36 000
Deferred tax adjustment (see example 4B: W1) – deferring the tax expense
20X2
We do not actually
Income tax expense (P/L: E) process nil journals ± 0
Current tax payable (L) this is just shown for 0
Current tax payable per tax law (see example 4A: W1) completeness sake

Income tax expense (P/L: E) 36 000

Deferred tax asset (L) 36 000
Deferred tax adjustment (see example 4B: W1) – recognising the tax expense

Solution 4D: Income received in advance (disclosure)

Comment: Notice the following:

x Deferred tax adjustments have no lasting effect on either µSURILWRUORVV¶RUµDVVHWVDQGOLDELOLWLHV¶
 Impact on tax expense (see Note 15): DT income (20X1): 36 000 ± DT expense (20X2): 36 000 = 0
 Impact on assets (see SOFP): there was a deferred tax asset in 20X1, but this balance was nil in 20X2
x The deferred tax asset (DTA) was caused by income received in advance (IRIA). Thus, while IRIA
exists, a DTA exists (20X1), but once IRIA reverses, the DTA reverses as well (20X2).

Entity name
Statement of financial position (extracts) 20X2 20X1
As at 31 December 20X2 Note C C
Non-current assets
Deferred tax asset 6 0 36 000
Current liabilities
Current tax payable 36 000 36 000
Income received in advance 0 120 000

Entity name
Statement of comprehensive income (extracts) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation 120 000 0
Income tax expense 15 (36 000) (0)
Profit for the year 84 000 0

Entity name
Notes to the financial statements (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
6. Deferred tax asset
The closing balance arose due to the effects of:
x Year-end accruals 0 36 000
15. Income tax expense
x Current 0 36 000
x Deferred 36 000 (36 000)
Income taxation per the statement of comprehensive income 36 000 0

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3. Deferred Tax Caused by Year-End Accruals and Provisions

3.1 Overview Year-end accrual balances:

x income received in advance;
There are five potential balances in the statement of
x expenses prepaid;
financial position that result directly from the use of the 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. 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 method.
Tax base of an asset – the
3.2 Expenses prepaid essence of the definition is:

An expense prepaid is an asset. The tax base of an asset is If the asset’s FEB are taxable the:
measured by applying the definition of the µtax base of an x TB = future tax deductions
asset¶ (see section 2.3.2, or the pop-up alongside). There If the asset’s FEB are not taxable, the
x TB = CA See IAS 12.7
are two versions of this definition ± one that applies if the
future economic benefits are taxable and another if the future economic benefits are not taxable.

In most cases the future economic benefits from an asset are taxable, in which case the tax base
will be the DVVHW¶VUHODWHG µfuture tax deductions¶

To calculate the µfuture tax deductions¶, we need to know how the tax authorities will treat this expense. If
the expense is not tax-deductible, it means there are no tax deductions at all and thus the tax base is
nil. However, if it is tax-deductible, we need to know when the tax deduction would be granted:

x Generally, tax authorities calculate taxable profits by deducting from income the tax-deductible
expenses when they have been incurred.

If this tax law applies, the tax authorities will not allow the deduction of the actual payment of a
tax-deductible expense if it is prepayment (i.e. since a prepayment means it is not yet incurred).
Instead, the tax authorities will only allow this deduction in the future, when it is incurred.

Thus, in terms of the definition of the tax base of an asset, a prepaid tax-deductible expense of
C100 in year 1 will have a tax base of C100, reflecting that we have a future deduction of C100.
Thus, the tax base is the same as the expense prepaid DVVHW¶Vcarrying amount.
Another way of determining the tax base, without using the definition of the tax base of an
asset, is to think about it DVVLPSO\EHLQJWKHWD[DXWKRULW\¶VHTXivalent of WKHDVVHW¶V carrying
amount. In other words, imagine the tax authority creates a ledger for us based on tax
legislation (an µLPDJLQDU\WD[OHGJHU¶). NowOHW¶VFRQVLGHU how the tax authority would record
the payment: since this expense is deductible only when it is incurred, the tax authority will not
yet recognise the payment as an expense (since it is not yet incurred) but as an expense
prepaid asset instead (i.e. Debit Expense prepaid; Credit Bank). Thus, the expense prepaid
asset has a tax base of C100.

Since the carrying amount and tax base are equal, the temporary difference and related
deferred tax is nil.

x Sometimes, the tax authorities allow the deduction of a payment when the payment is made,
even though the payment is made before the tax-deductible expense is incurred.

In this case, in the year the payment is made, the accountant will, as usual, recognise the
payment as an asset (expense prepaid) but the tax authorities will recognise it as a tax-
deduction (i.e. the tax authority will deduct the payment when calculating our taxable profits).

Thus, a prepaid tax-deductible expense of C100 in year 1 will be presented as an asset with a
carrying amount of C100, but it will have a tax base of nil, reflecting that we are expecting
future deductions of nil, because we had already been granted the deduction in year 1.

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The other way of looking at the tax base, by thinking about the LPDJLQDU\ WD[ OHGJHU¶, is to
consider how much the tax authority would have debited to the asset account: if the expense is
deducted when it is paid, instead of when incurred, the tax authority would debit an expense in
year 1 (because it was paid in year 1), not an expense prepaid asset (i.e. the tax authority would
not have an asset), thus the tax base of the expense prepaid asset would be nil.

Since an expense prepaid asset has a carrying amount (of C100) and a tax base (of nil) that differ, a
temporary difference and related deferred tax arise:

x The temporary difference (CA ± TB) equals future taxable profits:

Future income (CA: 100) ± Future deductions (TB: 0) = Future taxable profits (TD: 100)

x SLQFH WKH WHPSRUDU\ GLIIHUHQFH UHIOHFWV µfuture taxable profits¶ it is a taxable temporary
difference, which thus results in the recognition of a deferred tax liability (future tax: 30).

Example 5: Expenses prepaid

Profit before tax is C20 000 in 20X1 and in 20X2, according to both the accountant and the tax
authority, but before taking into account the following information:
x An amount of C8 000 in respect of electricity for January 20X2 is prepaid in December 20X1.
x The tax authority allows the full payment as a deduction against taxable profits in 20X1.
No payments were made to the tax authority in either year (amount owing at end 20X0: nil).
There are no other temporary or permanent differences and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred tax (i.e. the DT balance and DT adjustments) for 20X1 and 20X2.
B. Calculate the current tax for 20X1 and 20X2.
C. Show the related ledger accounts.
D. Disclose the above information in as much detail as possible for the 20X2 financial year.

Solution 5A: Expenses prepaid (deferred tax ± balance sheet approach)

Comment: When using the balance sheet approach,
x We calculate the deferred tax balance by comparing the carrying amount and tax base to calculate the temporary
difference, which we then multiply by the appropriate tax rate.
x We then calculate the deferred tax adjustment by comparing the deferred tax closing balance, with the deferred
tax opening balance.

W1. Deferred income tax (balance sheet approach):

Expenses Carrying Tax Temporary Deferred Details re DT
prepaid amount base difference tax balance /
(a) (b) (b ± a) (TD x 30%) adjustment
Opening balance: 20X1 0 0 0 0
Cr DT;
Movement (balancing) ± 20X1 8 000 0 (8 000) (2 400) Dr TE (Jnl 3)
Closing balance: 20X1 8 000 0 (8 000) (2 400) Liability
Dr DT;
Movement (balancing) ± 20X2 (8 000) 0 8 000 2 400 Cr TE (Jnl 6)
Closing balance: 20X2 0 0 0 0

x Carrying amounts (CA):

The accountant recognises a payment of C8 PDGHLQ;DVDQµH[SHQVHSUHSDLG¶ WKXVWKLVDVVHWKDVD
carrying amount of C8 000 at the end RI; 7KLVµH[SHQVHSUHSDLG¶DVVHWLs reversed in 20X2 when it is
recognised as an expense (thus WKLVDVVHW¶VFDUU\LQJDPRXQWLVQLODWthe end of 20X2).
x Tax base (TB):
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 autKRULW\¶V HTXLYDOHQW RI D FDUU\Lng amount: the payment is tax-deductible in 20X1 and thus, in the tax
DXWKRULWLHV¶YLHZLWLVDQH[SHQVHDQGQRWDQDVVHWDWDOOWKXVWKHWD[EDVHLVQLODWWKHHQG of 20X1 & 20X2.

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x Temporary difference (TD):

End of 20X1: Since the DVVHW¶V 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.
Since the temporary difference reflectVµIXWXUHWD[DEOHSURILWV¶it is a taxable temporary difference,
which thus results in the recognition of a deferred tax liability (future tax).
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.

W2. Tax base (expenses prepaid ± an asset):

The tax base at the end of both 20X2 and 20X1 were nil (see W1). These can be calculated by applying the
definition of the ‘tax base of an asset, where the future benefits will be taxable’ (per IAS 12):
µthe amount that will be deductible for tax purposes against any taxable economic benefits that will
flow to the entity when it recovers the carrying amount of the asset¶.
The definition can be depicted using the following formula:

Tax base of an asset whose economic benefits

will be taxable
= Future tax deductions

TB in 20X1 & 20X2 = 0

This calculation can also be laid out as follows:

20X1 20X2
Carrying amount (expense prepaid) 8 000 0
Less Portion that will not be tax-deductible in the future (1) (8 000) (2) 0
Tax base (Portion that will be tax-deductible in the future) 0 0

Notes (explaining the above TB calculation):

1) 20X1: The C8 000 will not be deducted in the future since it is all deducted in 20X1 (the first year).
2) 20X2: Not applicable since there is no expense prepaid carrying amount to consider.

Solution 5B: Expenses prepaid (current tax)

Comments:
x 20X1: The accountant recognises the payment of C8 000 as a prepaid expense, which is an asset, not an
expense, thus profit before tax is C20 000 (profit 20 000 ± expense 0). But, the tax authority allows the
payment as a deduction in 20X1, thus taxable profit is C12 000 (profit 20 000 ± deduction 8 000). Thus, to
convert profit before tax into taxable profits, we must deduct the payment (i.e. our expense prepaid closing
balance).
x 20X2: The accountant recognises the C8 000 as an expense in 20X2 since this is when it is incurred,
thus profit before tax is C12 000 (profit 20 000 ± expense 8 000). But, the tax authority, having already
allowed the C8 000 as a deduction in 20X1, does not deduct it in 20X2, thus taxable profit is C20 000
(profit 20 000 ± deduction 0). Thus, to convert profit before tax into taxable profit, we reverse (add back)
our expense (i.e. we add our expense prepaid opening balance).

W3. Current income tax 20X1 20X2

Profits Tax at 30% Profits Tax at 30%
Profit before tax (accounting profits) 20 000 12 000
Permanent differences 0 0
Taxable accounting profits and tax expense 20 000 6 000 12 000 3 600
Movement in temporary differences and deferred tax adj. (8 000) (2 400) 8 000 2 400
x Add expense prepaid (o/bal): deducted in 20X1 0 8 000
x Less expense prepaid (c/bal): deductible in 20X1 (8 000) (0)

Taxable profits and current tax expense 12 000 3 600 20 000 6 000

Notice: This calculation not only shows the current tax charge to be journalised, but also the deferred tax
adjustment (and the total tax expense for each year).

290 Chapter 6
Gripping GAAP Taxation: deferred taxation

Solution 5C: Expenses prepaid (ledger accounts)

Comment:
x Over the two years, the total tax expense incurred equals the total current tax charged:
 According to the accountant: total tax expense incurred is C9 600 (20X1: 6 000 + 20X2: 3 600); and
 According to the tax authority: total current tax charged is C9 600 (20X1: 3 600 + 20X2: 6 000).
x Since there is no difference between the total tax expense incurred and total current tax charged over
the 2-year period, the deferred tax balance reflects nil at the end of 20X2.
Ledger accounts: 20X1
Bank (A) Expenses prepaid (A)
Exp prepaid(1) 8 000 Bank (1) 8 000

Income tax expense (E) Current tax payable (L)

CTP (2) 3 600 Inc tax exp (2) 3 600
DTL (3) 2 400 Profit or loss 6 000
6 000 6 000

Deferred tax liability (L)

Inc tax exp (3) 2 400

Ledger accounts: 20X2

Electricity (E) Expenses prepaid (A)
Exp prepaid (4) 8 000 Balance b/d 8 000 Electricity (4) 8 000
Profit or loss 8 000 Balance c/f 0
8 000 8 000 8 000 8 000
Balance b/d 0

Income tax expense (E) Current tax payable (L)

CTP (5) 6 000 DTL (6) 2 400 Balance b/d 3 600
Profit or loss 3 600 Balance c/d 9 600 Inc tax exp (5) 6 000
6 000 6 000 9 600 9 600
Balance b/d 9 600

Deferred tax liability (L)

Balance b/d 2 400
Inc tax exp (6) 2 400
2 400 2 400
Balance b/d 0

Notes (describing the journals that are posted in the ledger):

1) 20X1: Electricity paid in 20X1 (C8 000) is an asset (expense prepaid) since the expense is not yet incurred.
2) 20X1: Current tax charged by the tax authority (C3 600; solution 5B): Dr Tax expense & Cr Current tax payable.
3) 20X1: Deferred tax adjustment: To recognise a deferred tax liability balance of C2 400 (solution 5A/ W1), we
must SURFHVVDµGHIHUUHGWD[DGMXVWPHQW¶Credit Deferred tax liability and Debit Tax expense.
Notice: By debiting tax expense, we increase it by C2 400 (to C6 000). Using the income statement method:
we need to increase the tax expense because we believe the current tax charge of C3 600 in 20X1 is too
small (i.e. the tax that matches our 20X1 taxable accounting profits is C6 000 ± see solution 5B/ W3).
4) 20X2: Reverse the expense prepaid opening balance: The expense is incurred in 20X2, so the expense
prepaid (asset) is reversed out to the expense. The expense prepaid asset now has a nil carrying amount.
5) 20X2: Current tax charged by the tax authority (C6 000; solution 5B): Dr Tax expense & Cr Current tax payable.
6) 20X2: Deferred tax adjustment in 20X2: To change the deferred tax liability opening balance of C2 400 to a
closing balance of nil at the end of 20X2 (see solution 5A/ W1), ZH SURFHVV DQRWKHU µGHIHUUHd tax
DGMXVWPHQW¶Debit Deferred tax liability, Credit Tax expense. The deferred tax liability balance is now nil.
Notice: By crediting tax expense, we decrease it by C2 400 (to C3 600). Using the income statement method:
we need to decrease the tax expense because we believe the current tax charge of C6 000 in 20X2 was too
big (i.e. the tax that matches our 20X2 taxable accounting profits is only C3 600 ± see solution 5B/ W3).

Chapter 6 291
Gripping GAAP Taxation: deferred taxation

Solution 5D: Expenses prepaid (disclosure)

Comment:
x Notice that deferred tax has no lasting impact on µDVVHWVDQGOLDELOLWLHV¶RU µSURILWRUORVV¶
 Impact on liabilities (see SOFP): there was a deferred tax liability in 20X1, but this reversed to nil in 20X2.
 Impact on tax expense (see Note 15): DT expense (20X1): 2 400 ± DT income (20X2): 2 400 = 0
x The DT liability balance at end 20X1 is C2 400, being 30% of the expense prepaid balance at end 20X1 ± thus,
when the expense prepaid balance reverses in 20X2, so will the DT liability.

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Current assets
Expense prepaid 0 8 000
Non-current liabilities
Deferred tax liability 6 0 2 400
Current liabilities
Current tax payable 9 600 3 600

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C

Profit before taxation 20X2: 20 000 ± 8 000 12 000 20 000

Income tax expense 15 (3 600) (6 000)
Profit for the year 8 400 14 000

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
6. Deferred tax asset/ (liability)
The closing balance is constituted by the effects of:
x Year-end accruals 0 (2 400)
15. Income tax expense
x Current 6 000 3 600
x Deferred (2 400) 2 400
Tax expense per the statement of comprehensive income 3 600 6 000

3.3 Expenses payable Tax base of a liability – the

essence of the definition is:
An expense payable is a liability (an expense that has been See IAS 12.8

incurred but not paid) and thus, when we measure its tax base, If the L represents expenses:
we apply the deILQLWLRQRIWKHµWD[EDVHRIDOLDELOLW\¶ VHHsection x TB = CA – Future tax deductions
2.3.3, or the pop-up alongside). This is an example of a liability If the L represents income in advance:
that reflects expenses (as opposed to a liability that represents x TB = CA – Portion not taxable in future

income in advance).

The tax base RIDQH[SHQVHSD\DEOHLVµcarrying amount ± IXWXUHWD[GHGXFWLRQV¶DQGWKXVZHQHHG to

know ZKDWWKHµfuture tax deductions¶ will be.
x In this regard, the tax authority generally allows tax-deductible expenses to be deducted when they
have been incurred irrespective of whether the amount incurred has been paid.
If this tax law applies, the tax authorities will treat the expense as a tax-deduction now, before it is
paid (on the basis that it has been incurred). This means the µIXWXUHWD[GHGXFWLRQV¶ will be nil.
If we then apply tKHGHILQLWLRQRIWKHµWD[EDVHRIDOLDELOLW\¶ 7% &$± Future deductions), it means
WKHSD\DEOH¶s tax base will equal its carrying amount (TB = CA ± Future deductions: nil = CA).
For example: A tax-deductible expense payable with a carrying amount of C100 at the end of year
1 will have a tax base of C100 (TB = CA: 100 ± Future deductions: 0 = 100).

292 Chapter 6
Gripping GAAP Taxation: deferred taxation

The other way of looking at the tax base, by thinking about an LPDJLQDU\WD[OHGJHU¶, is that,
because the tax authority allows the expense to be deducted in year 1, the tax authority would
debit an expense in year 1. Since this expense has not been paid, the tax authority would credit
expense payable. Thus, the tax authority records the transaction in the same way the accountant
GRHV7KXVWKHSD\DEOH¶Vtax base equals its carrying amount.
Since the carrying amount and tax base are equal (in the example above, the CA and TB are
both C100), the temporary difference and related deferred tax is nil.
x Sometimes the tax authority does not allow the expense to be deducted until it is paid.
In this case we would be expecting µfuture tax deductions¶. These future deductions will result in
the tax base being nil (TB = CA ± Future deductions).
For example: If we have a tax-deductible expense of C100 that we have not yet paid, and which
the tax authorities will only allow as a deduction in the future (when it is paid), then we have µfuture
tax deductions¶RI C100. Thus, our expense payable, which has a carrying amount of C100, will
have a tax base of nil (TB = CA 100 ± Future deductions 100).
Since the expense payable has a carrying amount of C100 and a tax base of nil, there will be a
temporary difference of C100 (TB = CA: 100 ± TB: nil). This would be a deductible temporary
difference (since it reflects a future tax deduction) and would thus result in a deferred tax asset
(since it reflects a future tax saving).

Example 6: Expenses payable

Profit before tax is C20 000 in 20X1 and in 20X2, according to the accountant and the tax
authority, but before taking into account the following information:
x A telephone expense of C4 000, incurred in 20X1, is paid in 20X2.
x The tax authority will allow the expense to be deducted in 20X1 (i.e. when it is incurred).
No payments were made to the tax authority in either year (amount owing at end 20X0: nil).
There are no other temporary or permanent differences 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 ledger accounts.
D. Disclose the above information in as much detail as possible 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 authority µUHFRJQLVH¶the C4 000 cost as an expense/ deduction in 20X1 and
since it remains unpaid at year-end, WKHSD\DEOH¶VCA and TB at the end of 20X1 is C4 000.
x After the cost is paid in 20X2, the expense payable CA and TB reverse to nil.
x Since there is no temporary difference at any stage, there is also no deferred tax.

W1. Deferred income tax (balance sheet approach):

Carrying Tax Temporary Deferred Details re DT
Expenses payable amount base difference tax balance /
(a) (b) (b) ± (a) (TD x 30%) 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):

The tax base at the end of 20X1 was C4 000, but at the end of 20X2, it was nil (see W1). These can be
calculated by applying the definition of the ‘tax base of a liability that is not income received in advance’,
which is µits carrying amount less any amount that will be deductible for tax purposes in respect of that
liability in future periods¶. IAS 12.8 Reworded

Chapter 6 293
Gripping GAAP Taxation: deferred taxation

Tax base of a
liability that is not
income received
= Carrying amount - Future deductions
in advance

TB in 20X1 = 4 000 - 0 (1) = 4 000

TB in 20X2 = 0 - 0 (1) = 0

This tax base calculation can also be laid out as follows: 20X1 20X2

Carrying amount (expense payable) 4 000 0

Less portion that is deductible in the future 0 (1) 0 (1)

Tax base SRUWLRQWKDWZRQ¶WEH deducted in the future) 4 000 0

Notes (explaining the above TB calculation):

1) 20X1 & 20X2: The reason why the future tax deductions are nil, at the end of both 20X1 and 20X2,
is because the entire expense payable had been deducted in 20X1 itself.

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)
Permanent differences 0 0
Taxable accounting profits & tax expense 16 000 4 800 20 000 6 000
Movement in temporary differences & deferred tax adj. 0 0 0 0
Taxable profits & current tax expense 16 000 4 800 20 000 6 000

Notice:
This calculation not only shows the current tax charge to be journalised, but also the deferred tax
adjustment (and the total tax expense for each year).

Solution 6C: Expenses payable (ledger accounts)

Ledger accounts - 20X1

Telephone (E) Expenses payable (L)

Exp payable (1) 4 000 Telephone (1) 4 000

Income tax expense (E) Current tax payable (L)

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/d 4 000

Income tax (E) Current tax payable (L)

CTP (5) (6) 6 000 Balance b/d 4 800
Balance c/f 10 800 Inc tax exp (5) 6 000
10 800 10 800
Balance b/d 10 800

294 Chapter 6
Gripping GAAP Taxation: deferred taxation

Notes (explaining amounts in the ledger accounts):

1) 20X1: Expense incurred: The telephone expense is incurred but not paid: Debit Telephone expense &
Credit Telephone payable
2) 20X1: Current tax charged by the tax authority (4 800 ± solution 6B): Dr Tax expense & Cr Current tax payable
3) 20X1: Deferred tax adjustment: not applicable. Since the accountant and tax authority both treat the expense
in the same way, tKHSD\DEOH¶VCA and TB are the same (see solution 6A/ W1). From an income statement
approach, the taxable accounting profits and taxable profits are also the same (see solution 6B).
4) 20X2: Expense paid: The expense is paid in 20X2, which results in the reversal of the expense
payable account: Debit Telephone payable and Credit Bank
5) 20X2: Current tax charged by the tax authority (6 000; solution 6B): Dr Tax expense & Cr Current tax payable
6) 20X2: Deferred tax adjustment: not applicable. See note 3 above for the explanation.

Solution 6D: Expenses payable (disclosure)

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Current liabilities
Expense payable 0 4 000
Current tax payable 10 800 4 800

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation 20X1: 20 000 ± 4 000 20 000 16 000
Income tax expense 5 (6 000) (4 800)
Profit for the year 14 000 11 200

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current 6 000 4 800
x Deferred 0 0
Income tax expense per the statement of comprehensive income 6 000 4 800

Tax base of a liability – the

3.4 Provisions essence of the definition is:
See IAS 12.8
A provision is a liability (an expense that has been incurred
If the L represents expenses:
but not paid) and thus to measure its tax base, we apply the
x TB = CA – Future tax deductions
definition of the µtax base of a liability¶ (see section 2.3.3, or
If the L represents income in advance:
the pop-up alongside). x TB = CA – Portion not taxable in future
A provision is a liability that relates to expenses (as opposed to
a liability that is income in advance). Thus, to calculate the tax base, we need to know its future tax
deductions (TB = CA ± Future deductions).

The tax base RIDQH[SHQVHSD\DEOHLVµFDUU\Lng amount ± future tax deductiRQV¶DQGWKXVZHQHHGWR

NQRZZKDWWKHµfuture tax deductions¶ZLOOEH
x µ3rovisions¶ and µexpenses payable¶ may sound similar, but there is a distinct difference: a
provision is a liability of uncertain timing or amount (see chapter 18) and this uncertainty generally
affects when the tax authorities will allow the related expense to be deducted.
x Thus, although tax authorities generally treat expenses as being tax-deductible when they
have been incurred, if the expense relates to a provision (debit expense and credit provision) it
means it involves a high level of uncertainty, and thus the tax authority treats the expense with
PRUH µVXVSLFLRQ¶. This means the tax authority will generally postpone allowing the tax
deduction of this expense until it is paid (i.e. the tax deduction will only be allowed in the future).

Chapter 6 295
Gripping GAAP Taxation: deferred taxation

x If this happens, a temporary difference will arise because the provision will have a carrying amount
but a tax base of nil:
Using the µtax base of a liability¶ definition (TB = CA ± Future tax deductions), the tax base will be nil
because the entire carrying amount represents a future tax-deduction.
For example, if we have a provision with a carrying amount of C100, which the tax authorities will
only allow as a tax-deduction in the future, it means we expect µfuture tax deductions¶ of C100, and
thus the tax base will be nil (TB = CA: 100 ± Future tax deductions: 100 = 0).
The other way of calculating the tax base is by using an µLPDJLQDU\ WD[ OHGJHU¶: since the tax
authority delays allowing the expense as a tax-deduction, it means he effectively does not yet
recognise the transaction at all (i.e. he would not process a journal at all). Thus, this liability has a
tax base of nil.
x In other words, we have deferred tax because, from a balance sheet approach, there is 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 tax deduction will only be allowed when it is paid).
x The temporary difference that arises (CA ± TB) is a deductible temporary difference (because
we are expecting a future tax deduction when the amount we have recognised is eventually paid).
x Since we have a deductible temporary difference, it means we will recognise a deferred tax asset.
This deferred tax asset reflects a future tax saving (future taxable profits will be reduced when the
related expense is eventually allowed as tax-deduction).

When our provision is reversed, our related deferred tax asset will also be reversed: the provision will be
derecognised when the amount is paid (CA: nil), which is also when we will get the tax-deduction (TB =
CA: 0 ± Future deductions: 0 = nil) and thus the expected tax saving is realised (DT asset: nil).

Example 7: Provisions
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 A provision for warranty costs of C4 000 is recognised in 20X1 and paid in 20X2.
x The tax authority will allow the warranty costs to be deducted only once they are paid.
No payments were made to the tax authority in either year (amount owing at end 20X0: nil).
There are no other temporary or permanent differences and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the related ledger accounts.
D. Disclose the above information in as much detail as possible for the 20X2 financial year.

Solution 7A: Provisions (deferred tax)

W1. Deferred income tax (balance sheet approach)

Provision: Carrying Tax Temporary Deferred Details re DT
warranty cost amount base difference tax balance /
(a) (b) (b) ± (a) (TD x 30%) adjustment
Opening balance ± 20X1 0 0 0 0
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
x Carrying amounts: The accountant recognises an expense and provision in 20X1 of C4 000.
7KLVµSURYLVLRQ¶OLDELOLW\LVUHYHUVHGLQ;ZKHQLWLs paid WKXVWKLVOLDELOLW\¶VCA is nil at the end of 20X2).
x Tax base: The TB is calculated in terms of IAS 12 (see W2). However, we can also think of it as the tax
DXWKRULW\¶VHTXLYDOHQWRIDFDUU\LQJDPRXQWWKHH[SHQVHLVQRWWD[-deductible in 20X1 and thus, in the tax
DXWKRULWLHV¶ view, there is no transaction at all. Thus, the tax base is nil at the end of both 20X1 & 20X2.
x Temporary difference: The deductible temporary difference at end 20X1 shows the expected tax deduction
of C4 000 (i.e. we will only get the deduction when we pay the amount of the warranty cost).
x Deferred tax: The deferred tax asset at end 20X1 shows that we expect a future tax saving of C1 200.

296 Chapter 6
Gripping GAAP Taxation: deferred taxation

W2. Tax base (provisions ± a liability)

The tax base at the end of both 20X1 and 20X2 is nil (see W1). These can be calculated by applying the
definition of the ‘tax base of a liability that is not income received in advance’, which is:
µLWVFDUU\LQJ DPRXQW OHVV DQ\ DPRXQWWKDWZLOO EH GHGXFWLEOH IRUWD[ SXUSRVHV LQ UHVSHFW RI WKDW
liabiOLW\LQIXWXUHSHULRGV¶. IAS 12.8 Reworded

Tax base of a
liability that is not
income received
= Carrying amount - Future deductions
in advance

TB in 20X1 = 4 000 - 4 000 (1)

= 0

TB in 20X2 = 0 - 0 (2)
= 0

This calculation can also be laid out as follows: 20X1 20X2

Carrying amount (provision) 4 000 0
Less Portion that will deductible in the future (4 000) (1) 0 (2)

Tax base (PRUWLRQWKDWZRQ¶WEHGHGXFWHGLQWKHIXWXUH 0 0

Notes (explaining the above TB calculation):

1) 20X1: Since the liability is a provision, the related expense will only be deducted in the future, when paid
EHFDXVHSURYLVLRQVDUHWUHDWHGZLWKµVXVSLFLRQ¶ . Thus, the entire CA of C4 000 reflects a future tax deduction.
2) 20X2: The amount provided for in 20X1 is paid during 20X2. Since it is paid in 20X2, the tax deduction is granted
in 20X2. Thus, at the end of 20X2, we no longer have any µfuture tax deductions¶.

Solution 7B: Provisions (current tax)

Comments:
x 20X1: The accountant recognises the C4 000 as an expense, thus profit before tax is C16 000 (profit
20 000 ± expense: 4 000). But the tax authority does not yet deduct the expense of C4 000, thus
taxable profit is C20 000 (20 000 ± tax-deduction: 0). Thus, to convert ;¶V profit before tax into
taxable profits, we add back (reverse) the expense (i.e. add the provision closing balance).
x 20X2: The accountant recognises (deducts) the C4 000 as an expense in 20X1 and thus has no expense in
20X2, thus profit before tax is C20 000 (20 000 ± expense: 0). However, the tax authority deducts the C4 000
in 20X2 (because it is now paid), thus taxable profit is C16 000 (20 000 ± tax-deduction: 4 000). Thus, to
convert ;¶V profit before tax into taxable profits, we must deduct the payment of C4 000 (i.e. deduct
the provision opening balance).
20X1 20X2
W3: Current income tax Profits Tax at 30% Profits Tax at 30%
Profit before tax (accounting profits) 16 000 20 000
(20 000 ± 4 000) and (20 000 ± 0)
Permanent differences (N/A) 0 0
Taxable accounting profits & tax expense 16 000 4 800 20 000 6 000
Movement in temporary differences & deferred tax adj. 4 000 1 200 (4 000) (1 200)
x Less provision opening balance (0) (4 000)
x Add provision closing balance 4 000 0
Taxable profits & current tax expense 20 000 6 000 16 000 4 800

Solution 7C: Provisions (ledger accounts)

Ledger accounts: 20X1
Warranty costs (E) Provision for warranty costs (L)
Provision (1) 4 000 Warranty cost (1) 4 000

Income tax expense (E) Current tax payable (L)

CTP (2) 6 000 DTA (3) 1 200 Inc tax exp(2) 6 000
Balance c/f 4 800
6 000 6 000 Deferred tax asset (A)
Balance b/d 4 800 Inc tax (3) 1 200

Chapter 6 297
Gripping GAAP Taxation: deferred taxation

Ledger accounts: 20X2

Bank Provision for warranty costs (L)
Provision (4) 4 000 Bank (4) 4 000 Balance b/d 4 000

Income tax (E) Current tax payable (L)

CTP (5) 4 800 Balance b/d 6 000
DTA (6) 1 200 Balance c/d 10 800 Inc tax (5) 4 800
Balance b/d 6 000 10 800 10 800
Balance b/d 10 800

Deferred tax asset (A)

Balance b/d 1 200 Inc tax (6) 1 200
Notes (explaining the amounts in the ledger accounts):
1) 20X1: Warranty costs incurred but not paid, estimated at C4 000: Dr Expense; Cr Provision
2) 20X1: Current tax charged by the tax authority (6 000; Solution 7B): Dr Tax expense Cr Current tax payable
3) 20X1: Deferred tax adjustment in 20X1: Create the DTA (Solution 7A/ W1): Dr DT Asset; Cr Tax expense
Notice: By crediting tax expense, we decrease it by C1 200 (to C4 800). Using an income statement approach,
we need to decrease the tax expense in 20X1 because the current tax charge of C6 000 is too big in 20X1 (i.e.
the tax that matches our 20X1 taxable accounting profits is C4 800 ± see solution 7B).
4) 20X2: Payment of warranty costs in 20X2 reduces the OLDELOLW\¶Vcarrying amount at the end of 20X2 to nil.
5) 20X2: Current tax charged by the tax authority (4 800; Solution 7B): Dr Tax expense Cr Current tax payable
6) 20X2: Deferred tax adjustment: Reverse the DTA (Solution 7A/ W1): Cr DT Asset; Dr Tax expense
Notice: By debiting the tax expense, we increase it by C1 200 (to C6 000). From an income statement
approach, we need to increase the tax expense in 20X2 because the 20X2 current tax charge of C4 800 is too
small (i.e. the tax that matches our 20X2 taxable accounting profits is C6 000 ± see solution 7B).

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).

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Non-current assets
Deferred tax asset 6 0 1 200
Current liabilities
Provision for warranty costs 0 4 000
Current tax payable 10 800 6 000

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation (20X1: 20 000 ± 4 000) 20 000 16 000
Income tax expense 15 (6 000) (4 800)
Profit for the year 14 000 11 200

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
6. Deferred tax asset/ (liability)
The closing balance is constituted by the effects of:
x Year-end accruals 0 1 200
15. Income tax expense
x Current 4 800 6 000
x Deferred 1 200 (1 200)
Tax expense per the statement of comprehensive income 6 000 4 800

298 Chapter 6
Gripping GAAP Taxation: deferred taxation

3.5 Income receivable Tax base of an asset –the

essence of the definition
Income receivable (income that has been earned but not yet is:
received) is an asset and thus, when we measure its tax If the asset’s FEB are taxable the:
base, we apply the definition of the µtax base of an asset¶ (see x TB = future deductions
section 2.3.2, or the pop-up alongside). If the asset’s FEB are not taxable, the
x TB = CA See IAS 12.7
If the future inflow that we are expecting is not taxable income (e.g. a dividend receivable
generally leads to the receipt of a dividend that is exempt from tax), then the tax base is simply the
asseW¶VFDUU\ing amount. In this case, there will thus be no temporary difference and no deferred tax.

However, if the future inflow that we are expecting is taxable income (e.g. interest receivable
relates to interest income; a trade receivable relates to sales income, rent receivable relates to rent
income etc), then the tax base is the assHW¶Vµfuture tax deductions¶. In this case, to calculate the
future deductions, we need to know when the tax authority will tax the income. In this regard, the
tax authority generally taxes income on the earlier of the date the income is earned or the date it is
received. The implications of this scenario are best explained by way of example.

For example: We have rent receivable of C100 at the end of 20X1. The rent income is taxable.
x The rent income, although not received, is taxed in 20X1 (because it is earned in 20X1 and
the tax authority is taxing this income on the earlier of the date received or earned).
x Since the receivable involves taxable income, the tax base is represented by WKH DVVHW¶V
µfuture tax deductions¶ This means the tax base is C100.
The future tax deductions are C100 because when we eventually receive the cash of C100,
in order to calculate taxable profits, the tax authorities will have to deduct C100 on the basis
that it has already been taxed in the past (in 20X1).
Taxable profit in the year it is received in cash (i.e. in the future) =
Receipt: 100 ± Deduction: portion of the receipt µalready taxed¶: 100 = 0
x Alternatively, the tax base can also be visualLVHGE\FRQVLGHULQJDQµLPDJLQDU\WD[OHGJHU¶.
Since the tax authority recognises the rent of C100 as taxable income in 20X1, he would µcredit
rent income¶, and since it had not been received, he would have to µdebit rent receivable¶.
Thus, the rent receivable would have a tax base of C100.
x Since the UHFHLYDEOH¶V FDUU\LQJ DPRXQW and tax base at end of 20X1 are both C100, the
temporary difference is nil and thus the deferred tax balance is nil.
x From an income statement approach, both the accountant and tax authority treat the rent
receivable as income in 20X1. Since there is no difference in the timing of the income
recognition, the accounting profit and taxable profit will be the same. This means the tax
expense and current tax will be the same. Since there are no differences, no deferred tax
adjustment is necessary.

Example 8: Income receivable

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 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.
No payments were made to the tax authority in either year (amount owing at end 20X0: nil).
There are no other items affecting the deferred tax balance.
There are no other temporary or permanent differences and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the related ledger accounts.
D. Disclose the above information in as much detail as possible for the 20X2 financial year..

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Gripping GAAP Taxation: deferred taxation

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 anGWD[DXWKRULWLHVµUHFRJQLVH¶WKH& 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.
W1. Deferred income tax (balance sheet approach):

Income receivable Carrying Tax Temporary Deferred Details re DT

amount base difference tax balance /
(a) (b) (b) ± (a) (TD x 30%) adjustment

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):

The tax base at the end of 20X1 (6 000) and 20X2 (nil) (see W1), can be calculated by applying the
definition of the ‘tax base of an asset, where the future benefits will be taxable’ (per IAS 12):
µthe amount that will be deductible for tax purposes against any taxable economic benefits that will
flow to the entity when it recovers the carrying amount of the DVVHW¶.
The definition can be depicted using the following formula:

Tax base of an asset

whose economic
benefits
= Future deductions

will be taxable

TB of asset in 20X1 = 6 000 (1)

TB of asset in 20X2 = 0 (2)

This calculation can also be laid out as follows: 20X1 20X2

Carrying amount (income receivable) 6 000 0
Less Portion that will be taxed in the future (0) (0)
Tax base (Portion already taxed and thus will be deducted in future) 6 000 (1) 0 (2)

Notes (explaining the amounts in W2):

1) At the end of 20X1, the future tax deduction is C6 000. This is because the income receivable at
the end of 20X1 (CA: 6 000) was taxed in 20X1. Thus, LWZRQ¶WEHWD[HGDJDLQLQWKHIXWXUe. Thus,
when we eventually receive the C6 000 cash, we will be given a deduction of C6 000:
TP in year of receipt = Receipt: 6 000 ± Deduction: portion of receipt already taxed: 6 000 = 0
Thus, at the end of 20X1, we are expecting a future tax deduction of C6 000.
2) At the end of 20X2, the income receivable no longer exists and thus there are no future tax deductions

Solution 8B: Income receivable (current tax)

Comments: Both the accountant and tax authority recognise the interest of C6 000 as income in 20X1 (when
earned). Thus, accounting profit and taxable profit are the same in both years.
20X1 20X2
Current income tax: Profits Tax at 30% Profits Tax at 30%
Profit before tax (accounting profits) 26 000 20 000
20X1: (20 000 + 6 000) and 20X2: (20 000 + 0)
Permanent differences 0 0
Taxable accounting profits and tax expense 26 000 7 800 20 000 6 000
Movement in temporary differences & deferred tax adj. 0 0 0 0
Taxable profits and current tax expense 26 000 7 800 20 000 6 000

300 Chapter 6
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Solution 8C: Income receivable (ledger accounts)

Ledger accounts ± 20X1

Income receivable (A) Interest income (I)
Int income (1) 6 000 Inc receivable (1) 6 000

Income tax expense (E) Current tax payable (L)

CTP (2) 7 800 Inc tax exp (2) 7 800
Ledger accounts ± 20X2
Income receivable (A) Bank (A)
Balance b/d 6 000 Bank (3) 6 000 Int receivable (3) 6 000 CTP (5) 7 800

Income tax expense (E) Current tax payable (L)

CTP (4) 6 000 Balance b/d 7 800
Inc tax exp (4) 6 000
Balance b/d 13 800

Notes (explaining amounts in the ledger accounts)::

1) 20X1: Interest earned in 20X1, but not yet received.
2) 20X1: Current tax charged for 20X1 (7 800 ± Solution 8B).
3) 20X2: Interest received, thus reversing the income receivable account to zero.
4) 20X2: Current tax charged for 20X2 (6 000 ± Solution 8B).

Solution 8D: Income receivable (disclosure)

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Current assets
Income receivable 0 6 000
Current liabilities
Current tax payable 13 800 7 800

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before taxation (20X1: 20 000 + 6 000) 20 000 26 000
Income tax expense 5 (6 000) (7 800)
Profit for the year 14 000 18 200

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current 6 000 7 800
x Deferred 0 0
Tax expense per the statement of comprehensive income 6 000 7 800

Another interesting type of receivable is a trade receivable, which is measured net of a loss
allowance (a trade receivable arises from sales income, where the sales are made on credit). How
we measure the deferred tax on this receivable is best explained by way of example.

Trade receivable example: We have a trade receivable at the end of 20X1 with a carrying amount
of C80 (Gross trade receivable account: C100 ± Loss allowance account: C20).
The related sales income is taxable when it is earned or received, whichever comes first. Thus, the
sales income of C100 is taxed in 20X1 (when it is earned).
However, since the impairment expense relating to the loss allowance has not yet been realised
(Debit Impairment expense and Credit Loss allowance), it is not yet tax deductible. The tax authority
will only allow the deduction of this impairment when the debt has µgone bad¶ (i.e. been realised).

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Gripping GAAP Taxation: deferred taxation

In other words, the impairment will be treated as µrealised¶ (i.e. an actual bad debt) when we have
received all the cash we will ever receive, and we find we have been short-paid.
x In this scenario, our carrying amount is C80, but the tax baseUHSUHVHQWHGE\RXUµIXWXUHWax
GHGXFWLRQV¶LV&
x 7KHUHDVRQWKDWRXUµfuture tax deductions¶ are C100 is because we are expecting to receive
cash of only C80, in full and final settlement of the debt of C100. This means that, when the
tax authority calculates the taxable profits in the year that we receive the C80, we will be
granted a total tax-deduction of C100, constituted by:
 A deduction of the entire receipt of C80, on the basis that it has already been taxed; plus
 A deduction for the bad debt of C20 (bad debts are allowed as a deduction when realised).
Thus, if we received C80 in settlement in 20X2, the taxable profit would be as follows:
Taxable profit 20X2 20X1
Income/ receipts 80 100
Less tax deductions (100) (0)
Portion of receipt already taxed (80)
Bad debt (20)

Taxable profit (20) 100

x The tax base could also be visualised by consideULQJDQµimaginary tax ledJHU¶. Since the tax
authority recognises the sales income in 20X1, he would credit sales income, and since it had
not been received, he would debit trade receivable. However, whereas the accountant would
then also recognise a loss allowance (Dr Impairment expense and Cr Loss allowance), the tax
authority does not recognise this transaction yet (he will only recognise this when this
estimated impairment is an actual bad debt). Thus, the trade receivable tax base is C100.
x Since, at the end of 20X1, the receivDEOH¶VFDUU\ing amount is C80, but its tax base is C100, we
have a deductible temporary difference of C20 and thus a deferred tax asset balance of C6.
x From an income statement approach, since the accountant recognises net income of C80 (sales
income: 100 ± impairment expense: 20) but the tax authority recognises the sales income of
C100 (i.e. with no expense), the profit before tax is less than taxable profit in 20X1 (i.e. there is a
difference in the timing of the expense). Thus we need a deferred tax adjustment.

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
x non-deductible for tax purposes.
Non-current assets can cause temporary differences and we
normally recognise deferred tax on all temporary differences ± This could affect whether deferred
tax is recognised.
but there is an exception. A temporary difference will be 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
as a tax expense in profit or loss (e.g. dr tax expense; cr deferred tax liability). However, if an asset is
measured at fair value under the revaluation model, the contra entry may be WKH µUHYDOXDWLRQ VXUSOXV¶
instead, thus recognized in other comprehensive income. Please see section 4.4 and chapter 8.

302 Chapter 6
Gripping GAAP Taxation: deferred taxation

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 settlHPHQW¶RIWKHXQGHUO\LQJDVVHWIAS 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, soPHWLPHV ZH ZLOO XVH PDQDJHPHQW¶V 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 DVVHW¶Vcarrying amount always starts off at cost and gradually reduces to nil by the
time its useful life has ended or it has been derecognised.

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Gripping GAAP Taxation: deferred taxation

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
DVµIXWXUe tax-GHGXFWLRQV¶LIWKHDVVHW¶V FRVWLVdeductible, 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 asset is expensed
(e.g. through depreciation) versus the rate at which the cost is deducted from taxable profits
(e.JWKURXJKDµZHDUDQGWHDU¶WD[GHGXFWLRQ may differ. 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
WKHUHZLOOEHGLIIHUHQFHVEHWZHHQWKHSODQW¶VFDUUying amount and tax base over its useful life.
Deductible NCAs
However, these differences are temporary differences
normally cause temporary
(and thus we recognise deferred tax) because eventually differences over time because:
the cost will have been fully expensed (e.g. through x the CA will reduce to zero and
depreciation) and fully deducted for tax purposes (e.g. x the TB will reduce to zero
through µZHDU DQG WHDU¶ deductions). Thus, from a balance x but the CA and TB will reduce by
sheet approach, the carrying amount and tax base will different amounts each year.
eventually both be nil. Similarly, from an income statement
approach, the total expenses and total tax-deductions over the life of the asset will be the same
(equalling the cost of the asset).

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).

This deferred tax balance will be nil when both the carrying amount and tax base are nil.

Example 9: Cost model: PPE:

x Deductible and
x Depreciable assets
Profit before tax is C20 000, according to the accountant and the tax authority, in each of the
years 20X1, 20X2 and 20X3, but 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.
No payments were made to the tax authority in any of the year (amount owing at end 20X0: nil).
There are no other temporary or permanent differences and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1, 20X2 and 20X3.
C. Show the related ledger accounts.
D. Disclose the above in as much detail as is possible for all three years.

Solution 9A: Deferred tax

Comment:
x If 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), the carrying amount and tax base will differ.
x If carrying amount and tax base differ, a temporary difference arises on which deferred tax must be
recognised. In this case, deductible temporary differences arise and thus a DT asset is recognised.

304 Chapter 6
Gripping GAAP Taxation: deferred taxation

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):
 20X1: Future benefits (CA) ± Future tax deductions (TB) = 15 000 ± 20 000 = 5 000 (net deduction)
 20X2: Future benefits (CA) ± Future tax deductions (TB) = 0 ± 10 000 = 10 000 (net deduction)
x Since net future deductions are expected (a deductible temporary difference), it means we expect
future tax savings, which must be recognised as a deferred tax asset. For example, at the end of 20X1,
we expect net future tax deductions of C5 000 and thus we expect future tax savings of C1 500.
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). Thus, both accountant and tax authority eventually write-RIIWKHSODQW¶VFRVW
x This example involves the cost model and thus WKHDVVHW¶VFDUU\LQJDPRXQWcannot possibly exceed cost
(if we use the revaluation model, the carrying amount could exceed cost, in which case we may need to
calculate the deferred tax slightly differently if the tax legislation exempts capital gains and management
intends to sell). Anyway, since we are using the cost model, we can ignore management intentions and
simply apply the tax rate to the temporary difference. In case you are interested, the following proves
management intentions have no effect when the cost model is used:
 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%.
W1. Deferred income tax (balance sheet approach):
Plant: x Depreciable Carrying Tax Temporary Deferred Details re DT bal /
x Deductible amount base difference tax adjust

Opening balance: 20X1 0 0 0 0

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
Depreciation / deduction (15 000) (10 000) 5 000 1 500 Dr DT; Cr TE
Closing balance: 20X2 0 10 000 10 000 3 000 Asset
Depreciation / deduction 0 (10 000) (10 000) (3 000) Cr DT; Dr TE
Closing balance: 20X3 0 0 0 0
Calculations:
x Depreciation (20X1 and 20X2): (Cost: 30 000 ± Residual value 0) x 50% = 15 000 per year
x Tax deduction (20X1 and 20X2 and 20X3): 30 000 x 33 1/3 % = 10 000 per year

W2. Tax base (depreciable assets):

The definition of a tax base of an asset (where future benefits are taxable) can be depicted as follows:

Tax base of an asset (if future benefits are taxable) = Future tax deductions

In the case of PPE, the tax base is automatically calculated in the deferred tax table (W1) (e.g. the TB at the end
20X1 is 20 000, end 20X2 is 10 000 & end 20X0 is nil (cost ± accumulated tax deductions granted to date).

Solution 9B: Current tax

Comments: Profit before tax is calculated after deducting depreciation (per IFRSs). But taxable profit is calculated
after dHGXFWLQJµWD[GHSUHFLDWLRQ¶ (per tax legislation). Thus, to convert µprofit before tax¶ into µtaxable profits¶, we
must add back WKHDFFRXQWDQW¶V depreciation DQGVXEWUDFWWKHWD[DXWKRULW\¶s µtax deduction¶(i.e. µWD[GHSUHFLDWLRQ¶).
20X1 20X2 20X3
Current income tax Profits Tax: 30% Profits Tax: 30% Profits Tax: 30%
Profit before tax (1) (4) 5 000 5 000 20 000
20X1 & 20X2: (20 000 ± depr: 15 000)
20X3: (20 000 ± depr: 0)
Permanent differences: 0 0 0
Taxable accounting profit 5 000 5 000 20 000
Movement in temporary differences: (1) 5 000 5 000 (10 000)
x add back depreciation: 30 000 x 50% 15 000 15 000 0
x 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

Chapter 6 305
Gripping GAAP Taxation: deferred taxation

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
Income tax expense (E) Current tax payable (L)
20X1 20X1 Inc tax (2) 3 000
CTP (2) 3 000 DTA (3) 1 500 Balance c/f 3 000
P/L 1 500 3 000 3 000
20X2 20X1 Bal b/d 3 000
CTP (2) 3 000 DTA (3) 1 500 Balance c/f 6 000 20X2 Inc tax (2) 3 000
P/L 1 500 6 000 6 000
20X3 20X2 Bal b/d 6 000
CTP (2) 3 000 Balance c/f 9 000 20X3 Inc tax (2) 3 000
DTA (3) 3 000 P/L 6 000 9 000 9 000
20X3 Bal b/d 9 000

Deferred tax asset (A)

20X1 Inc tax (3) 1 500
20X2 Inc tax (3) 1 500 Balance c/f 3 000
3 000 3 000
20X2 Bal b/d 3 000
20X3 Inc tax (3) 3 000
3 000 3 000
20X3 Bal b/d 0

Notes (explaining amounts in the ledger accounts):

(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.

Solution 9D: Disclosure

Comment: Notice the following:
x $IWHUWKUHH\HDUVZKHQWKHSODQW¶VFDUU\LQJDPRXQWDQd 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 µLQFRPHWD[H[SHQVH¶QRWH = 20X1: 1 500 +
20X2: 1 500 ± 20X3: 3 000 = 0).
x The total tax expense recognised of C9 000 (per IAS 12) (C1 500 + C1 500 + C6 000) equals the total current
tax charged of C9 000 (per tax legislation) (C3 000 x 3 years). See tKHµLQFRPHWD[H[SHQVH¶QRWH.
x The existence of deferred tax does not cause the effective tax rate to differ from the applicable tax rate. See
the µincome tax expense¶ note.

Entity name
Statement of financial position (extract) 20X3 20X2 20X1
As DW«X3 Note C C C
Non-current assets
Deferred tax asset 4 0 3 000 1 500
Property, plant and equipment 0 0 15 000
Current liabilities
Current tax payable 9 000 6 000 3 000

306 Chapter 6
Gripping GAAP Taxation: deferred taxation

Entity name
Statement of comprehensive income (extract) 20X3 20X2 20X1
For the year ended 20X3 Note C C C
Profit before tax 20 000 5 000 5 000
Income tax expense 12 (6 000) (1 500) (1 500)
Profit for the year 14 000 3 500 3 500

Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 20X3 C C C
4. Deferred tax asset
The closing balance is constituted by the effects of:
x Property, plant and equipment 0 3 000 1 500
12. Income tax expense
x Current 3 000 3 000 3 000
x Deferred 3 000 (1 500) (1 500)
Income taxation expense 6 000 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 initially temporary differences on
recognised at cost. Thus, the non-FXUUHQW DVVHW¶V carrying acquisition date because:
amount always starts off at cost, and gradually reduces to x the CA starts off at cost
nil by the time its useful life has ended, or if it is disposed of x the TB will start off at zero.
before the end of its life, when it is derecognised.

From a tax-perspective, the cost of a non-current asset Tax base of an asset –the
might be deductible or non-deductible when calculating essence of the definition is:
taxable profits. This will also affect its tax base.
If the asset’s FEB are taxable the:
x TB = future tax deductions
The tax base of a non-FXUUHQWDVVHWUHIOHFWVWKHµIXWXUHWD[- If the asset’s FEB are not taxable, the :
GHGXFWLRQV¶WKDWZLOOEHJUDQWHGThus, if the cost of a non- x TB = CA See IAS 12.7
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 tax
difference is
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.
x the carrying amount will equal tKHDVVHW¶VFRVW, but
x the tax base will be nil.

In other words, a temporary difference will arise immediately on initial acquisition.

Due to accounting complications that would occur if we were to recognise deferred tax on this initial
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.

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4.3.2 The exemption from recognising deferred tax liabilities (IAS 12.15 and IAS 12.24)
A taxable TD on acquisition
IAS 12.15 states that (the following is slightly reworded): date is an exempt TD if it
x a deferred tax liability shall be recognised for all taxable relates to:
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 other 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 isDVDOZD\VWKHDVVHW¶Vcost.
 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 recognise It is interesting to consider
a deferred tax liability. the reason why such an
exemption was required at all.
Let us consider this question with specific reference to the To recognise a DTL on a taxable TD
we obviously need to credit the DTL
purchase of a non-deductible asset. As already explained, and debit something else.
the 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
recognition of a deferred tax liability, which would have of a non-deductible asset, no-one
agreed on what we should debit!
required a credit to the deferred tax liability account. But let¶V
And so the exemption from having
think where we could have put the corresponding debit... to recognise this DT liability arose!
x We cannot debit µtax expense¶EHFDXse:
 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.

308 Chapter 6
Gripping GAAP Taxation: deferred taxation

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.

Example 10: Cost model: PPE:

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 No payments were made to the tax authority in any of the year (amount owing at end 20X0: nil).
x There are no other temporary or permanent differences and no taxes other than income tax at 30%.

Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1, 20X2 and 20X3.
C. Show the related ledger accounts.
D. Disclose the above in as much detail as is possible for all three years (doQ¶W do the deferred tax note).

Solution 10A: Deferred tax

Deferred income tax (balance sheet approach):

Building x Non-deductible Carrying Tax Temporary Deferred Details re DT
x Depreciable amount (1) Base (2) difference (3) tax (4) bal / adjust

Opening balance: 20X1 0 0 0 0

Purchase 30 000 0 (30 000) (4) 0 Exempt IAS 12.15
Depreciation/ deduction (15 000) (0) 15 000 (4) 0 Exempt IAS 12.15
Closing balance: 20X1 15 000 0 (15 000) (4) 0 Exempt IAS 12.15
Depreciation/ deduction (15 000) (0) 15 000 (4) 0 Exempt IAS 12.15
Closing balance: 20X2 0 0 0 (4) 0
Depreciation/ deduction (0) (0) 0 0
Closing balance: 20X3 0 0 0 0

Notes:
(1) The carrying amount shows the accountant recognising the building at cost and then depreciating
it at 50% pa (i.e. no depreciation in 20X3 since the asset was fully depreciated at the end of 20X2).
(2) The tax base (future tax deductions) shows nil because there are no future tax deductions expected
on this building (i.e. the tax authorities will not allow the deduction of the cost of this building).
(3) Temporary differences arise from the cost of acquisition and subsequent depreciated carrying
amounts since the tax base reflects the future tax deductions of nil.

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Gripping GAAP Taxation: deferred taxation

(4) Deferred tax is nil, despite the existence of the temporary differences, due to the IAS 12.15 exemption.
The exemption applies to all temporary differences arising from this asset (i.e. the exemption applies
to the original temporary difference of C30 000 arising due to the recognition of the cost, and also to
the subsequent movement in temporary differences caused by the depreciation of this cost).
Notice that depreciation causes the original temporary difference to reduce each year until it is completely
reversed (i.e. when the asset has been fully depreciated, it will have a carrying amount of nil).

Solution 10B: Current tax

Comment: When exempt temporary differences affect our profits (i.e. when we process depreciation but know
we will never have an equivalent tax-deduction), it means our total µprofit before tax¶ (accounting profits) over
the life of the asset will never equal the total µtaxable profits¶ over this period (i.e. the total µprofit before tax¶ will
always be C30 000 less than the total µtaxable profits¶). Thus, these movemenWV LQ µH[empt temporary
GLIIHUHQFHV¶DUHDFWXDOO\permanent in nature.
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)
Permanent differences
x Exempt income & non-deductible expenses 0 0 0
x Movement in temporary differences: exempt
x Building ± non-deductible (2) 0 15 000 15 000
 Add Depreciation 0 15 000 15 000
(20X1 & 20X2: 30 000 x 50%)
 Less Tax deduction (N/A) (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

Notes (explaining amounts in the ledger accounts):

(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 will always differ. Although this iVFDOOHGDµWHPSRUDU\GLIIHUHQFH¶
the fact that it is exempt from deferred tax means it is effectively a permanent difference in nature.

Solution 10C: Ledger accounts

Income tax expense (E) Current tax payable (L)
20X1 20X1
CTP (Sol 10B) 6 000 Inc Tax (Sol 10B) 6 000
P/L 6 000 Balance c/f 6 000
6 000 6 000 6 000 6 000
20X2 Balance b/d 6 000
CTP (Sol 10B) 6 000 20X2
P/L 6 000 Balance c/f 12 000 Inc Tax (Sol 10B) 6 000
6 000 6 000 12 000 12 000
20X3 Balance b/d 12 000
CTP (Sol 10B) 6 000 20X3
P/L 6 000 Balance c/f 18 000 Inc Tax (Sol 10B) 6 000
6 000 6 000 18 000 18 000
Balance b/d 18 000
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 b/d 30 000

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Solution 10D: Disclosure

Comments:
x Notice there is no deferred tax balance in the statement of financial position (see example 10A).
x Note that the movement in the exempt temporary differences appears as a reconciling item in the tax
rate reconciliation for 20X1 and 20X2 (see the tax expense note).
This is because the cost of the asset is not tax deductible and thus the effect of the depreciation
expense will never reverse in future years. This means that the depreciation has the same effect as, for
example, a non-deductible fine, and thus the effective tax rate will differ from the applicable tax rate.

Entity name
Statement of financial position (extract) 20X3 20X2 20X1
$VDW«; Note C C C
Non-current assets
Property, plant and equipment Ex 10A 0 0 15 000
Current liabilities
Current tax payable Ex 10B/C 18 000 12 000 6 000

Entity name
Statement of comprehensive income (extract) 20X3 20X2 20X1
For the year ended 20X3 Note C C C
Profit before tax Ex 10B 20 000 5 000 5 000
Income tax expense 12 (6 000) (6 000) (6 000)
Profit / (loss) for the year 14 000 (1 000) (1 000)

Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 20X3 C C C
12. Income tax expense
x Current Ex 10B 6 000 6 000 6 000
x Deferred Ex 10A: W1 0 0 0
Income taxation expense per SOCI 6 000 6 000 6 000
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 the cost of a non-deductible asset 0 4 500 4 500
20X1 & 20X2: 15 000 x 30%
Income taxation expense per SOCI 6 000 6 000 6 000
Effective tax rate 20X1 & 20X2: 6 000 / 5 000 30% 120% 120%
20X3: 6 000 / 20 000

Example 11: Cost model: PPE:

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 No payments were made to the tax authority in any of the year (amount owing at end 20X0: nil).
x There are no other temporary or permanent differences and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1, 20X2 and 20X3.
C. Show the related ledger accounts.
D. Disclose the above in as much detail as is possible for all three years GRQ¶WGRWKH deferred tax note)

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Gripping GAAP Taxation: deferred taxation

Solution 11A: Deferred tax

Deferred income tax (balance sheet approach):
Land x Non-deductible Carrying Tax Temporary Deferred Details re DT
x Non-depreciable amount (1) base (2) difference (3) tax (4) bal / adjust

Opening balance: 20X1 0 0 0 0

Purchase: cost 30 000 0 (30 000) (3) 0 Exempt IAS 12.15
Depreciation/ deduction (0) (0) 0 0
Closing balance: 20X1 30 000 0 (30 000) (3) 0 Exempt IAS 12.15

Depreciation/ deduction (0) (0) 0 0

Closing balance: 20X2 30 000 0 (30 000) (3) 0 Exempt IAS 12.15

Depreciation/ deduction (0) (0) 0 0

Closing balance: 20X3 30 000 0 (30 000) (3) 0 Exempt IAS 12.15

Notes:
(1) The carrying amount remains at C30 000 since it is not depreciated.
(2) The tax base (TB = future tax deductions) is zero from the start since the cost of land is not tax deductible
(3) A temporary difference originates in 20X1 since there will be no tax deductions on the asset.
Since land is not depreciated, this original temporary difference never reverses.
(4) There is no deferred tax on this temporary difference due to the IAS 12.15 exemption.
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.

Solution 11B: Current tax

20X3 20X2 20X1
Current income tax: Profit Tax: 30% Profit Tax: 30% Profit Tax: 30%
Profit before tax (accounting profits) (1) 20 000 20 000 20 000
Permanent differences
x Exempt income & non-deductible expenses 0 0 0
x Movement in temporary differences: exempt 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
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 (of C30 000), it does not appear in the taxable profit
calculation since there is no depreciation and thus no movement in temporary differences.

Solution 11C: Ledger accounts

Income tax expense (E) Current tax payable (L)
20X1 20X1
CTP (W2) 6 000 Inc tax (W2) 6 000
P/ L 6 000 Balance c/f 6 000
6 000 6 000 6 000 6 000
20X2 Balance b/d 6 000
CTP (W2) 6 000 20X2
P/L 6 000 Balance c/f 12 000 Inc tax (W2) 6 000
6 000 6 000 12 000 12 000
20X3 Balance b/d 12 000
CTP (W2) 6 000 20X3
P/L 6 000 Balance c/f 18 000 Inc tax (W2) 6 000
6 000 6 000 18 000 18 000
Balance b/d 18 000

Bank Land: cost (A)

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

312 Chapter 6
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Solution 11D: Disclosure

Comments:
x Notice that there is no deferred tax balance in the statement of financial position (see example 11A).
x Note that, unlike example 10D, there is no tax rate reconciliation required (see the tax expense note).

Entity name
Statement of financial position (extract) 20X3 20X2 20X1
$VDW«; C C C

Non-current assets
Property, plant and equipment W1 30 000 30 000 30 000

Current liabilities
Current tax payable Solution 11C 18 000 12 000 6 000

Entity name
Statement of comprehensive income (extract) 20X3 20X2 20X1
For the year ended 20X3 Note C C C

Profit before tax W2 ± unadjusted 20 000 20 000 20 000

Income tax expense 3 (6 000) (6 000) (6 000)
Profit for the year 14 000 14 000 14 000

Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 20X3 C C C
3. Income tax expense (2)
x Current W2 6 000 6 000 6 000
x Deferred (1) W1 0 0 0
Income taxation expense per SOCI 6 000 6 000 6 000
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.

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 RIUHFRYHU\RUVHWWOHPHQW¶RIWKHXQGerlying asset. IAS 12.51A
Deferred tax & measurement
If the way in which management expects to recover the at fair value:
carrying amount of an asset (e.g. a management intention to
use the asset or to sell the asset) may affect the If the carrying amount of an asset is
measurement of the future tax that could be payable, then we measured at a FV greater than cost:
must take these management intentions into account when x we must account for deferred tax
on the portion above cost (i.e. CA –
measuring the deferred tax balance. Cost)
x we must account for deferred tax
In other words, management intentions become important on the portion below cost as well
when the tax authority taxes income differently depending x we measure the DT using the rate
on how the income is generated. at which future proceeds from the
asset will be taxed (based on the
intention to use/ sell the asset).
For example, different tax calculations may apply to:
x Capital profits made on the sale of an asset (i.e. profit made by selling at above cost); and
x Profits other than capital profits.

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Gripping GAAP Taxation: deferred taxation

If an asset is measured using the cost model, its carrying amount is its depreciated cost (cost less
accumulated depreciation). Under the cost model, the carrying amount may never exceed this
depreciated cost. Thus, even if 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, we must remember that 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 (using the revaluation model or fair value model), the carrying
amount could end up:
x greater than WKHDVVHW¶VRULJLQDl cost; or
x less than WKHDVVHW¶VRULJLQDOFRVW.

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, it
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 the 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, rather than just intend to sell
it, 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 irrespective of what PDQDJHPHQW¶V actual
intentions are, 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.

If the non-current asset is measured at fair value, it not only has the potential to affect the measurement
of deferred tax, but it may also affect the recognition thereof. In this regard, in all our prior examples,
when creating or adjusting the deferred tax asset or liability, the contra-entry has always been the µtax
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, in other
comprehensive income (e.g. credit deferred tax liability and debit revaluation surplus).

If the non-FXUUHQWDVVHW¶Vcarrying amount changes (e.g. by 100) but its tax base does not change,
we have a movement in the temporary difference and thus a deferred tax adjustment is required.
x If the change in the DVVHW¶Vcarrying amount was caused by an adjustment affecting profit or loss
(e.g. credit plant and debit depreciation expense), the related deferred tax adjustment must also be
recognised in profit or loss (tax expense) (e.g. debit deferred tax asset credit tax expense).
x If the non-current asset is measured at fair value under the revaluation model (see chapter 8), a
change to its carrying amount due to a revaluation to fair value may affect the µrevaluation
surplus¶ which is an account recognised in other comprehensive income (debit plant and credit
revaluation surplus). If this happens, the related deferred tax adjustment must also be
recognised in other comprehensive income (revaluation surplus) (e.g. debit revaluation surplus
credit deferred tax liability). This is covered in more depth in chapter 8 where the revaluation of
property, plant and equipment is explained in detail.

314 Chapter 6
Gripping GAAP Taxation: deferred taxation

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¶V 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
Study tip
The reasoning for this presumption is based on the Read about IAS 16’s
revaluation model in
reasoning behind depreciation: chapter 8 (section 4).
x depreciation reflects that part of the carrying amount
that will be recovered through use (i.e. depreciation is expensed during the same periods in
which revenue is earned through usage); and thus
x LI\RXFDQ¶WGHSUHFLDWHDQDVVHWLWPHDQVWKDWLWFDQ¶WEe 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 measurH WKH DVVHW¶V IDLU
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, Revise IAS 40’s fair value
model in chapter 10
then the presumption should be that the management (section 4.5 & 5.3).
intention is 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).
The presumption that investment property would be sold would only 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 DVVHW¶Vbase 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 measuUHGLQWHUPVRI,$6¶VUHYDOXDWLRQPRGHO.
B. The non-current asset is a land measured in terms of IAS ¶VUHYDOXDWLRQPRGHO.
C. The non-current asset is a building PHDVXUHGLQWHUPVRI,$6¶VIDLU value model.
D. The non-current asset is a land measured in teUPVRI,$6¶VIDLUYDOXHPRGHO.

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¶V intention ± or presumed intention.

Chapter 6 315
Gripping GAAP Taxation: deferred taxation

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 managemHQW¶VUHDOLQWHQWLRQWKHGHIHUUHGWD[
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 ,$6¶VUHvaluation 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 meaVXUHGLQWHUPVRI,$6¶V 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 DVVHW¶V IXWXUH 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¶VIDLUYDOue 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.

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 RQPDQDJHPHQW¶Vactual 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.

316 Chapter 6
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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
not increase or decrease the tax deductions allowed). revalued to FV where the
intention is to sell in
x The deferred tax caused by the asset is measured
x Chapter 8: example 13: revaluation
based on the tax that would be due on the sale to a FV that does not exceed cost
thereof at its carrying amount. This could involve: x Chapter 8: example 16 – 18:
 Recoupment (or scrapping allowance), and a revaluation to a FV that exceeds cost.
 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 the
If the asset is measured at fair value and the intention is intention is to keep:
to keep the asset, the deferred tax caused by this asset x Chapter 8: example 13: revaluation
will be measured using the following logic: to 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.

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);

Chapter 6 317
Gripping GAAP Taxation: deferred taxation

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 thHDVVHW¶VIDir value does not exceed cost, the There are more examples on
deferred tax balance will be nil: non-deductible assets in:
 There is no recoupment possible because there
x Chapter 8: example 21: intention to
are no prior deductions to recoup; and keep (depreciable);
 There is no taxable capital gain possible since the x Chapter 8: example 20: intention to
expected selling price is less than cost. sell (depreciable).

x If the DVVHW¶VIDLUYDOXHdoes exceed cost, the 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 XSZDUGVLQWHUPVRI,$6¶Vrevaluation model:
x The taxable temporary difference that arose when the asset was initially acquired (equal to
the cost of the asset (TB ± CA) 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 and when this asset¶V FRVW 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, also applies to the consequential
movement in temporary differences relating to this cost (i.e. the exemption also applies to the
gradual writing-off of this same initial cost ± e.g. depreciation or impairments etc).
x However, if this asset is then revalued upwards, we are adding (debiting) an amount to the
carrying amount (which had previously reflectHGµdepreciated cost¶): this debit does not involve
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 from the initial recognition of the cost
of the asset ± a revaluation has nothing to do with the initial recognition of an asset ± instead, a
revaluation is simply a remeasurement of the asset).

Example 13: Revaluation above cost: PPE: intention to keep

x Non-deductible
x Depreciable
A building (an item of property, plant and equipment) was purchased for C1 200 on 1 January 20X1.
x It is depreciated on the straight-line method over its useful life of 4 years to a nil residual value.
x It is measured under the revaluation model. The first and only revaluation was on 31 December 20X2
to a fair value of C1 440.
x The tax authorities do not grant any tax deductions on this asset.
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 LVUHYDOXHGLQWHUPVRI,$6¶VUHvaluation model but since it is depreciable, managHPHQW¶Vactual
intention to keep it is not over-ridden by IAS %¶VSUHVXPHGLQWHQWLRQ to sell. (See example 15 where we
LJQRUHPDQDJHPHQW¶Vactual 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¶V
example 21, where this example also shows the revaluation journals and related deferred tax journals.

318 Chapter 6
Gripping GAAP Taxation: deferred taxation

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)
Profit before tax 1 000
Add back depreciation Per above: not deductible 720
Taxable profit 1 720
Current income tax at 30% 516

Solution 13B: Deferred tax

Comments:
x The tax base of the asset (i.e. future tax deductions) is nil because the asset¶VFRVt is not tax deductible.
x The closing deferred tax balances of C252 and C126 in W1, the µdeferred tax table¶, are actually
calculated separately in W2.
However, instead of calculating our deferred tax using the combination of W1 and W2, we could add
more detail into the deferred tax table. This alternative, more detailed layout is shown in W3.
Using a combination of W1 and W2 can be helpful when trying to understand the deferred tax implications,
but W3 tends to be quicker under exam conditions. Thus, this alternative (W3) is the layout we will use in
chapter 8, which is the chapter that explains how to account for revaluations.
x When the deferred tax movement is caused by an adjustment to WKHDVVHW¶V carrying amount that was
recognised in revaluation surplus, part of µother comprehensive LQFRPH¶ (OCI) (not µprofit or loss¶), then
the contra entry when debiting/crediting µdeferred tax¶ is to credit/debit the µrevaluation surplus¶ (not
µtax). The DT adjustment is thus recognised in OCI instead of P/L (see section 4.4.1)

W1. DT on PPE - intention to keep (FV greater than CP)

Building x Non-deductible Carrying Tax Temporary Deferred Details re DT
(keep) x Depreciable amount base difference tax bal / adjust

Cost: 1/1/20X1 1 200 0 (1 200) 0 Exempt IAS12.15

Depreciation / Deduction (300) 0 300 0 Exempt IAS12.15
Balance: 31/12/20X1 900 0 (900) 0 Exempt IAS12.15

Depreciation / Deduction (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) DTL (See W2)

Depreciation / Deduction (historic) (300) 0 300 0 Exempt IAS12.15

Depreciation / Deduction (extra) (420) 0 420 126 Dr DT; Cr RS
Balance: 31/12/20X3 720 0 (720) (126) DTL (See W2)

Depreciation / Deduction (historic) (300) 0 300 0 Exempt IAS12.15

Depreciation / Deduction (extra) (420) 0 420 126 Dr DT; Cr RS
Balance: 31/12/20X4 0 0 0 0

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 840 252 420 126
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)

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Gripping GAAP Taxation: deferred taxation

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 reDGVµ%DODQFH;¶LQWKH:WDble.
CA TB TD DT
Balances: 31/12/20X2 1 440 0 (1 440) (252) DTL
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 WKDWUHDGVµ%DODQFH;¶LQWKH:1 table.
CA TB TD DT
Balances: 31/12/20X3 720 0 (720) (126) DTL
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 these extra benefits are earned as operating profits.

Solution 13C: Disclosure

Entity name
Notes to the financial statements (extract) 20X4 20X3
For the year ended «; C C
3. Income tax expense
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
Rate reconciliation:
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

Example 14: Revaluation above cost: PPE: intention to sell

x Non-deductible
x Depreciable
A building, an item of property, plant and equipment, was purchased for C1 200 on 1 January 20X1.
x Depreciation is calculated at 25% pa to a nil residual value (straight-line).
x The asset was revalued, under the revaluation model, 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%. The
tax authority does not allow capital losses to be carried forward to reduce future taxable capital gains.
x The profit before tax and before depreciation (fully taxable) is C1 720 in 20X4.
Required: Assuming management intends to sell the asset:
A. Calculate the current income tax for 20X4.
B. Calculate the deferred tax balances and adjustments.
C. Disclose the tax expense note for 20X4. Comparatives are not required.

320 Chapter 6
Gripping GAAP Taxation: deferred taxation

Solution 14: Intention to sell

General comment:
x This situation (a non-deductible, depreciable asset that is to be sold) is covered in chapter 8¶V
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.

Solution 14B: Deferred tax

Comments: The tax base of the asset (i.e. future tax GHGXFWLRQV  LV QLO EHFDXVHWKH DVVHW¶VFRVW is not tax
deductible. The closing deferred tax balances in the deferred tax table in W1, are calculated separately in W2.
However, instead of using W2, we could use a slightly more detailed deferred tax table. This alternative working is
shown in W3. This alternative is used in chapter 8, example 20. Both alternatives achieve the same answer.

W1: DT on PPE - intention to sell (FV greater than CP)

Building x Non-deductible Carrying Tax Temporary Deferred Details re DT
(sell) x Depreciable amount base difference tax bal / adjust

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 / Deduction (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) DTL (W2: 0 + 57,6)

Depreciation / Deduction (historic) (300) 0 300 0 Exempt IAS12.15

Depreciation / Deduction (extra) (420) 0 420 57,6 Dr DT; Cr RS
Balances: 31/12/20X3 720 0 (720) 0 (W2: 0 + 0)

Depreciation / Deduction (historic) (300) 0 300 0 Exempt IAS12.15

Depreciation / Deduction (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
Taxable Tax at Taxable Tax at
W2.1 Tax on recoupment: 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«Not applicable (1) 1 200 0 720 0

W2.2 Tax on taxable capital gain:

Selling price 1 440 720
Less base cost (assumed = cost) (1 200) (1 200)
Capital gain/ (loss) 240 (480)
Inclusion rate (given) 80% 80%
(2)
Taxable capital gain/ (loss) and related tax 192 57,6 (384) 0
Total tax (tax on recoupment + tax on taxable capital gain) 57,6 0
Notes:
(1) It seems there is a recoupment, but it is not possible: the asset was not deductible, thus there is nothing to recoup.
(2) If we sold for C720 at end 20X3, a tax-deductible capital loss of C384 would arise. A capital loss is thus the
opposite of a capital gain.
The tax authority may allow a capital loss to be carried forward to a future year where it can then be used to
reduce any future taxable capital gains. However, capital losses (opposite of capital gains) are ignored in this
text. Thus, the possible deferred tax asset of C115,2, (the possible future tax saving of C384 x 30%), is ignored.

Chapter 6 321
Gripping GAAP Taxation: deferred taxation

W3. DT balances: an alternative calculation to W2

x The line in the DT table (W1) WKDWUHDGVµBalance: ;¶ could be replaced by:
CA TB TD DT
Balances: 31/12/20X2 1 440 0 (1 440) (57,6) DTL
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 readVµBalance: 3;¶ could be replaced by.
Balances: 31/12/20X3 720 0 (720) 0 DTL
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 caused by the revaluation.
However, this is a non-deductible asset (i.e. no tax-deductions are granted) and thus there is nothing to
recoup. Thus, we simply multiply this TD by 0% (instead of 30%).
(P.S. If the asset was deductible, then, at the end of 20X2, just before revaluation, the TD of C600 would mean
we are expecting a recoupment of C600, but after the revaluation upwards by C600 to original cost of C1 200 ,
we would be expecting 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, 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%).

Solution 14C: Disclosure

Entity name
Notes to the financial statements (extract) 20X4 20X3
For thH\HDUHQGHG«; C C
3. Income tax expense
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
Income taxation expense per statement of comprehensive income 516 xxx
Rate reconciliation:
Applicable tax rate 30% 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
Income taxation expense per statement of comprehensive income 516 xxx
Effective tax rate 516 / 1 000 51,6% xxx

Example 15: Revaluation above cost: PPE: intention to keep

x Non-deductible
x Non-depreciable
Land, an item of property, plant and equipment was purchased for C1 200 on 1 January 20X1.
x The land is not depreciated.
x The land was revalued, under the revaluation model, to fair value of 2 040 on 31 December 20X2.
x The land was sold for C1 800 during 20X4.
x The tax authorities do not grant any tax deductions on this asset. However, any capital gain from this
asset is included in taxable profits using an inclusion rate of 80%. The base cost is C1 200.
x The profit before tax and before the sale (fully taxable) is C1 000 in 20X4.

322 Chapter 6
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Required: Assuming PDQDJHPHQW¶Vintention is to keep the asset:

A. Calculate the current income tax for 20X4.
B. Calculate the deferred tax balances and adjustments.
C. Disclose the tax expense note for 20X4. Comparatives are not required.

Solution 15: Intention to keep

Comment:
x 7KLVDVVHWLVUHYDOXHGLQWHUPVRI,$6¶VUHYDOXDWLRQ model and since the asset is non-depreciable, the
deferred tax is measured on the presumed intention to sell the asset HYHQWKRXJKPDQDJHPHQW¶Vactual
intention is to keep the asset (i.e. the actual intention is overridden by ,$6%¶V presumed intention).
x This situation is also covered in chapter 8¶Vexample 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 The accounting loss is non-deductible 240
Add taxable capital gain (Proceeds: 1 800 ± Base cost: 1 200) x 80% 480
Taxable profit 1 480

Current income tax at 30% 444

Solution 15B: Deferred tax

W1. DT on PPE: intention to keep
Land x Non-deductible Carrying Tax Temporary Deferred
(keep) x Non-depreciable amount base difference 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) DTL (W2: 0 + 202)

Movement: 20X3 0 0 0 0
Balances: 31/12/20X3 2 040 0 (2 040) (202) DTL

Movement: 20X4 (Sold: CA) (2 040) 0 2 040 202 Dr DT; Cr RS

Balances: 31/12/20X4 0 0 0 0 DTL

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
Less base cost (1 200)
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 is nothing to recoup.

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Gripping GAAP Taxation: deferred taxation

Solution 15C: Disclosure

Entity name
Notes to the financial statements (extract) 20X4 20X3
)RUWKH\HDUHQGHG«; C C

3. Income tax expense

Income taxation expense 444 xxx
x Current Sol 15A 444 xxx
x Deferred Sol 15B W1 (the DT adj. was credited to RS not TE) 0 xxx

Rate reconciliation:

Applicable tax rate 30% xxx

Tax effects of
x Profit before tax Sol 15A: 760 x 30% 228 xxx
x Non-deductible loss Sol 15A: Accounting loss on sale 240 x 30% 72 xxx
x Taxable capital gain Sol 15A: Taxable capital gain: 480 x 30% 144 xxx
Tax expense on face of statement of comprehensive income 444 xxx

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 profit and/or non-capital profit), 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 tax 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.

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%
Taxable capital gain xxx

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

324 Chapter 6
Gripping GAAP Taxation: deferred taxation

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 deferred tax implications of the sale of an asset is very simple. Its carrying amount is
derecognised when set off against the proceeds, to calculate profit or loss on sale. Similarly,
any remaining tax base LVDOVRµGHUHFRJQLVHG¶ when set off against the proceeds to calculate the
recoupment/ scrapping allowance. At this point, both the carrying amount and tax base will be nil.
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.

The following two examples revise how the sale of an asset affects current tax (see chapter 5).
Then, examples 18 - 23 show the deferred tax implications of the sale of an asset.

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 cumulative depreciation expensed 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 profit / loss on sale and the recoupment of tax deductions / scrapping allowance.
D. Compare the cumulative effect of the asset on µprofit before tax¶ and on µtaxable profits¶ over the 3 years.

Solution 16A: Depreciation versus Tax deductions

Depreciation Tax deductions
20X1: Depreciation: (C1 200 ± 0) / 3 years; Deductions: C1 200 / 4 years 400 300
20X2: Depreciation: (C1 200 ± 0) / 3 years; Deductions: C1 200 / 4 years 400 300
Total expense/ total deductions over the 2 years 800 600

Solution 16B: Net cost to company

C
Cost of purchase (1/1/20X1) 1 200
Cost recovered through sale (1/1/20X3) (900)
Net cost to company (net cash outflow) 300

Solution 16C: Profit on sale versus Recoupment on sale

W1. Profit/ (loss) on sale C
Proceeds 900
Less carrying amount Cost: 1 200 ± Accum. depreciation: 800 (16A) (400)
Profit on sale 500

W2. Recoupment/ (scrapping allowance) on sale C

Proceeds (900) limited to cost (1 200) Cost is greater, so proceeds not limited 900
Less tax base Cost: 1 200 ± Tax deductions to date: 600 (16A) (600)
Recoupment Note 1 300
Note 1: The recoupment reflects the tax deductions granted in the past that the tax authority will now reverse (i.e.
the recoupment will be included as income in taxable profit).

The tax authority is recouping C300 of the prior tax deductions because the total tax deductions granted to
date is C800 and yet the net cost to the company is only C500 (800 ± 500).

Solution 16D: Comparison of effect of the asset on Profit before tax and Taxable profits
The real net cost to the company is a net cash outflow of C300 (see example 16B).
This is reflected in both µSURILWEHIRUHWD[¶DQGµWD[DEOHSURILW¶: Profit before tax Taxable profit
Depreciation/ Tax deductions 20X1 & 20X2 (Solution 16A) 800 600
Profit / Recoupment on sale 20X3 (Solution 16C W1 and W2) (500) (300)
Net expense/ tax deduction 300 300

Chapter 6 325
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Example 17: Non-current asset sold at a loss with a scrapping allowance

Use the same information as in example 16 except that, instead of selling it for C900, we sell
the asset for C300.
Required: Show how your answer to example 16 A - D would change, given the lower selling price:

Solution 17A: Depreciation versus tax deductions

The answer is the same as in Solution 16A (total depreciation is C800 and total tax deductions is C600).

Solution 17B: Net cost to company

C
Cost of purchase 1 200
Cost recovered through sale (300)
Net cost to company (net cash outflow) 900

Solution 17C: Loss on sale versus scrapping allowance

W1. Profit or loss on sale C

Proceeds 300
Less carrying amount Cost: 1 200 ± Accum. depreciation: 800 (17A) (400)
Loss on sale (100)

W2. Recoupment / (scrapping allowance) on sale C

Proceeds (300) limited to cost (1 200) Cost is greater, so proceeds not limited 300
Less tax base Cost: 1 200 ± Tax deductions to date: 600 (17A) (600)
Scrapping allowance Note 1: (300)

Note 1: The scrapping allowance reflects an extra tax deduction that will be granted when calculating taxable profit
in the year of the sale.
The tax authority is giving an extra deduction of C300 because the total tax deductions granted to date is
only C600 (Sol 17A) and yet the net cost to the company is C900 (Sol 17B).

Solution 17D: Comparison of effect of the asset on Profit before tax and Taxable profits
The real net cost to the company is a net cash outflow of C900 (see example 17B). This is reflected in both
the profit before tax and the taxable profit over the 3 years (20X1, 20X2 and 20X3). This proves that any
difference over the years is purely a temporary difference (i.e. the differences disappear over time):
Profit before tax Taxable profit
Depreciation/ Tax deductions 20X1 & 20X2 (Solution 17A) 800 600
Loss / Scrapping allowance on sale 20X3 (Solution 17C W1 and W2) 100 300
Total expense/ tax deduction 900 900

Example 18: Sale of a deductible, depreciable asset (plant) at below cost, and
showing the 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 plant is measured under the cost model and is depreciated straight-line at 50% p.a. to a nil
residual value. There are no other items of property, plant and equipment.
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 No payments were made to the tax authority in any of the years (amount owing at end 20X0: nil).
x There are no other temporary or permanent differences and no taxes other than income tax at 30%.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the tax-related ledger accounts.
D. Disclose the above in the SOFP, SOCI and tax-related notes for the year ended 31 December 20X2.

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Solution 18A: Deferred tax

W1. Deferred income tax
Plant x Deductible Carrying Tax Temporary Deferred
x Depreciable amount base difference tax
Opening balance ± 20X1 0 0 0 0
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 DT Asset
Sale: derecognise 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 allowed for tax purposes: after the asset is
sold, there can be no further tax deductions on the asset since the asset no longer exists.

Solution 18B: Current tax

W2. Recoupment on sale ± per tax authority 20X2
Proceeds (limited to cost): the cost is not a limiting factor in this example 21 000
Less tax base Future tax deductions (20 000)
Cost 30 000
Less accumulated tax deductions (30 000 ± 0) x 50% x 1 yr (10 000)
Recoupment on sale 1 000
W3. Profit on sale ± per accountant
Proceeds 21 000
Less carrying amount 15 000
Cost 30 000
Less accumulated depreciation 30 000 x 33 1/3 % x 1 yr (15 000)
Profit on sale: non-capital profit 6 000
20X2 20X1
W4. Current income tax Profit Tax: 30% Profit Tax: 30%
Profit before tax (accounting profits) 20 000 + 6 000; 20 000 ± 15 000 26 000 5 000
Movement in temporary differences
x Add depreciation (30 000 ± 0) x 50% (N/A in 20X2 0 15 000
x Less tax deduction (30 000 ± 0) x 33% (N/A in 20X2 (0) (10 000)
x Less profit on sale W3 (6 000) (0)
x Add recoupment on sale W2 1 000 0
Taxable profits and current income tax 21 000 6 300 10 000 3 000

Solution 18C: Ledger

Comment: The deferred tax asset eventually reverses because the net effect on profits over 20X1 and
20X2, in terms of both the accountant and the tax authority, is a total of C9 000:
x Accountant: 20X1 depreciation of C15 000 less 20X2 profit of C6 000 = C9 000 (net expense)
x Tax authority: 20X1 tax deduction of C10 000 less 20X2 recoupment of C1 000 = C9 000 (net tax deduction)
Income tax expense (E) Current tax payable (L)
20X1 20X1 O/balance 0
CTP (W4) 3 000 DTA (W1) 1 500 20X1 Inc tax exp 3 000
P/L (expense) 1 500 20X2 O/balance 3 000
3 000 3 000 20X2 Inc tax exp (W4) 6 300
20X2 20X2 C/balance 9 300
CTP (W4) 6 300
DT (W1) 1 500 P/L (expense) 7 800 Deferred tax (A)
7 800 7 800 20X1 O/balance 0
20X1 Inc tax exp1 500
20X2 O/balance 1 500
20X2 Inc tax exp (W1) 1 500
Balance c/f 0
1 500 1 500
20X2 C/balance 0

Chapter 6 327
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Solution 18D: Disclosure

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Non-current assets
Property, plant and equipment W1 0 15 000
Deferred tax asset W1 or ledger account 6. 0 1 500
Current liabilities
Current tax payable Ledger account 9 300 3 000

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note 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)
Profit for the year 18 200 3 500

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C

6. Deferred tax asset/ (liability)

The closing balance is constituted by the effects of:
x Property, plant and equipment W1 0 1 500

15. Income tax expense

x Current W4 6 300 3 000
x Deferred W1 1 500 (1 500)
Income tax expense per the statement of comprehensive income 7 800 1 500

Notice: This tax expense note does not include a tax rate reconciliation. This is because the effective tax
rate is 30% each year (7 800 / 26 000 and 1 500 / 5 000), which equals the applicable tax rate of 30%

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 Plant is measured under the cost model and depreciated straight-line at 50% p.a. to a nil residual value.
x The tax authorities allow the tax deduction of 331/3 % p.a. RIWKHSODQW¶V cost, straight-line. Any capital
gain on the sale of this asset is included in taxable profits using an inclusion rate of 80%. The base cost
used in calculating the capital gain is C31 000. The income tax rate is 30%.
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 No payments were made to the tax authority in any of the years (amount owing at end 20X0: nil).
x There are no other temporary or permanent differences.
x Assume you have all the information necessary to calculate the balances on all affected accounts.
Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Show the tax-related ledger accounts.
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.

Solution 19A: Deferred tax

Comment: The calculation of the deferred tax 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. 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. 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.

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Solution 19B: Current 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 Future tax deductions (20 000)
Cost 30 000
Less accumulated tax deductions 30 000 x 33 1/3% x 1 year (10 000)
Recoupment 10 000

W2. Taxable capital gain ± per tax authority 20X2

Proceeds 35 000
Less base cost (31 000)
Capital gain 4 000
Inclusion rate @ 80%
Taxable capital gain 3 200

W3. Profit on sale ± per accountant 20X2

Proceeds 35 000
Less carrying amount (15 000)
Cost 30 000
Less accumulated depreciation (30 000 ± 0) x 50% x 1 year (15 000)
Profit on sale 20 000
- Capital profit Proceeds 35 000 ± Cost 30 000 5 000
- Non-capital profit Proceeds limited to cost 30 000 ± CA 15 000 15 000

20X2 20X1
W4. Current income tax Profit Tax: 30% Profit Tax: 30%
Profit before tax (accounting profits) 20 000 + 20 000; 20 000 ± 15 000 40 000 12 000 5 000 1 500
Permanent differences (and tax rate reconciling items) (1 800) (540) 0 0
x Exempt income: (portion of capital profit exempt from tax)
x Less capital profit on sale W3 (5 000) 0
x Add taxable capital gain W2 3 200 0
Taxable accounting profits (and tax expense) 38 200 11 460 5 000 1 500
Movement in temporary differences (and DT adjustment) (5 000) (1 500) 5 000 1 500
x Add depreciation (30 000 ± 0) x 50% (N/A in 20X2 0 15 000
x Less tax deduction (30 000 ± 0) x 33% (N/A in 20X2 (0) (10 000)
x Less non-capital profit on sale W3 (15 000) (0)
x Add recoupment on sale W1 10 000 0
Taxable profits and current income tax 33 200 9 960 10 000 3 000

Solution 19C: Ledger

Income tax expense (E) Current tax payable (L)
20X1 20X1: Tax exp 3 000
CTP (W4) 3 000 DTA 1 500 Balance c/f 3 000
P/L 1 500 3 000 3 000
3 000 3 000 20X1: Bal b/d 3 000
20X2 Balance c/f 12 960 20X2: Tax exp 9 960
CTP (W4) 9 960 12 960 12 960
DTA 1 500 P/L 11 460 20X2: Bal b/d 12 960
Total 11 460 11 460

Deferred tax asset (A)

20X1: Tax exp 1 500
20X1: Bal c/f 1 500
1 500 1 500
20X1 Bal b/d 1 500
20X1: Tax exp 1 500
1 500 1 500
20X2 Bal b/d 0

Chapter 6 329
Gripping GAAP Taxation: deferred taxation

Solution 19D: Disclosure

Entity name
Statement of comprehensive income (extract) Note 20X2 20X1
For the year ended 31 December 20X2 C C

Profit before tax 20X2: 20 000 + 20 000; 20X1: 20 000 ± 15 000 40 000 5 000
Income tax expense 12 (11 460) (1 500)
Profit for the year 28 540 3 500

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C

6. Deferred tax asset/ (liability)

The closing balance is constituted by the effects of:
x Property, plant and equipment W1 (example 18A) 0 1 500

12. Income tax expense

x Current W4 9 960 3 000
x Deferred W1 (example 18A) 1 500 (1 500)
Income tax expense per the statement of comprehensive income 11 460 1 500

Tax rate reconciliation

Applicable tax rate 30% 30%
Tax effects of:
x Profit before tax (40 000 x 30%); (5 000 x 30%) 12 000 1 500
x Exempt portion of capital profit (capital profit 5 000 ± taxable capital gain 3 200) x 30% (540) 0
Income tax expense per the statement of comprehensive income 11 460 1 500
Effective tax rate (11 460 ÷ 40 000); (1 500 ÷ 5 000) 28,7% 30%

The following examples (Examples 20 ± 23) involve non-deductible assets. Since they are not
deductible, their tax bases are nil from date of acquisition and, in terms of IAS 12.15, the related
temporary differences are exempt from deferred tax. Exempt temporary differences act in the
same way as permanent differences. Thus, in each of these examples, we need to include a tax
rate reconciliation in the tax expense note (because permanent differences, which include exempt
temporary differences, cause the effective tax rate to deviate from the applicable rate).

Example 20: Sale of a non-deductible, non-depreciable asset at below cost

An entity bought land for C30 000 on 1 January 20X1 and sold it on 1 January 20X2 for C20 000.
x The land is measured under the cost model and is not depreciated.
x The tax authority does not allow the deduction of the cost of land, but taxes 80% of any capital gains
and does not allow the deduction of capital losses.
x The base cost for purposes of calculating capital gains is C30 000.
x The income tax rate is 30%.
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.
x There are no other temporary or permanent differences.
x There was no opening deferred tax balance or property, plant and equipment at the beginning of 20X1.

Required:
A. Calculate the deferred income tax using the balance sheet approach.
B. Calculate the current income tax for 20X1 and 20X2.
C. Disclose this in the statement of comprehensive income, statement of financial position and tax expense
note for the year ended 31 December 20X2.

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Solution 20A: Deferred tax

W1. Deferred income tax
Land x Non-deductible Carrying Tax Temporary Deferred
x Non-depreciable amount base difference tax
Opening balance ± 20X1 0 0 0 0
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: derecognise asset (30 000) (0) 30 000 (0) Exempt
Closing balance ± 20X2 0 0 0 0

Solution 20B: Current tax

Comment: Notice there is no capital profit or capital gain because the asset was not sold in excess of cost.

W2. Recoupment/ scrapping allowance on sale ± per tax authority 20X2

Proceeds (20 000) limited to cost (30 000) The cost of 30 000 is not a limiting factor 20 000
Less tax base TB = Future tax deductions = 0 (because the asset was not tax-deductible) (0)
Recoupment See note 1 Not applicable

Note 1: Since the asset was not tax-deductible, there are no past tax-deductions for the tax authority to recoup
(i.e. the tax base was not nil because it had been fully deducted ± instead, it was nil, from the
beginning, because it was not tax deductible at all).

W3. Profit/ (loss) on sale ± per accountant 20X2

Proceeds Given 20 000
Less carrying amount (30 000)
x Cost Given 30 000
x Less accumulated depreciation Given (this land was not depreciated) (0)
Loss on sale (10 000)

20X2 20X1
W4. Current income tax Profit Tax: 30% Profit Tax: 30%
Profit before tax (accounting profits) (and TE) 20X2: 20 000 ± 10 000 10 000 3 000 20 000 6 000
Permanent difference (and reconciling item )
x Add back loss on sale (non-deductible) W3 10 000 3 000 (0) 0
Taxable profits and current income tax 20 000 6 000 20 000 6 000
TE = Tax expense DT adj = Deferred tax adjustment
Notice: The loss on sale (calculated by the accountant) was not allowed as a tax deduction and is thus a
permanent difference. This means there will be a reconciling item of 3 000 in the tax rate reconciliation.

Solution 20C: Disclosure

Entity name
Statement of financial position 20X2 20X1
As at 31 December 20X2 Note C C
Non-current assets
Property, plant and equipment W1 0 30 000
Deferred tax asset W1 0 0

Notice: We did not show the current tax payable balance as we were not given enough information (e.g. we
were not given the opening balance and details of the amounts paid to the tax authorities).

Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit (loss) before tax (20 000 ± 10 000) (20 000 + - 0) 10 000 20 000
Income tax expense 5. (6 000) (6 000)
Profit for the year 4 000 14 000

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Entity name
Notes to the financial statements (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current W4 6 000 6 000
x Deferred W1 0 0
Income tax expense per the statement of comprehensive income 6 000 6 000

Tax rate reconciliation

Applicable tax rate 30% 30%
Tax effects of:
x Profit before tax (10 000 x 30%); (20 000 x 30%) 3 000 6 000
x Non-deductible loss (add back loss on sale: 10 000 x 30%) 3 000 0
Income tax expense per the 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

An entity purchased land for C30 000 on 1 January 20X1 and sold it for C40 000 on 1 January 20X3.
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.
x Land is not depreciated.
x The tax authority does not allow the deduction of the cost of land, but taxes 80% of any capital gains
and does not allow the deduction of capital losses. The base cost for purposes of calculating capital
gains is C30 000. The income tax rate is 30%.
x No payments were made to the tax authority in any of the years (amount owing at end 20X0: nil).
x There are no other temporary or permanent differences.
x There was no opening deferred tax balance or property, plant and equipment at the beginning of 20X1.
Required:
A. Calculate the deferred income tax.
B. Calculate the current income tax for 20X1 and 20X2.
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.

Solution 21A: Deferred tax

Comment:
x The calculation of deferred tax is identical to the calculation under example 20 (please see solution 20A)
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.

Solution 21B: Current tax

W1. Recoupment on sale ± per tax authority 20X2
Proceeds 40 000, limited to cost 30 000: (i.e. 30 000 is a limiting factor) 30 000
Less tax base TB = Future tax deductions = 0 (because not tax-deductible) (0)
Recoupment See note 1 Not applicable
Note 1: Since the asset was not tax-deductible, there are no past tax-deductions for the tax
authority to recoup (i.e. the tax base was not nil because it had been fully deducted ±
instead, it was nil, from the beginning, because it was not tax deductible at all).

W2. Taxable capital gain ± per tax authority 20X2

Proceeds Given 40 000
Less base cost Given (30 000)
Capital gain 10 000
Inclusion rate Given 80%
Taxable capital gain 8 000

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W3. Profit on sale ± per accountant 20X2

Proceeds Given 40 000
Less carrying amount (30 000)
Cost Given 30 000
Less accumulated depreciation Given (no depreciation on this land) (0)
Profit on sale 10 000
- Capital profit Selling price: 40 000 ± Cost price: 30 000 10 000
- Non-capital profit Selling price limited to cost price: 30 000 ± CA: 30 000 0

20X2 20X1
W4. Current income tax Profit Tax: 30% Profit Tax: 30%
Profit before tax (accounting profits) (20 000 + 10 000);(Given: 20 000) 30 000 20 000
Permanent differences (and reconciling items)
Exempt income (Portion of capital profit that is exempt from tax) (2 000)
x Less capital profit on sale W3 (10 000)
x Add taxable capital gain W2 8 000
Taxable accounting profits (and tax expense) 28 000 8 400 20 000 6 000
Movement in temporary differences (and DT adj) Solution 21A / 20A 0 0 0 0
Taxable profits and current income tax 28 000 8 400 20 000 6 000

Solution 21C: Disclosure

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C

Non-current assets
Property, plant and equipment W1 (Example 20A) 0 30 000
Deferred tax asset W1 (Example 20A) 6 0 0

Current liabilities
Current tax payable 20X1: o/b: 0 + CT 6 000 ± Pmt: 0 14 400 6 000
20X2: o/b: 6 000 + CT 8 400 ± Pmt: 0

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C

Profit (loss) before tax 20X2: 20 000 + 10 000 30 000 20 000

20X1: 20 000 + - 0
Income tax expense 5 (8 400) (6 000)
Profit for the year 21 600 14 000

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C

5. Income tax expense

x Current W4 8 400 6 000
x Deferred W1 (Example 20A) 0 0
Income tax expense per statement of comprehensive income 8 400 6 000

Tax rate reconciliation

Applicable tax rate 30% 30%

Tax effects of:

x Profit before tax 20X2: (30 000 x 30%) 20X1: (20 000 x 30%) 9 000 6 000
x Exempt capital profit (Capital profit 10 000 ± Taxable capital gain 8 000) x 30% (600) 0
Income tax expense per statement of comprehensive income 8 400 6 000

Effective tax rate (8 400 ÷ 30 000) & (6 000 ÷ 20 000) 28% 30%

Chapter 6 333
Gripping GAAP Taxation: deferred taxation

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, straight-line, at 10% p.a. to a nil residual value.
No tax deductions for the cost of the building had been allowed by the tax authorities. The tax authority
includes 80% of capital gains in taxable profits but does not allow the tax-deduction of capital losses.
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
There are no other temporary or permanent differences.
There was no opening deferred tax balance or property, plant and equipment at the beginning of 20X1.
Required:
A. Calculate the deferred income tax.
B. Calculate the current income tax for 20X2 and 20X1.
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.

Solution 22A: Deferred tax

W1. Deferred income tax
Building x Non-deductible Carrying Tax Temporary Deferred
x Depreciable amount base difference tax
Opening balance ± 20X1 0 0 0 0
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: derecognise asset (27 000) (0) 27 000 (0) Exempt
Closing balance ± 20X2 0 0 0 0

Solution 22B: Current tax

W2. Recoupment on sale ± per tax authority 20X2

Proceeds (28 000) limited to cost (30 000): (Thus 30 000 is not a limiting factor) 28 000
Less tax base TB = Future tax deductions = 0 (because the building was not tax-deductible) (0)
Recoupment See note 1 Not applicable
Note 1: Since the asset is non-deductible, there are no past tax-deductions for the tax authority to recoup.

W3. Profit on sale ± per accountant 20X2

Proceeds Given 28 000
Less carrying amount (27 000)
Cost Given 30 000
Less accumulated depreciation (Cost: 30 000 ± 0) x 10% x 1 year (3 000)
Profit on sale (all a ‘ non-capital profit’ since selling price was below original cost) 1 000

W4. Current income tax 20X2 20X1

Profit before tax (accounting profits) Given: 20 000 + Profit on sale: 1 000 21 000 47 000
Given: 50 000 ± Depreciation: 3 000
Permanent differences (1 000) 3 000
- Add depreciation (Cost: 30 000 ± 0) x 10% 0 3 000
- Less non-capital profit on sale W3 (will never be taxed) (1 000) 0
Taxable accounting profits 20 000 50 000
Movement in temporary differences 0 0
Taxable profits 20 000 50 000
Current income tax at 30% 6 000 15 000
Notice: The depreciation and non-capital profit are shown under permanent differences instead of under
temporary differences. This is because they relate to a non-deductible asset and thus the related
temporary differences are exempt from deferred tax and are thus permanent in nature.

334 Chapter 6
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Solution 22C: Disclosure

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 C C
Non-current assets
Property, plant and equipment W1 0 27 000
Deferred tax asset W1 0 0

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit (loss) before tax (20K + 1K) (50K ± 3K) 21 000 47 000
Income tax expense 5. (6 000) (15 000)
Profit for the year 15 000 32 000

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current W4 6 000 15 000
x Deferred W1 0 0
Income tax expense per statement of comprehensive income 6 000 15 000
Tax rate reconciliation
Applicable tax rate Given 30% 30%
Tax effects of:
x Profit before tax 20X2: 21 000 x 30%; 20X1: 47 000 x 30% 6 300 14 100
x Non-taxable profit on sale 20X2: non-capital profit 1 000 x 30% (300) 0
x Non-deductible depreciation 20X1: add depreciation: 3 000 x 30% 0 900
Income tax expense per statement of comprehensive income 6 000 15 000
Effective tax rate 20X2: 6 000/ 21 000; 20X1: 15 000 / 28.6% 31.9%
47 000

Notice: The depreciation and non-capital profit are presented as reconciling items in the tax rate
reconciliation. This is because the asset to which they relate is non-deductible and thus what would
normally be a temporary difference leading to deferred tax was a temporary different exempt from
deferred tax, thus causing the effective tax rate to deviate from the applicable tax rate.

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% p.a. was provided on the straight-line basis (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%. The income tax rate is 30%.
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.
x There are no other temporary or permanent differences.
x There was no opening deferred tax balance or property, plant and equipment at the beginning of 20X1.
Required:
A. Calculate the deferred income tax.
B. Calculate the current income tax for 20X2 and 20X1.
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.

Solution 23A: Deferred tax

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: when sold, both are simply derecognised, thus becoming zero.

Chapter 6 335
Gripping GAAP Taxation: deferred taxation

Solution 23B: Current tax

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 TB = Future tax deductions = 0 (the building is not tax-deductible) (0)
Recoupment See note 1 Not applicable
Note 1: Since the asset was not tax-deductible, there are no past tax-deductions for the tax
authority to recoup.

W2. Taxable capital gain ± per tax authority 20X2

Proceeds Given 40 000

Less base cost Given (30 000)
Capital gain 10 000
Inclusion rate Given 80%
Taxable capital gain 8 000

W3. Profit on sale ± per accountant 20X2

Proceeds Given 40 000
Less carrying amount (27 000)
Cost Given 30 000
Less accumulated depreciation (30 000 ± 0) x 10% x 1 year (3 000)
Profit on sale 13 000
- Capital profit Proceeds: 40 000 ± Cost: 30 000 10 000
- Non-capital profit Proceeds limited to cost: 30 000 ± CA: (30 000 ± 3 000) 3 000

W4. Current income tax 20X2 20X1

Profit before tax (accounting profits) 20X2: 20 000 + Profit on sale: 13 000 33 000 17 000
20X1: 20 000 ± Depreciation: 3 000
Permanent differences:
x Less exempt income (Portion of capital profit that is exempt from tax) (2 000) 0
 Less capital profit W3 (10 000) 0
 Add taxable capital gain W2 8 000 0
x Add depreciation (30 000 ± 0) x 10% x 1 year 0 3 000
x Less non-capital profit W3 (3 000) 0
x Add recoupment (1) W1 0 0
Taxable accounting profits 28 000 20 000
Movement in temporary differences: normal 0 0
Taxable profits 28 000 20 000
Current income tax at 30% 8 400 6 000
Notice: The depreciation and non-capital profit and recoupment are shown under permanent differences
instead of under temporary differences. This is because they relate to a non-deductible asset and thus the
related µtemporary differences¶ are exempt from deferred tax and are thus DFWXDOO\µpermanent¶ in nature.

Solution 23C: Disclosure

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 C C
Non-current assets
Property, plant and equipment W1: Example 22 0 27 000
Deferred tax asset W1: Example 22 0 0

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before tax W4 33 000 17 000
Income tax expense 5. (8 400) (6 000)
Profit for the year 24 600 11 000

336 Chapter 6
 Gripping GAAP Taxation: deferred taxation

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C
5. Income tax expense
x Current W4 8 400 6 000
x Deferred W1: Example 22 0 0
Income tax expense per statement of comprehensive income 8 400 6 000
Tax rate reconciliation
Applicable tax rate Given 30% 30%
Tax effects of:
x Profit before tax 20X2: 33 000 x 30% 20X1: 17 000 x 30% 9 900 5 100
x Exempt capital profit (Capital profit 10 000 ± taxable capital gain (600) 0
8 000) x 30%
x Exempt non-capital profit Non-capital profit 3 000 x 30% (900) 0
x Non-deductible depreciation (3 000 x 30%) 0 900
Income tax expense per statement of comprehensive income 8 400 6 000
Effective tax rate 20X2: 8 400/ 33 000; 20X1: 6 000 / 17 000 25.5% 35.3%
Notice: The depreciation and non-capital profit are presented as reconciling items in the tax rate
reconciliation. This is because the asset to which they relate is non-deductible and thus what would
normally be a temporary difference leading to deferred tax was a temporary different exempt from deferred
tax, thus causing the effective tax rate to deviate from the applicable tax rate.

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:
 goodwill; or
 the initial recognition of an asset or liability, which
 did not arise through a business combination, and which
 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.

In other words, no deferred tax will be recognised on a temporary difference that arises on goodwill or
on the initial recognition of an asset or liability where this initial recognition does not affect accounting
profit or taxable profit, and if the asset or liability is not acquired as part of a business combination.

Chapter 6 337
 Gripping GAAP Taxation: deferred taxation

We covered some examples that showed the exemption from Important! The exemptions
recognising a deferred tax liability on the taxable temporary from deferred tax (IAS 12.15
difference arising on the acquisition of non-current assets & IAS 12.24):
(see section 4.3.2). x only apply to the initial recognition
(e.g. the cost of purchase);
Since the exemption principles apply equally to the x applies to any asset (not just
exemption from recognising a deferred tax asset on non-current assets) or liability;
deductible temporary differences, this text does not include x do not apply to acquisitions arising
any further examples. through business combinations.

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 SHULRG¶Vtaxable profits (current year transactions per the tax legislation);
x multiplied by the tax rates that we expect will be applied by the tax authorities.

Deferred tax differs from current tax only in that it is the estimated future tax payable/ receivable. In
other words, it is the estimated future tax on future transactions i.e. future taxable income and
future tax deductions« WKXV LW LV the future tax expected on the future recovery of assets and
settlement of liabilities.

From time to time, governments will change the tax rates. Deferred tax assets or
When this happens, we measure the current tax and liabilities are measured at:
deferred tax, using the:
x tax rates that are expected
x enacted tax rate at the reporting date, or the to apply to the period when
x proposed new rate, if it has been substantively enacted x the A is realised or the L settled;
by reporting date. Re-worded IAS 12.46-47 x based on tax rates (& tax
laws) that are
However, we must also take into consideration when the - enacted at reporting date, or
proposed new rate will become applicable (effective) - substantively enacted at
because the intention could be for the new rate to apply reporting date. IAS 12.47 Reworded
retroactively, immediately or at some future date. In this regard, it is useful to remember the
overriding principles:
x current tax PXVW EH µPHDVXUHG DW WKH DPRXQW H[SHFted to be paid to (recovered from) the
taxation auWKRULWLHV¶ See IAS 12.46
x deferred tax PXVWEHµPHDVXUHGDWWKe tax rates that are expected to apply to the period when
the asset is realised or the liability is settOHG¶. See IAS 12.47

Consider the following example: Before reporting date, the government announced a proposed
change to the currently enacted tax rate. The proposed new rate is substantively enacted at
reporting date. However, this proposed new rate will only be applicable to taxable profits in the next
tax year. In this case, although the proposed new rate is substantively enacted at reporting date:
x We will measure our current tax using the currently enacted tax rate at reporting date (i.e. the old
rate) since this is the rate that the tax authorities will apply when taxing our current taxable profits.
x We will measure our deferred tax using the substantively enacted tax rate (i.e. the proposed
new rate) since it seems likely that this is the rate that the tax authorities will apply when the
taxable income or tax deductions from our assets and liabilities eventually arise.

So when is a new rate µHQacted¶DQGµVXEVWDQWLYHly enacted¶"

The date on which the new tax rate is written into law and this new legislation is passed by Parliament,
is referred to as the date of enactment.

338 Chapter 6
Gripping GAAP Taxation: deferred taxation

In South Africa, the date of substantive enactment is generally considered to be the date on which
the new rate is announced by the Minister of )LQDQFH¶V%XGJHW6SHHFK.

But if the announcement of this new rate is inextricably linked to changes to other tax laws, it is only
substantively enacted when the other changes to the legislation µhave been approved by
Parliament and signed by the President¶. See SAICA FRG1.6 A substantively
enacted tax rate that
Care needs to be taken when deciding whether a proposed new has an effective date
that won’t affect the
rate (i.e. a rate that has been announced but not yet enacted) is
current tax assessment but will
substantively enacted at reporting date. See chapter 5, section affect future tax assessments,
B: 3.2 for an example. x the CT payable will be
measured using the enacted
If a proposed new tax rate is announced before reporting rate, whereas
date but it is not considered substantively enacted by x the DT liability (or asset) will be
reporting date, then our deferred tax balance at reporting measured using the
date must remain measured using the old rate (i.e. the rate substantively enacted tax rate.
that was currently enacted at reporting date).

This is interesting because if, for example, this proposed new tax rate gets enacted after the
reporting date but before the financial statements are authorised for issue, it means that, before
our financial statements were published, we would actually know that our taxes payable in the
future (deferred tax) will no longer be based on the old rate. However, the tax balances at
reporting date may not be adjusted to reflect the new rate. Instead, a change in tax rate that is enacted
or substantively enacted after reporting date but before publication of the financial statements is
considered to be a non-adjusting event after the reporting period (see chapter 18: part B)

To counter the problem of not being allowed to adjust our deferred tax balances to reflect new rates that
are enacted or substantively enacted after reporting date, we will disclose the change in tax rate in our
notes DVDµQRQ-adjustinJHYHQWDIWHUWKHUHSRUWLQJSHULRG¶VKRZLQJthe new rate and the effect that the
new rate will have on our deferred tax balances, assuming we think that this information will be useful to
our users. See IAS 10.21

At time of writing, the currently enacted corporate income tax rate in South Africa was 28% and no new
tax rates had been proposed. For ease of calculation, however, we 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 FRPSDQ\¶V\HDURIDVVHVVPHQWHQGVRQ'HFHPber 20X0.
B. The coPSDQ\¶V\HDURIDVVHVVPHQWHQGVRn 28 February 20X1.
C. 7KHFRPSDQ\¶V\HDURIDVVHVVPHQWHQGVRQRUDIWHU0DUFK;

Solution 24: Enacted and substantively enacted tax rates

Tax rates to be used in measuring Solution 24A Solution 24B Solution 24C
the 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 (because no significant changes to other taxes
were announced at the time).

x The effective date is 1 March 20X1.

Chapter 6 339
Gripping GAAP Taxation: deferred taxation

Explanations for each part (A, B and C):

A. The new tax rate is not enacted at reporting date at 31 December 20X0 (enacted on 21 April 20X1)
and is also not substantively enacted at reporting date (substantively enacted on 20 January 20X1).
Thus, the current tax will remain measured at 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).
Since this is a µQRQ-adjusting event after the reporting GDWH¶Ze would disclose a note showing the proposed
new tax rate and the expected amount by which the deferred tax balances will decrease in future.
B. The new tax rate is not enacted at reporting date of 28 February 20X1 (enacted on 21 April 20X1) but
it is substantively enacted at reporting date (substantively enacted on 20 January 20X1).
The current tax 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-ULGLQJ UXOH LV WKDW FXUUHQW WD[ LV WR EH µPHasured at the amount
expected to be paid to the taxatioQDXWKRULWLHV¶ 
The deferred tax balance will be based on the new rate since the new rate was substantively
enacted before reporting date and will be effective (applicable) when the assets and liabilities giving
rise to temporary differences are realised or settled.
C. The new tax rate is not enacted at reporting date of 31 March (enacted on 21 April 20X1) but it is
substantively enacted at reporting date (substantively enacted on 20 January 20X1) and is already
effective (applicable).
The current tax will be measured using the new rate (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 apply to the current year taxable profits (even though the new rate
is not yet legislated ± i.e. not yet enacted). In other words, the current tax will thus be based on the
new rate, since the new rate was both 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 and will be effective (applicable) when the assets and liabilities giving
rise to temporary differences are realised or settled.

7. Rate Changes and Deferred Tax (IAS 12.47 and SAICA FRG1)

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 rate changes, so does the
estimate of the amount of tax owing by or owing to the tax authority in the future. Therefore, if an
entity has an opening deferred tax balance in a year during which the rate of tax changes, the
opening deferred tax balance may need to be re-estimated.

An adjustment to the opening deferred tax balance is accounted for as a µFKDQJH LQ accounting
estimate¶, which means it is accounted for prospectively. This simply means we process
adjustments to prior year balances in WKHFXUUHQW\HDU¶VDFFRXQWLQJUHFRUGV (see chapter 26).

Thus, if there has been a change in tax rate that requires us to remeasure our opening deferred tax
balance, our tax expense in the current year effectively includes an adjustment relating to the prior
year closing deferred tax balance. This will mean that, in the current year, our effective tax rate will
not equal the cXUUHQW\HDU¶V applicable tax rate. The difference between the effective and applicable
tax rates means we will need to include a µtax rate reconciliation¶ in the tax expense note.

These principles apply if a new rate was enacted by reporting date, or if it is not yet enacted, if it
was substantively enacted by reporting date.

The opening deferred tax balance is adjusted to reflect the new tax rate unless it has neither been
enacted nor substantively enacted on or before reporting date (see section 6). In other words, we
generally adjust for the new rate:
x If it is enacted on/ before reporting date;
x If it is not yet enacted but is substantively enacted on/ before reporting date.

340 Chapter 6
Gripping GAAP Taxation: deferred taxation

If the proposed change in tax rate has not been enacted or substantively enacted on or before
reporting date, no adjustments are made. Instead, the proposed rate change is disclosed as a non-
adjusting event in terms of IAS 10 Events after the reporting period. (Also see section 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/ (Credit) Debit/ (Credit) Debit/ (Credit) Debit/ (Credit)
Deferred tax asset/ (liability) (a); (b); (c); (d) 20 000 (20 000) (15 000) 15 000
Income tax expense (20 000) 20 000 15 000 (15 000)
Rate change: adjustment to DT opening balance

Calculations
(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).
This deferred tax balance arose purely due to temporary differences caused by tax-deductible capital
allowances on depreciable items of 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 There are no other adjustments that would affect current tax payable (amount owing at end 20X1: nil).
x There were no permanent differences and there was no movement in temporary differences during 20X2.

Required:
A. Calculate and explain the effect of the rate change on deferred tax.
B. Show the calculation of deferred income tax using the balance sheet method.
C. Calculate the current income tax for 20X2.
D. Show the tax-related 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 deferred tax balance means we have a deferred tax liability and thus that the company is
expecting the tax authority to charge them tax in the future on the temporary difference of C100 000.

Chapter 6 341
Gripping GAAP Taxation: deferred taxation

Since the tax rate has now dropped to 35%, the estimated future tax on this temporary difference of
C100 000 needs to be changed from C45 000 to C35 000:

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 liability balance was (45 000) Balance: credit
Deferred tax liability balance should now be (35 000) Balance: credit
Adjustment needed 10 000 Debit deferred tax liability, Credit tax expense

Solution 26B: Deferred tax

W1. Deferred income tax

PPE x Deductible Carrying Tax Temporary Deferred
x Depreciable amount base difference tax
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)
(1)
Movement 0 0 0 0
Closing balance @35% xxx xxx (100 000) (35 000) Liability

Notes:
(1) There is no movement as we are told there was no movement in temporary differences during 20X2.

Solution 26C: Current tax

Taxable profits and current income tax - 20X2 Profits Tax at 35%
Profit before tax (accounting profits) (given) 200 000
Permanent differences (given) 0
Taxable accounting profits 200 000 70 000
Movement in temporary differences: (given) 0 0
Taxable profits and current income tax 200 000 70 000

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 expense (E) Deferred tax liability (L)

CTP 70 000 DTL (1) 10 000 Balance b/d 45 000
Total c/f 60 000 Income tax (1) 10 000
70 000 70 000 Balance c/d 35 000
Total b/d 60 000 45 000 45 000
P/L 60 000 Balance b/d 35 000
60 000 60 000

Current tax payable (L)

Balance b/d 0
Income tax 70 000
Balance b/d 70 000

342 Chapter 6
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Solution 26E: Disclosure

Entity name
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 Note C C
Non-current liabilities
Deferred tax liability 26A or 26B or 26D 4 35 000 45 000
Current liabilities
Current tax payable (o/balance: 0 + current tax exp: 70 000 0
70 000 (26C) ± payment: 0); Or: 26D

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the year ended 31 December 20X2 Note C C
Profit before tax (given) 200 000 xxx
Income tax expense 3 (60 000) xxx
Profit for the year 140 000 xxx

Entity name
Notes to the financial statements (extract) 20X2
For the year ended 31 December 20X2 C
3. Income tax expense
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)
Income tax expense per statement of comprehensive income 60 000

Tax rate reconciliation

Applicable tax rate 35%
Tax effects of:
x Profit before tax 200 000 x 35% 70 000
x Rate change Ex 26A or Ex 26B (10 000)
Income tax expense 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
C C
The closing balance is constituted by the effects of:
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.
IAS 12 refers to three categories that could result in a deferred tax asset:
x Deductible temporary differences (DTDs)
For example: if a plaQW¶V 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;

Chapter 6 343
Gripping GAAP Taxation: deferred taxation

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
recognised, not all DTAs
Although a deferred tax asset (DTA) may exist (section 8.1), 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 tax To recognise or not to
assets on unused tax losses than on unused tax credits or recognise… that is the
deductible temporary differences is simply that, if we make question!
a tax loss, it may mean that we are already in financial x A DTA may only be recognised if
difficulty, in which case it is possible that we may never the future tax saving is probable.
make future profits big enough to be able to deduct the tax x It may be difficult to recognise a
loss and realise the related tax saving. DTA on unused tax losses

Worked Example 1: 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 1: Tax losses may or may not reflect probable future tax savings
Scenario 1:
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)
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.
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.

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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)
Tax loss brought forward (100 000) 0
Taxable profit/ (tax loss) (400 000) (100 000)
Current income tax at 30% 0 0
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:

The recognition criteria per the 2018 CF require information to be both relevant and a faithful
representation. However, IAS 12 has not been updated for the new 2018 CF and thus IAS 12
still makes reference to a probable inflow of future economic benefits being one of the two recognition
criteria in the old 2010 CF. The IASB will update IAS 12 in time but believes the recognition 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, anGWKXVWKHHQWLW\¶Vnet 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 income tax rate is 30%.
x 7KH HQWLW\¶V ILQDO PDQDJHPHQW-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.

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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. Current income tax: C C
Taxable profit/ (tax loss) before adjusting for tax losses b/ forward (50 000) (100 000)
Tax loss brought forward (100 000) 0
Reverse 20X1 unutilised tax loss expiring 31/12/20X2 100 000
Taxable profit/ (tax loss) (50 000) (100 000)
Current income tax at 30% 0 0

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.
x The income tax rate is 30%.
Required: Calculate and prove what portion of the deferred tax asset balance should be recognised at
31 December 20X1 assuming that the entit\¶VILQDOPDQDJHPHQW-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: Recognising DTA: deductible temporary difference

W1. Deferred income tax
Computer x Deductible Carrying Tax Temporary Deferred
x Depreciable amount base difference tax
Opening balance ± 20X1 0 0 0 0
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
Closing balance ± 20X3 0 0 0 0

W2. Future income tax payable Scenario A Scenario B Scenario 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)

Taxable profit/ (tax loss) 210 000 (20 000) (270 000)
Future income tax payable at 30% 63 000 0 0

346 Chapter 6
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W3. Future tax savings Scenario A Scenario B Scenario C

Tax that would be GXHRQµIXWXUH A: 240 000 x 30% 72 000 3 000 0
profit beforHWD[WKDWLVWD[DEOH¶ 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.

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Gripping GAAP Taxation: deferred taxation

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

Cost of vehicle purchased on 1 January 20X1 C120 000
Depreciation on vehicles to nil residual value 4 years straight-line
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 20X2 Loss: C20 000
x 31 December 20X3 Profit: C400 000
Other information:
x There are no permanent or temporary differences other than those evident from the information given.
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 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
Taxable profit/ (tax loss) 310 000 (120 000) (70 000)
Current income tax at 30% 93 000 0 0

Solution 29B: Calculation of deferred income tax

W2. Deferred income tax

W2.1 Vehicle x Deductible Carrying Tax Temporary Deferred
x Depreciable amount base difference tax
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 x Deductible Carrying Tax Temporary Deferred

amount base difference tax
Balance: 1 Jan 20X1 0 0 0 0
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

348 Chapter 6
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Solution 29C: Journals

Journals 20X1 Debit Credit

Income tax expense (P/L: E) W2.1 9 000
Deferred tax liability (L) 9 000
Origination: DT adjustment due to temporary differences: vehicle (20X1)
Deferred tax asset (A) W2.2 21 000
Income tax expense (P/L: E) 21 000
Origination: DT adjustment due to tax loss being created (20X1)
Journals 20X2
Income tax expense (P/L: E) W2.1 9 000
Deferred tax liability (L) 9 000
Origination: DT adjustment due to temporary differences: vehicle (20X2)
Deferred tax asset (A) W2.2 15 000
Income tax expense (P/L: E) 15 000
Origination: DT adjustment due to tax loss being created (20X2)
Journals 20X3
Deferred tax liability (L) W2.1 9 000
Income tax expense (P/L: E) 9 000
Reversal: DT adjustment due to temporary differences: vehicle (20X3)
Income tax expense (P/L: E) W2.2 36 000
Deferred tax asset (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 payable (L) 93 000
Current tax estimated based on current taxable profits (20X3)

Solution 29D: Disclosure

Entity name
Statement of financial position (extract) 20X3 20X2
As at 31 December 20X3 Note C C
Non-current assets
Deferred tax asset 5 0 18 000
Non-current liabilities
Deferred tax liability 5 9 000 0

Entity name
Statement of comprehensive income (extract) 20X3 20X2
For the year ended 31 December 20X3 Note 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)

Entity name
Notes to the financial statements (extract) 20X3 20X2
For the year ended 31 December 20X3 C C
5. Deferred tax asset/ (liability)
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

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Gripping GAAP Taxation: deferred taxation

Entity name
Notes to the financial statements FRQWLQXHG« 20X3 20X2
For the year ended 31 December 20X3 C C
12. Income tax 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
Income tax expense per statement of comprehensive income 120 000 (6 000)

Rate reconciliation:
Applicable tax rate 30% 30%
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.
x In 20X2 future taxable profits sufficient to be able to utilise the tax loss 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:
x Cost of vehicle purchased on 1 January 20X1 C120 000
x Depreciation on vehicles to nil residual value 4 years straight-line
x Capital allowance on vehicle allowed by the tax authorities 2 years straight-line
x Income tax rate 30%
x 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 20X2 Loss: C20 000
x 31 December 20X3 Profit: C400 000
x There are no permanent or 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 Summary of deferred tax: Vehicle: Tax loss:

W2.1 W2.2
Recognised Total Recognised Unrecognised
Balance: 1 Jan 20X1 0 0 0 0
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:
x Since, in 20X2, future taxable profits are no longer considered probable, it means that from 20X2 the
total net deferred tax balance must not go into debit (i.e. the net effect of the deferred tax liability on
the vehicle and deferred tax asset on the tax loss can result in a net liability or can net each other off
to nil, but must not result in a net deferred tax asset).

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x Thus, although the deferred tax asset resulting from the tax loss is C36 000, since the deferred tax
liability caused by the vehicle is only C18 000, recognising the full deferred tax asset would result in a
net deferred tax asset of C18 000, which is not allowed. This means the maximum deferred tax asset
that we can recognise is limited to the deferred tax liability balance of C18 000 (resulting in a net
deferred tax balance of nil).

x Thus, the unrecognised portion of the deferred tax asset on the tax loss is C18 000:
Total DT asset on tax loss C36 000 ± DT asset recognised C18 000 = DT asset unrecognised C18 000.

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended 31 December 20X2 C C

5. Deferred tax asset/ (liability)

The deferred tax balance comprises tax on the following types of temporary differences:
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.

12. Income tax expense

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
Income tax expense per statement of comprehensive income 12 000 (12 000)

Tax rate reconciliation

Applicable tax rate 30% 30%

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
Income 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¶VLQIRUPDWion was repeated in Example 30), but now assume:
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: Current income tax

There would be no change to the calculation of current income tax

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Solution 31B: Deferred income tax

There would be no change to the calculation of deferred tax with the exception of a further calculation
(W2.3 below) 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).
W2.3 Vehicle: Tax loss:
Summary of deferred tax: W2.1 W2.2
Recognised Total Recognised Unrecognised
Balance: 1 Jan 20X1 0 0 0 0
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
x Portion of DTA used (36 000) (36 000)
x Prior year unrecognised DTA now 18 000 (18 000)
recognised
Balance: 31 Dec 20X3 (9 000) 0 0 0

Comment:
x The effect of the situation in 20X2 was that the total net deferred tax balance was not allowed to go
into debit.
This resulted in part of the deferred tax asset of C36 000 not being recognised (i.e. we were allowed
to recognise a deferred tax asset of C18 000, leaving us an unrecognised portion of C18 000).
x Although in 20X2 we did not expect the tax loss to be used in full, in 20X3 the tax loss is fully utilised,
(i.e. we achieved a tax saving of C36 000, not just C18 000 as we had predicted).
x However, a deferred tax asset of only C18 000 had been recognised.
Thus, since we need to show that a deferred tax asset of C36 000 has been used up, the
unrecognised portion of the deferred tax asset of C18 000 must now be recognised.

Solution 31C: Journals

Journals 20X1 Debit Credit

Income tax expense (P/L: E) Sol 29B (W2.1) 9 000

Deferred tax liability (L) 9 000
Originating: DT adjustment due to temporary differences: vehicle (20X1)

Deferred tax asset (A) Sol 29B (W2.2/ W2.3) 9 000

Income tax expense (P/L: E) 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

Deferred tax liability (L) 9 000
Originating: DT adjustment due to temporary differences: vehicle (20X2)
Deferred tax asset (A) Sol 29B (W2.2/ W2.3) 9 000
Income tax expense (P/L: E) 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)

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Journals 20X3 Debit Credit

Deferred tax liability (L) Sol 29B (W2.1) 9 000

Income tax expense (P/L: E) 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 asset (A) 36 000
Reversing: DT adjustment due to tax loss being used (20X3)
Deferred tax asset (A) W2.3 18 000
Income tax expense (P/L: E) 18 000
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 93 000
Current tax charge in 20X3

Solution 31D: Disclosure

Entity name
Statement of financial position (extract) 20X3 20X2 20X1
$VDW««; Note C C C

Non-current liabilities
Deferred tax liability W2.3 5 9 000 0 0

Entity name
Statement of comprehensive income (extract) 20X3 20X2 20X1
For the year eQGHG«; Note 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)

Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 31 December C C C

5. Deferred tax asset/ (liability)

The deferred tax balance comprises tax on the following types of temporary differences:
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).

15. Income tax expense

x Current 29A: W1 93 000 0 0

x Deferred
x Current year movement in temp diff¶V 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 or
recognised W2.3 or Jnl (18 000)

Tax expense per statement of comprehensive income 102 000 0 0

Income tax expense note continues on the next page

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Gripping GAAP Taxation: deferred taxation

Entity name
Notes to the financial statements (extract) 20X3 20X2 20X1
For the year ended 31 December C C C

15. Income tax expense continued…

Tax rate reconciliation
Applicable tax rate 30% 30% 30%
Tax effects of:
x Profit before tax (400K profit x 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 year unrecognised DTA now recognised Above (18 000) 0 0
Tax expense per statement of comprehensive income 102 000 0 0

Effective tax rate (102 000 ÷ 400 000) (0÷loss) (0÷loss) 25.5% N/A N/A
Calculations:
(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

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:

Comprehensive
C basis
x is presented as part of the tax expense in the profit or
loss section of the statement of comprehensive income; x the term used to describe the
and method whereby
x is supported by a note (the tax expense note). x the tax effects of all temporary
differences are recognised
Where the tax is caused by gains or losses recognised directly
in equity (other comprehensive income), this tax is:
x shown as a separate line item in the other comprehensive income section of the statement of
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
Notes to the financial statements (extract) 20X2 20X1
For the year ended «; C C
2. Significant accounting policies
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.

354 Chapter 6
Gripping GAAP Taxation: deferred taxation

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 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:

The following example applies if the above criteria were not met and thus set-off of the deferred tax
asset and deferred tax liability was not allowed

Entity name
Statement of financial position (extract) 20X2 20X1
$VDW««; C C

Non-current assets
Deferred tax asset 5. xxx xxx

Non-current liabilities
Deferred tax liability 5. xxx xxx

Current liabilities
Current tax payable 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 municipal 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/liability line-item 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.

Solution 32A: Settlement on a net basis is allowed

Entity name
Statement of financial position (extract) 20X2 20X1
As DW««; C C

Non-current liabilities
Deferred tax: income tax 80 000 - 20 000 60 000 xxx

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Gripping GAAP Taxation: deferred taxation

Solution 32B: Settlement on a net basis is not allowed

Entity name
Statement of financial position (extract) 20X2 20X1
$VDW««; C C

Non-current assets
Deferred tax asset: municipal tax 20 000 xxx

Non-current liabilities
Deferred tax liability 80 000 xxx

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 µdeferred tax note¶ in the µnotes to the financial statements¶,
whether the balance is an asset or liability (if, for example, you reflect liabilities in brackets, then
the heading would be: µdeferred tax asset/ (liability)¶).

In practice, it is also common for the µdeferred tax line-item¶ on the face of the µstatement of
financial position¶ to indicate whether the deferred tax balance 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
Notes to the financial statements (extract) 20X2 20X1
For the year ended conWLQXHG« C C

5. Deferred tax asset / (liability)

The closing balance is constituted by the effects of:

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 µtax 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).

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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 µother 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 µother comprehensive income¶, and
x a deferred tax adjustment recognised in µprofit 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.

Example of the layout of the reconciliation that may be needed in the deferred tax asset/ liability note:

Entity name
Notes to the financial statements (extract) 20X2 20X1
)RUWKH\HDUHQGHGFRQWLQXHG« C C
5. Deferred tax asset / (liability) continued ...
«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
Notes to the financial statements (extract) 20X2 20X1
For the yeDUHQGHGFRQWLQXHG« C C
5. Deferred tax asset / (liability) continued ...
«&RQWLQXHGIURPQRWH 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.

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Gripping GAAP Taxation: deferred taxation

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 WKHHQWLW\¶V 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

Example of the disclosure of tax expense on the face of the statement of comprehensive income:

Entity name
Statement of comprehensive income (extract) 20X2 20X1
For the \HDUHQGHG«20X2 C C

Profit before tax xxx xxx

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

Total comprehensive income 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 HQWLW\¶V 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)

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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)

Example of the layout of a basic income tax expense note:

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year HQGHG« C C

6. Income tax expense

 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)

Income tax expense per the statement of comprehensive income xxx xxx

Rate reconciliation:

Applicable tax rate (ATR) Income tax rate: 30% x% x%

Tax effects of:

x Profit before tax Profit before tax x ATR xxx xxx

x Exempt income (add) Exempt income x ATR (xxx) (xxx)
x Non-deductible expenses (less) Non-deductible expenses x ATR xxx xxx
x Current tax under/ (over) provision Per above xxx (xxx)
x Deferred tax rate change Per above xxx xxx
x Add other taxes on profits Per above: current + deferred xxx xxx

Income tax expense per the statement of comprehensive income xxx xxx

Effective tax rate (ETR) Taxation expense ÷ Profit before tax x% x%

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)

Chapter 6 359
Gripping GAAP Taxation: deferred taxation

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)

Example of the layout of a detailed income tax expense note:

Entity name
Notes to the financial statements (extract) 20X2 20X1
For the year ended ... C C
6. Income tax expense
 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) (xxx) (xxx)
Income tax expense per the statement of comprehensive income xxx xxx

Rate reconciliation:
Applicable tax rate (ATR) Income tax rate: 30% x% x%
Tax effects of:
x Profit before tax Profit before tax x ATR xxx xxx
x Exempt income Exempt income x ATR (xxx) (xxx)
x Non-deductible expenses Non-deductible expenses x ATR xxx xxx
x Prior year under/ (over) provision Per above xxx xxx
x Prior year deferred tax balance: rate change Per above xxx (xxx)
x Current year deferred tax asset not recognised Per above xxx xxx
x Prior year recognised def tax asset written-down/ (back) Per above xxx (xxx)
x Prior year unrecog def tax asset now recognised Per above (xxx) (xxx)
x Other tax on profits Per above xxx xxx
Income tax expense per the statement of comprehensive income xxx xxx
Effective tax rate (ETR) Taxation expense ÷ Profit before tax x% x%

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).

360 Chapter 6
Gripping GAAP Taxation: deferred taxation

Tax on profit RUORVVLVVKRZQLQWKHµLQFRPHWD[H[SHQVH¶ line item and details thereof are disclosed in
WKHµLQFRPHWD[H[SHQVH¶ 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
Notes to the financial statements (extract) 20X2 20X1
For the yHDUHQGHG« C C
23. Other comprehensive income: cash flow hedge
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)

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Gripping GAAP Taxation: deferred taxation

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 Income tax rate

x Prior year estimate under/ (over) provided

x Tax assessment for the prior year – Current tax expense recognised in prior year

Deferred income tax

x Current year’s DT adjustment =
Movement in temporary differences x Income tax rate
or
Temporary differences at end of year x Tax rate - Temporary differences at beginning of year x Tax rate
x Prior year DT adjustment due to rate change =
Opening def. tax balance / Old tax 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 does not affect deferred 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 that declares the dividend and is thus not included
in that entity’s tax expense and similarly, there are no deferred tax consequences

Deferred tax is
Recognised on certain
Temporary differences:

How to calculate temporary differences and Examples of items that cause

deferred tax temporary differences
x Balance sheet approach x Accruals:
 new IAS 12  income received in advance
x Income statement approach  expenses prepaid
 old IAS 12 x Provisions
See next page for the calculations x Non-current assets

Summary continues on the next page …

362 Chapter 6
Gripping GAAP Taxation: deferred taxation

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 or will not be taxed
in the future in the future

Tax base

The portion that The portion that

will not be will be taxed
or
deducted in the future
in the future

The tax bases can also be calculated as follows:

x TB of an Asset (If economic benefits are taxable) = Future tax deductions

x TB of an Asset (If economic benefits are not taxable) = Carrying Amount
x TB of a Liability (If income received in advance) = Carrying Amount – Portion won’t be taxed in the future
x TB of a Liability (If not income received in advance) = Carrying Amount - Future tax deductions

Chapter 6 363
Gripping GAAP Taxation: deferred taxation

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:
ƒ On the date announced by the Minister of Finance
o If the new rate is inextricably linked to changes to other tax laws, when:
ƒ announced by the Minister of Finance; and
ƒ President has approved the change.

Measuring current tax Measuring deferred tax

The amount expected to be paid to
(recovered from) the taxation authorities
IAS 12.46
The amt calculated using tax rates that are
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 =0
amounts 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

364 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 2021)

Contents: Page
1. Introduction 367
2. Recognition 367
2.1 Overview 367
2.2 Meeting the definition 367
2.3 Meeting the recognition criteriaI 368
2.4 Recognising significant parts 368
Example 1: Significant parts 368
3. Initial measurement 369
3.1 Overview 369
3.2 Cost and the effect of the method of acquisition 369
3.2.1 Item acquired by way of cash (or something similar) 369
Example 2: Cash payments ± µZLWKLQ¶YVµEH\RQG¶QRUPDOFUHGLWWHUPV 370
3.2.2 Item acquired via an asset exchange 370
Example 3: Asset exchange ± fair values are known 371
Example 4: Asset exchange ± involving cash and cash equivalents 371
Example 5: Asset exchange ± with no commercial substance 372
3.2.3 Item acquired via a government grant 372
Example 6: Government grant is a non-monetary asset 373
Example 7: Government grant is a monetary asset (to acquire another asset) 373
3.3 Initial costs 374
3.3.1 Overview 374
3.3.2 Purchase price 374
Example 8: Initial costs: purchase price 374
Example 9: Initial costs: purchase price with settlement discount 375
3.3.3 Directly attributable costs 376
Example 10: Initial costs: purchase price, directly attributable costs and 376
significant parts
Example 11: Initial costs: purchase price and directly attributable costs 377
3.3.4 Future costs: dismantling, removal and restoration costs 378
3.3.4.1 Future costs: overview 378
3.3.4.2 Future costs: existing on acquisition 378
Example 12: Initial cost involving future costs 378
3.3.4.3 Future costs: caused/increases over time 379
Example 13: Subsequent costs involving future costs 379
3.3.4.4 Future costs: caused/increases over time ± more detail 380
3.4 Subsequent costs 381
3.4.1 Day-to-day servicing 381
Example 14: Vehicle repainting 381
Example 15: Vehicle acquired without engine: engine purchased afterwards 381
Example 16: Vehicle engine overhaul ± extending the useful life 382
Example 17: Vehicle engine service 382
3.4.2 Replacement of parts and de-recognition of assets 383
3.4.2.1 Derecognition of the old part 383
3.4.2.2 Capitalisation of a new part 383
Example 18: Replacement of a part 383
Example 19: Replacement of a part that was not previously identified 384

Chapter 7 365
Gripping GAAP Property, plant and equipment: the cost model

&RQWHQWVFRQWLQXHG« Page
3.4.3 Major inspections 384
Example 20: Major inspection performed 385
Example 21: Major inspection purchased as part of the asset 385
Example 22: Major inspection derecognised 386
4. Subsequent measurement 387
4.1 Overview 387
4.2 Cost model 387
4.3 Depreciation 387
4.3.1 Overview 387
4.3.2 Residual value and the depreciable amount 388
4.3.3 Method of depreciation 388
4.3.3.1 Straight-line method 389
4.3.3.2 Diminishing balance method 389
4.3.3.3 Units of production method 389
4.3.3.4 Choosing a method 390
4.3.4 Useful life 390
4.3.5 Depreciating the whole asset or the parts thereof 391
Example 23: Depreciation calculation with many dates 391
Example 24: Depreciable amount and straight-line depreciation 391
Example 25: Depreciation using diminishing balance 392
Example 26: Depreciation using units of production 393
Example 27: Depreciation of a self-constructed asset 393
4.3.6 Change in estimate 394
Example 28: Units of production depreciation; change in total expected production 394
4.4 Impairments 394
4.4.1 Overview 394
4.4.2 Recoverable amount 395
4.4.3 Comparing the carrying amount with the recoverable amount 395
4.4.4 Depreciation in periods following an impairment 396
Example 29: Cost model ± impairment loss 397
Example 30: Cost model ± reversal of impairment loss 398
Example 31: Cost model ± a summary example (the asset is not depreciated) 399
Example 32: Cost model ± a summary example (the asset is depreciated) 400
5. Derecognition 401
6. Deferred tax consequences 402
6.1 Overview 402
6.2 Comparing the carrying amount and tax base 402
Example 33: Deferred tax caused by the purchase, depreciation and sale of PPE 403
Example 34: Deferred tax involving the impairment of PPE 405
6.3 Deferred tax exemptions 406
Example 35: Deferred tax involving exempt temporary differences 407
7. Presentation and disclosure 407
7.1 Overview 407
7.2 Accounting policies and estimates 408
7.3 Statement of comprehensive income disclosure 408
7.4 Statement of financial position disclosure 409
7.5 Further encouraged disclosure 409
7.6 Disclosure regarding fair value measurements 409
7.7 Sample disclosure involving property, plant and equipment 409
Example 36: Cost model disclosure ± no impairment 410
Example 37: Cost model disclosure ± with impairments 412
8. Summary 415

366 Chapter 7
Gripping GAAP Property, plant and equipment: the cost model

1. Introduction

µProperty, plant and equipment¶ refers to a collection of assets that are vital to most businesses.
Key characteristics include that they are physical and that they will be used by the business for
more than one year (thus they are non-current in nature). See the definition in the section below.

The standard covering this class of assets is IAS 16 Property, plant Examples of
and equipment. In it, we are told how to recognise these assets, how classes of PPE
to derecognise them, how to measure them, and how to disclose them. include:
x land;
Measurement of this asset involves two stages: x buildings;
x plant;
x Initial measurement, which is always at cost, and
x equipment (factory);
x Subsequent measurement, which involves: x equipment (office);
 choosing the measurement model1: cost or revaluation model; x furniture; and
 depreciation; and x vehicles.
 impairment testing.

Note 1: this chapter explains the cost model and the next chapter explains the revaluation model.

Under the cost model, we first measure the asset at cost. The PPE carrying amount
(under the cost model) is
As time goes by, we then subsequently measure it to reflect reflected by three amounts:
the effects of usage (depreciation) and the effects of any x Cost: this shows how much it was
damage (impairments). Thus, the asset¶s carrying amount is initially measured at (see section 3).
measured as a combination of three amounts: x Accumulated depreciation: this
x cost shows the cumulative effect of
usage of the asset.
x less accumulated depreciation, and
x Accumulated impairment losses:
x less accumulated impairment losses. this shows the cumulative effect
of damage (any kind – not just
The depreciation and impairments, which reduced the asset¶s physical) to the asset.
value, are recognised as expenses. Reducing an asset¶s
value and recognising the reduction as an expense is referred to as µexpensing the asset¶.

Although the µdepreciation¶ and µimpairment loss¶ expenses must be separately disclosed, the
µaccumulated depreciation¶ and µaccumulated impairment losses¶ do not need to be disclosed
separately, and thus we may combine these amounts into a single account (µaccumulated
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 DQLWHPDVµSURSHUW\SODQWDQGHTXLSPHQW¶, it must meet:
x the definition of property, plant and equipment; and
x the recognition criteria. PPE is defined as:

x tangible items, that are held:

2.2 Meeting the definition (IAS 16.6)
- for use in the production or
supply of goods or services,
There are three key factors for an item to meet the definition of
- for rental to others, or
property, plant and equipment (see pop-up alongside).
- for administration
x It must be tangible. This means that it must have a physical form purposes; and
x are expected to be used
(e.g. a machine has physical form, but a patent does not). during more than one period.
x We must be planning to use it. We could use it in one of three IAS 16.6

ways ± we could use it to produce or supply goods or services (e.g. a machine that we use to
make inventory or to polish floors), to rent to third parties (e.g. a machine that we rent to
someone) or for administration purposes (e.g. a building that we use as our head office).
x We must plan to use the item for more than one period, which means property, plant and
equipment is a non-current asset. An asset that will be used for a year or less is a current asset.

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Recognition criteria
2.3 Meeting the recognition criteria (IAS 16.7 - 10) (per IAS 16):
x an inflow of future
If this definition is met, the next step is to check if the recognition economic benefits to the
criteria are also met. IAS 16 specifies two recognition criteria: an entity is probable; and
inflow of future economic benefits from the asset must be x the its cost can be
probable, and it 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 µsignificant¶ 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. This is important because significant parts often have different
useful lives and residual values to the remaining parts of the item of property, plant and
equipment, both of which will affect the amount of depreciation (see section 4.3). See IAS 16.43

Example 1: Significant parts

On 30 June 20X1, Noah Limited owned farm equipment, with a carrying amount of C300 000.
On this day, to mitigate risks, he bought a ship for C600 000 cash. The ship has three parts:
x Hull: C150 000 (a significant part)
x Engine: C200 000 (a significant part)
x Various other parts: C250 000 (individually insignificant).
Required:
a) Journalise the purchase of the ship.
b) Present Noah¶s assets in the statement of financial position on 30 June 20X1.

Solution 1A: Significant parts: Journals

30 June 20X1 Debit Credit

Ship: engine: cost (A) 200 000
Ship: hull: cost (A) 150 000
Ship: other insignificant parts: cost (A) 250 000
Bank (A) 600 000
Purchase of ship

Solution 1B: Significant parts: Disclosure

Noah Limited
Statement of financial position (extracts) 20X1
As at 30 June 20X1 C
Non-current assets
Property, plant and equipment Farm equipment: 300 000 + Ship: 600 000 900 000

Comment: When disclosing the assets 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 from the farm equipment.

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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 pop-up), which clarifies that it could be Cost is defined as
a cash amount (or cash equivalent), a fair value, or in certain
x the amount of cash or
cases, it could even be an amount simply attributed to that asset. cash equivalents paid; or
x the fair value of the
The cost of the asset on the date it is initially recognised is called the consideration given (if it is
initial cost (see section 3.3). This initial cost includes: not cash) at the time of
acquisition or construction; or
x its purchase price (see section 3.3.2);
x the amount attributed to
x directly attributable costs (see section 3.3.3); and that asset if initial
x certain future costs (see section 3.3.4). See IAS 16.16 recognition is per other
IFRSs. Reworded IAS 16.6
/DWHULQWKHDVVHW¶VOLIHIXUWKHUFRVWVPD\EHLQFXUUHGLQUHODWLRQWRWhe
asset, which we refer to as subsequent costs (see section 3.4).
Initial costs
These subsequent costs involve, 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 LWHP¶VFRVWFRXOGEHWKHIDLUYDOXHRIWKHDVVHWJLYHQXSWKH
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 where the government gave us an asset,
its cost could be measured at its fair value or at a nominal amount (used purely for recording
purposes), or, if the government gave us cash to help subsidise the acquisition of an asset, the
asset¶s cost could be reduced by the amount of grant (see section 3.2.3).

3.2.1 Item acquired by way of cash (or something similar) (IAS 16.23)

If the acquisition price is paid in cash (or something similar If payment is deferred
to cash), then the cost of the item is the cash price beyond normal credit
terms, cost is the present
equivalent on date of recognition. value of the cash payments.
x If the payment occurs immediately on date of acquisition Note:
Total amount we’ll pay
or within normal credit terms, the µcash price equivalent¶ Less: Present value of the payment (cost)
is the amount of the cash payment (i.e. the nominal amount). = Interest (expensed over the pmt
period, or capitalised: section 3.2.3)
x If the payment is delayed beyond normal credit terms,
the µFDVKSrice equivalHQW¶is not the total future cash payment/s (nominal amount), but is
the present value of these 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:
 is generally recognised as an expense, although it
 may need to be recognised as part of the cost of the asset, referred to as capitalisation
(section 3.3.3).

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Example 2: Cash payments ± µZLWKLQ¶YVµEH\RQG¶QRUPDOFUHGLWWHUPV

Shem Limited purchased a factory plant on 1 January 20X1. The purchase price is
C100 000, payable on 31 December 20X1. There were no individually significant parts.

Required: Show the journals relating to the purchase and payment of the plant 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 ± µZLWKLQ¶YV µEH\RQG¶QRUPDOFUHGLWWHUPV

Part A Part B
Dr/ (Cr) Dr/ (Cr)
Plant: 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 plant, 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 plant

Comment: The amount of the µpayable¶ is the same in Part A and Part B, but the asset¶s cost differs
depending on whether payment was:
Part A: within normal credit terms, in which case the asset is measured at the cash amount.
Part B: beyond normal credit terms, in which case it is measured at the present value of the cash amount.

3.2.2 Item acquired via an asset exchange (IAS 16.24 – 26)

Sometimes an item of property, plant and equipment is not Fair value is defined
acquired in exchange for a cash payment but instead involves an as:
exchange of a non-monetary asset (e.g. we could acquire a x the price that would be:
machine by givinJXSDYHKLFOH «RU it could involve an exchange  received to sell an asset, or
of a combination of 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 assHWUHFHLYHGLVµmore 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.
x An exchange is considered to have no commercial substance if the exchange of assets:
 will not change the future cash flows in any way (risk, timing or amount);
 will not change the value of the operation that is to use the asset; or
 any expected change in cash flows or value is insignificant relative to the fair value of
the assets exchanged. See IAS 16.25
x 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.

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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
x of the asset received – if this is more substance; or
clearly evident. See IAS 16.26 x if the FV’s of both assets were unable
Only use FV if it is reliably measurable! to be 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):

Scenario A Scenario B Scenario C

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 DQGWKHIDLUYDOXHRIWKHYHKLFOHLVµPRUH
cleaUO\HYLGHQW¶WKDQWKHIDLr value of the machine.
Required: For each scenario, journalise the exchange and explain your answer.

Solution 3: Asset exchange - fair values known

Scenario A Scenario B Scenario C
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 fair value 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
(FV) of the asset given up because the FV of the asset given up (machine) is readily available.
Note: Where the FV of the asset given up and FV of the asset received are materially different, the FV of
the asset received may be considered µPRUHFOHDUO\HYLGHQW¶,QWKLVH[DPSOHKRZHYHUZHZHUHWROGWKDW
the difference between the two fair values (C1 000) is immaterial.
Scenario B: Explanation:
The vehicle is measured at the fair value 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 (FV) 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 acquiUHGLVDVVXPHGWREHµPRUHFOHDUO\HYLGHQW¶WKDQWKHIDLUYDOXHRIWKHDsset given up.
Scenario C: Explanation:
The vehicle is measured at the fair value 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.

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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 is 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: There is possibly evidence of an µimpairment¶ ± here is a quick explanation of what this means:
x If the difference in fair values is considered to be material, it may indicate that the asset given up was
impaired (damaged in some way). In this case, before journalising the exchange, we must first calculate the
recoverable amount of the asset given up µrecoverable amounW¶LVGHILQHGLQ,$6± see section 4.4).
x The recoverable amount of an asset is essentially the higher of the amount expected from either (a) using or
(b) selling the asset.
x If the recoverable amount is lower than the carrying amount, the asset is considered to be impaired and thus
the carrying amount of the asset given up must be reduced before accounting for the exchange.
x Impairments are explained in section 4.4 and also 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.

,WLVWKHµJUDQWVUHODWHGWRassets¶WKDWDUH relevant to this chapter on property, plant and equipment.

Government grants are covered by IAS 20 and are explained in detail in chapter 15 (see
chapter 15, section 3.4, for the explanation as to KRZWRDFFRXQWIRUµJUDQWVUHODWHGWRDVVHWV¶).
The following is just a brief overview of grants in the context of property, plant and equipment.

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A grant received from 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 any 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 need to be recognised as deferred grant
income. This will then be transferred out and recognised as income in profit or loss on the following basis:
x if the item is depreciable, it will be recognised as income in profit or loss over the DVVHW¶V useful life.
x if the item is non-depreciable, it will be recognised as income in profit or loss as and when the cost of
meeting the conditions attached to the grant, if any, are expensed. See IAS 20.18

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 buy a machine), the recognition principles are the same: the grant is income that must be
recognised in profit or loVVRYHUWKHDVVHW¶VXVHIXO OLIH +RZHYHU WKHIRUPLQ ZKLFK it is received, could
affect the measurement of the aVVHW/HW¶VORRNDWWKHLPSDFWRIWKHse 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¶V fair value or a nominal amount.
A µnominal amount¶ is simply a small amount (e.g. C1) used to record the transaction (e.g. if the entity
cannot determine the item¶Vfair value or prefers not to use fair value).
Debit Property, plant and equipment & Credit Deferred grant income (liability).
This deferred grant income is then recognised as grant income in P/L RYHUWKHLWHP¶Vuseful life:
Debit Deferred grant income & 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 & Credit Deferred grant income (liability). NOTE 1 Government grants
relating to PPE affect
This deferred grant income is then recognised as grant measurement of cost:
income in P/L over the item¶VXVHIXOOLIH: x If we receive PPE for free, its cost
Debit Deferred grant income & Credit Grant income. is either measured:
 at FV or
NOTE 1: if we must use the cash to acquire a depreciable asset, we  at nominal amount (e.g. C1)
may choose to credit WKHDVVHW¶V carrying amount instead of deferred x If we receive cash to buy PPE:
grant income. The grant will then reach P/L as a reduced depreciation  the PPE’s cost could be reduced
charge. This option does not apply if the asset is non-depreciable (e.g. by this cash amount (cr PPE) or
 deferred income could be
land), because then the grant would never affect P/L. See IAS 20.26-7 recognised instead (cr def income).

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 journals assuming the entity 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 thus the deferred
income would be recognised as income in profit or loss over the equipmHQW¶Vuseful 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)

Hothead receives a government grant of C50 000, (cash) to be used to buy a nuclear plant.
Hothead buys the plant for C80 000. It chooses to set the grant off against the SODQW¶Vcost.

Required: Show the journals relating to the grant and subsequent purchase of the nuclear plant.

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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 - grant: C50 000). The grant iVµKLGGHQ¶LQWKHFRVWRI
the asset and will thus be recognised indirectly as income in profit or loss, through a reduced
depreciation charge (depreciation will be based 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 thHDVVHW¶VFRVWWKHdeferred 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
Deferred grant income (L) 50 000
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 - 22A)

3.3.1 Overview

The cost of an item of property, plant and equipment comprises three elements: the purchase
price, any directly attributable costs (those that are necessary to bring the asset to a location and
condition suitable for the use intended by 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 (i.e. future costs). See IAS 16.16
see IAS 16.16
Elements of Cost

Purchase Price Directly Attributable Costs Initial Estimate of some Future Costs

3.3.2 Purchase price (IAS 16.16)

The µpurchase price¶ includes import duties and non-refundable taxes. If the invoiced price includes a tax
that can be claimed back from the tax authorities (i.e. refundable, such as VAT), we exclude this tax 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 µGLVFRXQWUHFHLYDEOH¶).
The principles of 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)
The principle of increasing the cost of an asset with any forfeited discount, instead of debiting it to
a finance expense, is not expressly required, but is an interpretation based on the concepts used to measure
revenue that involved discounts offered - see IFRS 15 Revenue from contracts with customers. (IFRS 15.48)

Example 8: Initial costs: purchase price

Emil, a VAT vendor, bought a machine. The invoice showed the following details and added 15% VAT:
x Marked price: C100 000 (excluding VAT)
x Less discount (on the basis that Emil is a long-standing customer): C15 000
x Less volume rebate: C5 000
x Less cash discount: C2 000
Required: Show the journal entry for the acquisition of this machine.

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Solution 8: Initial costs: purchase price

Comment: Notice tKDWWKHPDFKLQH¶VFRVW must:
x be net of all trade discounts and rebates; and must
x not include VAT: since Emil 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 TKHPDFKLQH¶VFRVWPXVW 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 receivable Also called Deferred discount/ Right to a discount N/A 5 000
Purchase of machine
25 May 20X5
Payable N/A 5 000
Discount receivable 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

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3.3.3 Directly attributable costs (IAS 16.16-17 & 19–21 & IAS 23) Directly attributable
costs are those
Directly attributable costs are those we believe were necessary
x that were necessary;
to get the asset into a location and condition that enabled it to be
x to get the asset to the
used as management intended. As a result, they are included in location and condition;
the cost of the asset (i.e. they are capitalised). Conversely, costs x that enabled it to be used
that are not considered µdirectly attributable¶ are expensed.See IAS 16.16(b) as intended by management.
Reworded IAS 16.16(b)

Yes Directly attributable cost? No

Capitalise
Examples:
x cost of preparing the site;
x initial delivery and handling costs;
x installation and assembly costs;
x professional fees;
x employee benefits (eg salaries, wages.) relating
directly to its construction/ acquisition; &
x cost of testing the asset is functioning correctly
(but if any products made during testing are
then sold, the proceeds must be recognised in
profit or loss and their cost must be recognised
as an inventory asset). See IAS 16.17 & 20A
Expense
Examples:
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

Another example of a directly attributable cost is borrowing costs (e.g. interest). Under certain
circumstances, we may be required to capitalise borrowing costs to the DVVHW¶s cost (instead of
expensing them). Borrowing costs are covered by IAS 23 Borrowing costs (see chapter 14).See IAS 16.22

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 LW LV QRW D µGLUHFWO\ DWWULEXWDEOH FRVW¶DQG WKXV 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

By definition, costs incurred after the asset was brought into the required location and condition
that enables it to be used as intended by management cannot EHUHIHUUHGWRDVµGLUHFWO\DWWULEXWDEOH¶
and thus must 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 DVVHW¶VRXWSXWincreases;
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, directly attributable costs & significant parts
Enoch Limited bought an aircraft on 1 January 20X2, incurring the following related costs:
Purchase price: C
Outer-body component 49 000
Engine component 84 000
Internal fittings component 7 000
Other costs:
Legal costs associated with purchase rights* 10 000
Costs of safety certificate 1 000
x *These costs are incurred in proportion to the purchase price of the 3 components.

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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 10: Initial costs: purchase price, directly attributable costs & significant parts

Outer-body Engine Interior fittings Safety certificate

Initial cost C49 000 C84 000 C7 000 C0
Safety certificate 1 000
Legal costs 10 000 x 49/140 3 500 6 000 500 0
10 000 x 84/140
10 000 x 7/140
Cost: 1 January 20X2 52 500 90 000 7 500 1 000
Less: depreciation (52 500-0)÷30 yrs (1 750) (9 000) (1 500) (500)
(90 000-0)÷10 yrs
(7 500-0)÷5 yrs
(1 000-0)÷2 yrs
Carrying amount: 31/12/20X2 50 750 81 000 6 000 500
Total carrying amount C138 250

Example 11: Initial costs: purchase price and directly attributable costs
Elias Limited (a registered VAT vendor) constructed a factory plant, details of which follow:
x Construction costs, including materials (including VAT of 15%) C575 000
x Import duties on certain construction materials - non-refundable (no VAT) 100 000
x Fuel used to transport construction materials to the construction site (no VAT) 45 000
x Fuel destroyed by construction workers during an illegal strike (no VAT) 30 000
x Administration costs (no VAT) 10 000
x Staff party to celebrate the completed construction of the new plant (no VAT) 14 000
x Testing to ensure plant fully operational before start of production (no VAT) 42 123
x Borrowing costs (all criteria for capitalisation in terms of IAS 23 were met) (no VAT) 15 000
x $GYHUWLVLQJRIWKHµDPD]LQJZLGJHWV¶WREHSroduced by the new plant (no VAT) 50 000
x 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.

Solution 11: 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 µSODQWFRVW¶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 in) 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.

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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 Future costs could arise:
x due to an acquisition; or
The ownership of an asset may come with an obligation to x due to the usage
dismantle it, remove it and/or restore the site on which it is located of PPE. IAS 16.6(c)
at some stage in the future. This obligation, which may arise: They are capitalised to PPE unless
the PPE is used to make inventories.
x On acquisition date (i.e. simply by having purchased it), is
capitalised as an initial cost; or
x Over time (i.e. through having used the asset), is capitalised as a subsequent cost.

Obligation for future costs

(to dismantle, remove, restore):

If it arises on acquisition date (due to acquiring it) If it arises over time (from using it)
Capitalise as an Initial Cost Capitalise as a Subsequent Cost

If the property, plant and equipment is used to make inventories, then the additional future costs are
never 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)

Future costs arising
If an obligation (for future costs of dismantling, removal and on acquisition are:
restoration costs) arises due to simply having acquired the x capitalised as an initial cost; &
asset, then these estimated future costs must be included as an x measured at PV if “FV – PV
initial cost of the asset. The time value of money, if material, = a material amount”.
must be included when calculating this initial cost. In other
words, if there is a material difference between the future amount and the present value
thereof, the initial cost will be the present value (not the future amount).

Example 12: Initial cost involving future costs

Elias Limited bought a plant on 1 January 20X1 for C702 123, cash. This included the
purchase price and 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 difference between the future amount and present value is material.
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

Initial cost of the plant: C702 123 + C57 877 (measured at PV) = C760 000

1 January 20X1 Dr/ (Cr)

Plant: cost (A) Two separate cost accounts are created for the 702 123
Plant: rehabilitation: cost (A) 2 significant parts ± since the useful lives differ 57 877
Bank (A) Given (702 123)
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 99 151
Plant: accum depreciation (-A) (702 123 ± 0) ÷ 10 years x 1 year (70 212)
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 x 10% or W1 5 788
Provision for rehabilitation (L) (5 788)
Unwinding of the discount – recognised as an expense (always an expense!)

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Solution 12: Continued «

31 December 20X2 continued « Dr/ (Cr)
Depreciation: plant (E) 99 151
Plant: accum depreciation (-A) (702 123 ± 0) ÷ 10 years x 1 year (70 212)
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 W1 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)
Derecognition of the cost of the plant’s part being the related obligation to
rehabilitate the river (now fully depreciated)

W1: Effective interest rate table for the provision

Interest @ 10% Payment Balance
01 January 20X1 57 877
31 December 20X1 5 788 0 63 665
31 December 20X2 6 366 (70 031) 0
12 154 (70 031)

3.3.4.3 Future costs: caused/ increases over time (IAS 16.16 (c) & 16.18)

If an obligation for future costs arises as a result of the item of property, plant and equipment
being used (i.e. there is no obligation on the date of purchase but, instead, it arises only as and
when it is used), these costs must be capitalised to the cost of the property, plant and equipment,
as a subsequent cost. However, remember that, if it is used to produce inventories, then these
costs would be capitalised to inventories instead.
Future costs arising
The amount added to the cost of the property, plant and equipment due to usage:
will be measured at the present value of the future costs if the x are capitalised as a
difference between the present value and future cost is material. subsequent cost;
x unless the asset has reached
This subsequent capitalisation of costs relating to an obligation the end of its UL, in which
case the future costs are
that continually grows as the asset is used will result in the cost recognised in P/L; and
of the asset increasing every time the usage thereof leads to an x are measured at PV if:
additional obligation. This will obviously also affect our depreciation FV – PV = a material amount
calculation. This is because depreciation is the expensing of the DVVHW¶V
µdepreciable amount¶, which is its µcost OHVVUHVLGXDOYDOXH¶, RYHUWKHDVVHW¶VXVHIXO life (see section 4.3).

If the asset has reached the end of its useful life (i.e. it has been fully depreciated), then any
increase in the obligation from that point on, will have to be recognised directly in profit or loss.

Example 13: Subsequent costs involving future costs

Bubble Limited bought a chemical plant for C600 000 on 1 January 20X1, at which point its
estimated useful life was 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 affecting all companies operating chemical plants on 31 December 20X4.
x The law requires that those affected companies pay for environmental rehabilitation at the
end RIWKHDVVHW¶VXVeful life based on the damage caused by such plants, assessed from
the effective date of 1 January 20X4 (i.e. the law was applied retroactively by a year).

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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, measured at 31 December 20X4, using a discount rate of 10%, was C57 877. The difference
between the future amount and its present value is material. No further damage was caused during 20X5.
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 as 30% 30%
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

31 December 20X4 Debit Credit
Depreciation: plant (E) (600 000 ± 0) ÷ 6 years 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: plant (E) 100 000
Depreciation on plant capitalised to inventory and machinery
Inventory (A) Present value: 57 877 x 70% 40 514
Plant: cost (A) Note 1 Present value: 57 877 x 30% 17 363
Provision for environmental restoration: plant 57 877
Recognition of environmental rehabilitation obligation, measured at present
value at 31 December 20X4, capitalised to inventory & plant
31 December 20X5
Depreciation: plant (E) (217 363 ± 0) ÷ 2 remaining yrs Note 2 & 3 108 682
Plant: accumulated depreciation (-A) Or: (600 000-0) ÷ 6 yrs + 17 363 ÷ 2 yrs 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: plant (E) 108 682
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

Note 1. The amount of the provision was not GHELWHGWRDVHSDUDWHµSOant rehabilitation: cost¶ account (as in the prior
example) but was included in the µSODQWcost¶ account (and inventory) instead. This is because the
rehabilitation will take place at the end of the plDQW¶VXVHIXOOLIHDQGWKXVWKHUHKDELOLWDWLRQFRVWDQG the plant¶s
original cost will be fully depreciated over the remaining 2 years (unlike the previous example, where the
useful lives differed).
Note 2. Carrying amount on 1 January 20X5: Cost: (600 000 + 17 363) ± Acc Depr: (100 000 x 4 years) = 217 363
Note 3. Remaining useful life (RUL) on 1 January 20X5: 6 years ± 4 years = 2 years left

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.

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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 This topic is covered in
the estimated current market discount rate would affect detail in chapter 18.
WKH DVVHW¶V FDUU\LQJ DPRXQW (e.g. an increase in future
cash outflows would be capitalised to the asset).
x The journal adjustments to account for changes in either the 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.
x Since IFRIC 1 requires an understanding of both the cost model (explained in this chapter)
and the revaluation model (explained in chapter 8) and it 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 only
After incurring the initial costs of acquiring or constructing an
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. Thus, a cost should only be (if not, cost must be expensed)
added to the DVVHW¶VFDUU\LQJamount if it is reliably measurable We account for replacement of parts
and leads to probable future economic benefits. Further costs and major inspections as follows:
x derecognise old carrying amount, &
can involve adding to the asset, day-to-day servicing of the
x capitalise new cost (generally as
asset, replacing parts thereof and performing major inspections. a 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 this ensures that the recognition criteria are met, the item must be capitalised.

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Solution 15: Continued «

For interest:
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 technicaOO\DQµLQLWLDO FRVW¶
UDWKHUWKDQDµVXEVHTXHQWcRVW¶EXWWKHUHFognition 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 (A) 8 000
Bank/ trade payables 8 000
Purchase of engine for the vehicle

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 HQJLQH¶Vuseful 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 in terms of IAS 16 are thus met and thus 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
causes the vehicle µengine¶ to have a materially longer useful life than the vehicle µERG\¶, 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 KDGEHHQVLPSO\UHFRUGHGDVDµYHKLFOH¶WKen the carrying amount of the old engine will
now need to be estimated and removed from this µvehicle¶DFFRXQWDQGUHFRUGHd as a separate µvehicle
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 was estimated to be 15% of the cost of the vehicle purchase, the journals will be:
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 (cost: 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 iVµGD\-to-day serviciQJ¶ .

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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 replaced every 3 years). Conversely, a part may unexpectedly need
replacement (e.g. a damaged part may need to be replaced). Where a part of an asset is
replaced, the carrying amount of the old part must be removed from the asset accounts
(derecognised) 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).
x This 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,
the carrying amount of the part will need to be estimated (see example 18).
x 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 the SDUW¶V carrying amount.
The part is impaired if damage causes its true value (its recoverable amount) to drop below
its carrying amount. In this case, we must:
 first reduce the part¶s carrying amount to reflect its impaired value (i.e. debit
impairment loss expense and credit accumulated impairment losses), and
 then derecognise it (i.e. credit cost, debit accumulated depreciation and accumulated
impairment losses and debit/ credit the profit or loss with the net carrying amount).
Impairments are explained in section 4.4.

3.4.2.2 Capitalisation of a new part

The cost of the replacement part, if material, must be recognised as an asset if the property, plant and
equipment definition and recognition criteria (per IAS 16) are met. 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 or method of
depreciation that is different to the rest of the asset, then this new part must be recorded in a separate
asset account. The cost of immaterial replacement parts should be expensed as day-to-day servicing.

Example 18: Replacement of a part

Saviour Limited owned a car that had a carrying amount of C30 000 on 1 January 20X1 and
which, on this date, was recorded as two significant parts, as follows:
x Car body: 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.
The old engine (cost: C12 000) was scrapped during late September 20X1 and replaced on 30 September 20X1
at a cost of C15 000. The new engine is depreciated straight-line over 3 years to a nil residual value.
Required: Show all related journal entries during the year ended 31 December 20X1.

Solution 18: Replacement of a part

Comment: We depreciate the old engine to the date it is scrapped. We then impair 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.

30 September 20X1 Debit Credit

Depreciation: car (E) (CA: 10 000 ± RV: 0) ÷ RUL 2 years x 9/12 3 750
Car engine: acc. depreciation (-A) 3 750
Depreciation of the car’s engine to date of replacement
Impairment loss: car (E) CA o/b: 10 000 ± Depr: 3 750 ± 6 250
Car engine: acc. impairment loss (-A) Value after damage: 0 (Scrapped) 6 250
Impairment of car’s engine on date of replacement & derecognition
Car engine: acc. depreciation (-A) (Cost 12 000 ± CA o/b 10 000)+ Depr 3 750 5 750
Car engine: acc. impairment loss (-A) See journal above 6 250
Car engine: cost (A) Given 12 000
Derecognition of old engine

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Solution 18: Continued «

30 September 20X1 continued « Debit Credit

Car engine: cost (A) 15 000
Bank/ trade payables 15 000
Purchase of new engine
31 December 20X1
Depreciation: car (E) 3 250
Car engine: acc. depreciation (-A) (Cost: 15 000 ± RV 0) ÷ UL 3 yrs x 3/12 1 250
Car structure: acc. depreciation (-A) (CA: 20 000 ± RV 0) ÷ RUL 10 yrs x 12/12 2 000
Depreciation of the car at year end: (old body & new engine)
Abbreviations used: CA = carrying amount RUL = remaining useful life RV = Residual value

Example 19: Replacement of a part that was not previously identified

Elijah bought a plant 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
Comment: Notice that since the engine is to be scrapped, it means the asset¶s value after the damage is
nil. Thus, this means that the entire carrying amount (C270) is expensed as an impairment (see first jnl).

1 January 20X2 Debit Credit

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) (CA: 500 ± RV: 0) ÷ RUL: 5 years 100
Plant: without engine: acc. depr (-A) (Cost: 700 ± RV: 0) ÷ UL: 10 yrs; Or 70
(CA: 630 ± RV: 0) ÷ RUL: 9 yrs
Depreciation of plant: two separate parts

Calculations: Original Original Asset without

asset engine engine
Cost: 1 January 20X1 1 000 300 700
Accum. depreciation: (1 000 ± 0) ÷ 10 x 1; & (300 ± 0) ÷ 10 x 1 (100) (30) (70)
Carrying amount: 31 December 20X1 900 270 630

Abbreviations used: CA = carrying amount RUL = remaining useful life RV = Residual value

3.4.3 Major inspections (IAS 16.14)

When an asset requires µregular major inspections as a condition to its continued use¶ (a good
example, given in IAS 16.14, is an aircraft), then the cost thereof (or an estimate thereof), must
be capitalised as soon as either the cost is incurred, or an obligation arises. This inspection
will be recognised as an asset.

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7KLV µPDMRU LQVSHFWLRQ¶ DVVHW LV WKHQ GHSUHFLDWHG RYHU WKH SHULod 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.
Taxi 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 Taxi /LPLWHG¶V statement of financial position at 31 December 20X1.

Solution 20A: Journals

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 Taxi Limited since it can choose simply not to drive
the bus publicly. Instead, the obligation 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 is depreciated over these 3 months.

1 October 20X1 Debit Credit

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) (CA 80 000 ± RV 0) ÷ RUL 10 yrs x 1 yr 8 000
Bus major inspection: acc. depr. (-A) Cost 20 000 / UL 2 years x 3 / 12 2 500
Depreciation of bus: physical bus and major inspection of the bus
Abbreviations used: CA = carrying amount RUL = remaining useful life RV = Residual value

Solution 20B: Disclosure

Taxi Limited
Statement of financial position (extracts) 20X1
As at 31 December 20X1 C
Non-current assets
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).

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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 future 20X3 inspection is not recognised at 31 December 20X1 because, in 20X1, there
was no obligation to have it done QR µSDVW HYHQW¶ KDd yet occurred). However, we use the expected
20X3 inspection cost to estimate the value of the 20X0 inspection that had already been performed.

1 January 20X1 Debit Credit

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 are separated (because of differing
useful lives) and measured based on the PV of the estimated 20X3 cost
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, (present value is C500 000 as at 31 December 20X3).
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 estimated 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: there is no obligation
because the inspection can be avoided (e.g. the ship could be sold before the next inspection date).

31 December 20X2 Debit Credit

Depreciation: ship (E) 200 000
Ship structure: acc. depreciation (-A) (1 000 000 ± 0) ÷ 10 yrs 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 ± 0) ÷ 10 yrs 100 000
Ship major inspection: acc. depreciation (-A) 300 000/ 3 years 100 000
Depreciation of ship and depreciation of major inspection
Ship major inspection: accumulated depreciation (-A) (20X0) 300 000
Ship major inspection: cost (A) (20X0) 300 000
Derecognition of carrying amount of 20X0 inspection
Ship major inspection: cost (A) (20X3) 400 000
Bank (A) 400 000
Payment: 20X3 major inspection

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Solution 22: Continued «

31 December 20X4 Debit Credit

Depreciation (E) 300 000
Ship structure: acc. depreciation (-A) (1 000 000 ± 0) ÷ 10 yrs 100 000
Ship major inspection: acc. depreciation (-A) 400 000/ 2 years 200 000
Depreciation of ship and depreciation of major inspection

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.
x Initial measurement of property, plant and equipment is always at cost and thus the
measurement of its carrying amount will initially simply reflect cost.
x Subsequent measurement involves: Carrying amount is
 using the cost model or revaluation model; defined as:
 depreciation: this reflects the usage of the asset; and
x Cost (or Fair value)
 impairments: this reflects any damage to the asset. x Less Accumulated depreciation
x Less Accumulated impairment
Thus, the subsequent measurement of its carrying amount is losses (if applicable)
reflected by ledger accounts that show its cost, its subsequent IAS 16.6 reworded

accumulated depreciation and its subsequent accumulated impairment losses.

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
When using the cost model, the subsequent measurement of our
measures PPE as:
asset (which is initially measured at cost), involves processing
x Cost (initial + subsequent costs)
x subsequent depreciation, if the asset is depreciable (land x Less Accumulated depreciation
may not necessarily be depreciable), and possibly also x Less Accumulated impairment
x subsequent impairment losses (all items of property, plant losses (if applicable) See IAS 16.6
and equipment are subsequently tested for impairment).

Let us now look at how to measure depreciation and impairment losses.

4.3 Depreciation Depreciation is

defined as:
4.3.1 Overview
x systematic allocation of the
x depreciable amount of an asset
Depreciation reflects the exteQWWRZKLFKWKHDVVHW¶VFDUU\LQJDmount x over its useful life. IAS 16.6
has decreased because of having used the asset. All items of
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.

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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.

It is thus only the depreciable amount that is depreciated. The depreciable amount is calculated
by subtracting from the cost of the asset the portion that we believe will not be lost through
usage. This portion is referred to as its residual value. This can be expressed as follows:

Depreciable amount = Cost – Residual value

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 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 (they have):
The 3 variables of
x a different useful life; or
depreciation:
x a different pattern of future economic benefits. See IAS 16.43 - 47
x Residual value
x Useful life
The measurement of depreciation involves making three
x Method.
estimates ± in other words, there are three variables:
residual value (used to calculate the depreciable amount), useful life and method of
depreciation. The estimation of each of these variables requires professional judgement.

4.3.2 Residual value and the depreciable amount (IAS 16.51 – 54)

The depreciable amounW LV WKH SRUWLRQ RI WKH DVVHW¶V Fost Depreciable amount is
that we believe will be µlost¶ through usage whereas the defined as
residual value is the portion that will not be lost. This x the cost of the asset (or other
residual value is simply an estimate and thus we need to amount, for example its fair value)
reassess our estimated residual value at the end of each x less its residual value. IAS 16.6 reworded
financial year to be sure that it has not changed. See IAS 16.51

The residual value is calculated as follows: Residual value is defined as:

x Expected proceeds on disposal: x the estimated amount that an

This is the amount for which the entity would currently entity would currently obtain
be able to sell the asset assuming it had already (i.e. at from disposal of the asset,
reporting date) reached the end of its useful life; x after deducting the estimated
costs of disposal,
x Less the expected costs of disposal:
x if the asset were already of the age
These are the costs that would be incurred in disposing
and in the condition expected at
of the asset in a way that would achieve these proceeds. the end of its useful life. IAS 16.6

Residual Value = Expected Proceeds on Disposal – Expected Costs of Disposal

It can happen that the residual value exceeds the asVHW¶V FXUUent 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 (also known as the reducing balance method); and
x the units of production method (also called the sum-of-the-units method). See IAS 16.62

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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 the asset to 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. cost - residual value) over the life of the asset:
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 this case, the formula will involve multiplying the
depreciable amount by this depreciation rate:
Depreciation expense = Depreciable amount x Depreciation rate for straight-line (%)
= (Cost – Residual value) x Depreciation rate for straight-line (%)

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 the asset to be used the most
during the earlier years of its life and that the usage thereof will diminish as it ages.

The diminishing balance method involves multiplying the carrying amount (which will obviously
be decreasing each year) by a specific rate of depreciation. It is important to note that this rate
is not applied to the depreciable amount (cost ± residual value). This does not mean that we
are ignoring the residual value. Instead, the residual value is built into the 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 we have calculated the rate of depreciation for purposes of the diminishing balance
method, we 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, 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: After 4 years, the closing carrying amount reflects the residual value of C62 667, which is
close to C62 500 (there is a rounding error of C167 since 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 when it is possible
to estimate the asset's total estimated output and that the actual output achieved in each
period can also be determined. It is calculated as follows:
Actual output in the period
Depreciation expense = Depreciable amount x Total estimated output over the useful life

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The depreciation method

4.3.3.4 Choosing a method should reflect:
x the pattern in which,
The method chosen should match the way in which we
x the FEB from the asset,
expect to earn the future economic benefits through use of x are expected to be
the asset. See IAS 16.60 consumed. IAS 16.60 reworded

However, it must be emphasised that the depreciation method should reflect the pattern of the
consumption RIWKHDVVHW¶VH[SHFWHGIXWXUHHFRQRPLFEHQHILWVUDWKHUWKDQUHIOHFWWKH revenue
generated by the asset. The reason for 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 180 000 units: 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.
Solution - discussion:
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.
x The sum of the units of output would be the most appropriate method to apply. See IAS 16.62A

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 x the period over which an asset is
that it is brought into use). See IAS 16.55 expected to be available for use
by an entity; or
Depreciation ceases at the earlier of: x the number of production or similar
units expected to be obtained from
x the date that the asset is classified as held for sale in
the asset by an entity. IAS 16.6
accordance with IFRS 5 (see chapter 12); and
x the date that the asset is derecognised.

This means that an asset that does not meet the criteria for classification as µheld for sale¶ but
is no longer being used and is simply awaiting disposal continues to be depreciated! See IAS 16.55

Similarly, 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 µWKHH[SHFWHGXVDJHRIWKHDVVHW¶ e.g. the total units expected to be manufactured by a plant);
x µWKH H[SHFWHG physicDO ZHDU DQG WHDU¶ RQ WKH DVVHW IRU LQVWDQFH WKLV ZRXOG EH OHVV LQ D
company that has a repairs and maintenance programme, than in another company that
does not have such a programme);

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x µWHFKQLFDORUFRPPHUFLDOREVROHVFHQFH¶ZKLFK may shorten the assHW¶V 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 imPLQHQWµWHFKQLFDORUFRPPHUFLDOREVROHVFHQFH¶RI
the asset and thus may indicate a potential decreaVHLQWKHDVVHW¶Vuseful life; and
x RWKHUOLPLWVRQWKHDVVHW¶VXVHIXOOLIHLQFOXGLQJOHJDOOLPLWV ZLWKWKHUHVXOWWKDWWKHXVHIXOOLIH
to the company ma\EHVKRUWHUWKDQWKHDVVHW¶Vactual useful life). See IAS 16.56

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)

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). These are referred to as µsignificant parts¶.
For example: a vehicle may have an engine and a body where these two parts have different
useful lives. Alternatively, 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.

Depreciation is usually expensed. However, 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

Journal expensing depreciation Debit Credit

Depreciation: asset name (E) xxx
Asset name: Accumulated depreciation (-A) xxx
Depreciation of PPE is expensed

Journal capitalising the depreciation expense (if applicable) Debit Credit

Constructed asset: cost (A) xxx
Depreciation: asset name (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 based on 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 Thus, Depreciation in 20X1 = (100 000 ± 0) ÷ 5 years x 9 / 12 = C15 000

Example 24: Depreciable amount and straight-line depreciation

On 1 January 20X1, Rebeka Limited purchased an asset at a cost of C110 000.
x The asset has a total useful life of 10 years.
x The company expects to sell the asset after 4 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.

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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: 4 years

Being the shorter of:
x Total useful life of the asset 10 years
x The useful life to the business 4 years
Depreciation 20X1: C25 000
Depreciable amount C100 000
Divided by useful life (from the perspective of the entity) 4 years

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 Opening Depreciation Closing Calculations
of its useful life (UL): balance at 20% balance
1st yr of its UL ending 31/03/X2 12m 800 000 160 000 640 000 800 000 x 20% x 12/12
2nd yr of its UL ending 31/03/X3 12m 640 000 128 000 512 000 640 000 x 20% x 12/12
3rd yr of its UL ending 31/03/X4 12m 512 000 102 400 409 600 512 000 x 20% x 12/12
4th yr of its UL ending 31/03/X5 12m 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
x to the financial year ended 30 Mar X2 (01/07/X1 ± 30/03/X3): 128 000 x 12/12 128 000
x to the financial year ended 30 Mar X3 (01/07/X2 ± 30/03/X4): 102 400 x 12/12 102 400
x to the financial year ended 30 Mar X4 (01/07/X3 ± 30/03/X5): 81 920 x 12/12 81 920
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 X3 (01/07/X2 ± 30/06/X3): 128 000 x 9/12 + 102 400 x 3/12 121 600
x to the financial year ended 30 June X4 (01/07/X3 ± 30/06/X4): 102 400 x 9/12 + 81 920 x 3/12 97 280
x to the financial year ended 30 June X5 (01/07/X4 ± 31/03/X5): 81 920 x 9/12 61 440
472 320

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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

Lorna 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 Lorna used one of its machines in the process of constructing this asset. The machine
was used for a period of nine 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.
Required: Show the journals for the year ended 31 December 20X1 that relate 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 9 months 15 000
Depreciation: machine (E) 15 000
Allocating a portion of the machine’s depreciation (9/12) to the cost of the
plant: the machine was used for 9m in the construction of the plant
Depreciation: plant (E) (100 000 + 15 000 ± 0) ÷ 5 yrs x 3/12 5 750
Plant: accumulated depreciation (-A) 5 750
Depreciation of plant

Solution 27B: Depreciation involved with manufacture of inventory

Debit Credit
Inventory (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)
Inventory (A) 20 000 / 12 x 9 15 000
Depreciation: machine (E) 15 000
Allocation of depreciation of machine to inventory in respect of 6-month
usage thereon
Cost of sales (E) (100 000 + 15 000 ± 0) x 50% 57 500
Inventory (A) 57 500
Sale of half of the inventory

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4.3.6 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, also called µinputs¶ (residual value, useful life changed:
or method of depreciation) needs to be changed, this must x estimated useful life
be adjusted for as a change in accounting estimate (in terms x method of depreciation
of IAS 8 Accounting policies, errors and estimates). x the residual value
x estimated costs of dismantling,
In addition to changes in estimated depreciation (due to removing or restoring items of PPE.
changes in the estimated variables of depreciation, called
µinputs¶), we might need to change our estimate of the present value of the future costs of
dismantling, removing or restoring items of property, plant and equipment. This was explained
briefly in section 3.3.4 and in more detail 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.

Changes in estimates are explained in detail in chapter 26, including the disclosure requirements. In
the meantime, the journals, which are simple, 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 it
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:
A by adjusting the carrying amount for the cumulative effect on depreciation to date.
B by reallocating the opening 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. depr. to 31/12/20X2 (new estimate) = (C100 000 ± RV: 0) ÷ 90 000 units x (10 000u + 15 000u) = C27 778
W2: Acc. depr. 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 µRUL¶ because, when we use the reallocation method, our
depreciable amount is the µopening CA ± residual value¶ instead of µRULJLQDOcost ± residual value¶)

4.4 Impairments (IAS 16.63 and IAS 36) An impairment loss is

defined as:
4.4.1 Overview
x the excess of
Impairments are recognised if we conclude that the x the carrying amount
carrying amount is too high, but that the accumulated x over the recoverable amount
IAS 16.6 reworded
depreciation, which reflects usage, is reflected correctly.
In this case, the other reason the carrying amount could CA – RA = IL (if the answer is positive)
be overstated is that the asset is damaged in some or PS. If the ans. is negative, there is no IL
other way. Usage is reflected by depreciation and damage is reflected by impairments.

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Items of property, plant and equipment must be tested for indications of impairments at the end
of each reporting period. This is referred to as an impairment indicator review and simply means
we are looking for evidence that might suggest the asset is damaged in some or other way.

Damage does not only refer to physical damage. We must look for any kind of damage that
reduces the value of the asset. For example, an economic downturn may reduce demand for
aQDVVHW¶VRXWSXWLQZKLFKFDVHthe asset becomes less valuable to the entity.

In essence, impairment testing is checking to ensure WKH DVVHW¶V FDUU\LQJ DPRXQW LV QRW overstated.
However, if we think the carrying amount may be too high, it may simply be because we have not
processed enough depreciation «so the variables of depreciation are first checked:
x If we believe we have not processed enough depreciation to date, extra depreciation gets
processed (and accounted for as a change in estimate in accordance with IAS 8); but
x If we believe the depreciation processed to date is a fair reflection of past usage, we then
calculate the recoverable amount and compare it with the assHW¶VFDUU\LQJDPRXnt « if the
carrying amount exceeds the recoverable amount, we will process an impairment.

Impairment testing is governed by IAS 36 and is explained in detail in chapter 11.

4.4.2 The recoverable amount The recoverable amount

is defined as:
The µrecoverable amount¶ is simply an estimate of the highest The higher of an asset’s:
possible future economic benefits that we expect to be able x fair value less costs of disposal; &
to get from the asset ± logically, there are only two options x its value in use. IAS 16.6
and so we simply choose the option with highest benefit: i.e. RA = > of FV-CoD & VIU
x We could sell the asset ± the future economic benefits
from the sale of the asset are referred to as the fair value less costs of disposal; or
x We could use the asset ± the future economic benefits from the use of the asset are referred
to as the value in use.

4.4.3 Comparing the carrying amount with the recoverable amount

If the indicator test suggests that the asset may be 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
ZLWKWKHDVVHW¶Vrecoverable amount.
Impairment loss reversed
If the carrying amount exceeds the 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
x but only to the extent that the
in a future year, the carrying amount may be increased to this
CA does not exceed the
higher recoverable amount. The increase is recognised in depreciated 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 DVDµPDJLFDO¶KLVWRULFDOFDUU\LQJDPRXQWOLQe, 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

(depreciated cost/ cost): using the cost model):
x original cost x original cost
x less accumulated depreciation x less accumulated depreciation and
(based on the original cost), if any x less accumulated impairment losses

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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 WKHDVVHW¶V
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)
Diagram 2: Example adjustments using the cost model – 4 scenarios
Scenario 1 Scenario 2 Scenario 3 Scenario 4

HCA/
ACA HCA HCA RA
Imp
Not
loss allowed
(E)
RA ACA RA HCA
Further: Imp loss Imp loss
Imp Reversed Reversed
loss (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 caQ DOVR EH H[SODLQHG E\ ZD\ RI D JUDSK )LUVW SORW WKH µPDJLFDO¶ KLVWorical
carrying amount line (HCA), otherwise known as the depreciated cost (or cost, if the asset is
non-depreciable). After this, we need to plot our actual carrying amount (ACA) and our
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 depreciated cost
(historical carrying amount) as the asset is depreciated over its useful life. It would be a horizontal line if
the asset is not depreciated.

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When using the cost model, the DVVHW¶VDFWXDOFDUU\LQJDPRXQWPD\EHGHFUHDVHGEHORZWKLVGLDJRQDO

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 tKH DVVHW¶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.

Example 29: Cost model - impairment loss

Cost of plant at 1/1/20X1: C100 000
Depreciation: 20% straight-line p.a. (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
Plant: accumulated depreciation (-A) 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)

Historical carrying amount line

60 000(RA)

0 Useful Life
Journals: 20X2 Debit Credit
Depreciation: plant (E) (60 000 ± 0) ÷ 4yrs remaining (5-1) 15 000
Plant: accumulated depreciation (-A) 15 000
Depreciation of asset for year ended 31 December 20X2

Note: No further impairment is journalised at 31/12/20X2 since the new carrying amount of C45 000
(60 000 ± 15 000) equals the recoverable amount.

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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, combine the accumulated depreciation and accumulated impairment loss account
into a single account called the ‘accumulated depreciation and impairment loss account’.

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: Part A Part 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 Part A Part 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)
Depreciation of asset for year ended 31 December 20X2
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)
Historical carrying amount line
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)

Historical carrying amount line

45 000( ACA)

0 Useful Life

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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/X1 Bank (1) 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/X1 Land(1) 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:

Entity name
Statement of financial position 20X4 20X3 20X2 20X1
As at 31 December (extracts) 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.

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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)

31/12/X1 AD&IL (2) 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

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Solution 32: Continued «

Disclosure:

Entity name
Statement of financial position 20X4 20X3 20X2 20X1
As at 31 December (extracts) C C C C

ASSETS
Non-current Assets
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 20X1 20X2 20X3 20X4
Jnl No Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
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.

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
µSURILW RU ORss RQ GLVSRVDO¶ DFFRXQW 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.

Disposals occur if, for example, the asset is sold, leased to someone else under a sale and
leaseback agreement or donated.

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The date on which the disposal must be recorded revolves around when the other entity obtains
control of our asset (or when we lose control over our asset). This date also depends on how the
asset is disposed of;
x If we have sold our asset and are now leasing it back (caOOHG D µVDOH DQG OHDVHEDFN¶ , to
determine when control has passed we must apply IFRS 16 Leases. (see chapter 16).
x If a disposal occurs in any other way (e.g. by way of a sale or donation), to determine when
control passes from us to the other entity, we must apply IFRS 15 Revenue from contracts
with customers (specifically, we use the criteria for determining when a performance
obligation has been satisfied). 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 RIµRWKHULQFRPH¶

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 (per IFRS 15); 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 were explained in detail in the chapter on deferred tax. If you are
unsure of the deferred tax consequences of property, plant and equipment, please revise the following:
x Deductible assets: See chapter 6: section 4.2;
x Non-deductible assets (and the exemption): See chapter 6: section 4.3 and section 5;
x Sale of property, plant and equipment: See 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 (PPE) 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.

402 Chapter 7
Gripping GAAP Property, plant and equipment: the cost model

The tax base of an item of property, plant and equipment (PPE) 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:

x cost x future tax deductions See IAS 12.7

x less accumulated depreciation, and

x less accumulated impairment losses

Generally, 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 deferred tax effects of PPE measured under the cost model:
x Example 33: shows us how to account for the deferred tax effects arising from basic
transactions involving PPE (purchase, depreciation and sale of the asset).
x Example 34: shows us how to account for the deferred tax effects arising from PPE that
has been impaired (impairment loss).
x Example 35: shows us the deferred tax implications when accounting for an item of PPE
that is not tax-deductible (i.e. where the tax authorities do not allow a related tax-deduction
when calculating taxable profit) (i.e. a deferred tax exemption).

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.
x 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% pa.
x The tax authorities apportion the tax deduction for part of a year.
x The income tax rate is 30%.
x The financial year-end is 31 December.
Required:
Show all related journal entries possible.

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 impacWRQHLWKHUWKHDVVHW¶VFDUU\LQJDPRXnt 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 (see chapter 5).
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 (credit the disposal account); and then
- transfer the net amount in the disposal account to either profit on disposal (if the proceeds
exceed the carrying amount) or loss on disposal (if the carrying amount exceeds the proceeds).

Chapter 7 403
Gripping GAAP Property, plant and equipment: the cost model

2 January 20X0 Debit Credit

Plant: cost (A) 100 000
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
Depreciation of plant
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
Depreciation: plant (E) (100 000 ± 0) ÷ 4 years x 12/12 25 000
Plant: acc. depreciation (-A) or: (75 000 ± 0) ÷ 3 years x 12/12 25 000
Depreciation of plant
Deferred tax: income tax (A) W1 or (25 000 ± 20 000) x 30% 1 500
Tax expense (E) 1 500
Deferred tax adjustment due to plant
30 June 20X2
Depreciation: plant (E) (100 000 ± 0) ÷ 4 years x 6/12 12 500
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
Plant: cost (A) 100 000
Asset disposal 37 500
Carrying amount of plant transferred to asset disposal account
Bank (A) Given 80 000
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 table

PPE: x Depreciable Carrying Tax Temporary Deferred Details
x Deductible amount base difference taxation
Balance: 1/1/20X0 0 0 0 0
Purchase: 02/01/20X0 100 000 100 000
Dr DT (SOFP)
Depreciation 100 000 / 4 yrs; (25 000) (20 000) 1 500 Cr Tax (SOCI)
100 000 x 20%
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)
Cr Tax (SOCI)
100 000 x 20%
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) Dr Tax (SOCI)
37 500 50 000
CA/ TB: Sale of plant: 30/06/X2 (37 500) (50 000)
Balance: 31/12/20X2 0 0 0 0

404 Chapter 7
Gripping GAAP Property, plant and equipment: the cost model

Example 34: Deferred tax involving the impairment of PPE

An entity buys plant on 2 January 20X1 for C100 000 in cash.
x Depreciation is calculated on the straight-line basis to a nil residual value over 4 years.
x The tax authorities allow the deduction of the SODQW¶VFRVWIURPWD[DEOHSURILWVDWSD
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
x The income tax rate is 30%.
Required:
Prepare all related journal entries for all the affected years (the financial year end is 31 December).
Show the calculation of the deferred tax balance and adjustments using the balance sheet approach.

Solution 34: Deferred tax involving the impairment of PPE

Journal entries Debit Credit
2 January 20X1
Plant: cost (A) 100 000
Bank (A) 100 000
Purchase of plant for cash
31 December 20X1
Depreciation: plant (E) (100 000 - 0) ÷ 4 years 25 000
Plant: acc depr & imp losses (-A) 25 000
Depreciation of plant
Impairment loss: plant (E) CA: (100 000 ± 25 000) ± RA: 60 000 15 000
Plant: acc depr & imp losses (-A) 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
Deferred tax adjustment due to plant
31 December 20X2
Depreciation: plant (E) (60 000 - 0) ÷ 3 years 20 000
Plant: acc depr & imp losses (-A) 20 000
Depreciation of plant
Plant: acc depr & imp losses (-A) CA: (60 000 ± 20 000) ± RA: 45 000 5 000
Impairment loss reversed (I) (RA 45 000 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
Deferred tax adjustment due to plant
31 December 20X3
Depreciation: plant (E) (45 000 - 0) ÷ 2 years 22 500
Plant: acc depr & imp losses (-A) 22 500
Depreciation of plant
Plant: acc depr & imp losses (-A) CA: (45 000 ± 22 500) ± RA: 25 000 2 500
Impairment loss reversed (I) (RA 30 000 limited to HCA: 25 000) 2 500
Previous impairment of plant now reversed
31 December 20X4
Depreciation: plant (E) (25 000 - 0) ÷ 1 years 25 000
Plant: acc depr & imp losses (-A) 25 000
Depreciation of plant
Deferred tax: income tax (A/L) W1 or 1 500
Tax expense (E) (25 000 ± 20 000) x 30% 1 500
Deferred tax adjustment due to plant

Chapter 7 405
Gripping GAAP Property, plant and equipment: the cost model

31 December 20X5 Debit Credit

Tax expense (E) W1 or 6 000
Deferred tax: income tax (A/L) (0 ± 20 000) x 30% 6 000
Deferred tax adjustment due to plant

W1: Deferred tax table

PPE: x Depreciable Carrying Tax Temporary Deferred Details
x Deductible amount base difference taxation
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 DT Asset
Depreciation (20 000) (20 000) Cr DT (SOFP)
(1 500) Dr Tax (SOCI)
Impairment loss reversed 5 000 0
Balance: 31/12/20X2 45 000 60 000 15 000 4 500 DT 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 DT 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 DT 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 ± Lower of RA & HCA: 45 000 = 5 000 impairment loss reversed
P.S. RA was not limited since HCA = 50 000; (Cost 100 000 ± Acc. depreciation (100 000 ± 0) ÷ 4 x 2)
x 20X3: CA: 22 500 ± Lower of RA & HCA: 25 000 = 2 500 impairment loss reversed
P.S. RA of 30 000 was limited to HCA of 25 000 (Cost 100 000 ± Acc. depreciation (100 000 ± 0) ÷ 4 x 3)
This is because, under the cost model, WKHDVVHW¶V&A must not exceed its HCA.

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 we 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 tax deduction), the tax base is zero on purchase date because the future tax
deductions are nil. However, the carrying amount on purchase date will be WKHDVVHW¶Vcost. Thus,
the purchase of this asset will cause a taxable temporary difference immediately on acquisition (this
will gradually decrease to zero as the asset is depreciated to zero).

406 Chapter 7
Gripping GAAP Property, plant and equipment: the cost model

However, if we recognise the deferred tax liability on this temporary difference, where would we
process the debit side of the entry (i.e. credit deferred tax liability and debit what?):
x It cDQ¶WEHGHELWHGWRWD[H[SHQVH (which is what we normally do when recognising a deferred
tax liability), because this deferred tax was caused by the purchase journal, which does not
involve income or expenses and thus does not affect accounting profit (debit asset and credit
bank/payable) and does not affect taxable profit (because it is not allowed as a tax deduction);
x We could try to argue that, since it cannot be debited to tax expense, it should be debited to the
account that caused the temporary difference (i.e. the item of property, plant and equipment),
EXWWKLVFDQ¶WEHdone either since this would increase the value of this asset simply because of
a deferred tax liability (this does not make sense because this does not represent a cost).

Since WKLV TXHVWLRQ FRXOGQ¶W EH VROYHG, IAS 12 states that the deferred tax liability should not be
recognised if the taxable temporary difference arises due 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. See IAS 12.15

In other words, this initial taxable temporary difference is exempt from deferred tax. However, all
subsequent expenses relating to the initial cost (e.g. depreciation) are 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 income tax rate is 30%.
Required: Calculate the deferred tax balance and journals for each of the four years ended 31 December.

Solution 35: Deferred tax involving exempt temporary differences

Comment: Since the initial temporary difference (100 000) and all subsequent annual movements therein
(25 000) are all exempted, there are no deferred tax journals and all deferred tax balances are nil.
W1: Deferred tax table
PPE: x Depreciable Carrying Tax Temporary Deferred Details
x Non-deductible amount base difference taxation
Balance: 1/1/20X1 0 0 0 0
Purchase: 1 January 20X1 100 000 0 (100 000) 0 Exempt: IAS 12.15
Depreciation Calculation 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: 31/12/20X2 50 000 0 (50 000) 0 Exempt: IAS 12.15
Depreciation (25 000) 0 25 000 0 Exempt: IAS 12.15
Balance: 31/12/20X3 25 000 0 (25 000) 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 = 25 000

7. Presentation and disclosure (IAS 16.73 - .79)

7.1 Overview
Presenting and disclosing property, plant and equipment involves all financial statements:
x The total closing balance is presented as a single line-item on the face of the statement of financial position.
x Income and expenses emanating from property, plant and equipment (e.g. depreciation) are
included in the statement of comprehensive income but are generally not presented on its face.
x The opening and closing balances by class of asset, together with the related movements, are
disclosed in the supporting notes together with details relating to the accounting policies.

Chapter 7 407
Gripping GAAP Property, plant and equipment: the cost model

x The statement of changes in equity is affected if we use the revaluation model (see chapter 7).
x Property, plant and equipment also affects the presentation and disclosure of the statement of
cash flows (e.g. acquisitions and sales), but this is covered in another chapter (see chapter 27).

Since property, plant and equipment is explained over two chapters, only the core disclosures are
explained here. The complete disclosure requirements are provided in the next chapter.

7.2 Accounting policies and estimates Accounting policies note:

x depreciation methods
For each class of property, plant and equipment (e.g. x rates (or useful lives)
land, machines) the following must be disclosed: x model (e.g. cost model)
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

If there was a change in estimate (e.g. change in estimated useful life), the nature and effect
thereof must be disclosed in terms of IAS 8, the stDQGDUGJRYHUQLQJµDFFRXQWLQJSROLFLHVFKDQJHVin
DFFRXQWLQJHVWLPDWHVDQGHUURUV¶ (see chapter 26).

7.3 Statement of comprehensive income disclosure

SOCI Disclosure
Income and expenses relating to property, plant and equipment will xOther income line item: profit
affect the statement of comprehensive income by either: on sale of PPE may be
x Decreasing profit: depreciation, impairments, loss on disposals; or included in ‘other income’
xProfit before tax note:
x Increasing profit: reversals of depreciation (changes in estimate),
- depreciation,
reversals of impairments and profits on disposal.
- impairment loss/reversal
If we use the function method, then, instead of presenting the nature - profit or loss on disposal
and amount of the related income and expenses on the face of the statement of comprehensive income
(i.e. as we do if using the nature method), these income and expenses would be included in one of the
line-items classified by function. For example:
x depreciation on a plant used to manufacture inventories would be capitalised to the inventory
assets, and this would then be included in the µcost of sales’ line-item when the inventory was sold;
x depreciation on office desks would be included directly in the µcost of administration’ line-item.
x a profit on disposal could be included in the µother income¶ line-item.

In other words, when using the function method, the µseparately¶ disclosable income and expenses
relating to property, plant and equipment are not presented as separate line items in the statement
of comprehensive income. Instead, they are included within the line-items based on function (e.g.
cost of sales) and thus the nature and amount of these items must then be disclosed in the notes.

The related income and expenses that are separately disclosable include, for example:
x depreciation expense See IAS 1.102 & 104
x impairment losses; See IAS 1.98 (a) and IAS 36.126 (a) ± also see note 1
x impairment losses reversed; See IAS 1.98 (a) and IAS 36.126 (b) ± also see note 1
x profits or losses on the disposal of items of property, plant and equipment. See IAS 1.98 (c)
Note 1. If the function method has been used, then we would also need to indicate the line-item of the
statement of comprehensive income in which the income or expense has been included. See IAS 36.126

Interestingly, we also disclose µdepreciation, whether recognised in profit or loss or as a part of the cost of
other assetV¶ (see section 7.4). This depreciation is presented in the reconciliations per class of asset,
which are given within the µproperty, plant and equipment note¶. However, this depreciation will not equal
the µdepreciation expense¶ if part of our depreciation is capitalised to another asset (i.e. the depreciation
expense will be smaller than the amount disclosed as the total depreciation in the asset note). Therefore, it
is suggested that we provide a reconciliation between total depreciation and the depreciation expensed to
help our users understand (see WKHVXJJHVWHGµprofit before tD[QRWH¶LQ section 7.7). See IAS 16.74

408 Chapter 7
Gripping GAAP Property, plant and equipment: the cost model

7.4 Statement of financial position disclosure

SOFP Disclosure
Property, plant and equipment must be presented as a line-
item on the face of the statement of financial position. See IAS 1.54
x One line-item: Property, plant & equip
This line-item must be supported by a µSURSHUW\SODQWDQG x PPE note: Reconciliation between
HTXLSPHQW¶ note, the requirements of which are below. opening and closing balances; &
Break-down of these balances into
For each class of property, plant and equipment (e.g. - gross carrying amount and
land, buildings, plant etc.) we disclose: - accumulated depreciation
x µJURVVFDUU\LQJDPRXQW¶DQGµDFFXPXODWHGGHpreciation and impairment losseV¶DWWKHEHJLQQLQJ
and end of each period (the net of these two amounts is WKHµQHWFDUrying DPRXQW¶ ;
x a UHFRQFLOLDWLRQ EHWZHHQ WKH µQHW FDUU\LQJ DPRXQW¶ DW WKH EHJLQQing 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 within the cost, accumulated
depreciation and accumulated impairment loss accounts):
 additions;
 disposals;
 depreciation;
 impairment losses/ impairment losses reversed;
 acquisitions through business combinations;
 assets transfeUUHGWRµQRQ-current assets heOGIRUVDOH¶LQDFFRUGDQFHZLWK,)56
 other movements (e.g. currency translation differences);
We should also disclose (but not necessarily by class):
x the existence and amounts of restrictions on title;
x the existence and amounts of assets that have been pledged as security for a liability;
x the costs capitalised to property, plant and equipment under construction;
x the amount of any contractual commitments relating to future acquisitions of PPE. 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 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 has been used and if the difference between
fair value and carrying amount under the cost model is material. See IAS 16.79

7.6 Disclosure regarding fair value measurements

Even when using the cost model, we may want to disclose the asseW¶V fair value in the note
(see section 7.5). If we do disclose the fair value, there are further minimum disclosures
required by IFRS 13 Fair value measurement (see chapter 25 for a summary thereof).

7.7 Sample disclosure involving property, plant and equipment

The disclosure below includes figures that are simply assumed figures so that you can see how the various
amounts tie together across the various notes and statements.

ABC Limited
Statement of financial position (extracts) 20X2 20X1
As at 31 December 20X2 C C
ASSETS Note
Non-current assets
Property, plant and equipment 3 1 070 000 785 000

Chapter 7 409
Gripping GAAP Property, plant and equipment: the cost model

ABC Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X2

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 ten years.

3. Property, plant and equipment

20X2 20X1
Total net carrying amount: C C
Land 515 000 310 000
Plant 555 000 495 000
Property, plant and equipment 1 070 000 805 000

Reconciliations per class Land: Plant:

20X2 20X1 20X2 20X1
C C C C
Net carrying amount: 1 January 310 000 100 000 495 000 150 000
Gross carrying amount 330 000 100 000 975 000 600 000
Accumulated depreciation & impairment losses (20 000) (0) (480 000) (450 000)

Add additions 200 000 260 000 250 000 450 000
Less disposals See comment below (0) (30 000) (0) (45 000)
Less depreciation (0) (0) (150 000) (75 000)
Less impairment losses (0) (20 000) (40 000) (15 000)
Add impairment losses reversed 5 000 0 0 30 000

Net carrying amount: 31 December 515 000 310 000 555 000 495 000
Gross carrying amount 530 000 330 000 1 225 000 975 000
Accumulated depreciation and impairment losses (15 000) (20 000) (670 000) (480 000)

24. Profit before tax 20X2 20X1

Profit before tax is stated after taking the following separately disclosable C C
(income) / expenses into account:
x Depreciation expense on plant 50 000 25 000
 Total depreciation 150 000 75 000
 Less capitalised to inventory (100 000) (50 000)
x Impairment losses on plant 40 000 15 000
x Impairment loss reversals on plant (0) (30 000)
x (Profit) / loss on sale of plant 0 15 000
Comment:
The disposals in 20X1 included:
x land costing C30 000, which was sold for C10 000 (thus at a loss of C20 000); and
x plant costing C75 000 and with accumulated depreciation of C30 000 (i.e. carrying amount of
C45 000), which was sold for C50 000 (thus at a profit of C5 000).

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 50 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)

410 Chapter 7
Gripping GAAP Property, plant and equipment: the cost model

The only movements in property, plant and equipment during 20X0 was depreciation.
The only movements in property, plant and equipment during 20X1 included:
x The purchase of a second plant on 1 June 20X1 for C100 000
x Machine sold on 30 June 20X1 for C70 000 on which date the following was relevant:
 cost: C100 000,
 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 entity pledged both plants as security for a loan. Details of the loan will be given in note 16.
The entity 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 FODVVLILHGDVµRWKHUFRVWV¶LQWKHstatement of
comprehensive income.
x Plant is used to manufacture inventories.

Required:
Disclose the above in the financial statements for the year ended 31 December 20X1 in accordance
with International Financial Reporting Standards. Ignore deferred tax

Solution 36: Cost model disclosure ± no impairment

Flowers Limited
Statement of financial position (extracts) 20X1 20X0
As at 31 December 20X1 C C

ASSETS Note
Non-current assets
Property, plant and equipment 15 980 750 1 600 000

Flowers Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X1

2. Accounting policies

2.1 Property, plant and equipment

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.

10. Profit before tax

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 (machine) 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 (plant) 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

Chapter 7 411
Gripping GAAP Property, plant and equipment: the cost model

Flowers Limited
Notes to the financial statements (extracts) continued.... 20X1 20X0
For the year ended 31 December 20X1 C C

15. Property, plant and equipment

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
15.1 Land

Land was purchased for C50 000. Land is not depreciated.

15.2 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)

15.3 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 0
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 20X1: (3 000 000 + 100 000 + 833) 3 100 833 3 000 000
Accumulated depreciation 20X1: (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.

Example 37: Cost model disclosure with impairments

Plant, with a cost of C100 000, was purchased on the 1/1/20X1. There are no other items
of property, plant or equipment. The entity measures its plant under the cost model.
x It is depreciated at 25% p.a., straight-line, to a nil residual value.
x The estimated recoverable amount at 31 December 20X2 is C55 000
x The estimated recoverable amount at 31 December 20X1 is C60 000
Required:
A. Disclose the above in the financial statements for the years ended 31 December 20X1, 20X2,
20X3 and 20X4 in accordance with the IFRSs. Ignore 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.
x There are no temporary differences other than those evident from the information provided.

412 Chapter 7
Gripping GAAP Property, plant and equipment: the cost model

Solution 37A: Cost model disclosure with impairments

x deferred tax ignored

Entity name
Statement of financial position 20X4 20X3 20X2 20X1
As at 31 December 20X4 (extracts) C C C C
ASSETS Note
Non-current Assets
Property, plant and equipment 4 0 25 000 50 000 60 000

Entity name
Notes to the financial statements
For the year ended 31 December 20X4
2. Accounting policies
2.5 Property, plant and equipment
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:
 Plant: 25% per annum, straight-line method.
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
Accumulated depreciation and impairment 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
Accumulated depreciation and impairment losses: (100 000) (75 000) (50 000) (40 000)
25. Profit before tax 20X4 20X3 20X2 20X1
C C C C
Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
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

Solution 37B: Cost model disclosure with impairments

x With related deferred tax effects
Journals:
20X1: Dr/ (Cr)
Plant: cost (A) 100 000
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)
Depreciation on plant
Impairment loss: plant (E) CA: (100 000 ± 25 000) ± RA: 60 000 15 000
Plant: accumulated depreciation and impairment losses (-A) (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) (20 000)
Depreciation on plant

Chapter 7 413
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20X2 FRQWLQXHG« Dr/ (Cr)

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)
Impairment loss reversed
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
Plant: accumulated depreciation and impairment losses (-A) (25 000)
Depreciation on plant
20X4:
Depreciation: plant (E) (25 000 ± 0) ÷ 1 year remaining 25 000
Plant: accumulated depreciation and impairment losses (-A) (25 000)
Depreciation on plant

Disclosure:

ABC Limited
Statement of financial position 20X4 20X3 20X2 20X1
As at 31 December 20X4 (extracts) C C C C
ASSETS Note
Non-current assets
Property, plant and equipment 4 0 25 000 50 000 60 000
Deferred taxation 5 0 0 0 4 500

ABC Limited
Notes to the financial statements 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 (extracts) C C C C
5. Deferred taxation asset/ (liability) 0 0 0 4 500
The deferred taxation balance comprises:
- Capital allowances See the balances in W1 0 0 0 4 500
26. Income tax expense/ (income) xxx xxx xxx xxx
Current xxx xxx xxx xxx
Deferred See journals in W1 0 0 4 500 (4 500)
…. All other notes would remain the same.

Workings:

W1: Deferred tax: plant Carrying Tax Temporary Deferred Details

amount base difference taxation (journal/balance)
Balance: 1/1/20X1 0 0 0 0
Purchase 100 000 100 000
Depreciation (25 000) (25 000)
Dr DT (SOFP)
(100 000 ± 0) ÷ 4 years 4 500
Cr TE (P/L)
100 000 x 25%
Impairment loss (15 000) 0
Balance: 31/12/20X1 60 000 75 000 15 000 4 500 DT Asset balance
Depreciation (20 000) (25 000)
(60 000 ± 0) ÷ 3 years Cr DT (SOFP)
(4 500)
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 No journal
(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 No journal
(25 000 ± 0) ÷ 1 year
100 000 x 25%
Balance: 31/12/20X4 0 0 0 0

414 Chapter 7
Gripping GAAP Property, plant and equipment: the cost model

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 held for use in the production or supply of
goods or services, for rental to others, or for
administrative purposes; and
x are expected to be used during more than one period
x probable that future economic benefits will
flow to the entity AND
x cost must be reliably measured
Note: The Recognition criteria in IAS 16 has not
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 x Impairments and impairments reversed
for it to be capable of operating in the manner (impairments are governed by IAS 36 and
intended by management. 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
on a systematic basis over the estimated useful
life of the asset.
The method used should reflect
the pattern in which economic benefits are expected
to be generated from the asset (it should never be
based on related revenue generated by the asset).
The depreciation charge is
expensed unless it is capitalised to another asset.
Changes in accounting estimates occur if any of
the following are changed:
x the estimated useful life
x the method of depreciation
x the residual value
x the estimated costs of dismantling, removing or
restoring items of PPE.
See IAS 8 for more details (chapter 26)

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MEASUREMENT: PPE continued …

Subsequent Measurement: Impairments

Impairment loss Impairment loss reversed

If carrying amount (CA) exceeds recoverable
amount (RA), write the CA down to the RA (before
doing so, check that processing extra depreciation
would not be a more appropriate way of reducing
the CA, in which case the extra depr would be
processed as a change in estimate, and not as an
impairment)
If at a subsequent date the RA increases above CA,
increase the CA, but only to the extent that the
CA does not exceed the historical carrying amount:
- if the asset is non-depreciable, the HCA
= cost
- if the asset is depreciable, the HCA
= cost – accumulated depreciation (depreciated cost)

MEASUREMENT: THE RELATED DEFERRED TAX BALANCE

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:
x depreciation methods
x rates (or useful lives)
Profit before tax note:
x depreciation
x impairment losses/
reversals
x profit or loss on disposal
Property, plant and equipment note:
x Reconciliation between
opening and closing balances
x Break-down of these balances into
- gross carrying amount, &
- accumulated depreciation
& impairment losses

416 Chapter 7
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 2021)

Contents: Page

1. Introduction 419
1.1 Overview of the two models 419
1.2 Choosing between the two models 419

2. Recognition and measurement under the revaluation model 420

2.1 Overview 420

2.2 Recognition 420
2.3 Initial measurement 420
2.4 Subsequent measurement 420
2.4.1 Depreciation 420
2.4.2 Impairment testing 421
2.4.3 The choice of models 421
3. Subsequent measurement: revaluation model 421
3.1 Overview 421
3.2 How to account for increases or decreases in fair value 422
Example 1: Carrying amount increases: no prior revaluation recognised in P/L 422
Example 2: Carrying amount decreases: no balance in revaluation surplus 422
Example 3: Carrying amount decreases: there is a balance in the revaluation surplus 423
3.3 Characteristics of a revaluation surplus account 423
3.4 Transfer of the revaluation surplus to retained earnings 423
Worked example 1: Revaluation surplus and a sale of a revalued non-depreciable asset 424
Example 4: Transfer of revaluation surplus to retained earnings 425
3.5 Presentation of the revaluation surplus 426
3.6 Diagrammatic explanation of how the revaluation model works 426
3.7 Upward and downward revaluation involving a non-depreciable asset 428
Example 5: Revaluation model ± a summary example (the asset is not depreciated) 428
3.8 Upward and downward revaluation involving a depreciable asset 429
Example 6: Revaluation model ± a summary example (the asset is depreciated) 429
3.9 The two methods of accounting for a revaluation 432
3.9.1 Overview 432
3.9.2 Proportionate restatement method (gross replacement value method) 432
Example 7: Revaluation model ± using the gross replacement value method 433
3.9.3 Elimination restatement method (net replacement value method) 434
Example 8: Revaluation model ± using the net replacement value method 434
Example 9: Revaluation model ± increase in value, creating a revaluation
surplus 435
Example 10: Revaluation model ± decrease in value, reversing the
revaluation surplus and creating a revaluation expense 437
Example 11: Revaluation model ± increase in value, reversing a previous
revaluation expense and creating a revaluation surplus 438

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Gripping GAAP Property, plant and equipment: the revaluation model

&RQWHQWVFRQWLQXHG« Page

3.10 The revaluation model and impairments 439

Worked example 2: Revaluation model and negligible disposal costs 440
Example 12: A low fair value does not necessarily mean an impairment loss 440

4. Deferred tax consequences 442

4.1 Overview 442
4.2 Deferred tax effects of the revaluation surplus 442
4.3 Deferred tax effects of the revaluation surplus and management intentions 443
4.3.1 Deferred tax and a revaluation that does not exceed cost 443
Example 13: Revaluation surplus and deferred tax: revaluation upwards but not
exceeding cost 443

4.3.2 Deferred tax and a revaluation that exceeds cost 444

4.3.2.1 Deferred tax: Revaluation above cost: intention to keep the asset 445
Example 14: Deferred tax: revaluation above cost: intend to keep ±
short example 445
Example 15: Deferred tax: revaluation above cost: intend to keep ±
full example 446
4.3.2.2 Deferred tax: Revaluation above cost: intention to sell the asset 449
Example 16: Deferred tax: Revaluation surplus above cost: intend to sell 449
Example 17: Revaluation above cost: deferred tax: intend to sell ±
short example 450
Example 18: Revaluation above cost: deferred tax: intend to sell 451
Example 19: Revaluation above cost: Deferred tax: change in intention 454
4.3.3 Deferred tax on revalued assets: depreciable but non-deductible assets 455
Example 20: Revaluation above cost: deferred tax: intend to sell 455
Example 21: Revaluation above cost: deferred tax: intend to keep 457
4.3.4 Deferred tax on revalued assets: non-depreciable and non-deductible 457
Example 22: Revaluation of land above cost: deferred tax: intend to keep 458
5. Disclosure 459
5.1 Overview 459
5.2 Accounting policies and estimates 459
5.3 Statement of comprehensive income and related note disclosure 460
5.4 Statement of financial position and related note disclosure 460
5.5 Statement of changes in equity disclosure 461
5.6 Further encouraged disclosure 461
5.7 Sample disclosure involving property, plant and equipment 462
Example 23: Revaluation model disclosure 463

6. Summary 470

418 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

1. Introduction

1.1 Overview of the two models

IAS 16 Property, plant and equipment allows entities to choose between using the cost model
and the revaluation model when subsequently measuring the carrying amount of its property,
plant and equipment. In this chapter, we look at how to apply the revaluation model, whereas
the prior chapter explained the cost model. A comparison of the two models is shown below:

Subsequent Measurement Models

Cost Model Revaluation Model

x cost (often referred to as historic cost); x fair value;

x less subsequent accumulated depreciation; x less subsequent accumulated depreciation;
x less subsequent accumulated impairment x less subsequent accumulated impairment
losses See IAS 16.30 losses. See IAS 16.31

As we can see, the choice of the model affects only one aspect of subsequent
measurement: whether we use cost or fair value. All other principles of recognition, initial
measurement and the other aspects of subsequent measurement (such as depreciation and
impairment testing) are identical whether we use the cost model or revaluation model. These
principles are revised in section 2.

The carrying amount under the cost model is often calleGµGHSUHFLDWHGFRVW¶DQGWKHFDUU\LQJ

DPRXQWXQGHUWKHUHYDOXDWLRQPRGHOLVRIWHQFDOOHGµGHSUHFLDWHGIDLUYDOXH¶

1.2 Choosing between the two models Subsequent measurement of

PPE allows choice between:

We can choose a different model for different classes of x Cost model:

assets. Examples of classes of assets include machines, - Cost
Less AD
vehicles, land, buildings, plant etc. This means we could Less AIL
choose to use, for example, the cost model to measure x Revaluation model:
machines and the revaluation model to measure - FV on date of revaluation
vehicles. However, we must apply the chosen model to the Less subsequent AD
Less subsequent AIL
entire class of assets. For example, we may not use the cost
The model chosen must be used for all
model for a machine that bakes bread and the revaluation assets within a class of PPE (e.g. plant)
model for a machine that slices bread. All types of machines
would fall under the single class called µmachines¶ and thus they must all be measured using the
same model, for example, the cost model.. See IAS 16.29 & .37

The cost model is based on the DVVHW¶V original cost. The Fair value is defined as
revaluation model requires revaluation of the asset to its the:
fair value. Both models still involve the principles of x Price that would be received to
depreciation and impairment testing. sell an asset (or paid to transfer
a liability)
x In an orderly transaction
The cost model is easier to apply in practice and research
x Between market participants
suggests that it is currently the most commonly used model.
Fortunately for students, the difficulty in applying the x At the measurement date. IAS 16.6
revaluation model is not due to any real complexity from an academic point of view, but is merely a
difficulty from a practical point of view (i.e. revaluations must be performed regularly, and accounting
and computer systems may need to be updated to enable the revaluation model to be used). Using
the revaluation model requires double the work, since we are still required to calculate and disclose
the carrying amount of the asset had it been measured under the cost model!

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Gripping GAAP Property, plant and equipment: the revaluation model

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 identical to 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 The principles of the
measured at cost. If the asset is acquired via an asset revaluation model and
the cost model are the
exchange or by way of a government grant, the cost is same in terms of:
generally its fair value. In all other cases, cost would include x Recognition criteria
the purchase price, directly attributable costs and the initial x Initial measurement
estimate of certain future costs. x Subsequent measurement:
- Depreciation
Examples of directly attributable costs are given in chapter 7.
- Impairments
One of these examples is borrowing costs. If we incur
µERUrowing costs that are directly attributable to the acquisition, construction or pURGXFWLRQ¶ RI RXU
asset, and if it is D µTXDOLI\LQJ DVVHW¶ (which is defined as µDQ DVVHW WKDW QHFHVVDULO\ WDNHV D
substantial period of time to get ready for its intended use RU VDOH¶ , we are normally forced to
capitalise these costs. However, if the asset is measured under the revaluation model, we may
choose to capitalise these borrowing costs (see chapter 14 and IAS 23 Borrowing costs). Since
the calculation of the amount of borrowing costs to be capitalised can be complex, one may think
it¶s better to choose the revaluation model because it gives us the ability to avoid this calculation.
Sadly, however, we cannot avoid calculating the amount of borrowing costs to capitalise because,
if we choose to use the revaluation model and then choose not to capitalise the borrowing costs,
we are still required to disclose the carrying amount of the asset had it been measured under the
cost model, where capitalisation of borrowing costs is compulsory. See IAS 23.4 and 8

If the purchase price is paid within normal credit terms, the price paid is called a µFDVK SULFH
HTXLYDOHQW¶DQGXVHGDVWKHPHDVXUHPHQWRIFRVW+owever, if the payment is beyond normal credit
terms, we must determine this µFDVKSULFHHTXLYDOHQW¶,IWKLVFash 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
µFDVKSULFHHTXLYDOHQW¶ SUHVHQWYDOXHRIWKHIXWXUHSayments) 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.

420 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

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, WKHDVVHW¶Vrecoverable 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 called 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 of measured as:
tKH DVVHW¶V FDUU\LQJ DPRXQW WR LWV IDLU YDOXH It is important to x FV on date of revaluation
remember that, even when using the revaluation model, the initial x Less subsequent AD
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 DVVHW¶V 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.

,I ZH LQFUHDVH WKH DVVHW¶V FDUU\LQJ DPRXQW WR 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.

If we revalue our asset above depreciated cost, it means 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 aQµDUWLILFLDO¶ decrease in our profit
over time (or an increase in a loss). Profit or loss is accumulated in retained earnings and thus, to offset the
µartificial GHFUHDVH¶ in our retained earnings, we transfer our revaluation surplus balance (equity account) to
our retained earnings account (another equity account). This transfer can be done gradually over the
DVVHW¶V life, or as one single adjustment when the asset is derecognised (when it is disposed of or retired).
See IAS 16.41

Chapter 8 421
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3.2 How to account for increases or decreases in fair value

Where an asset is revalued to fair value, its carrying amount If FV > CA See IAS 16.39
either increases or decreases.
x Debit: Asset
,I WKH DVVHW¶V FDUU\LQJ DPRXQW increases as a result of a x Credit:
revaluation, the increase is: - P/L: if it reverses a previous
revaluation expense in P/L
x recognised in profit or loss as revaluation income, if it reverses a
- OCI: with any excess
previous revaluation decrease that was 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 LIWKHDVVHW¶VFDUU\LQJ DPount 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 thH DVVHW¶V FDUU\LQJ DPRXQW decreases as a result of a If FV < CA See IAS 16.40
revaluation, the decrease is:
x Credit: Asset
x first recognised in other comprehensive income as a debit to
x Debit:
any revaluation surplus balance that may exist on this asset:
- OCI: if there is a RS balance
 credit carrying amount, and from a prior revaluation
 debit revaluation surplus; and then - 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 wordsLIWKHDVVHW¶VFDUU\LQJDPRXQWLVdecreased, 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:

There is no balance in the 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

422 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

Example 3: Carrying amount decreases:

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

1 January 20X2 Debit Credit
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 7KXV ZH ZLOO XVH WKH WHUP µUHYDOXDWLRQ H[SHQVH¶ IRU GHFUHDVHV LQ WKH FDUU\LQJ Dmount to
fair value that are expensed in profit or loss (as opposeGWRWKHWHUPµLPSairment losV¶ZKHQ
decreasing the carrying amount down to the recoverable amount).

3.3 Characteristics of a revaluation surplus account

,I WKH DVVHW¶V FDUU\LQJ DPRXQW LV LQFUeased above its µhistorical carrying amount¶, the increase is
reflected as a revaluation surplus account (i.e. debit carrying amount and credit revaluation surplus).
Historical carrying amount +&$  LV HLWKHU WKH DVVHW¶V 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 ZLWKLQµother comprehensive income¶ 2&, 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 must be
preseQWHGDVµother 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 EHFDXVH ZKHQ DQ DVVHW¶V FDUU\Lng 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 aVVHW¶V FDUU\LQJ DPount 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

Chapter 8 423
Gripping GAAP Property, plant and equipment: the revaluation model

This transfer makes sense if you consider the effect of the revaluation on profits. We will first
consider a non-depreciable asset (e.g. land) and then a depreciable asset (e.g. plant).

If a non-depreciable asset 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. This means the profit on disposal will be lower (or loss on disposal
higher) than it would have been had it not been revalued. This effect on profit or loss then impacts
retained earnings, when the profit or loss is closed off to retained earnings. Thus, to negate the artificial
decrease in retained earnings, we transfer the µUHYDOXDWLRQVXUSOXV¶EDODQFHWRµUHWDLQHGHDUQLQJV.

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
Land: cost (A) 50 000
Revaluation surplus (OCI) 50 000
Revaluation of land

A few years later, this land is then subsequently sold for C220 000:
x WKHODQG¶VFDUU\LQJDPRXQWDW)9RI& 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
Land: cost (A) 150 000
Bank 220 000
Asset disposal (Temporary account) 220 000
Asset disposal (Temporary account) 70 000
Profit on sale of land (I) 70 000
Sale of land

+RZHYHUZHNQRZWKDWWKHµUHDO¶SURILWZDVDFWXDOO\& 000 (Proceeds: 220 000 ± Cost: 100 000). This

means 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 eaUQLQJV EDODQFH ZLOO QRZ LQFOXGH WKH µUHDO¶ SURILW RI & 000 (profit on sale: 70 000 +
transfer from revaluation surplus: 50 000).

If a depreciable DVVHW¶V FDUU\LQJ DPRXQW LV LQFUHDVHG The RS balance must be

subsequent depreciation will increase, thus µDUWLILFLDOO\¶ transferred directly to RE.
See IAS 16.41
reducing profits. Even if the asset is sold (or disposed of)
before the asset is fully depreciated, the effect on profit This can be done:
will be the same: the carrying amount at the time of x As the asset is used;
GHUHFRJQLWLRQZLOOEHµDUWLILFLDOO\KLJK¶DQGso the profit on x When the asset is retired; or
sale will be µartificially low¶. Either way, a revaluation x When the asset is disposed of.
causes a larger expense (via depreciation or the carrying amount expensed on disposal), thus a
lower profit (or bigger loss) and thus a lower retained earnings balance. Thus, to counter this
artificial decrease in profits, we transfer the revaluation surplus to retained earnings.

There are three methods of transferring the revaluation surplus to retained earnings:
x Transfer it as the asset is used (i.e. transfer it gradually over the useful life of the asset,
often referred to as an µannual transfer to retained earnings¶); or
x Transfer it when the asset is retired (i.e. transfer it as one lump sum); or
x Transfer it when the asset is disposed of (i.e. transfer it 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 the entity chooses to transfer the revaluation surplus to retained earnings over the life of a
depreciable asset (i.e. gradually), the revaluation surplus will decrease at the same rate as the
DVVHW¶VFDUU\LQJDPRXQW

424 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

This means thatLIWKHDVVHW¶Vfair 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 DVVHW¶Vcarrying amount:
x Down to the historical carrying amount, will be debited against the revaluation surplus:
Credit Asset and Debit Revaluation surplus (OCI)
x Below the historical carrying amount, will be debited If we transfer the RS to RE
as a revaluation expense in profit or loss: over the asset’s useful life,
the amount transferred
Credit Asset and Debit Revaluation expense (P/L).
each year will be the
difference between the:
However, please note that, if the revaluation surplus is
x depreciation based on fair value; &
only transferred to retained earnings when the asset is
x depreciation based on historic cost.
retired or disposed of, then the revaluation surplus
balance will still 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

Part A Part B Part C
31 December 20X2 Dr/ Cr Dr/ Cr Dr/ Cr
Revaluation surplus (OCI) Part A: Calculation 1 15
Retained earnings (Eq) (15)
Transfer of revaluation surplus to retained earnings
31 December 20X3
Revaluation surplus (OCI) Part A: Calculation 2 15
Retained earnings (Eq) (15)
Transfer of revaluation surplus to retained earnings
31 December 20X4
Revaluation surplus (OCI) Part A: Calculation 3 15 45
Retained earnings (Eq) Part B: Balance in RS on date of retirement (15) (45)
Transfer of revaluation surplus to retained earnings
18 September 20X5
Revaluation surplus (OCI) Part A: Calculation 3 45
Retained earnings (Eq) Part C: Balance in RS on date of disposal (45)
Transfer of revaluation surplus to retained earnings
(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

W1. Determining the revaluation surplus 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

Chapter 8 425
Gripping GAAP Property, plant and equipment: the revaluation model

3.5 Presentation of the revaluation surplus (IAS 16.39 & 41, IAS 1.82A & 106)
A revaluation surplus is a component of µother comprehensive income¶ and LVµaccumulated in
equity¶. This means that:
x bHFDXVH D UHYDOXDWLRQ VXUSOXV LV µother Reclassification
comprehensive income¶, an increase or decrease in adjustments are defined as
the revaluation surplus would be presented in the x amounts reclassified to P/L in the
µRWKHU FRPSUHKHQVLYH LQFRPH¶ VHFWLRQ RI WKH current period
statement of comprehensive income; and x that were recognised in OCI in the
current or previous periods. IAS 1.71
x because other comprehensive income is accumulated
in µequity¶, the revaluation surplus balance is also presented in the statement of changes in equity.

Other comprehensive income (OCI) be presented in the statement of comprehensive income

and the movement in each component of OCI be
separated under the following sub-headings:
Presentation of the RS:
x Items that may be reclassified to profit or loss (i.e.
when certain conditions are met); and x SOCI:
- in the OCI section;
x Items that may never be reclassified to profit or loss.
- under the heading: ‘items that
may never be reclassified to P/L’
The transfer of the revaluation surplus to retained earnings
x SOCIE: in its own column.
must be done directly. In other words, it must not affect
profit or loss (i.e. an indirect transfer to retained earnings by transferring the revaluation surplus to
income in profit or loss, is not allowed). Thus, revaluation surplus movements are presented in the
µother 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 overaOOµELJger SLFWXUH¶

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
DWWKHVDPHUDWHDVWKHDVVHW¶VFDUU\ing 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 the asset 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.

426 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

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/
HCA/ increased) decreased)
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 DVVHW¶VXVHIXOlife.

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: Using a graph approach for the revaluation model

You may find it easier to draw a graph of the situation, plotting the depreciated cost line (HCA):

Historical carrying amount line

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 asseW¶VXVHIXOOLIH
For a revaluation to fair value, you would then plot yoXUDVVHW¶VDFWXDOFDUU\LQJDPRXQW $&$ DQGIDLUYDOXH )9 RQWR
this graph. Then look at your graph carefully:
x If you are increasing the assHW¶VDFWXDOFDUU\Lng 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 ,I\RXDUHGHFUHDVLQJWKHDVVHW¶VDFWXDOFDUU\LQJDPRXQWWRLWVIDLUYDOXHWKHGHFUHDVHLQYDOXHZRXOGEHDFFRXQWHG
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).

Chapter 8 427
Gripping GAAP Property, plant and equipment: the revaluation model

The prior examples, graphs and diagrams show how to account for a revaluation by simply
debiting or crediting WKHDVVHW¶Vcarrying 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)

An entity purchased land on 1/1/20X1 for C100 000.
This land is not depreciated.
Fair values:
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 HQWLW\¶V 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:
A. Show the ledger accounts.
B. Present the above in the statement of financial position for 20X1 to 20X5.

Solution 5A: 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: R/ 31/12/20X3/4:
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

428 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

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

Solution 5B: Disclosure

Entity name
Statement of financial position 20X5 20X4 20X3 20X2 20X1
As at 31 December (extracts) C C C C C

Non-current assets
Land 110 000 70 000 90 000 120 000 100 000

Equity
Revaluation surplus 10 000 0 0 20 000 0

W1. PPE carrying amount and adjustments Jnl 20X2 20X3 20X4 20X5
No. Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
O/balance 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

Notice:
x 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 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 of
C100 000. Thereafter, the further increase in CA is then 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 entity transfers the realised portion of the revaluation surplus to retained earnings as the asset is used.
Required:
A. Show the ledger accounts for the years ended 31 December 20X2 to 20X5. Use a carrying amount
account (i.e. do not prepare separate cost and accumulated depreciation accounts). Ignore tax.
B. Prepare the statement of financial position as at 31 December 20X2 to 20X5. Ignore tax.

Chapter 8 429
 Gripping GAAP Property, plant and equipment: the revaluation model

Solution 6A: 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 Depreciation(2) 20 000 Ret earnings 10 000 Machine: CA (1) 90 000
(1)
Rev surplus 90 000 (90 000/ 9)
Balance c/f 160 000 Balance c/f 80 000
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 surplus (3) Machine: CA
(3)
80 000 80 000
(4)
Rev expense 20 000 Balance c/f 0
80 000 80 000
31/12/20X3 31/12/20X3
Depreciation(5) 7 500 Balance b/f 0
Balance c/f 52 500 31/12/20X4: 1/1/20X4
Ret earnings 1 000 Machine: 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
Balance b/f 52 500 Balance b/f 6 000
1/1/20X4 31/12/20X4 31/12/20X5: 1/1/20X5
Rev Income (6) 17 500 Depreciation(8) 11 000 Ret earnings 10 000 Machine: CA (9) 54 000
Rev surplus (7)
7 000 (60 000/ 6)
Balance c/f 66 000 Balance c/f 50 000
77 000 77 000 60 000 60 000
31/12/20X4: 31/12/20X5:
Balance b/f 66 000 Balance b/f 50 000
1/1/20X5 31/12/20X5
(9)
Rev surplus 54 000 Depreciation (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
Machine: CA (2) 20 000 P/L 20 000 Rev Surp 10 000
31/12/20X3 31/12/20X3 31/12/20X4:
Machine: CA (5) 7 500 P/L 7 500 Rev Surp 1 000
31/12/20X4 31/12/20X4 31/12/20X5:
Machine: CA (8) 11 000 P/L 11 000 Rev Surp 10 000
31/12/20X5 31/12/20X5
Machine: 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
Machine: CA (4) 20 000 P/L 20 000 P/L 17 500 Machine: CA (6) 17 500

430 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

Solution 6B: Disclosure

Entity name
Statement of financial position 20X5 20X4 20X3 20X2
As at 31 December (extracts) C C C C
Non-current assets
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

Some 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
Historical carrying amount: Cost – depreciation 50 000 60 000 70 000 (a) 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 ± 0) x 10% x 5 years (50 000)
Transfer: RS to RE See ledger: 10 000 + 1 000 + 10 000 21 000

W1: PPE carrying amount and adjustments Jnl 20X2 20X3 20X4 20X5
No. Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
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 calculations 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 = 20 000 X3: 60 000 / 8 yrs = 7 500 X4: 77 000 / 7 yrs = 11 000 X5: 120 000 / 6 yrs = 20 000

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 examSOHVPDGHXVHRIDµFDUU\LQJDPRXQW¶DFFRXQW. 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):
x the gross replacement value method (or proportional restatement method); or
x the net replacement value method (or net method).

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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,
tKHDVVHW¶VFDUU\LQJDPRXQWLVUHSUHVHQWHGE\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 aVVHW¶V cost.

Under the revaluation model, however, adjustments to the carrying amount could be made to the
cost account and/or to the accumulated depreciation and impairment loss accounts. Since
adjustments are sometimes made to the cost account, the cost account would no longer reflect its
cost. (Incidentally, this so-calOHGµFRVWDFFRXQW¶LVSUHVented in the financial statements, within the
property, plant and equipment note, as a line-item called µJURVVFDUU\LQJDPRXQW¶).

:KHQ PDNLQJ DGMXVWPHQWV WR DQ DVVHW¶V FDUU\LQJ DPRXQW Two methods of
under the revaluation model, the entity may choose to journalising a revaluation:
account for the adjustment using:
x Proportionate restatement
x the proportionate restatement method method (gross method or gross
(also called: gross replacement value method); or replacement value method)
x Elimination restatement method
x the elimination restatement method (net method or net replacement
(also called: net replacement value method). 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 (ZKLFKLVHTXLYDOHQWWRZKDWZHFDOOWKHµnet replacement value¶).

However, the balances in the separate accounts that constitute carrying amount (cost,
accumulated depreciation and impairment loss accounts) will differ depending on whether the
gross or net method was used. Since the balances on these separate accounts need to be
separately disclosed in the notes, we must know how to process the journals using each method.

3.9.2 Proportionate restatement method (gross replacement value method) (IAS 16.35(a))

The proportionate restatement method is often called the gross replacement value method (or
simply, the gross method). When using this method, we must:
x proportionately restate the cost account, and
x proportionately restate the accumulated depreciation and impairment loss 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 embodied in the asset on date of purchase. In other words, it is an estimation of
the fair value on date of purchase (as opposed to the fair value today) (or, simply, the amount that
the valuer thinks we should have paid for the asset on date of purchase).

Proportionately restating the accumulated depreciation

Proportionate restatement:
account means adjusting its balance to reflect µDFFXPXODWHG
depreciation on the gross replacement value’ (it normally
x Proportionately restate (adjust):
shRZV µDFFXPXODWed depreciation on cost’). We can also - Cost account to show GRV; &
visualise this as showing us KRZ PXFK RI WKH DVVHW¶V re- - AD account to show AD on GRV
estimated original economic benefits would have been earned x So that net effect is CA = FV
by now (or, simply, what the accumulated depreciation would
have been had we bought the asset at the gross replacement value instead of at its actual cost).

432 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

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

Answer: 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 DVVHW¶V FDUU\LQJ DPRXQW should
reflect the future economic benefits that we expect 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 on this date.
x The fair value of C90 000 was measured on 1 January 20X3, (2 years after it was first available for
use), when it had 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).
Assuming estimated benefits of C30 000 per year, the total future benefits on the date the asset was
purchased (i.e. fair value on 1 January 20X1) is 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 ± 0) / 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

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 ± 0) / 5 years 20 000
Plant: acc depreciation (-A) 20 000
Depreciation of asset
31/12/20X2
Depreciation: plant (E) (100 000 ± 0) / 5 years 20 000
Plant: acc depreciation (-A) 20 000
Depreciation of asset
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 account now shows GRV of 150 000

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Gripping GAAP Property, plant and equipment: the revaluation model

31/12/20X3 Debit Credit

Depreciation: plant (E) (FV/ NRV: 90 000 ± 0) / 3 remaining years 30 000
Plant: acc. depreciation (-A) 30 000
Depreciation of asset

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 before re-PHDVXULQJ WKH DVVHW¶V FDUU\LQJ
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 (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 before the revaluation.

The next journal would be to adjust this cost account

Elimination restatement:
(which currently reflects the carrying amount prior to the
revaluation) so that it reflects the DVVHW¶V latest fair value x First set off:
(otherwise known as the net replacement value). - AD account against
- Cost account
so that the ‘cost account’ shows
Thus, when using the elimination restatement method (i.e. CA before revaluation
the net method), immediately after the revaluation, the x Now adjust this ‘cost account’ (CA)
accumulated depreciation account will have a nil balance so that the cost account = FV
and the cost accoXQWZLOOUHIOHFWWKHDVVHW¶VODWHVW 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)

Depreciation: straight-line over 5 years to a nil residual value
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

Answer: 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 following working is not necessary, but may help you understand the solution.

Solution 8B: Journals using the net replacement value method

1/1/20X1 Debit Credit

Plant: cost (A) Given 100 000
Bank (A) 100 000
Purchase of asset
31/12/20X1
Depreciation: plant (E) (100 000 ± 0) / 5 years 20 000
Plant: acc depreciation (-A) 20 000
Depreciation of asset

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Gripping GAAP Property, plant and equipment: the revaluation model

31/12/20X2 Debit Credit

Depreciation: plant (E) (100 000 ± 0) / 5 years; OR 20 000
Plant: acc depreciation (-A) (CA: 80 000 ± 0) / 4 remaining years 20 000
Depreciation of asset
1/1/20X3
Plant: acc depreciation (-A) 20 000 + 20 000 40 000
Plant: cost (A) 40 000
Netting off of acc depr immediately before revaluation
Plant: cost (A) 30 000
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) (CA: 90 000 ± 0) / 3 remaining years 30 000
Plant: accumulated depreciation (-A) 30 000
Depreciation of asset

W1: Plant accounts at 1/1/X3 Using cost: Using FV: Revaluation surplus
Cost 100 000 5 years in total 90 000 Given
Acc deprec (100K-0) / 5 x 2 (40 000) 2 years used (0)
Carrying amount: 1/1/X3 60 000 3 years remaining 90 000 Given 30 000

Notice: 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:
Comparison of account balances: 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
Depreciation: straight-line over 5 years to a nil residual value
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)

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 ± 0) / 5 years remaining 20 000 20 000
Plant: accumulated depreciation (-A) (20 000) (20 000)
Depreciation of asset

Chapter 8 435
Gripping GAAP Property, plant and equipment: the revaluation model

Journals FRQWLQXHG« Ex 9A Ex 9B
NRVM GRVM
1/1/20X2: revaluation (increase) Dr/ (Cr) Dr/ (Cr)
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 ± 0) / 4 years remaining 22 500 22 500
Plant: accumulated depreciation (-A) (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 ± Historic (2 500) (2 500)
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 NRVM (A) & GRVM (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
Workings: applicable to just GRVM (B)

W3: Adjustments needed for the GRV Method

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

Graph depicting both NRVM (A) & GRVM (B): 1/1/20X2

90 000 (FV)
10 000 (Credit revaluation surplus)
80 000 (HCA & ACA)
Cost

Historical carrying amount line

0 Useful Life

436 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

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

Journals: 20X3 Ex 10A Ex 10B

NRVM GRVM
1/1/20X3: revaluation (decrease) Dr/ (Cr) Dr/ (Cr)
Plant: accum. depreciation (-A) From example 9A 22 500 N/A
Plant: cost (A) (22 500) N/A
NRVM: set-off of acc. depreciation before revaluing asset
Revaluation surplus (OCI) The balance in the RS acc from Example 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
NRVM: Revaluation journal – cost account now reflects fair value
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
Adjust the cost account to reflect ‘GRV’ and adjust the AD account to
reflect ‘AD on GRV’ (i.e. adjust CA to reflect FV).
The contra entries: first debit revaluation surplus (reducing it to nil) and
then debit revaluation expense with any excess.
31/12/20X3: depreciation
Depreciation: plant (E) (FV: 54 000 ± 0) / 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

W1: NRVM (A) & GRVM (B): Historical carrying amount at 1/1/20X3: C
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 ± 0)/ 4yrs; Or (112 500 ± 0)/ 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

W4: For GRVM (B) only:

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)
Fair value: 1/1/20X3 Given 54 000

Chapter 8 437
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Graph relevant to both NRVM (A) & 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

Notice:
x The difference between the journals using the NRVM and the GRVM is important because it affects the
GLVFORVXUH RI µJURVV FDUrying DPRXQW¶ DQG µDFFXPXODWHG GHSUHFLDWLRQ DQG LPSDLUPHQW ORVVHV¶ LQ WKH
property, plant and equipment note. However, irrespective of the method used, the effect of these
MRXUQDOVRQµQHWFDUU\LQJDPRXQW¶LVWKHVDPHDQGFDQ be 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 TKHDVVHW¶VFDUU\LQJDPRXQW(CA) is reduced to below historical carrying amount (depreciated cost).

 Dropping the CA to historical carrying amount, means the revaluation surplus is reduced to zero. This
also means that there is no journal transferring revaluation surplus to retained earnings in 20X3.
 Dropping the CA C6 000 below the historical carrying amount of C60 000, means C6 000 is expensed.

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
Ex 11A Ex 11B
NRVM GRVM
1/1/20X4: Revaluation (increase) Dr/ (Cr) Dr/ (Cr)
Plant: accum. depreciation (-A)) 18 000 N/A
Plant: cost (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
NRVM: Revaluation journal – cost account now reflects fair value
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

438 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

Ex 11A Ex 11B
NRVM GRVM
31/12/20X4: Depreciation and transfer of RS to RE Dr/ (Cr) Dr/ (Cr)
Depreciation: plant (E) (FV 44 000 ± 0) / 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 depr 20 000 (2 000) (2 000)
Transfer of revaluation surplus to retained earnings: over life of asset (the
extra depreciation for 20X4 due to the revaluation above HCA)

Workings applicable to both NRVM (A) & GRVM (B)

W1: Historical carrying amount (depreciated cost) at 1/1/20X4: C

Cost 100 000
Accumulated depreciation (100 000 ± 0) x 20% x 3yrs (60 000)
40 000

W2: Actual carrying amount at 1/1/20X4

Carrying amount at 1/1/20X3 after revaluation on 1/1/20X3 54 000
Depreciation in 20X3 (FV: 54 000/ 3 rem years) or (GRV: 90 000/ 5 total years) (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

W4: For GRVM (B) only:

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)
Fair value: 1/1/20X4 Given 44 000

Graph depicting both NRVM (A) & GRVM (B): 1/1/20X4

44 000 (FV)
4 000 (Credit revaluation surplus)

40 000 (HCA)
Cost

4 000 (Credit reversal of revaluation expense)

Historical carrying amount line

36 000 (ACA)

0 Useful Life

3.10 The revaluation model and impairments (IAS 36 and IAS 16.63 - 66)
All property, plant and equipment must undergo an impairment indicator review at the end of
every financial year ± even those measured under the revaluation model. The indicator review
involves looking for indicators that the asset may be impaired and is not the actual impairment
test. If, during the indicator review, we find anything that indicates the asset may be impaired,
we carry out an impairment test. This test involves calculating the recoverable amount and
comparing it to the carrying amount. If the recoverable amount is less than the carrying amount,
the asset is impaired and the carrying amount must be reduced to the recoverable amount.

Chapter 8 439
Gripping GAAP Property, plant and equipment: the revaluation model

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 (i.e. in
which case the carrying amount reflects FV) 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, in this
case, the FV-CoD (i.e. FV ± an amount that is close to nil) would 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 See the worked example below (also chapter 11, example 10).

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 if CoD are negligible, then FV-CoD = 100. Thus, no matter what the VIU is,
we need not calculate it because the asset is automatically not impaired. For example, imagine:
x If VIU = 120, then RA = 120 (greater of VIU 120 and FV-CoD 100) & since RA 120 > CA 100: = no impairment
x If VIU = 80, then RA = 100 (greater of VIU 80 and FV-CoD 100) & since RA 100 = CA 100: = no impairment.

IAS 16 does not tell us what to name the income and expense accounts that arise when adjusting
DQDVVHW¶VFDUU\LQJDPRXQW. However, where an adjustment is to be recognised in profit or loss, we
should differentiate between adjustments to fair value (a revaluation expense/ income) and
adjustments to recoverable amount (an impairment expense/ impairment reversal income).

This differentiation is relevant because decreasing DQDVVHW¶VFDUU\LQJDPRXQW to reflect a lower fair

value does not necessarily mean the recoverable amount has also decreased. Instead, recoverable
amount might be represented by the value in use (because RA = higher of VIU and FV-CoD), in
which case, although we might have to reduce the carrying amount to a lower fair value (in terms of
a revaluation), the recoverable amount reflecting value in use could be higher than this carrying
amount (in terms of impairment testing). 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
Plant, bought for C100 000 cash on 1/1/20X1, is measured using the revaluation model. The
entity uses the net replacement value method to account for the revaluation adjustments.
The plant is depreciated on the straight-line method over its useful life of 5 years to a nil residual value.
The following values applied on 31 December 20X1:
Fair value C70 000
Value in use C110 000
Costs of disposal C10 000
Required: Provide the journal entries necessary in 20X1.

Solution 12: A low fair value does not necessarily mean an impairment loss
Comment:
x The asset is measured under the revaluation model. Thus, we first revalue it to fair value of C70 000. This
revaluation was a decrease in value, called a revaluation expense (or something similar ± no guidance is
given 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 year-end, items of property, plant and equipment be
checked for impairments unless the revaluation model is used, and the costs of disposal are negligible.
In terms of IAS 36.5(c), when the revaluation model is used and the costs of disposal are not negligible,
as was the case in this example, an impairment is possible.
However, in this example, although the fair value less costs of disposal of C60 000 (FV 70 000 ± Costs
of disposal 10 000) is less than the carrying amount of C70 000 (fair value), the actual recoverable
amount of C110 000 (the higher of fair value less costs of disposal and value in use) exceeds the
carrying amount. Thus, there is no impairment loss.
x Notice how there was a revaluation expense, but the asset is not impaired.

440 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

1/1/20X1 Debit Credit

Plant: cost (A) 100 000
Bank (A) 100 000
Purchase of plant
31/12/20X1
Depreciation: plant (E) W1 20 000
Plant: accumulated depreciation (-A) 20 000
Depreciation of plant
Plant: accumulated depreciation (-A) 20 000
Plant: cost (A) 20 000
NRVM: Set-off of acc depreciation against cost before revaluing
Revaluation expense: plant (E) W1 10 000
Plant: cost (A) 10 000
Revaluation of plant to fair value of C70 000

W1: Revalue to fair value C

Cost Given 100 000
Depreciation (100 000 ± 0) / 5 x 1 (20 000)
Carrying amount (before reval.) 80 000
Revaluation expense Balancing (10 000)
Fair value Given 70 000
W2: Check for impairment losses or reversals C
Carrying amount (after reval.) 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

In summary then:
x If the carrying amount is decreased and part or all of the decrease is to be recognised as an
expense in profit or loss, 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 in profit or loss, 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.

The above discussion refers only to income and expenses recognised in profit or loss (P/L).
However, when adjusting an asset measured under the revaluation model for impairments or
impairment reversals, the income or expense might also affect other comprehensive income (OCI).
x If the asset has previously been revalued and thus has a balance in a revaluation surplus
account (OCI), then any impairment loss must first be debited to the revaluation surplus
(OCI), and only once this balance is reduced to nil, would any further impairment loss be
recognised as an expense in profit or loss (P/L). (See chapter 11 example 9).
x Conversely, when using the revaluation model, an impairment loss reversal is allowed to
increase the carrying amount above historical carrying amount (HCA): depreciated cost if
the asset is depreciable, or cost if the asset is non-depreciable.
To the extent the impairment reversal increases the carrying amount:
 up to HCA, the reversal is credited as income in profit or loss (P/L); and
 above HCA, the reversal is credited as a revaluation surplus in other comprehensive income (OCI).
However, when reversing a prior impairment loss, we must not increase the DVVHW¶V carrying
amount above the carrying amount it would have had, had it never been impaired. This
means, if an asset is measured under the revaluation model, its carrying amount should
never be increased above the previous fair value less subsequent accumulated depreciation
(i.e. depreciated fair value). (See chapter 11 example 12).
Further discussion and examples of the impairment of an asset measured under the revaluation
model are included in the chapter on impairments (see chapter 11, section 4.3 and section 5.3)

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4. Deferred Tax Consequences (IAS 12)

4.1 Overview
Deferred tax consequences arise if the tax base of an asset (measured in terms of IAS 12) does
not equal its carrying amount (measured in terms of IAS 16). 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, which focussed on the cost model, temporary differences (and thus
deferred tax) can arise from basic transactions such as:
x buying the asset (if the asset is not tax-deductible);
x depreciating and impairing the asset;
x selling the asset.

However, when using the revaluation model, there is a further transaction that could lead to
temporary differences (and thus deferred tax): when we revalue an asset to fair value, its carrying
amount changes, but its tax base (which simply reflects µIXWXUH WD[ GHGXFWLRQV¶  does not change.
When recognising the deferred tax on this temporary difference, we need to remember that a change
LQ DQ DVVHW¶V FDUU\LQJ DPRXQW WKDW LV UHFRJQLVHG DV D UHYDOXDWLRQ VXUSOXV HJ GHbit asset, credit
revaluation surplus), affects other comprehensive income and does not affect profit or loss. Thus, the
deferred tax effect of the revaluation surplus must also be recognised in other comprehensive income
(i.e. debit revaluation surplus, credit deferred tax liability).This is explained in section 4.2.

Another issue to watch out for is when revaluing an asset¶VFDUU\ing amount to a fair value that
exceeds cost. If this happens, the measurement of the deferred tax balance may get a little
complicated. However, the trick here is to remember the golden rule that the deferred tax balance
must simply 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 revaluation surplus

reflects extra future
In context of deferred tax, a significant difference between the benefits which means
cost model and the revaluation model is that, when using the extra future tax:
revaluation model, the carrying amount may be increased above x Thus, if we have a RS balance
its historical carrying amount (depreciated cost in the case of a we must show the DT on the RS.
depreciable asset, or cost in the case of a non-depreciable asset).
This revaluation adjustment, which reflects extra future benefits expected from the asset, is
credited to a revaluation surplus account, which is part of other comprehensive income (i.e. it
does not affect profit or loss). This has implications for the deferred tax adjustment.
x If deferred tax arises from items that are recognised in profit The DT liability (future
or loss (e.g. depreciation and impairments), the deferred tax is tax payable) on the
also recognised in profit or loss. In other words, when adjusting creation of a RS
(future extra income)
the deferred tax asset or liability balance, the contra entry will
is journalised as:
be debited or credited to the tax expense account, and
x Debit RS
presented in the µprofit or loss section¶ of the statement of
comprehensive income. These deferred tax adjustments are x Credit DTA/L.
often called income statement-based deferred tax adjustments.
x 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. In other words, when adjusting the deferred tax asset or liability balance, the contra entry
will be debited or credited to the revaluation surplus account, and be presented in the µother
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 often
called balance sheet-based deferred tax adjustments. IAS 12.61A - .62

442 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

4.3 Deferred tax effects of the revaluation surplus and management intentions
When using the revaluation model, it is possible IRUDQDVVHW¶V 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 WKHDVVHW¶V 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
DT on a RS is affected by
To understand this, we must remember the deferred tax whether mgmt intends to:
liability (or asset) balance related to an asset simply reflects
x Use the asset:
the future tax payable (or receivable) on the estimated future - measure DT normally
inflows of economic benefits expected from that asset. x Sell the asset:
If the CA ” Cost:
If management intends to recover the DVVHW¶V carrying - measure DT normally
amount (i.e. the estimated future inflow of economic benefits) If the CA > Cost,
through the sale thereof rather than through its use, and if its - measure DT in a way that takes
into account the fact that part
carrying amount reflects a fair value greater than cost, the of the potential profit on sale
measurement of the related deferred tax balance will be will be taxed as a capital gain.
affected if the tax authorities tax capital profits from the sale
of an asset differently to any other profit (e.g. at different rate). 7KHHIIHFWRIPDQDJHPHQWV¶LQWHQWLRQV
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.
ODQG WKHQZHLJQRUHPDQDJHPHQW¶Vactual intentions and presume that the intention of management
is to sell the asset. 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 DVVHW¶VFDUU\LQJDPRXQWKDVEHHQLQFUHDVHGDERYH

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.
'HSHQGLQJ RQ PDQDJHPHQW¶V LQWHQWLRQV 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 prior tax deductions, which will be taxed at the income tax rate; or a further
deduction of 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 of the entire temporary difference will be measured at a
constant income tax rate.

Example 13: Revaluation surplus and deferred tax:

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%.
The plant is depreciable and tax-deductible.
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.

Chapter 8 443
Gripping GAAP Property, plant and equipment: the revaluation model

x If the intention was to keep (use) the asset, the SODQW¶Vcarrying amount would reflect future income
from the sale of the plant’s output: C
Future sales income Carrying amount at fair value 140 000
Less Future tax deductions Tax base µIXWXUHWD[GHGXFWLRQV¶ (100 000)
Future taxable profits 40 000
Future tax 40 000 x 30% 12 000
x If the intention was to sell the asset, the SODQW¶V carrying amount, at fair value, would reflect future
income from the expected selling price (SP) of the plant: C
Future selling price of plant (FV), limited to cost price SP of 140 000 (FV), limited to cost of 140 000
150 000 (cost not a limitation)
Less Tax base Tax base = future tax deductions (100 000)
Future recoupment on sale (increases taxable Tax deductions already received 40 000
profits) Note 1 that will be recouped
Future tax Note 2 40 000 x 30% 12 000

This situation (intention to sell, but fair value (expected selling price) < cost price) can be shown as follows:

Tax base (Future tax deductions) 100 000

Recoupment of past tax deductions: 40K x 30% 12 000
Revalued carrying amount (SP) 140 000
Past tax-GHGXFWLRQVWKDWZRQ¶WEHUHFRXSHG: 10K 0
Original cost 150 000
12 000
Notes:
1) The cost was 150 000 and the tax base was 100 000 (future tax deductions), which means the tax authorities had
already given us tax deductions of 50 000. However, if we sell the asset for 140 000 (FV), it would mean we would
only be µout of pocket¶ by 10 000 (outflow when buying 150 000 ± inflow when selling 140 000). Thus, since the tax
authorities have already given us deductions of 50 000, they will want to µWDNHEDFN¶ 000 of these deductions (tax
deductions already granted 50 000± recoupment of tax deductions 40 000 = net deduction of 10 000).
2) Since we expect the asset to be sold for 140 000, there will only be tax on a recoupment ± there will be no tax on a capital
gain. This is because the expected selling price (FV) of C140 000 is less than the original cost of C150 000.
Also see chapter 5: section 3.5.3.3 (sale of PPE at a price below cost) & section 3.5.3.4 (sale of PPE at a price above cost).

Solution 13B: Revaluation upwards but not exceeding cost: deferred tax: journals

Journals on revaluation date: Debit Credit

Plant: carrying amount (A) FV 140 000 ± CA 100 000 40 000
Revaluation surplus (OCI) 40 000
Revaluation above depreciated cost (historical carrying amount
Revaluation surplus (OCI) W1 or (40 000 x 30%) & Note 1 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
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) DT Liability: 0-12+0
CA/ TB before revaluation 100 000 100 000 0 0 TD: 0 x 30%
Revaluation surplus - up to cost 40 000 0 (40 000) (12 000) TD: -40K x 30%
Revaluation surplus - above cost 0 0 0 0 N/A
Note 1:
x When the CA is increased from C100 000 (HCA) to C140 000 (FV), it creates a temporary difference of C40 000.
x Since the extra C40 000 on revaluation is credited to revaluation surplus (OCI) ± not to income (P/L) (see first journal), the
deferred tax contra entry will be a debit to the revaluation surplus account ± not to tax expense (see second journal).

4.3.2 Deferred tax and a revaluation that exceeds cost

As already mentioned, if an asset is revalued 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.

444 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

If the revalued carrying amount exceeds cost, it is important to ascertain if management intends to keep
the asset or sell the asset. If the entity intends 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 sell it, the future economic benefits will be a mixture of the above.

These management intentions are important to consider because the tax laws and tax rates may differ
depending on the type of income we earn. For example, the tax rate applicable to income from normal
trading (e.g. sales revenue) may be 30% whereas the effective tax rate applicable to income from the
sale of an item of property, plant and equipment (e.g. profit on sale of an asset) may, for example, be
24%. ThusWKHHQWLW\¶VLQWHQWLRQregarding the asset must be considered when measuring the deferred
tax liability (or asset), because this balance must reflect how much tax the entity is expecting to pay (or
receive) in the future, and this amount may be affected by the type of income it is expecting to earn.

An exception occurs when the deferred tax balance relates to a revalued non-depreciable asset
(for example, land), in which case we must always presume that management intends to sell the
DVVHWLUUHVSHFWLYHRIPDQDJHPHQW¶Vactual intention. (See section 4.3.4) 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 future economic benefits) is expected to be earned through normal trading activities. In other
words, we expect that the future economic benefits (i.e. inflows) emanating from the asset will be
in the form of sales revenue or similar.

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 thus also be taxed at this same
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 also be measured at 30%.

Note: when measuring deferred tax relating to non-depreciable land, we ignore maQDJHPHQW¶V
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 depreciable and tax-deductible machine is revalued to a fair value of C140 000 when:
x its carrying amount (actual and historical) was 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.
For the purposes of this example, you may combine the cost and accumulated depreciation accounts.

Solution 14: Deferred tax: revaluation above cost: intend to keep

Comment: Since the intention is to keep the asset, there is no complication of a capital profit on sale and thus, the
increase in WKHDVVHW¶Vcarrying amount simply reflects extra future income expected from the use of the asset.

Journals on revaluation date: Debit Credit

Machine (carrying amount) (A) FV 140 000 ± Actual CA: 100 000 40 000
Revaluation surplus (OCI) 40 000
Increase in asset value above historical carrying amount (depreciated cost)
Revaluation surplus (OCI) W1 or (RS: 40 000 x 30%) 12 000
Deferred tax (A/L) 12 000
Deferred tax on the revaluation surplus

Chapter 8 445
Gripping GAAP Property, plant and equipment: the revaluation model

Solution 14: Deferred tax: revaluation above cost: intend to keep

W1: Deferred tax table
PPE x Depreciable Carrying Tax Temporary Deferred
(keep) x Deductible amount Base difference tax
(1)
Balances before revaluation 100 000 100 000 0 0
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) DT Liability (2) (3)
CA/ TB before revaluation 100 000 100 000 0 0 TD: 0 x 30% (1) (3)
Revaluation surplus ± up to cost 10 000 0 (10 000) (3 000) TD: -10K x 30% (3)
Revaluation surplus ± above cost 30 000 0 (30 000) (9 000) TD: -30K 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 (both equal C100 000), and therefore there is no deferred tax.
2) The revaluation surplus causes a taxable temporary difference of C40 000, which reflects the future
taxable profits from the use of the asset in excess of those originally expected. Since these profits
would be trading profits taxed at 30%, the future tax on these extra profits would be levied at 30%.
Thus, the deferred tax liability is measured at C12 000 (taxable temporary difference: 40 000 x 30%).
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. Thus, since the entire temporary
difference will be taxed at the income tax rate of 30%, there is no need to show this breakdown of the
carrying amount after revaluation into the components of 100 000, 10 000 and 30 000.
4) The deferred tax adjustment is a balancing figure (t is the journal you need to process to convert the
DT opening balance into the DT closing balance).
Yet another way of explaining the deferred tax balance is to imagine that, since we intend to keep the
asset, by revaluing 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 income Carrying amount at fair value 140 000
Less future tax deductions Tax base µIXWXUHWD[GHGXFWLRQV¶ (100 000)
Future taxable profit 40 000
Future tax payable at 30% 40 000 x 30% 12 000
This situation (intention to keep, and fair value (expected sales income) > cost price) can also be shown as follows:

Tax base (Future tax deductions) 100 000

Future taxable profits (future sales
Original cost 110 000 income ± future tax deductions):
12 000
(140 000 ± 100 000) x 30%
Revalued carrying amount (Future sales income) 140 000
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. When calculating the deferred tax using the balance sheet method, include
an extra column showing the movement in the revaluation surplus.

Solution 15: Deferred tax: revaluation above cost: intend to keep

2 January 20X1 Debit Credit
Machine: cost (A) 100 000
Bank (A) 100 000
Purchase of machine

446 Chapter 8
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31 December 20X1 Debit Credit

Depreciation: machine (E) (100 000 ± 0) x 25%; OR 25 000
Machine: accumulated depreciation (-A) (100 000 ± 0) / 4 years 25 000
Depreciation on machine
Deferred tax (A/L) W1; OR 1 500
Tax expense (E) (Depr: 25 000 ± Deduction: 20 000) x 30% 1 500
Deferred tax on depreciation versus tax deduction
1 January 20X2
Machine: accumulated depreciation (-A) 25 000
Machine: cost (A) 25 000
NRVM: accumulated depreciation set-off against cost
Machine: cost (A) FV: 120 000 ± CA: (100 000 ± 25 000) 45 000
Revaluation surplus (OCI) 45 000
Revaluation of machine (increase in value)
Revaluation surplus (OCI) W1 or 45 000 x 30% 13 500
Deferred tax (A/L) 13 500
Deferred tax on creation of revaluation surplus (increase in future tax because
future benefits increased)
31 December 20X2
Depreciation: machine (E) (120 000 ± 0) / 3 remaining years 40 000
Machine: accumulated depreciation (-A) 40 000
Depreciation on machine
Revaluation surplus (OCI) (45 000 ± 13 500) / 3 remaining years 10 500
Retained earnings (Eq) 10 500
A portion of revaluation surplus (after tax) transferred to retained earnings
Deferred tax (A/L) W1; OR 6 000
Tax expense (E) (Depr: 40 000 ± Deduction: 20 000) x 30% 6 000
Deferred tax on depreciation versus tax deduction
1 January 20X3
Machine: accumulated depreciation (-A) 40 000
Machine: cost (A) 40 000
NRVM: accumulated depreciation set-off against cost
Revaluation surplus (OCI) FV 60 000 ± CA (120 000 ± 40 000) 20 000
Machine: cost (A) 20 000
Revaluation of machine (decrease in value)
Deferred tax (A/L) 20 000 x 30% 6 000
Revaluation surplus (OCI) 6 000
Deferred tax on adjustment to revaluation surplus (decrease in future tax
because future benefits decreased)
31 December 20X3
Depreciation: machine (E) (60 000 ± 0) / 2 remaining years 30 000
Machine: accumulated depreciation (-A) 30 000
Depreciation on machine
Revaluation surplus (OCI) (45 000 ± 13 500 ± 10 500 ± 20 000 + 3 500
Retained earnings (Eq) 6 000) / 2 remaining years 3 500
A portion of revaluation surplus (after tax) transferred to retained earnings
Deferred tax (A/L) W1; OR 3 000
Tax expense (E) (Depr: 30 000 ± Deduction: 20 000) x 30% 3 000
Deferred tax on depreciation versus tax deduction

Chapter 8 447
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31 December 20X4 Debit Credit

Depreciation: machine (E) (30 000 ± 0) / 1 remaining year 30 000
Machine: accumulated depreciation (-A) 30 000
Depreciation on machine
Revaluation surplus (OCI) (45 000 ± 13 500 ± 10 500 ± 20 000 + 3 500
Retained earnings (Eq) 6 000 ± 3 500)/ 1 remaining year 3 500
Portion of revaluation surplus transferred to retained earnings (revaluation
surplus balance now nil)
Deferred tax (A/L) W1; OR 3 000
Tax expense (E) (Depr: 30 000 ± Deduction: 20 000) x 30% 3 000
Deferred tax on machine: depreciation versus wear and tear
31 December 20X5
Tax expense (E) W1 ; OR 6 000
Deferred tax (A/L) (Depr: 0 ± Deduction: 20 000) x 30% 6 000
Deferred tax on machine: depreciation versus wear and tear

W1: Deferred tax: machines

PPE x Depreciable Carrying Tax Temporary Deferred Revaluation
(keep) x Deductible amount Base difference tax 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 DT Asset
Cr DT (SOFP) (45 000)
Revaluation surplus (increase) 45 000 0 (45 000) (13 500)(1)
Dr RS (OCI) (3) 13 500
120 000 80 000 (40 000) (12 000) Subtotal (31 500)
Depreciation/ Deduction Dr DT (SOFP) (4)
(40 000) (20 000) 20 000 6 000 10 500
120 000 / 3 years; 100 000 x 20% Cr TE (P/L)
Balance: 31/12/20X2 80 000 60 000 (20 000) (6 000) DT 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 DT Asset (3 500)

Depreciation/ Deduction Dr DT (SOFP) (4)

(30 000) (20 000) 10 000 3 000 3 500
Cr TE (P/L)
30 000 / 1 years; 100 000 x 20%
Balance: 31/12/20X4 0 20 000 20 000 6 000 DT Asset 0

Depreciation/ Deduction Cr DT (SOFP)

(0) (20 000) (20 000) (6 000)
Dr TE (P/L)
N/A;100 000 x 20%
Balance: 31/12/20X5 0 0 0 0

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 future income (all from trading activities
because we plan to keep the asset). A decrease in future income from trading activities will result in a
corresponding decrease in income tax: 20 000 x 30% = 6 000
3) 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

448 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

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 reflects the expected selling price of the
asset. Thus, if the asset is revalued to fair value, the revaluation surplus (fair value less carrying
amount) reflects this expected profit on sale (selling price less carrying amount).

From a tax perspective, if the fair value exceeds cost, the amount by which the fair value exceeds
cost reflects the H[SHFWHG µcapital profit on sale¶, part of which may be exempt from tax. Any
remaining portion of the profit on sale will reflect a non-capital profit on sale (generally taxable).

Therefore, when measuring the deferred tax on a revaluation surplus where the fair value
exceeded cost and our intention is to sell, we must remember that part of the capital profit on
sale may be exempt from tax (and thus the deferred tax will not simply be the resultant
µWHPSRUDUy difference x tax rate: 30%).

Example 16: Deferred tax: Revaluation surplus above cost: intention to sell
A depreciable and tax-deductible plant, with a carrying amount of C60 000 and original cost
of C100 000, is revalued to a fair value of C110 000. The entity intends to sell this plant.

Required:
a) Calculate the revaluation surplus and analyse it into capital and non-capital profit components.
b) If the tax rate is 30%, the base cost equalled the cost price of C100 000, the tax base equalled the
carrying amount of C60 000, and 80% of capital gains are taxable, calculate the deferred tax that
would be recognised on the revaluation surplus.

Solution 16: Deferred tax: Revaluation surplus above cost: intention to sell

Comment: When the intention is to sell the asset, it is useful to visualise the revaluation surplus as being
the expected future profit on sale. We then ascertain whether we revalued above cost, in which case:
x part of the revaluation surplus brings WKHDVVHW¶VFDUU\LQJ amount back up to cost: this would be the
non-capital portion of the profit on sale (i.e. from carrying amount of C60 000 to cost of C100 000); and
x part of the revaluation surplus increases the carrying amount above cost: this would be the capital
portion of the profit on sale (i.e. from cost of C100 000 to fair value of C110 000).

a) Analysis of revaluation surplus balance, assuming the asset was sold C

Revaluation surplus: profit on sale FV (SP): 110 000 ± CA: 60 000 50 000
x Capital profit FV (SP): 110 000 ± Cost: 100 000 10 000
x Non-capital profit FV (SP), limited to Cost: 100 000 ± CA: 60 000 40 000

b) Taxable profit and tax, assuming the asset was sold C

Revaluation surplus: taxable portion 48 000
x Taxable capital gain on sale (FV (SP): 110 000 ± Base cost: 100 000) x 80% 8 000
x Recoupment on sale FV (SP), limited to Cost: 100 000 ± TB: 60 000 40 000

Deferred tax on revaluation surplus RS: 48 000 x 30% 14 400

Notice: If we compare part (a) and (b), we can see that the only difference is that capital profit was C10 000, but
the taxable capital gain was C8 000 (i.e.C2 000 of the capital profit was exempt from tax). As a result, the deferred
tax recognised on this revaluation surplus is C14 400, and cannot simply be calculated as 30% of the revaluation
surplus (i.e. it was not: RS 50 000 x 30% = C15 000), (compare this to example 15, where we recognised
deferred tax of C13 500, being 30% of the revaluation surplus of C45 000).

The principle is simply that the measurement of the deferred tax balance should reflect the tax
that would be owing if the asset were sold. In this regard, taxable profits might include:
x a recoupment of past tax deductions (increases taxable profit), or a further tax deduction
such as a scrapping allowance (decreases taxable profit); and/ or
x a taxable capital gain.

The next page reminds us how to calculate the tax that would be levied if an asset is sold.

Chapter 8 449
Gripping GAAP Property, plant and equipment: the revaluation model

If the tax authorities allow an entity to deduct DQDVVHW¶V cost by way of annual tax deductions
LHLIWKHDVVHWLVµGHGXFWLEOH¶ , and the asset is subsequently sold, then, depending on whether
the selling price is greater or less than its tax base, the taxable profit could include either:
x a taxable recoupment of some, or all, of the past tax deductions; or
x a further tax deduction (e.g. a scrapping allowance).

Furthermore, if the asset is sold at more than its cost, then there will also be a capital profit.
Depending on the tax laws, only a portion of the capital profit might be included in taxable profits
(i.e. part, or all, of the capital profit may be exempt from tax). For example, in some tax jurisdictions:
x a capital profit is totally exempt from tax, in which case deferred tax is not recognised on the
entire portion of the revaluation surplus that reflects an expected capital profit;
x a capital profit is completely taxable, in which case deferred tax is recognised on the entire portion
of the revaluation surplus that reflects an expected capital profit (i.e. capital profit x tax rate); or
x a capital profit is partially exempt (i.e. partially taxable), in which case deferred tax is
recognised, but only on the portion RIWKHUHYDOXDWLRQVXUSOXVWKDWUHIOHFWVWKHµtaxable portion
RIWKHFDSLWDOSURILW¶ (i.e. taxable capital gain x tax rate).

The impact of our intention (to keep or sell the asset) on the deferred tax balance will be best
understood by trying a few examples. All prior examples (with the exception of example 16)
involved assets that we intend to keep whereas the following examples (example 17 and 18)
involve assets we intend to sell. Then example 19 shows what to do if we change our intention.

Example 17: Revaluation above cost: Deferred tax: Intention to sell

A short example
A depreciable and tax-deductible machine is revalued to C140 000 when:
x its carrying amount (actual and historical) was 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 capital gains is 80% (i.e. 80% of the capital gain is taxable).
The intention is to sell the asset.
For the purposes of this example, you may combine the cost and accumulated depreciation accounts.
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 fair value (FV) reflects the selling price (SP). 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 (i.e. the DT balance is C10 200, and
not simply TD 40 000 x 30% = 12 000).

Journals on revaluation date: Debit Credit

Machine: carrying amt (A) FV (SP): 140 000 ± CA: 100 000 40 000
Revaluation surplus (OCI) 40 000
Increase in asset value above historical carrying amount (depreciated cost)
Revaluation surplus (OCI) W1 10 200
Deferred tax (A/L) 10 200
Deferred tax caused by the creation of the revaluation surplus: DT c/balance
must reflect tax on taxable capital gain of 24 000 plus recoupment of 10 000

W1: Deferred tax table

PPE x Depreciable Carrying Tax Temporary Deferred
(sell) x Deductible amount Base difference tax
Balances before revaluation 100 000 100 000 0 0
(3)
Revaluation surplus 40 000 0 (40 000) (10 200) Cr DT Dr RS

Balances after revaluation 140 000 100 000 (40 000) (10 200) DT Liability (2) (W2) (W3)
CA/ TB before revaluation 100 000 100 000 0 0 TD: 0 x 30% (1) (2)
Revaluation surplus ± up to cost 10 000 0 (10 000) (3 000) TD: 10K x 30% (2)
Revaluation surplus ± above cost 30 000 0 (30 000) (7 200) TD: 30K x 80% x 30% (2)

450 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

Notes
1) There are no temporary differences when we compare the historical carrying amount and tax
base, as these happen to be the same (both equal C100 000), and thus there is no deferred tax.
2) The entire revaluation surplus of 40 000 (10 000 + 30 000) reflects the expected future profit on
sale of the asset (because the intention is to sell). Because the expected selling price exceeds
cost, part of this profit is a capital profit, of which a portion is exempt from tax. The measurement
of the deferred tax balance must thus reflect the expected tax liability if we were to sell:
x The profit on sale up to cost leads to a recoupment of past tax deductions (selling price,
limited to cost price ± tax base) and will be taxed at 30%.
x The profit on sale above cost leads to a capital gain (proceeds ± base cost), 80% of which will be
taxed at 30%
Thus, the DT closing balance = (Recoupment x 30%) + (Capital gain x 80% taxable x 30%)
= (SP ltd to Cost: 110 000 ± TB: 100 000) x 30% + (SP 140 000 ± BC: 110 000) x 80% x 30%
= (10 000 x 30%) + (30 000 x 80% x 30%)
= 3 000 + 7 200 = 10 200
Please note: If, for example, the base cost was 130 000 (i.e. if it did not equal cost of 110 000),
then the deferred tax on the taxable capital gain would not be 7 200, but would be 2 400 instead:
= (SP ± BC) x 80% x 30% = (140 000 ± 130 000) x 80% x 30% = 2 400.
In this case, the DT closing balance would be 5 400 (3 000 + 2 400). If you are battling, other workings
that may help you understand are shown in W2 and W3.
3) This is the DT journal needed to convert the DT opening balance (nil) to the DT closing balance
(10 200 liability). P.S. Since the cause of the DT was a revaluation surplus, the contra entry is
the revaluation surplus.
W2: Deferred tax closing balance uVLQJDµGLDJUDP¶

Tax base (future deductions) 100 000 Recoupment of past deductions: 3 000
10 000 x 30%
Original cost (and base cost) 110 000
Taxable capital gain:
7 200
30 000 x 80% x 30% (see 3 above)
Revalued carrying amount (SP) 140 000
10 200

W3: Deferred tax closing balance using income statement approach Taxable profits Deferred tax
Capital portion
Selling price Fair value 140 000
Less Base cost (110 000)
Capital gain 30 000
Taxable capital gain (TCG) 30 000 x 80% 24 000
Tax on TCG 24 000 x 30% 7 200
Non-capital portion
Selling price limited to cost 140 000 ltd to 110 000 110 000
Less Tax base Given (100 000)
Recoupment 10 000 10 000
Tax on recoupment 10 000 x 30% 3 000
Future taxable profits and deferred tax liability 34 000 10 200

Example 18: Revaluation above cost: Deferred tax: Intention to sell ± full example
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 revaluation surplus to retained earnings on disposal of the asset
x uses the net replacement value method to record its revaluations.
On date of rHYDOXDWLRQ -DQXDU\; WKHHQWLW\¶VLQWHQWLRQLVto sell the asset.
x The criteria for reclassification as a non-current asset held for sale are not met (see chapter 12).
x The asset is not sold until 1 January 20X3 (for C90 000).
The tax authorities levy income tax at 30% and will:
x allow the deduction of the cost of the asset at 20% of the cost per annum
x use a base cost of C100 000 and apply an 80% inclusion rate if sold at a capital gain.
Required: Provide all related journal entries. When calculating the deferred tax using the balance sheet
method, include an extra column showing the movement in the revaluation surplus.

Chapter 8 451
Gripping GAAP Property, plant and equipment: the revaluation model

Solution 18: Revaluation above cost: deferred tax: intention to sell

2 January 20X1 Debit Credit

Machine: cost (A) 100 000
Bank (A) 100 000
Purchase of machine
31 December 20X1
Depreciation: machine (E) (100 000 ± 0) x 25% x 12 / 12; OR: 25 000
Machine: acc depreciation (-A) (100 000 ± 0) / 4 years x 12 / 12 25 000
Depreciation on machine
Deferred tax (A/L) W1; OR: 1 500
Tax expense (E) (Depr: 25 000 ± Deduction: 20 000) x 30% 1 500
Deferred tax on machine: depr vs tax deduction (income-statement based DT)
1 January 20X2
Machine: accumulated depreciation (-A) 25 000
Machine: cost (A) 25 000
NRVM: accumulated depreciation set-off against cost
Machine: cost (A) FV: 120 000 ± CA: (100 000 ± 25 000) 45 000
Revaluation surplus (OCI) 45 000
NRVM: Revaluation of machine (increase in value)
Revaluation surplus (OCI) W1 12 300
Deferred tax (A/L) 12 300
Deferred tax on machine: due to revaluation surplus (balance-sheet based DT)
31 December 20X2
Depreciation: machine (E) (120 000 ± 0) / 3 remaining years 40 000
Machine: accumulated depreciation (-A) 40 000
Depreciation on machine (remember: CA=FV & RUL=3)
Deferred tax (A/L) W1; OR: 6 000
Tax expense (E) (Depr: 40 000 ± Deduction: 20 000) x 30% 6 000
Deferred tax on machine: depr vs tax deduction (income-statement based DT)
Revaluation surplus (OCI) W1 (DT adjustment needed to make the 1 200
Deferred tax (A/L) DT liability balance = C6 000); See note 9 1 200
Deferred tax on machine: due to revaluation surplus (balance-sheet based DT)
1 January 20X3
Machine: accumulated depreciation (-A) 25 000 ± 25 000 + 40 000 40 000
Machine: cost (A) Given 120 000
Asset disposal Balancing 80 000
Sale of machine – derecognising the cost and accumulated depreciation
Bank Given 90 000
Asset disposal 90 000
Sale of machine – recognising the proceeds on sale
Asset disposal 10 000
Profit on sale 10 000
Sale of machine – asset disposal closed off to profit on sale
Deferred tax (A/L) W1; OR: 6 000
Tax expense (E) [Profit on sale: 10 000 ± Recoupment on 6 000
sale: (SP: 90 000 ± TB: 60 000)] x 30%
Deferred tax effect of sale: profit vs recoupment (income-statement based DT)
Revaluation surplus (OCI) RS balance: 45 000 ± 12 300 ± 1 200 31 500
Retained earnings (Eq) 31 500
Transfer revaluation surplus to retained earnings on date of sale of machine

452 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

W1: Deferred tax

PPE x Depreciable Carrying Tax Temporary Deferred RS
(sell) x Deductible amount Base difference tax
O/balance: X1 0 0 0 0
Purchase 100 000 100 000 0 0 Dr DT (SOFP)
Depr/ tax deduction (1) (25 000) (20 000) 5 000 1 500(2) Cr TE (P/L)

C/balance: X1 75 000 80 000 5 000 1 500(3) DT Asset

Cr DT (SOFP) (45 000)
Reval surplus 45 000 0 (45 000) (12 300)(5)
Dr RS (OCI) 12 300
Fair value 120 000 80 000 (40 000) (10 800)(4) Interim bal (32 700)
Dr DT (SOFP)
Depr/ tax deduction (6) (40 000) (20 000) 20 000 6 000(7)
Cr TE (P/L)
Subtotal (4 800) Interim balance
Cr DT (SOFP)
Adjust DT due to RS (1 200)(9) 1 200
Dr RS (OCI)
C/balance: X2 80 000 60 000 (20 000) (6 000)(8) DT Liability (31 500)
Sale (10)
(80 000) (60 000) 20 000 6 000 (11) Dr DT (SOFP) 31 500
Cr TE (P/L)

C/balance: X3 0 0 0 0 0

1) 20X1 Depreciation and Tax deduction calculations: Depreciation (20X1) = (100 000 ± 0) / 4 years = 25 000
Tax deduction (20X1) = 100 000 x 20% = 20 000

2) 20X1 DT adjustment on temporary difference between depreciation and tax deduction: TD: 5 000 x 30% = 1 500

3) 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 a DT asset (reflecting expected tax savings of C1 500) calculated as follows:

Tax base 80 000 If we sellZH¶GJHWDQ extra tax deduction of 5 000; or

If we keep: ZH¶GKDYHa tax loss from trade of 5 000 1 500
Carrying amount 75 000 Both cases: Decrease in taxable profits 5 000 x 30%
Expected tax saving: 1 500 DTA

4) 1/1/20X2: The deferred tax balance (an interim balance immediately after the revaluation). Since we now intend
to sell, the measurement of the deferred tax balance must reflect the expected tax liability if we were to sell: there is
an expected recoupment of past tax deductions (selling price, limited to cost price ± tax base), which will be taxed at
30% and there is an expected capital gain (selling price ± base cost), 80% of which will be taxed at 30%
Thus, the DT closing balance = (Recoupment x 30%) + (Capital gain x 80% taxable x 30%)
= (SP limited to Cost: 100 000 ± TB: 80 000) x 30% + (SP 120 000 ± BC: 100 000) x 80% x 30%
= 6 000 + 4 800 = 10 800 «If you prefer, this calculation can be illustrated as follows, instead:

Tax base 80 000

Recoupment:
(6 000)
20 000 x 30%
Original cost (and base cost) 100 000
Taxable capital gain: (4 800)
Revalued carrying amount (SP) 120 000 20 000 x 80% x 30%
Expected tax owing: (10 800) DTL

5) 1/1/20X2: Deferred tax adjustment on temporary difference caused by revaluation surplus:

DT Balance before revaluation: 1 500 asset (2) ± DT Balance after revaluation: 10 800 liability (4) = 12 300 (Cr DT and Dr RS *)
*: To convert the DT asset into a DT liability, we need to credit the DT account. Because the DT was caused by the
revaluation surplus (i.e. not caused by an income or expense in P/L), we must debit revaluation surplus (not tax expense).
Please note that the DT adjustment on the revaluation surplus is not calculated at 30% of the temporary
difference movement of C45 000 (because the FV exceeds cost and the intention is to sell). Instead, this DT
adjustment has to be calculated as a balancing exercise.

6) 20X2 Depreciation and Tax deduction calculations: Depreciation (20X2) = (120 000 ± 0) / 3 years = 40 000
Tax deduction (20X2) = 100 000 x 20% = 20 000

7) 20X2 DT adjustment on temporary difference between depreciation and tax deduction: TD: 20 000 x 30% = 6 000

Chapter 8 453
Gripping GAAP Property, plant and equipment: the revaluation model

8) 31/12/20X2: The deferred tax balance. Since the intention is still to sell the asset, the measurement of the
deferred tax balance must continue to reflect the expected tax liability if we were to sell: we still expect a
recoupment of past tax deductions (selling price, limited to cost price ± tax base), but there is no longer an expected
capital gain (because the carrying amount of 80 000, which reflects the expected selling price, has dropped below
cost of 100 000). Thus, we could simply calculate the deferred tax closing balance at 30% on the entire temporary
difference. Alternatively, we can calculate it as follows: (Recoupment x 30%) + (Capital gain x 80% taxable x 30%)
= Recoupment: (SP ltd to Cost: 80 000 ± TB: 60 000) x 30% + Capital gain: N/A = 6 000
This calculation can also be illustrated as follows, instead:

Tax base 60 000

Recoupment:
(6 000)
20 000 x 30%
Revalued carrying amount (SP) 80 000
No tax implications: 0
Original cost (and base cost) 100 000 BHFDXVHµ&$ 63 < CoVW¶
Expected tax owing: (6 000) DTL

9) 31/12/2X2 Deferred tax adjustment on temporary difference caused by revaluation surplus:

We need to make an adjustment to the DT liability balance because it is currently C4 800 (see the DT table above, or DT
liability balance after the revaluation: 10 800 ± DT adjustment due to depreciation vs tax deduction: 6 000 = 4 800) and yet the
closing balance needs to be C6 000 (8)
Thus, a DT adjustment is needed = DT liability is currently 4 800 ± DT liability needs to be 6 000 (8) = C1 200 (Cr DT and Dr RS *)
This adjustment is needed due to the fact that the revalued carrying amount of 120 000 has since been depreciated
and thus the initial deferred tax of 12 300 caused by the revaluation surplus is no longer appropriate.

10) 01/01/20X3 Sale of the asset: When the asset is sold:

x the carrying amount would be derecognised (it is set off against proceeds to calculate profit on sale).
x the tax base would be µderecognised¶ (it is set off against proceeds to calculate recoupment on sale).
11) 20X3 DT adjustment on temporary difference between profit and recoupment: TD: 20 000 x 30% = 6 000

Example 19: Revaluation above cost: Deferred tax: Change in intention

An entity owns 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 eQWLW\¶V intention was originally to keep the asset, but on 1 January 20X4, the entity 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 selling 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%).

01 January 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

DTL balance was [Sales income (FV): 110 000 ± Future tax deductions: 60 000] x 30% 15 000
DTL balance must now be: (Selling price (FV): 110 000 ± Base cost: 100 000) x 80% x 30% + 14 400
(Selling price limited to Cost: 100 000 ± Tax base: 60 000) x 30%
Deferred tax balance to be decreased by: 600

454 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

4.3.3 Deferred tax on revalued assets: depreciable but non-deductible assets

If we have an asset that is non-deductible for tax purposes (i.e. if the tax authority does not
allow the cost of our asset to be deducted in the calculation of taxable profits), a temporary
difference will arise immediately on the purchase of our asset because:
x the carrying amount is the cost, but
x the tax base is nil (since there will be no future tax deductions).

As was explained in the previous chapter (and chapter 6 DT on the revaluation

surplus of a depreciable,
section 4.3), deferred tax is not recognised on the related
non-deductible asset:
temporary differences since these are exempted in terms
x Intention to sell:
of IAS 12.15. This exemption applies to the temporary
- FV - Cost: Tax @ CGT rates (24%)
differences arising on recognition of the cost and any
- Cost - HCA: Tax at 0%
subsequent expensing of this cost (e.g. depreciation).
- HCA – TB: Exempt (0%)

An exemption from recognising deferred tax on these x Intention to keep:

temporary differences does not apply to any subsequent - FV - HCA: Tax @ Normal rate (30%)

temporary differences caused by a revaluation above the - HCA – TB: Exempt (0%)
DVVHW¶V historical carrying amount (cost if the asset is non-depreciable, or depreciated cost if
the asset is depreciable). In other words, the exemption will not apply to the temporary
difference arising from the debit (increase) to WKHDVVHW¶VFDUU\Lng amount when processing a
revaluation surplus and nor does it apply to the temporary differences arising from the
subsequent related increase in the depreciation resulting from this upward revaluation.

If a non-deductible and depreciable asset is revalued:

x If the intention is to keep it, the revaluation surplus represents the future profits expected from
the use of the asset in excess of the profits originally expected (i.e. the revaluation surplus
reflects expected extra trading profits). Profits earned through use of an asset are normal trading
profits that would be taxed at 30%. Thus, the deferred tax on the temporary difference caused
by the revaluation surplus is simply calculated at 30%. Similarly, deferred tax on the subsequent
temporary differences caused by the increase in depreciation is also measured at 30%.
x If the intention is to sell it, the revaluation surplus reflects the expected profit on sale. Thus,
the deferred tax on the temporary difference caused by the revaluation surplus must reflect
the tax that would be due if the asset were sold at its revalued carrying amount. When doing
this calculation, we must ascertain if there is a capital gain and how much thereof is taxable,
and we would also need to remember that, in the case of a non-deductible asset, there
would be no recoupment possible since there are no tax-deductions to recoup.
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).
The tax authorities:
x do not grant deductible allowances on this asset 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 ¶VH[DPSOH, 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) 40 000
Increase in asset value above historical carrying amount (depreciated cost)

Chapter 8 455
Gripping GAAP Property, plant and equipment: the revaluation model

Journals continued « Debit Credit

Revaluation surplus (OCI) W1 7 200
Deferred tax (A/L) 7 200
Deferred tax on the revaluation surplus

W1: Deferred tax table (extract)

PPE x Depreciable Carrying Tax Temporary Deferred Revaluation
(sell) x Non-deductible amount base difference tax surplus
(1)
Balance before revaluation 100 000 0 (100 000) 0 Exempt (0%) 0
Cr DT (40 000)
Revaluation surplus 40 000 0 (40 000) (7 200)
Dr RS (balancing) 7 200
Balance after revaluation (FV) 140 000 0 140 000 (7 200) Liability (4) 22 800
CA/TB before revaluation 100 000 0 (100 000) 0 Exempt (1)
Depreciated cost: given
Reval. surplus - up to cost: 10 000 0 (10 000) 0 Exempt (2)
CA 100 000 ± Cost 110 000
Reval. surplus ± above cost: 30 000 0 (30 000) (7 200) TD 30K x 80% x 30% (3)
Cost 110 000 ± FV 140 000

1) This temporary difference of C100 000 (TB ± Historical CA) is exempt in terms of IAS 12.15 since the asset is non-
deductible (LW¶V part of the TD that arose on initial acquisition that affected neither accounting profit nor taxable profit).
2) 7KLVµPRYHPHQWLQWKHWHPSRUDU\GLIIHUHQFH¶RI&LVexempt in terms of IAS 12.15 as the exemption applies to
cost and this C10 000 is a revaluation up to cost.
This portion of the µPRYHPHQW LQ WKH WHPSRUDU\ GLIIHUHQFH¶ of C10 000 reflects the increase in the expected
recoupment caused by the revaluation. As this is a non-deductible asset (i.e. no tax deductions are granted) and no
recoupment is possible (i.e. there are no prior tax deductions to recoup). Thus, DT effects on this portion of the TD
(10 000) is exempt ± or we can show this calculation as TD x 0%.
If you are battling to understand: Imagine this had been a deductible asset that we were intending to sell. In this
case, the TB of nil would mean the tax authorities had already allowed us to deduct the full cost of C110 000.
Revaluing the asset from its CA of C100 000 to it cost of C110 000 means we now expect to sell it for C110 000. If
we had sold for C100 000, the expected tax on the recoupment would have been C30 000 [(SP limited to Cost:
100 000 ± TB: 0) x 30%]. But if we now expect to sell it for C110 000, the tax on the recoupment increases by
C3 000, to C33 000 [(SP limited to Cost: 110 000 ± TB: 0) x 30%]. Thus, the deferred tax on the movement in TD of
C10 000 (the increase in the selling price) would have reflected the extra tax of C3 000.
However, the asset in this example is non-deductible. Thus, the increase in the TD of C10 000 does not reflect
an increase in a recoupment (no recoupment is possible because the asset is non-deductible, which means there
are no prior tax deductions to recoup). We get around this by multiplying this TD by 0% or treating it as N/A.
3) This µmovement in the temporary difference¶ of C30 000 is not exempt in terms of IAS 12.15 since the exemption only
applies to cost and subsequent depreciation thereof and this C30 000 is a revaluation above depreciated cost.
Whereas the previous portion of the revaluation surplus (C10 000) relates to a recoupment that does not exist, this
portion of the revaluation surplus (C30 000) increases the carrying amount above cost and thus the deferred tax on
this portion of the revaluation surplus (capital profit) must reflect the tax consequences of any related µtaxable capital
gain¶ (SP: 140 000 ± Base cost: 110 000) x 80% x 30% = 7 200
4) The deferred tax balance is C7 200 (C0 + C0 + C7 200). Notice it is not 30% of the TD of C140 000. There are two reasons
the total DT balance cannot be calculated as simply µTD x 30%¶:
x The asset was revalued above cost, which means we will have a capital profit, part of which is exempt from tax (in
terms of capital gains tax legislation); and
x The asset is non-deductible, which means that any temporary difference relating to depreciated cost will be
exempt from deferred tax (in terms of IAS 12.15).
Another way of showing the calculation of this deferred tax balance of C7 200 is as follows:

Tax base 0
NOTE 1
Recoupment: N/A 0
Original cost (and base cost) 110 000
Taxable capital gain (TCG): 30 000
7 200
Revalued carrying amount 140 000 (SP: 140 000 ± Base cost 110 000) x 80% x 30%
7 200

Note 1: This portion of the temporary difference (C110 000) normally reflects the taxable recoupment 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 (i.e. if there were no previous tax deductions granted, there is nothing to recoup).

456 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

Example 21: Revaluation above cost: Deferred tax: Intention to keep

x depreciable,
x non-deductible asset
Use the same information given in the prior example, but now assume the entity intends to keep the asset.
Required: Show the journal entries.

Solution 21: Revaluation: deferred tax: intention to keep

Comment:
x If we have an item of property, plant and equipment that has been revalued and we intend to keep it,
we must be careful when measuring the related deferred tax. This is because, although deferred tax is
normDOO\ PHDVXUHG EDVHG RQ PDQDJHPHQW¶V actual intentions, if it is an asset revalued under the
revaluation model and the asset is non-depreciable (e.g. land), we ignore the actual intentions and
always presume the intention is to sell (IAS 12.51B ± see chapter 6 section 4.4.2 and examples 12).
x However, the asset in this example is depreciable and thus maQDJHPHQW¶VUHDOLQWHQWLRQWRkeep the
asset is not over-ridden by IAS 12%¶VSUHVXPHGLQWHQWLRQWRsell (see chapter 6 example 12 for a
similar example that focuses on how the deferred tax balance should be measured).

Journals on date of revaluation Debit Credit

Property, plant and equipment: carrying amount (A) 40 000
Revaluation surplus (OCI) 40 000
Increase in asset value above historical carrying amount (depreciated cost)
Revaluation surplus (OCI) 12 000
Deferred tax (A/L): see calculation below 12 000
Deferred tax on the revaluation surplus – see W1

W1: Deferred tax table (extract)

PPE x Depreciable Carrying Tax Temporary Deferred Revaluation
(keep) x Non-deductible amount base difference tax surplus
Balance before revaluation 100 000 0 (100 000) 0 Exempt (1) 0
Cr DT (40 000)
Revaluation surplus 40 000 0 (40 000) (12 000)
DR RS (balancing) 12 000
Balance after revaluation 140 000 0 140 000 (12 000) DT Liability (3) 28 000
CA/TB before revaluation 100 000 0 (100 000) 0 Exempt (1)
Depreciated cost: given
Revaluation surplus ± up to cost: 10 000 0 (10 000) (3 000) TD: -10K x 30% (2)
CA 100 000 ± Cost 110 000
Revaluation surplus ± above cost 30 000 0 (30 000) (9 000) TD: - 30K x 30% (2)
Cost: 110 000 ± FV: 140 000

1) This temporary difference of C100 000 arises due to the difference between the depreciated cost of C100 000 and
the tax base of nil. Because the asset is non-deductible, the TD is exempt from deferred tax (in terms of IAS 12.15)
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%, a deferred
tax liability of C12 000 must be recognised (Future trading profits 40 000 x 30%) (i.e. we do not treat it as exempt
if the intention is to keep the asset).
3) Since the entire temporary difference relates to the revaluation surplus and since this entire revaluation surplus
represents extra trading profits that will be taxed at 30%, the deferred tax liability is 30% of the temporary difference.

4.3.4 Deferred tax on revalued assets: non-depreciable and non-deductible

If we have an asset that is non-deductible for tax purposes (i.e. if the tax authority does not
allow the cost of our asset to be deducted in the calculation of taxable profits), a temporary
difference will arise immediately on the purchase of our asset because:
x the carrying amount is the cost, but
x the tax base is nil (since there will be no future tax deductions).

Chapter 8 457
Gripping GAAP Property, plant and equipment: the revaluation model

As was explained in the previous chapter previous chapter (and chapter 6 section 4.3), 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 if 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,
amount will no longer reflect cost, but a fair value instead. The non-deductible asset:
extra temporary difference caused by the revaluation is not x Always assume intention to sell:
exempt from deferred tax and the calculation of the related - FV - Cost: Tax @ CGT rates
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-GHSUHFLDEOH DVVHW HJ ODQG  QHYHU JHWV µXVHG XS¶ LW LV DUJXHG What 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 the revaluation of a non-depreciable and non-deductible asset:
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: Intentions:

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. The base cost equalled cost.
Required: Show the journal entries for the revaluation assuming that the intention is to:
A sell the asset. Include a revaluation surplus column in your deferred tax table.
B keep the asset. Include a revaluation surplus column in your deferred tax table.

Solution 22: Revaluation (ODQG  GHIHUUHG WD[ PDQDJHPHQW¶V LQWHQWLRQ WR NHHS LV
overridden by the presumed intention to sell (IAS 12.51B)
Comment:
x This asset is rHYDOXHG LQ WHUPV RI ,$6 ¶V UHYDOXDWLRQ PRGHO DQG VLQFH Whe asset is non-
depreciable, PDQDJHPHQW¶V UHDO LQWHQWLRn to keep the asset is over-ULGGHQ E\ ,$6 %¶V
presumed intention. The deferred tax is thus measured on the presumed intention to sell the asset
HYHQWKRXJKPDQDJHPHQW¶VUHDOLQWHQWLRQLVWRNHHS the asset.
x This situation is also covered in chapter 6¶VH[DPSOH, which shows the calculation and disclosure
of current and deferred tax.

Solution 22A: Revaluation (land): deferred tax: intention to sell

Journals on date of revaluation: Debit Credit

Land: cost (A) 40 000
Revaluation surplus (OCI) 40 000
Revaluation of land: Increase above historical carrying amount (cost)
Revaluation surplus (OCI) W1 9 600
Deferred tax (A/L) 9 600
Deferred tax on the revaluation surplus

458 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

W1: Deferred tax on land ± actual intention to keep but use presumed intention to sell
PPE x Non-depreciable Carrying Tax Temporary Deferred Revaluation
(sell) x Non-deductible amount base difference tax surplus
Balance before revaluation 100 000 0 (100 000) 0 Exempt(1) 0
Cr DT (40 000)
Revaluation surplus 40 000 0 (40 000) (9 600)
DR RS (balancing) 9 600
Balance after revaluation 140 000 0 140 000 (9 600) DT Liability (4) 30 400
CA/TB before revaluation 100 000 0 (100 000) 0 Exempt (1)
Cost (not depreciated)
Revaluation surplus ± up to cost: 0 0 0 0 N/A (2)
No depreciation was provided
Revaluation surplus ± above cost 40 000 0 (40 000) (9 600) TD: - 40 000
Cost: 100 000 ± FV: 140 000 x 80% x 30% (3)

1) This temporary difference is exempt in terms of IAS 12.15.

2) 7KLV SRUWLRQ RI WKH µPRYHPHQW LQ WKH WHPSRUDU\ GLIIHUHQFH¶ UHODWLQJ WR WKH SRUWLRQ RI WKH UHYDOXDWLRQ surplus
bringing the asset back up to cost does not apply since the asset is not depreciated.
3) Since, in the case of a non-depreciable asset, it is always assumed that the fair value reflects the expected
selling price (no matter whether the company intends to keep or sell it), this revaluation surplus reflects an
expected capital profit. This revaluation surplus (C40 000) increases the carrying amount above cost and thus
the deferred tax on this revaluation surplus must reflect the tax consequences of any UHODWHGµtaxable capital gain¶
(SP: 140 000 ± Base cost: 100 000) x 80% x 30% = 9 600
4) Notice that the deferred tax does not equal 30% of the temporary difference since only part of the
temporarydifference represents a capital profit, and this part is effectively taxed at 24%.
Another way of explaining this deferred tax balance is as follows:
Tax base 0 Recoupment: N/A 1
0
Original cost (and base cost) 100
Taxable capital gain: 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).

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

Chapter 8 459
Gripping GAAP Property, plant and equipment: the revaluation model

The nature and effect of a change in estimate must be disclosed in accordance with IAS 8
(the standard on µDFFRXQWLQJSROLFLHVFKDQJHVLQDFFRXQWLQJHVWLPDWHVDQGHUURUV¶  See IAS 16.76

5.3 Statement of comprehensive income and related note disclosure

The note that supporWV WKH µSURILW EHIRUH WD[¶ OLQH LWHP LQ WKH VWDWHPHQW RI FRPSUHKHQVive
income should include the following items:
x depreciation expense (the total depreciation, whether expensed in profit or loss or included in the
cost of another asset must also be disclosed: where some of the depreciation has been included
in the cost of another asset, a reconciliation between the depreciation expense and the total
depreciation would need to be presented); IAS 16.75(c) & IAS 1.102-104
x impairment losses ; IAS 1.98(a)
x reversal of impairment losses; IAS 1.98(a)
x profits or losses on the realisation, scrapping or other disposal of a non-current asset
x compensation from third parties (e.g. insurance proceeds) on sale of items of property, plant
and equipment that had previously been impaired, lost or given up IAS 16.74A(a)
x proceeds from the sale of items that were produced by an item of property, plant and
equipment before it was formally available for use (i.e. items produced during the testing of
the asset) and the cost of these items that were sold IAS 1.74A(b)

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 linH LWHP XQGHU µRWKHU FRPSUHKHQVLYH LQFRPH¶ XQGHU
the sub-KHDGLQJµitemVWKDWPD\QHYHUEHUHFODVVLILHGWRSURILWRUORVV¶;
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)

5.4 Statement of financial position and related note disclosure (IAS 16 & IFRS 13)

The following is the primary information that IAS 16 requires to be disclosed in the note to the
µSURSHUW\SODQWDQGHTXLSPHQW¶Oine 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 µJURVV FDUU\LQJ DPRXQW¶ DQG µDccumulated depreciation and impairment loVVHV¶ DW WKH
beginning and end of each period; See IAS 16.73(d) & 75(b)
x DUHFRQFLOLDWLRQEHWZHHQWKHµQHWFDUU\LQJDPRXQW¶DWWKe beginning and end of the period
separately disclosing each of the following where applicable:
 additions;
 disposals;
 depreciation;
 impairment adjustments:
 impairment losses recognised in profit or loss,
 impairment losses in other comprehensive income (i.e. revaluation surplus decrease),
 impairment loss reversals recognised in profit or loss,
 impairment loss reversals in other comprehensive income (i.e. revaluation surplus increase);

460 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

 revaluation adjustments:
 revaluation expense recognised in profit or loss,
 revaluation expense in other comprehensive income (i.e. revaluation surplus decrease),
 revaluation income recognised in profit or loss,
 revaluation income in other comprehensive income (i.e. revaluation surplus increase),
 DVVHWVWUDQVIHUUHGWRµQRQ-current DVVHWVKHOGIRUVDOH¶LQDFFRUGDQFHwith 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.

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.

Chapter 8 461
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5.7 Sample disclosure involving property, plant and equipment

Entity name
Notes to the financial statements
For the year ended 31 December 20X2 (extracts)

2. Accounting policies
Plant is measured under the revaluation model and is revalued annually to fair values. It is thus
carried at fair value less accumulated depreciation and impairment losses. All other property, plant
and equipment is measured under the cost model and is thus carried 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 expected residual values using the following
rates and methods:
- Plant at 10% per annum, reducing balance method.

4. 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
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
Gross carrying amount
Accumulated depreciation & impairment losses

Plant 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).
Land is provided as security for a loan (see note 15: loans).

27. Profit before tax 20X2 20X1

C C
Profit before tax is stated after taking the following into account:
Depreciation on plant
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.

462 Chapter 8
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Entity name
Statement of financial position 20X2 20X1
As at 31 December 20X2 (extracts) Note C C

ASSETS
Non-current assets
Property, plant and equipment 4

Entity name
Statement of changes in equity
For the year ended 31 December 20X2 (extracts)
Revaluation Retained Total
surplus 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

Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 (extracts) Note C C

Profit for the year 27

Other comprehensive income for the year
x 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

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 entity 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
Fair value at 1/1/20X3 is C54 000
Fair value at 1/1/20X4 is C44 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 tax.

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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 Income tax rate 30%
x The entity 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 entity 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.

Entity name
Notes to the financial statements (extracts)
For the year ended 31 December 20X4 (extracts)

2. Accounting policies

2.8 Property, plant and equipment

Plant is measured under the revaluation model and is revalued annually to fair values. It 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:
Plant: 20% per annum, straight-line method.

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

27. Profit before tax

Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
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

464 Chapter 8
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Entity name
Notes to the financial statements (extracts)
)RUWKH\HDUHQGHG'HFHPEHU;FRQWLQXHG«

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.

Entity name
Statement of financial position (extracts) 20X4 20X3 20X2 20X1
As at 31 December 20X4 C C C C
Note
ASSETS
Non-current assets
Property, plant and equipment 12 22 000 36 000 67 500 80 000

EQUITY AND LIABILITIES

Revaluation surplus (from SOCIE) 2 000 0 7 500 0

Entity name
Statement of comprehensive income (extracts) 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 C C C C
Notes
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
33 4 000 (7 500) 10 000 0
increase/(decrease), net of tax: plant

Total comprehensive income for the period 104 000 92 500 110 000 100 000

Entity name
Statement of changes in equity (extracts)
For the year ended 31 December 20X4
Revaluation Retained Total
surplus earnings
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
Total comprehensive income 10 000 100 000 110 000
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
Balance at 31 December 20X3 0 X X
Total comprehensive income 4 000 100 000 104 000
Realised portion transferred to retained earnings (2 000) 2 000
Balance at 31 December 20X4 2 000 X X

Chapter 8 465
Gripping GAAP Property, plant and equipment: the revaluation model

Solution 23B: Revaluation model disclosure - with deferred tax

1/1/20X1 Dr/ (Cr)

Plant: cost (A) 100 000
Bank/ Loan (A/L) (100 000)
Purchase of asset
31/12/20X1
Depreciation: plant (E) (100 000 ± 0) / 5 years remaining 20 000
Plant: accumulated depreciation (-A) (20 000)
Depreciation
1/1/20X2:
Plant: accumulated depreciation (-A) 20 000
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
Revaluation surplus (OCI) W1 3 000
Deferred tax (A/L) (3 000)
Deferred tax on revaluation surplus
31/12/20X2:
Depreciation: plant (E) W1 22 500
Plant: accum. depreciation (-A) (22 500)
Depreciation on plant
Revaluation surplus (OCI) (7 000 ± 0) / 4 years remaining; OR: 1 750
Retained earnings (Equity) (22 500 revalued depr ± 20 000 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
Plant: accumulated depreciation (-A) 22 500
Plant: cost (A) (22 500)
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
Depreciation: plant (E) W1 18 000
Plant: accum. depreciation (-A) (18 000)
Depreciation on plant
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)

466 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

-RXUQDOVFRQWLQXHG« Dr/ (Cr)

1/1/20X4

Plant: accumulated depreciation (-A) 18 000

Plant: cost (A) (18 000)
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
Depreciation: plant (E) W1 22 000
Plant: accumulated depreciation (-A) (22 000)
Depreciation on plant
Revaluation surplus (OCI) (2 800) / 2 years; OR (Revalued depreciation: 22 000 ± 1 400
Retained earnings (Equity) Historic depreciation: 20 000) 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)

Disclosure:

Entity name
Statement of financial position (extracts) 20X4 20X3 20X2 20X1
As at 31 December 20X4 C C C C
Note
ASSETS
Non-current assets
Property, plant and equipment 12 22 000 36 000 67 500 80 000
Deferred taxation 4 0 1 200 0 0

EQUITY AND LIABILITIES

Equity
Revaluation surplus (from SOCIE) 7 1400 0 5 250 0
Non-current liabilities
Deferred taxation 4 600 0 2 250 0

Entity name
Statement of comprehensive income (extracts) 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 C C C C
Note
Profit for the period 100 000 100 000 100 000 100 000

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

Chapter 8 467
Gripping GAAP Property, plant and equipment: the revaluation model

Entity name
Statement of changes in equity (extracts)
For the year ended 31 December 20X4
Revaluation Retained Total
surplus earnings
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
Total comprehensive income 7 000 100 000 107 000
Realised portion transferred to retained earnings (1 750) 1 750 0
Balance at 31 December 20X2 5 250 X X
Total comprehensive income (5 250) 100 000 94 750
Balance at 31 December 20X3 0 X X
Total comprehensive income 2 800 100 000 102 800
Realised portion transferred to retained earnings (1 400) 1 400 0
Balance at 31 December 20X4 1 400 X X

Entity name
Notes to the financial statements (extracts) 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 C C C C

4. Deferred taxation asset/ (liability)

The deferred taxation balance relates to
temporary differences arising from:
- 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 xxx xxx xxx xxx
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 table

Plant Depreciable Carrying Tax Temp Deferred Details Revaluation
(keep) Deductible 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)
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)

468 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model

W1: Deferred tax WDEOHFRQWLQXHG«

Carrying Tax Temp Deferred Details Revaluation
Continued«
amount base diff taxation surplus
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
(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)
3
Depreciation (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)
(increase) Dr RS (OCI) 1 200
Fair value 44 000 40 000 (2 800)
4
Depreciation (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)

Calculations:
(1) Depreciation 20X1 (100 000 ± 0) / 5 years
(2) Depreciation 20X2 (90 000 ± 0) / 4 remaining years
(3) Depreciation 20X3 (54 000 ± 0) / 3 remaining years
(4) Depreciation 20X4 (44 000 ± 0) / 2 remaining 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
HQWLWOHGµWD[RQRWKHUFRPSUHKHQVLYHLQFRPH¶ VHH%QRWHQXPEHU) 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.

Entity name
Statement of comprehensive income (extracts) 20X4 20X3 20X2 20X1
For the year ended 31 December 20X4 C C C C
Notes
Profit for the period 100 000 100 000 100 000 100 000

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

Chapter 8 469
Gripping GAAP Property, plant and equipment: the revaluation model

6. Summary

Measurement models: a comparison

Cost model (explained in Ch 7) Revaluation model (explained in Ch 8)

Measurement of the carrying amount:
 cost
 less accumulated depreciation
 less accumulated impairment losses
The rule:
an asset may be written down below HCA,
but may never be revalued above its HCA
(HCA is cost, in the case of a non-
depreciable asset, or depreciated cost, in
the case of a depreciable asset)
Increase in CA: previous impairment
reversed
 debit: asset;
 credit: reversal of impairment loss (I)
limited to the carrying amount that it
would have had, had there never been an
impairment loss (i.e. limited to its HCA:
cost or depreciated cost, depending on
whether the asset is depreciable)
Measurement of the carrying amount:
 fair value on date of revaluation
 less subsequent accumulated
depreciation
 less subsequent accumulated
impairment losses
The rule:
the asset may be valued to its fair value
(whether it is greater/less than its HCA)
Increase in CA:
 debit: asset (FV – ACA);
 credit: income (to extent reverses
previous reval expense: HCA – ACA)
 credit revaluation surplus (FV – HCA)
Decrease in CA:
x credit: asset (FV – ACA);
x debit: RS (to extent reverses previous
RS increases: ACA – HCA)
x debit: reval expense (HCA - FV)

Decrease in CA: impairment The revaluation surplus:

x debit: impairment loss (E);  transferred annually to retained
x credit: asset earnings (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)

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: Represents:
x Future economic benefits, being: x Future tax deductions, being:
 Cost  Cost
 Less accumulated depreciation  Less accumulated tax deductions
 Less accumulated impairment losses

470 Chapter 8
Gripping GAAP Property, plant and equipment: the revaluation model
Revaluation model: deferred tax
 Depreciable  Depreciable
 Deductible  Non-deductible
Intention to keep: Intention to keep:
 TDs x 30%  Split TDs as follows:
- 0 to HCA: @ 0%
(because exempt)
- HCA to Cost: @ 30%
- Above cost: @ 30%
Intention to sell: Intention to sell:
 Split TDs as follows:  Split TDs as follows:
- 0 - Cost: - 0 to HCA: @ 0%
@ 30% (because exempt)
- Above cost: - HCA to Cost: @ 0%
@ 80% x 30% (no recoupment)
- 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
comprehensive income changes in equity
 Depreciation  Increase or decrease in RS
 Impairment losses  Tax effect of creation or
increase in RS
 Reversals of
impairments  Transfers from RS to RE
 Revaluation expense  Any restrictions on
 Revaluation income distributions to
shareholders
Chapter 8
 Non-depreciable
 Non-deductible
Intention to keep:
 Measure DT as if your
intention is to sell
Intention to sell:
 Split TDs as follows:
- Up to cost:
@ 0% (exempt)
- Above cost:
@ 80% x 30%
Statement of
financial position
 Reconciliation between
opening and closing
balances
 Break-down of these
balances into gross
carrying amount and
accum. depreciation and
impairment losses
 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
471
 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 2021)

Contents: Page
1. Introduction 474
2. Scope 474
3. Recognition and initial measurement 474
3.1 Overview 474
3.2 Recognition 475
3.2.1 Overview 475
3.2.2 Definition 475
3.2.3 Recognition criteria 475
3.2.4 Difficulties in meeting the definitions 476
3.2.4.1 The item must have no physical substance 476
Example 1: Physical substance and a fishing licence 476
Example 2: Physical substance and software 476
Example 3: Physical substance and a prototype 476
3.2.4.2 The item must be identifiable 477
Example 4: Identifiability 477
Example 5: Identifiability in a business combination 477
3.2.4.3 The item must be controllable 478
Example 6: Control 478
3.3 Initial measurement ± the basics 478
3.3.1 Overview 478
3.3.2 Purchase price 478
3.3.3 Directly attributable costs 478
Example 7: Recognition and initial measurement 479
3.4 The effect of the method of acquisition on recognition and initial measurement 480
3.4.1 Overview of the methods of acquisition 480
3.4.2 The effect of the method of acquisition on the initial measurement 480
3.4.3 Intangible assets acquired through a separate purchase 480
3.4.3.1 Recognition 480
3.4.3.2 Initial measurement 481
3.4.4 Intangible assets acquired through an exchange of assets 481
3.4.4.1 Recognition 481
3.4.4.2 Initial measurement 481
3.4.5 Intangible assets acquired by government grant 481
3.4.5.1 Recognition 481
3.4.5.2 Initial measurement 481
3.4.6 Intangible assets acquired in a business combination 482
3.4.6.1 Recognition 482
3.4.6.2 Initial measurement 483
Example 8: Intangible asset acquired in a business combination 483
3.4.7 Intangible items that are internally generated 483
3.4.7.1 Overview 483
3.4.7.2 Internally generated goodwill 484
3.4.7.3 Internally generated intangible items other than goodwill 485
3.4.7.3.1 Overview of issues regarding recognition 485
3.4.7.3.2 Certain internally generated items may never be capitalised 485
3.4.7.3.3 The stages of internal generation 485
3.4.7.3.4 Recognition of costs in the research phase 486
3.4.7.3.5 Recognition and measurement of costs in the development phase 486
Example 9: Research and development costs 487
3.4.7.3.6 In-process research and development that is purchased 488
Example 10: In-process research and development 489
3.4.7.4 Web site costs 489
3.4.8 Intangible assets acquired through a service concession agreement 490

472 Chapter 9
Gripping GAAP Intangible assets

&RQWHQWVFRQWLQXHG« Page

4. Recognition of subsequent expenditure 491

5. Subsequent measurement: amortisation and impairment testing 491
5.1 Overview 491
5.2 Amortisation 492
5.2.1 Overview 492
5.2.2 Residual value and the depreciable amount 492
5.2.3 Period of amortisation 493
Example 11: Amortisation period and renewable rights 493
5.2.4 Method of amortisation 494
5.2.5 Annual review 495
5.3 Impairment testing 495
5.3.1 Impairment testing in general 495
5.3.2 Impairment testing of intangible assets with finite useful lives 496
5.3.3 Impairment testing of intangible assets with indefinite useful lives 496
5.3.4 Impairment testing of intangible assets not yet available for use 497
5.3.5 Reversing an impairment 497
Example 12: Impairments and reversals of an asset not yet available for use 497
6. Subsequent measurement: the two models 498
6.1 Overview 498
6.2 Cost model 498
6.3 Revaluation model 499
7. Derecognition 500
8. Deferred tax 500
9. Disclosure 501
9.1 General 501
9.2 Sample disclosure involving intangible assets (excluding goodwill) 502
10. Goodwill 504
10.1 Overview 504
10.2 Internally generated goodwill 504
10.3 Purchased goodwill 504
10.3.1 Positive goodwill: asset 504
Example 13: Positive purchased goodwill: asset 505
10.3.2 Negative goodwill: income 505
Example 14: Negative purchased goodwill: income 505
10.3.3 Initial recognition measured provisionally 506
Example 15: Provisional accounting of fair values 506
10.3.4 Adjustment in the initial accounting 507
10.3.5 Subsequent measurement of purchased goodwill 507
10.4 Disclosure of goodwill 507
10.4.1 Disclosure: positive goodwill: asset 507
10.4.2 Disclosure: negative goodwill: income 507
10.4.3 Sample disclosure involving goodwill 508
11. Black Economic Empowerment (BEE) transactions 508
Example 16: BEE equity credentials 509
12. Summary 510

Chapter 9 473
 Gripping GAAP Intangible assets

1. Introduction

Something that is intangible is simply something that is µXQDEOH Examples of items

WREHWRXFKHG¶ Thus, this chapter is simply about assets that without physical
have no physical substance. substance
Research & development, Brands,
Intangible items are interesting because although we may know
Patents, Trademarks, Copyrights,
they exist and may know they are beneficial to the entity, the fact Licences, Software, Training
WKDWZHFDQ¶WVHHRUWRXFKWKHPVRPHWLPHVPDNHs it difficult to
prove these assets exist. This means that we are sometimes unable to recognise the fact that we have
intangible asset. In such cases, any costs related to this µinvisible item¶ will 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),
 are insurance contracts (IFRS 17);
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: Recognise an IA if it meets IAS 38’s:
x the definition of an intangible asset; and x IA definition; and
x the recognition criteria laid out in IAS 38. See IAS 38.18 x recognition criteria. See IAS 38.18

If an item meets both of these, 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 x at cost. See IAS 38.24
difficult to prove that it should be recognised as an intangible
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 due to 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 is
relevant information & 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.

474 Chapter 9
 Gripping GAAP Intangible assets

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 acquisition could affect its
recognition and measurement (section 3.4).
When recognising an intangible
asset, the IA definiton and
3.2 Recognition (IAS 38.18 - .23) recognition criteria must be met:

3.2.1 Overview IAdefinition

x identifiable
As mentioned above, an item may only be recognised x non-monetary
as an intangible asset if it meets both the definition of x asset *, where an ‘asset’ is defined as:
- a resource controlled by the entity
an intangible asset and the recognition criteria that are - as a result of past events
provided in IAS 38. Let us first consider the definition - from which an inflow of FEB is expected
and then the recognition criteria. x without physical substance. Reworded IAS 38.8
IA recognition criteria *
3.2.2 Definition x the expected inflow of FEB are probable
x the cost is reliably measured. See IAS 38.21
An intangible asset is defined as an µidentifiable, non-
*: IAS 38 versus ‘2018 CF’
monetary asset without physical substance¶. See IAS 38.8
The asset definition & recognition
criteria in IAS 38 are from the old
This definition refers to WKHZRUGµDVVHW¶, which it then ‘2010 CF’ (i.e. thus they differ
GHILQHVDVEHLQJµDUHVRXUFHFRQWUROOHGE\DQHQWLW\DV from those in the new ‘2018 CF’)
DUHVXOWRISDVWHYHQWVDQGIURPZKLFKIXWXUHHFRQRPLFEHQHILWVDUHH[SHFWHGWRIORZWRWKHHQWLW\¶
Note: IAS 38 uses the asset definition from the old conceptual framework (2010 CF) and thus,
when recognizing an intangible asset, we do not use WKHDVVHWGHILQLWLRQLQWKHQHZµ&)¶

7KHµDVVHW definition¶ refers to an expectation of future economic benefits. These benefits could be in
any form e.g. revenue, other income or even cost savings. For example: a new recipe may reduce
production costs. See IAS 38.17

However, due to the nature of intangible assets, it may be difficult to meet certain aspects of
ERWKWKHµLQWDQJLEOHDVVHWGHILQLWLRQ¶DQGµDVVHWGHILQLWLRQ¶ 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

Before an item that meets the µintangible asset definition¶ (which includes PHHWLQJWKHµDVVHWGHILQLWLRQ¶ 
may be recognised as an intangible asset, it must also meet the following recognition criteria:
x the expected inflow of future economic benefits from the asset must be probable; and
x the cost must be reliably measured. See IAS 38.21
Note: IAS 38 uses the recognition criteria from the old conceptual framework (2010 CF) and thus, when
recognizing an intangible asset, we do not use the recognition criteria LQWKHQHZµ&)¶

The nature of intangible assets can also lead to difficulties in meeting the recognition criteria. Possibly
the greatest difficulty is proving that the cost of the asset is µreliably measurable’. For example:
x A reliable measure of the cost may be possible if the intangible asset was the only asset
purchased as part of a purchase transaction.
x 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.
x In this case we would need to be able to prove that we can reliably measure the portion of the
cost of the group of assets that should be allocated to the intangible asset within this group.
x 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.

Chapter 9 475
 Gripping GAAP Intangible assets

3.2.4 Difficulties in meeting the definitions

3.2.4.1 The item must have no physical substance (IAS 38.4-7)

Costs are frequently incurred on items that have both No physical substance
intangible and tangible aspects. We will need professional
judgment to assess which element is more significant: the x If the item has physical and
tangible (physical) or the intangible (non-physical) aspects. non-physical aspects:
x apply IAS 38 or IAS 16
The standard that should be applied to the asset depends on depending on which aspect
is more significant.
which aspect is the most significant, either:
x IAS 38 Intangible Assets; or x Needs professional judgement.
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
FRQVLGHUHGLQWDQJLEOHUDWKHUWKDQWDQJLEOHVLQFHWKHPRVWVLJQLILFDQWDVSHFWLVWKHOLFHQVHGµDELOLW\¶WRILVK
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
WKHVRIWZDUHZDVµVWDQG-DORQH¶VRIWZDUH LHWKHVRIWZDUH 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 RQH¶V 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
RZQHU¶V SDUHQW RU SDUWQHU LQ RUGHU WR µJHW KHOS¶ *HH KDV PDQDJHG WR FUHDWH WKH ILUVW ZRUNLQJ
prototype for this wallet.
Required: Briefly explain if 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).

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 Gripping GAAP Intangible assets

Identifiable: an item is
3.2.4.2 The item must be identifiable (IAS 38.11 - 12) identifiable if it:

An important aspect of the µLQWDQJLEOHDVVHWdefinition¶ is that the x is separable; or

x arises from contractual/legal rights.
item must be identifiable. An asset is identifiable if either: See IAS 38.12
x it is separable; or
x it arises from contractual or other legal rights. See IAS 38.12
If it is not identifiable:
For something to be separable, it must be:
x it is not an IA
x capable of being separated or divided from the entity, and
x it is internally generated goodwill.
x sold, transferred, licensed, rented or exchanged,
x either individually or together with a related contract, identifiable asset or liability,
x regardless of whether the entity intends to do so. IAS 38.12(a)

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
FRQVLGHUHGµVHSDUDEOH¶IURPWKHFRVWVRIMXVWUXQQing the business.

Acquired goodwill is not FRYHUHG E\ WKH VWDQGDUG RQ µLQWDQJLEOH DVVHWV¶ ,$6   EXW UDWKHU E\ WKH
VWDQGDUGRQµEXVLQHVVFRPELQDWLRQV¶ ,)56  +RZHYHU VLQFHLWLV OLQNHGWRLQWDQJLEOHDVVHWV LW LV
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 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.
Thus, since neither criteria are met, the cost of the advertising campaign is not identifiable.
Comment: Since it is not identifiable, the intangible asset definition is not met and thus advertising costs
must be expensed. P.S. these costs create internally generated goodwill, which is always 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 to another entity.
However, identifiability 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 thus considered identifiable.
Comment: If the rest of the definition and the recognition criteria are met, these rights will be recognised
as a separate intangible asset.

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3.2.4.3 The item must be controllable (IAS 38.13 - 16)

As mentioned above, the µLQWDQJLEOHDVVHWdefinition¶ UHIHUVWRDQµDVVHW¶ZKLFK,$6GHILQHV

DVEHLQJDµUHVRXUFHFRQWUROOHGE\WKHHQWLW\DVDUHVXOWRI past events and from which an inflow
RIIXWXUHHFRQRPLFEHQHILWVLVH[SHFWHG¶This means WKDWIRUVRPHWKLQJWRPHHWWKHµLQWDQJLEOH
DVVHWGHILQLWLRQ¶LWZLOOQHHGWR 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 WKHDVVHW¶VIXWXUHHFRQRPLFEHQHILWVand
x the power to obtain the DVVHW¶VIXWXUHHFRQRPLFEHQHILWV See IAS 38.13

$QDVVHW¶VIXWXUHHFRQRPLFEHQHILWVFDQ 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; &
x have the power to obtain the FEB.
an intangible asset. On the other hand, control over technical 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)

3.3.1 Overview
Cost includes:
Intangible assets are initially measured at cost. See IAS 38.24 x purchase price and
x directly attributable costs. See IAS 38.27
This cost can be broken down into: - those that are necessary to
x the purchase price; and - bring the asset to a condition that
x any directly attributable costs. See IAS 38.27 - enables it to be used in the
manner management intended.
See IAS 38.31
3.3.2 Purchase price (IAS 38.27 & .32)

The purchase price must be calculated after: Spot the difference!

x Deducting: discounts, rebates, refundable taxes and
Costs capitalised to
interest included due to the payment being deferred PPE include:
beyond normal credit terms; x Purchase price
x Adding: import duties and non-refundable taxes. x Directly attributable costs
x Future costs of dismantling,
3.3.3 Directly attributable costs removal and site restoration.
How does this compare to IAs?
Costs are considered to be directly attributable costs, if: Ans: The third bullet doesn’t
x they were necessary apply to IAs.
x to bring the asset to a condition that enables it to be used as intended by management. See IAS 38.30 - .31

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Quick! Do this…Compare the

Only those costs that were necessary are capitalised to examples of directly attributable
an intangible asset. This also means that any income and costs
expenses arising from incidental operations occurring x relevant to IAs;
x relevant to PPE (see chapter 7, section 3.3.3).
before or during the development or acquisition of an
Are they the same? If not, why not?
intangible asset may not be included in the cost of the
Ans: They are similar but exra examples apply to
recognised asset (i.e. they must be recognised as PPE that do not apply to IAs. This is due to the
income or expenses in profit or loss instead). See IAS 38.31 nature of IAs. E.g. One cannot install an IA and
so the list of directly attributable costs relevant
to IAs does not include ‘installation costs’.
The necessary costs that may be capitalised are those
that 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 it had been manufacturing a product
illegally: this product was patented and Bee had not bought the rights to use the patent.
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 under patent.
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 shaUHZDV ORVWZLWK WKH UHVXOW WKDW %HH¶V WRWDOVDOHV RYHU$XJXVW DQG
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 with 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 Incidental costs may not -
to the acquisition of the rights (the shut-down was only 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 (i.e. the cash price). If
it 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 Fair value measurement provides guidance on how fair value should be measured,
defining fair value as:
Method of acquisition and initial
x the price that would be received to sell an measurement
asset (or paid to transfer a liability)
x Initial measurement = cost
x in an orderly transaction x Cost is measured at FV, unless the asset was
x between market participants purchased as a separate asset (in which case,
x at the measurement date. IFRS 13: Appendix A follow the normal rules).

This definition refers to market participants, PHDQLQJµfair value¶ is a market-based measurement.

See IAS 38.33

Although the definition of fair value requires that market participants exist, the initial measurement at fair
value on acquisition date 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. However, 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 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:

When recognising an asset that was acquired via a x Recognition: only need to meet the
definition (the recognition criteria are
separate purchase, we only need to prove that the
always met)
intangible asset definition is met. This is because the
x Measurement: cost (follow normal
recognition criteria are met automatically. rules: see section 3.3)

The recognition criteria are considered to be met automatically for the following reasons:
x Since the asset is purchased separately, it has a value that is reliably measured: its purchase price;
x The mere fact that the asset was purchased means the entity expects the inflow of future economic
benefits to be probable (i.e. 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 LHQRWDVSDUWRIDµEXQGOHRIDVVHWV¶ IRUFDVKits µcost¶ is relatively

easy to measure and follows the general rules (see section 3.3), being the sum of:
x the purchase price, calculated after:
- deducting: discounts, rebates, refundable taxes and interest included due to the
payment being deferred beyond normal credit terms, and
- adding: import duties and non-refundable taxes; plus
x directly attributable costs.

,ISD\PHQWLVGHIHUUHGVXFKWKDWWKHUHLVDGLIIHUHQFHEHWZHHQWKHµFDVKFRVW¶DQG 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 µcost¶ of the intangible
x Recognition: only if it meets the
asset acquired will be at fair value, measured as the: definition and recognition criteria &
x fair value of the asset given up; or the only if transaction has commercial
x fair value of the acquired asset if this is more clearly substance
evident; or the x Initial measurement: cost, where cost is:
- FV of asset given up; or
x carrying amount of the asset given up if neither of
- FV of asset acquired (if more
the fair values are available or the transaction lacks clearly evident); or
commercial substance. IAS 38.45 & .47 - CA of asset given up (if no FV).

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. we follow the
normal rules)
3.4.5.2 Initial measurement
x Measurement: cost
This cost is measured at:
The initial measurement of intangible assets acquired by way of - FV of asset acquired; or
government grants is µcost¶. We may choose to measure cost either: - Nominal amount plus
directly attributable costs
x at the fair value of the asset acquired, or
x at 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 µfair
value¶, then any further directly attributable costs that are incurred must be expensed through
profit or loss since the asset would otherwise be overstated.

For further detail on intangible assets acquired by way of government grants, please see chapter 15.

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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 all the
(i.e. recognition criteria always met)
assets and liabilities of B, including any intangible assets
x Measurement: cost where cost is
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 The µreliable measurement’ criterion will be met. This is because, to meet the intangible asset
definition, the asset acquired in a business combination would have had to be identifiable (i.e. it
either is separable or arises from contractual/ legal rights): therefore the standard explains that,
because an asset acquired in a business combination is identifiable (either due to it being separable
or arising from contractual/legal rights) sufficient information will exist to reliably measure its fair value.
x The µprobability’ criterion will be met. We assume this because the cost of an intangible asset acquired
in a business combination equals its fair value, and, as the standard explains, the fair value of an
intangible asset acquired in a EXVLQHVVFRPELQDWLRQZLOODXWRPDWLFDOO\UHIOHFWWKHPDUNHWSDUWLFLSDQWV¶
expectations, at acquisition-date, of the probability of the inflow of future economic benefits. Thus, the
mere existence of the reliably measurable fair value is proof enough that the inflow of future economic
benefits is probable even if there is uncertainty over the timing and amount of the inflow. 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. KRZPXFKRIDWHOOHU¶VVDODU\UHODWHVWR(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. It arises when an entity purchases another
entity for a price that exceeds the fair value of its individual net assets. This excess is an asset
WKDWLVUHFRJQLVHGLQWKHDFTXLUHU¶VERRNVDVµpurchased goodwill¶
Purchased goodwill (A) = Purchase price ± Fair value of the net assets acquired that are separately recognised.
(P.S. if the acquirer paid less than the fair value of these net assets, the acquirer recognises an income:
µJDLQRQDEDUJDLQSXUFKDVH¶

In other words, the entity that created the goodwill will not recognise it as an asset in its own books
(because it is not reliably measurable), but if another entity 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
QRWLGHQWLILDEOH WKHQLWVYDOXHLVH[FOXGHGIURPWKHµQHWDVVHWYDOXH Goodwill that is:
RIWKHHQWLW\¶. The value of this unrecognised intangible asset will x internally generated: expensed
thus be included and recognised as part of the purchased goodwill. x purchased: capitalised

Another issue: For an asset to meet the intangible asset definition it must be identifiable. One way
to prove identifiability is to be µseparable’. However, an intangible asset acquired in a business
combination is sometimes only separable from the rest of the entity that is being acquired if it is
grouped with certain other assets (e.g. a µ¶trademark¶ for a chocolate may be useless without the
related µrecipe¶). 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 µcost¶, 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

*UHDW/LPLWHGDFTXLUHV6WXII/LPLWHGIRU&6WXII¶VQHWDVVHWVDQGOLDELOLWLHVDUH
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
Liabilities Given 200 000
Bank Given 700 000
Goodwill (A) Balancing 400 000
Acquisition of Stuff Limited
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 µintangible asset¶, but as part of the µgoodwill¶ 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
Liabilities Given 200 000
Bank Given: revised in part C to 300 000 300 000
Gain on bargain purchase (I) Balancing 100 000
Acquisition of Stuff Limited
Comment:
x Great paid less for Stuff than 6WXII¶V QHW DVVHW YDOXH (i.e. we paid less than the value of the
identifiable assets acquired), and thus Great effectively made a profit on the acquisition.
x This is recognised immediately as income in P/L (not as an asset as in solutions 8A and 8B).
x The income is referred to as a gain on a bargain purchase (negative goodwill).

3.4.7 Intangible items that are internally generated (IAS 38.48 - 67)

3.4.7.1 Overview

We may expend resources on the creation of intangible items that we hope will 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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 Gripping GAAP Intangible assets

The intangible items may be very specific items (e.g. patents and trademarks) or could be a bit
µPRUH YDJXH¶ EXW ZKLFK, 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 µJRRGZLOO¶ 6LQFH the entity is creating goodwill (as opposed to
SXUFKDVLQJDQRWKHUHQWLW\¶VJRRGZLOO LWLVUHIHUUHGWRDV µLQWHUQDOO\JHQHUDWHGJRRGZLOO¶

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 ZRQ¶WLQZhich 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,
x not an intangible asset!
market share, and efficient and happy staff members are x always expensed
costs that 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 not possible 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 purchased x internally generated: expensed

by another entity in a business combination, it becomes x purchased: capitalised

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:

Purchased Goodwill = Purchase price of entity ± )DLUYDOXHRIWKHHQWLW\¶VUHFRJQLVHGQHWDVVHWV

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 LW PD\ EH GLIILFXOW WR LGHQWLI\ µZKHWKHU DQG ZKHQ WKHUH LV DQ LGHQWLILDEOH DVVHW WKDW ZLOO
JHQHUDWHH[SHFWHGIXWXUHHFRQRPLFEHQHILWV¶DQG
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
µPDLQWDLQLQJRUHQKDQFLQJWKHHQWLW\¶VLQWHUQDOO\JHQHUDWHGJRRGZLOORURIUXQQLQJGD\-to-day
RSHUDWLRQV¶ZKHUHWKHVHare 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 may never be 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 See IAS 38.54 - 56 split between 2 phases:
x development. See 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
possible to prove future benefits are expected and probable. findings 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

486 Chapter 9
 Gripping GAAP Intangible assets

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 If all 6 criteria

Always
criteria are not met 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 such that it will be able to operate in the manner intended by management. Reworded from IAS 38.66

3URIHVVLRQDOMXGJHPHQWLVUHTXLUHGWRGHFLGHZKHWKHURUQRWDFRVWLVµGirectly 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 EHFRQVLGHUHGµGLUHFWO\DWWULEXWDEOH¶
x If the creation of the intangible asset required money to be borrowed, then the borrowing
costs ZRXOGEHFRQVLGHUHGµGLUHFWO\DWWULEXWDEOH¶DQGFDSLWDOLVHG on condition that they met
the criteria for capitalisation set out in IAS 23 Borrowing costs (see chapter 14). 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;
x costs of training staff how to operate the asset. Reworded from IAS 38.67

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 impairment disappears! See IAS 38.71 & IAS 36.114
this asset must stop. 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 loss reversed). However, this does not apply to an impairment of goodwill:
these may 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 ± VRPHWKLQJWKH\SODQQHGWRFDOOWKHµ/HVV-ZLUH:LUHOHVV¶7KHIROORZLQJLVD
summary of the costs incurred by the Research & Development (R&D) Department each year:
20X1: R&D costs C180 000
20X2: R&D costs C100 000
20X3: R&D costs C80 000

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Additional information:
x The costs listed above were incurred evenly throughout each year.
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. 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
Bank/ liability 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
Bank/ liability 80 000
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
DQRWKHUFRPSDQ\¶VUHVHDUFKDQGGHYHORSPHQW x Recognised: if it:
- meets the asset definition; and
If a company buys (either separately or as part of a - is identifiable
EXVLQHVV FRPELQDWLRQ  DQRWKHU FRPSDQ\¶V µLQ-process x Measured:
UHVHDUFKDQGGHYHORSPHQW¶, 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

488 Chapter 9
 Gripping GAAP Intangible assets

The cost of the asset is measured at the fair value on acquisition date. This is the fair value of both the
UHVHDUFKDQGGHYHORSPHQW6RZKHQZHEX\VRPHERG\HOVH¶VUHVHDUFKDQGGHYHORSPHQWZHHQGXS
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 FRVWVRQWKLVSXUFKDVHGµLQ-SURFHVVUHVHDUFKDQGGHYHORSPHQW¶SURMHFW

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
Bank/ liability 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

Chapter 9 489
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,UUHVSHFWLYH RI WKHVH  VWDJHV LI D FRPSDQ\¶V ZHE site is mainly Accounting for web
involved in advertising, then all the web site costs should be expensed site costs:
as advertising (since it is impossible to reliably measure the specific x Stage 1 (Planning):
future economic benefits that would flow from this advertising). On - research expense
the other hand, if the web site is able to take orders, then it may be
x Stage 2 – 4 (Development):
possible to identify and measure the future economic benefits
- development asset; or
expected from the web site. If the web site is expected to result in an
- development expense
inflow of future economic benefits, we will need to analyse the costs
into the various stages and account for them as follows: x Stage 5 (Operating):
- operating expense (unless
x Stage 1 costs (planning): are always expensed as research. it is a subsequent expense
x Stage 2±4 costs (developing): are recognised either as a development to be capitalised)
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 withLQ WKH µZHE site
developmenWDVVHW¶DQGshould 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 if the terms mean that 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 (because receiving any revenue would be 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.

490 Chapter 9
 Gripping GAAP Intangible assets

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 is given a licence to operate a state hospital, and measures it at
C1 million since this is the market price for similar licences). If the entity is not able to reasonably
estimate the fair value of the intangible asset, it must be measured 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

Capitalisation of subsequent costs:
expenditure is common (e.g. replacement of parts and
enhancements), subsequent expenditure on intangible assets x Is unusual (due to the nature of IAs)
does not often arise. However, if it does, the nature of intangible x Occurs if the costs meet the IA:
assets often makes it so difficult to prove that the subsequent - definition
- recognition criteria (the basic 2)
expenditure relates to a specific intangible asset rather than to
x Is not allowed if it relates to
the general operation of the business, that subsequent internally generated:
expenditure on intangible assets is seldom capitalised. - brands, mastheads, publishing titles,
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).
Subsequent measurement
An intangible asset that is available for use could have: 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 We refer to indefinite useful
the amortisation and impairment testing of that asset: lives.
Indefinite  Infinite
x If it has a finite useful life, it will be amortised and tested 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

Chapter 9 491
 Gripping GAAP Intangible assets

Please note that indefinite does not mean infinite. If an asset has an indefinite useful life, it means
µWKHUHLVQRforeseeable limit to the period over which the asset is expected to generate net cash inflows
for the HQWLW\¶. 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 DWDOOWRWKHDVVHW¶VXVHIXOOLIH! 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 WKHVWDELOLW\RIWKHPDUNHWGHPDQGIRUWKHDVVHW¶VRXWSXW
x expected actions by competitors;
x the level of maintenance required to obtain the expected future economic benefits and
PDQDJHPHQW¶V 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

5.2 Amortisation (IAS 38.97-107 and .117) Intangible assets refer to

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
DVVHW¶VUHPDLQLQJIXWXUHHFRQRPLFEHQHILWVLVUHIOHFWHGWKURXJKWKHSURFHVVRIDPRUWLVDWLRQ General
principles regarding amortisation can be summarised as follows:
x Amortisation is expensed unless the intangible asset is being used to create yet another
asset, in which case it is capitalised to this other asset.
x Only intangible assets with finite lives are amortised. Amortisation:
x There are three variables that must be estimated Reflects: the usage of the IA
when calculating the amortisation: Recognise: normally as an exp.
- residual value; Only applies to IAs that are:
- period of amortisation; and x available for use & with a finite life
Does not apply to IAs:
- method of amortisation. x available for use but with indefinite life
x Amortisation of an intangible asset does not cease x not yet available for use
when it is not being used ± unless, of course, it has either x goodwill.
IAS 38.97 & IAS 38.107

EHHQIXOO\DPRUWLVHGRUEHHQUHFODVVLILHGDVµKHOGIRUVDOH¶ LHand 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 IA at the end of its UL; OR
x the expected proceeds on disposal of the asset, x The IA has an active market (AM) &
x less expected costs of disposal, the RV can be measured from this AM
x where these disposal proceeds and costs reflect those & it’s probable that the AM will
exist at the end of the IA’s UL.
of an asset that is currently already of the age and in
Should be reassessed at least:
the condition that the asset is expected to be when it - at the end of every financial year.
reaches the end of its useful life (i.e. we must use a
current value for our residual value). IAS 38.8 reworded

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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
- LWLVSUREDEOHWKDWWKHPDUNHWZLOOVWLOOH[LVWDWWKHHQGRIWKHDVVHW¶VXVHIXOOLIH 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 time or in units
x derecognition of the asset; and x Shorter of:
x reclassification of the asset as a µQRQ-current asset - useful life, or
- legal life (include renewal periods if
KHOGIRUVDOH¶See IAS 38.97 evidence suggests renewal will
occur at insignificant cost).
The amortisation period should be the shorter of: Should be reassessed at least:
x WKHDVVHW¶VH[SHFWHG 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 future economic - check for impairments.
benefits are controlled via legal rights for a finite period),
its amortisation period must be limited to the period of the legal rights. If the legal rights are
renewable, we should include the renewal periods if:
x there is evidence to suggest that the rights will be renewed; and
x the cost of renewal is not significant. See IAS 38.94

7KHDVVHW¶Vamortisation period could be estimated either in terms of:

x time (e.g. it may have an economic useful life of 5 years); or
x units (e.g. it may have an economic useful life of 50 000 production 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 how many years the licence should be amortised over, 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 legal life of the licence is 5 years, but we must also consider the fact that the legal rights are
renewable. The rights are renewable at an insignificant cost (C1 000 versus the C100 000 original
cost, (1%)), and there is evidence to suggest that the rights would be renewed since renewal is
necessary for the continuation of the business and the government has indicated that it would be
renewed. Thus, 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 legal life of the licence is 5 years, but we must also consider the fact that the legal rights are
renewable. 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).

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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
H[SHFWVWRXVHXSWKHDVVHW¶VHFRQRPLFEHQHILWV9DULRXVPHWKRGVare possible, including:
x straight-line;
x diminishing balance; and
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
DQGWKHDVVHW¶VUHPDLQLQJFDUU\LQJDPRXQWVKRXOGUHIOHFWKRZPXFKRIWKHHFRQRPLFEHQHILWV
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

Methods that may be used include:
expires after 5 years, and we are able to use the 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
x but if you can’t determine the
use it evenly over 5 years, then the straight-line 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 LWFDQEHVKRZQWKDWWKHµFRQVXPSWLRQRIHFRQRPLFEHQHILWV¶LVµKLJKO\FRUUHODWHG¶ZLWKµUHYHQXH¶
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
UDZPDWHULDOKDYHEHHQPLQHGIURPWKHJURXQG ,QWKLVFDVHWKHµSUHGRPLQDQWOLPLWLQJIDFWRU¶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

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Amortisation methods based on revenue – a comparison between

x IAS 38 Intangible assets and
x 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
the change should be accounted for as a change in following at reporting date:
estimate (IAS 8). See IAS 38.102 & .104 x The 3 variables of amortisation:
- amortisation period;
$QDVVHVVPHQWRIDQLQWDQJLEOHDVVHW¶VXVHIXOOLIHDVEHLQJ - amortisation method;
indefinite is something that must be reassessed every year - residual value;
to confirm that it is still an appropriate conclusion.
x For IAs with an indefinite UL,
reassess whether this assessment
If circumstances have changed such that a useful life that of UL is still appropriate or
was once thought to be indefinite is now thought to be finite, whether it now has a finite UL.
we would need to: If any of the above changes, it is
x process amortisation as a change in estimate (IAS 8); accounted for as a change in estimate.
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:
x 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).
x Generally, this must be done at reporting date (however, see section 5.3.3 and 5.3.4 for exceptions).
x When we talk about damage, we are referring to any kind of damage that reduces the value of
the assHW HJDQHFRQRPLFGRZQWXUQPD\UHGXFHGHPDQGIRUDQDVVHW¶VRXWSXWLQZKLFKFDVH
the asset becomes less valuable to the entity, similarly, new legislation may affect the continued
use of the asset).
x Damage is different to usage. Both usage and damage reduce an asset¶V carrying amount, but
usage LVFDOOHGµamortisation¶ZKHUHDVdamage LVFDOOHGDQµimpairment¶

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Impairment testing is thus essentially a check to ensure WKDW WKH DVVHW¶V FDUU\LQJ 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).

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 WKHQFDOFXODWHWKHUHFRYHUDEOHDPRXQWDQGFRPSDUHLWZLWKWKHDVVHW¶VFDUU\LQJDPRXQW 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 iIWKHDVVHW¶VUHFRYHUDEOH
amount was calculated in a prior year and found to be µsignificantly JUHDWHU¶ 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 µHOLPLQDWHG¶WKHQZHGRQRWQHHGWRUHFDOFXODWHWKHUHFRYHUDEOHDPRXQW. 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 WKHDVVHW¶V carrying amount exceeds its recoverable amount, the asset is said to be impaired: the
carrying amount must be reduced to reflect its recoverable
Impairment testing of an IA
amount and this adjustment is recognised as an impairment that has a finite useful life
loss expense in profit or loss. (general impairment testing)
x Perform an impairment indicator
Impairment testing of an intangible asset is affected by review at reporting date
whether the intangible item: x If there is a possible impairment that:
x is available for use and: - is material; and
- has a finite useful life - cannot be ‘fixed’ by processing
extra amortisation
- has an indefinite useful life;
we calculate the RA at reporting date
x is not yet available for use; or
x if the CA > RA = the IA is impaired
x is purchased goodwill. See IAS 36.10

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 Impairment testing of an IA

with an indefinite useful life:
an indefinite useful life follows the same general
process described above, with the exception that: x Calculate RA at least annually, at any
time, but the same time every year
x we must calculate the recoverable amount, even if x It is possible for a previous
there is no indication of an impairment; calculation of RA to be used
instead of recalculating the RA
x the recoverable amount calculation does not need to be (but 3 criteria must be met)
done at reporting date, but must be done annually and
at the same time each year (however if an asset was acquired during the current year, the
recoverable amount must be calculated in the same year of acquisition); Note 1

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 Gripping GAAP Intangible assets

x if available, we may XVHDSULRU\HDU¶VGHWDLOHGFDOFXODWLRQRIUHFRYHUDEOHDPRXQWEXWRQO\

on condition that:
 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
 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. FRUSXUSRVHVRIWKHVHµDQQXDOWHVWV¶,$6FODULILHVWKDWGLIIHUHQWintangible assets
may be tested for impairment at different times. See IAS 36.10

Remember: intangible assets with µindefinite useful lives’ must have their useful lives reassessed
annually to confirm that it is still an appropriate assessment. If circumstances have changed and
the useful life is now thought to be µfinite’, 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 \HDU¶V 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 is no longer x First check if the amortisation
present in a subsequent year, such that the recoverable should not simply be decreased
amount increases or even exceeds the carrying amount, (change in estimate);
then the impairment may need to be reversed in that x If the CA is still too low, then
process an impairment reversal;
subsequent year. However, the carrying amount must never
x When processing an impairment reversal,
exceed amortised cost (historical carrying amount). do not increase the CA above what
See IAS 36.114 & .113 & .117
it would’ve been had the original
impairment never been processed.
However, we need to be careful to only reverse an impairment if the increase in carrying amount
is indeed related to an impairment reversal. This is because the 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. 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).

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The recoverable amounts were as follows:

31 December 20X7 C90 000
31 December 20X8 C110 000
31 December 20X9 C250 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
Bank/ liability 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
Bank/ liability 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
Impairment loss reversed
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 chapter 7 and 8 for
examples on 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.

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6.3 Revaluation model (IAS 38.75 ± 87 and IFRS 13: Appendix A)

If the intangible asset is measured under the revaluation Revaluation model
model, it is initially measured at cost but is subsequently
measured at its fair value. The carrying amount of an asset This model is almost identical
to the model used for PPE:
held under the revaluation model is its: x FV at date of revaluation
x fair value at date of revaluation, x Less: Subsequent AD & AIL
x less any subsequent accumulated amortisation and any The only difference is that:
accumulated impairment losses. - the FV used in the RM
- must be measured with
When using the revaluation model to subsequently measure an reference to an active
intangible asset, the fair value used must be measured in terms market if dealing with IAs.
of an active market. Interestingly, the fair value used to revalue
The revaluation model
an item of property, plant and equipment may be determined with
may never be used for:
reference to an active market or by other means (see chapter 8). the following intangible
assets since their uniqueness
An active market is defined as: means an active market for
x A market in which transactions for the asset or liability them 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
WKH LQWDQJLEOH DVVHW¶V FDUU\LQJ DPRXQW GRHV QRW GLIIHU VLJQLILFDQWO\ IURP LWV IDLU YDOXH 7KH
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

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 Gripping GAAP Intangible assets

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
DVVHW¶VUHFRYHUDEOHDPRXQWLQWHUPVRI,$6 36 Impairment of assets. See IAS 38.83

7. Derecognition (IAS 38.112 - 117)

An intangible asset must be derecognised: Derecognition means:

x on disposal; or to remove from the
x when no future economic benefits are expected accounting records.
from its use or disposal. IAS 38.112

Notice that, if we are simply not using an asset at the moment (i.e. it is currently idle), 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 disposing of the asset, the entity earned proceeds on its 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 disposal account now shows the expensed carrying amount on the debit side and any proceeds
on the credit side. The carrying amount and proceeds are set off against each other to determine if a
gain or loss arose (e.g. if the proceeds exceed the carrying amount, we will have a credit balance,
which would reflect a gain on disposal: we would debit the disposal account to remove this credit
balance and we would FUHGLWµJDLQRQGLVSRVDO¶ It is important to note that a gain on disposal is not
classified as revenue (i.e. it is simply classified as income). 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 µuse the cost of the replacement 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 or fair value less any subsequent
amortisation and impairments. Its tax base represents the future tax-deductions, if any. Any difference
between DQLQWDQJLEOHDVVHW¶V 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 DVVHW¶Vcost 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).

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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 µGross carrying amount¶ and µaccumulated amortisation and impairment losses¶ at the
beginning and end of each period; IAS 38.118 (c)
x A reconciliation between the µnet 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 µinternally generated¶
and µacquired 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)

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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)

Entity name
Statement of financial position
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

Entity name
Statement of changes in equity (extracts)
For the year ended 31 December 20X9
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

Entity name
Statement of comprehensive income (extracts)
For the year ended 31 December 20X9
Notes 20X9 20X8
C C
Profit for the year xxx xxx
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

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Entity name
Notes to the financial statements
For the year ended 31 December 20X9 (extracts)
2. Significant accounting policies
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 KDVEHHQRIIHUHGDVVHFXULW\IRUWKHORDQOLDELOLW\ VHHQRWH« 
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

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Entity name
1RWHVWRWKHILQDQFLDOVWDWHPHQWVFRQWLQXHG«
For the year ended 31 December 20X9 (extracts)

22. Profit before tax 20X9 20X8

C C
Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
- 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. FDQ¶WFRQWUROFXVWRPHUOR\DOW\ . See IAS 38.49

10.3 Purchased goodwill (IFRS 3.32 and .34) Purchased goodwill:

Purchased goodwill arises on the acquisition of another x Positive (debit): asset

entity. It is measured as follows: x Negative (credit): income
x Amount paid for the entity,
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 DFTXLUHH¶V x Recognition: asset
assets exceeds the value of those assets. This is:
x Subsequent measurement:
x always capitalised; - NEVER amortise; but
x never amortised; and - Test for impairments
x tested annually for impairment. x Impairments may NEVER be reversed.

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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 µcost 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 µbad 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
µwin 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.

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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 µprovisional¶ 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 /LPLWHG¶V SODQW LWV RQO\ DVVHW  FRXOG QRW EH PHDVXUHG E\ WKH
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 7KHSODQW¶VXVHIXOOLIHZDVHVWLPDWed on date of acquisition to be 10 years (residual value: nil).
On 30 September 20X9 the plant¶VDW-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
Bank (A) Given 80 000
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 therefore have reflected the following 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. Thus, the following journals would be processed:
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 depreciation in the prior year (20X8), which has since been closed off to retained earnings
(it is a retrospective adjustment, thus we must adjust the prior year« not the current \HDU¶VSURILW).
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

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x Plant is depreciated during 20X9. Thus, the following journal would be processed:
31 December 20X9 Debit Credit
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
IAS 36.124
An impairment of goodwill may never be reversed.

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.

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10.4.3 Sample disclosure involving goodwill

Entity name
Statement of financial position
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

Entity name
Notes to the financial statements
For the year ended 31 December 20X9 (extracts)

2. Significant accounting policies

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)

22. Profit before tax

Profit before tax is stated after taking the following disclosable (income)/ expenses into account:
x Gain on a bargain purchase (xxx) (xxx)
x 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 the BEE equity credentials
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
HQWLW\¶V%((UDWLQJ RUWKURXJKSURYLGLQJVSHFLILFJRRGVDQGVHUYLFHVWRWKHFRPSDQ\

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
the following must be expensed, and not capitalised as an intangible asset:
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).

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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
WKHHQWLW\¶Vpossible 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 Oke 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 Oke 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 Oke 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
Bank (A) Given 5 000
BEE equity credentials (E) Balancing 4 000
Stated capital (equity) Fair value: C3 x 3 000 9 000
BEE transaction with Mr Oke to acquire BEE credentials

Solution 16B: BEE Equity Credentials ± cash and an intangible asset received
Debit Credit
Bank (A) Given 5 000
Patent: cost (A) Balancing 4 000
Stated capital (equity) Fair value: C3 x 3 000 9 000
BEE transaction with Mr Oke to acquire BEE credentials & a patent.

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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 Recognise as an IA if IA definition met
x brands (recognition criteria always met)
x mastheads
x Measure at cost: purchase price, import
x publishing titles
duties, non-refundable taxes, directly
x customer lists
attributable costs
If the internal generation relates to some item
Business combination:
other than one of the items above, then separate
costs into research and development: x Recognise as an IA if IA definition met
(recognition criteria always met)
Research: x Measure at cost: FV on acquisition date
x Recognise as an expense
Government grant:
Development:
x Recognise as an IA if IA definition met and
x Recognise as an asset if all 6 recognition recognition criteria met
criteria can be demonstrated:
x Measure at cost: FV or nominal amount

technical feasibility of completing the IA plus other necessary costs

intention to complete and sell/ use the IA

ability to sell/ use the IA Asset exchange:

how the IA will generate future economic x Recognise as an IA if transaction has
benefits (e.g. prove that there is a market commercial substance
if the intention is to sell; or prove its
x Measure at cost:
usefulness if the intention is to use)
 FV of the asset given up adjusted for C & CE;
 availability of necessary resources to complete
or
the development and to sell/ use the IA
 FV of IA acquired if more clearly evident; or
 the ability to reliably measure the costs of
 CA of asset given up if both FV not available
developing the IA.
P.S. the first 5 recognition criteria are the
Service concession agreement:
criteria we need to prove that the future
inflow is probable (i.e. this is one of the 2 x Recognise if the SCA gives us the right to
recognition criteria provided in the old 2010 CF) charge customers directly (and other
criteria are met…)
x Measure at FV of the IA or at the SASP of the
goods and services

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Subsequent measurement: amortisation

Finite useful lives Indefinite useful lives

x Amortise and x Don’t amortise

x Perform an impairment indicator test x Calculate the RA at the same time every year
annually (in accordance with IAS 36)

Amortisation

Depreciable amount Method Period

x Cost less RV; or x Straight-line or Start from date available for use.
x FV less RV, x Other method if Shorter of its
Where RV is zero unless: more appropriate x UL or
x 3rd party committed to x Legal life …include any
purchase the IA at the end of renewal periods if:
its UL; or  evidence suggests renewal
x An AM exists and the RV can be will occur; and
measured using this AM and  renewal will be at
probable that AM will exist at insignificant cost
the 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 x Calculate RA at least
indicator test annually annually (anytime but at the annually (anytime but at
(in terms of IAS 36) same time) the same time)

x Where there is a possible x A situation exists where a

impairment that is: previous calculation could
 material; and is be used instead of
 not ‘fixed’ by recalculating the RA
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 x Always expense
for 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 (same as for PPE)
x Amount paid
x less value of net assets acquired

Subsequent amount:
x Cost
x Less accumulated impairment losses

Negative = Income Negative = Income

x Amount paid x Amount recognised as income
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

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Chapter 10
Investment Properties

Reference: IAS 40, IAS 12, IFRS 13, IFRS 15 and IFRS 16 (including any amendments to 10 December 2021)

Contents: Page

1. Introduction 515

2. Classification as investment property 515

2.1 Overview 515
2.2 Classification in general 515
2.3 Classification of joint use properties 516
Example 1: Joint use properties 517
2.4 Classification of properties leased in a group context 518
Example 2: Group investment properties 518
2.5 Classification of properties involving ancillary services 519
Example 3: Ancillary services 519

3. Recognition of an investment property 520

3.1 Overview 520
3.2 Investment property that is owned 520
3.3 Investment property that is held under a lease 520

4. Measurement 521
4.1 Overview 521
4.2 Initial measurement: cost 521
4.2.1 Overview 521
4.2.2 Initial cost of owned investment property 521
4.2.2.1 Owned property that was not acquired in an asset exchange 521
4.2.2.2 Owned property that was acquired in an asset exchange 522
4.2.3 Initial cost of investment property held as a right-of-use asset 522
4.2.4 Subsequent costs 523
Example 4: Subsequent expenditure 523
4.3 Subsequent measurement: the cost model 524
4.3.1 Overview 524
4.3.2 Property that is owned 524
4.3.3 Property that is owned, but is to be reclassified as held for sale 524
4.3.4 Property held under a lease 524
4.4 Subsequent measurement: the fair value model 525
4.4.1 Overview 525
4.4.2 Property that is owned 525
4.4.3 Property that is owned, but meets the criteria as held for sale 525
4.4.4 Property that is held under a lease 525
4.4.5 Fair value model: What is a fair value? 526
4.4.6 Fair value model used, but unable to measure fair value 526
4.4.6.1 Overview 526
4.4.6.2 Investment property that is not under construction 527
4.4.6.3 Investment property under construction 527
Example 5: Fair value cannot be reliably measured 528

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Contents continued: Page

5. Transfers 529
5.1 Change in use 529
Example 6: Transfers in and out of investment property 530
5.2 Measurement of transfers due to a change in use ± an overview 530
5.3 Measurement of the transfer: investment property under the cost model 531
5.4 Measurement of the transfer: investment property under the fair value model 531
5.4.1 Change from owner-occupied property to investment property (FVM) 531
Example 7: Change from owner-occupied to investment property 532
5.4.2 Change from inventories to investment property 533
Example 8: Change from inventory to investment property 533
5.4.3 Change from investment property to owner-occupied property or inventories 534
Example 9: Change from investment property to owner-occupied property 534

6. Derecognition 535
Example 10: Disposal 536

7. Deferred tax 536

Example 11: Deferred tax: fair value model (depreciable and deductible) 537
Example 12: Deferred tax: fair value model (depreciable and non-deductible) 539
Example 13: Deferred tax: fair value model (land and building) 541

8. Current tax 543

Example 14: Current tax: intention to keep and use (including land) 543

9. Disclosure 544
9.1 General disclosure requirements 544
9.1.1 An accounting policy note for investment properties 544
9.1.2 An investment property note 544
9.1.3 Profit before tax note 544
9.1.4 Contractual obligations note 545
9.2 Extra disclosure when using the fair value model 545
9.2.1 Investment property note 545
9.3 Extra disclosure when using the cost model 545
9.3.1 An accounting policy note for investment properties 545
9.3.2 Investment property note 546
9.4 Sample disclosure involving investment properties 546

10. Summary 547

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1. Introduction

7KHWHUPµSroperty¶ refers to land and/or buildings (or a part of a building). Property can be accounted for
in many ways, for example: as property, plant and equipment (IAS 16), inventory (IAS 2), or investment
property (IAS 40). This is illustrated below.
Possible ways to account for Property (Land and/ or Buildings)

Owner-occupied Held for sale Held for lease

If we use our property for
admin purposes or for
production or supply of
goods, then it is
property, plant & equipment
If it’s sale will be in the
ordinary course of business,
then it is inventory, whereas
If it’s to profit from capital
appreciation, then it will
probably be
investment property
If lease is to a 3rd party under
a finance lease, then it is
property, plant & equipment.
If lease is an operating lease,
then it will probably be
investment property

This chapter discusses property accounted for as investment property. For property to be classified as
investment property, it must meet the definition of investment property, which is essentially property the
entity intends to use to earn capital appreciation or rental income or both. If the property is classified as
investment property, we then decide if it meets the criteria for recognition as an asset. If it does, we
need to know the amount to recognise it at (initial measurement), and will then need to know how to
measure it thereafter (subsequent measurement), where the latter involves choosing between the cost
model and fair value model. If investment property exists at reporting date, it will need certain disclosures.
Each of these aspects, as well as derecognition and tax effects will now be discussed. See IAS 40.5

2. Classification as investment property (IAS 40.7 - 15)

Investment property is
2.1 Overview
defined as:

For property to be classified as an investment property, it must x land/ buildings/ both/ or part of a building;
x held by:
meet the definition of investment property. Deciding whether - an owner or
the definition is met is generally simple« but not always. For - a lessee as a right-of-use asset;
example, complications may arise if a property: x to earn rentals or for capital
appreciation, or both;
(a) has a dual purpose (i.e. a joint-use property), x rather than for use in the
production or supply of goods or
(b) is held by an entity within a group context, services or for administrative
(c) has ancillary services provided by the entity (e.g. security purposes or sale in the ordinary
course of business. See IAS 40.5
services), and also if
(d) experiences a change in use (e.g. from being used to earn rentals, in which case it was investment
property, to being used as the HQWLW\¶V head office, in which case it is property, plant and equipment).

All these classification issues will now be explained, with the exception of a change in use. Changes
in use may UHTXLUHDµWUDQVIHU¶LQWRRURXWRILQYHVWPHQWSURSHUW\. Transfers are covered in section 5.

2.2 Classification in general (IAS 40.7 - 9)

To classify a property as an investment property, we must simply ensure that it meets the definition
of an investment property (see pop-up above). In this regard, we basically need to decide what the
HQWLW\¶V 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
Owner-occupied property is essentially land or buildings that are property is defined as:
either owned or are held by a lessee as a right-of-use asset and x land or buildings (or both,
are used to produce goods or services or used for administration or part of a building)
purposes. Examples include: x held by an owner, or by a
lessee as a right-of-use asset,
x Property that is owner-occupied and awaiting disposal; x for use in the production or
x Property held for future use as owner-occupied property; supply of goods or services,
x Factory buildings or shops; or for administration use.
x Administration buildings; IAS 40.5 reworded

x Employee housing (even if the employees pay market-related rentals). See IAS 40.7 & 40.9

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; Transfers in / out
x a vacant building that is held with the intention to lease it out of investment
under an operating lease; property occur if:
x a property being constructed or developed for future use as an x there is evidence
investment property; x of a change in use,
x a property that is being redeveloped for continued use as an x with the result that the:
investment property; and - IP definition is now met
x land held for an undetermined future use (i.e. land is regarded (transfer into IP)
as held for capital appreciation). See IAS 40.8 & IAS 40.58 - IP definition is not met
(transfer out of IP)
It is also possible that a property that was classified as investment
property could cease to be classified as an investment property, in which case it would need to be
transferred out of investment property (e.g. investment property to inventory). Conversely, a
property that was classified as something else other than investment property (e.g. inventory) could
become classified as investment property, in which case it would need to be transferred into
investment property (e.g. inventory to investment property). Situations do arise where there is a
change in use that results in the 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
It sometimes happens that property (i.e. land and buildings) is properties are
used for a variety of purposes with the result that a portion of the properties where:
property meets the definition of investment property and a portion x part appears to be IP
of the property meets the definition of property, plant and (e.g. used to earn rent); &
equipment. These properties are called joint use properties (see x part appears to be PPE
pop-up alongside). (e.g. used in production
of goods/ services)

These two portions may need to be classified separately.

Whether to classify each portion separately is determined as follows: Joint use properties
x if each portion can be sold or leased out separately (under a finance are properties where:

lease), then each portion is classified separately: x a portion is used to earn

capital appreciation
 the one portion is classified as an investment property; and and/or rental income (an
 the other portion is classified as an owner-occupied property; investment property); and
x a portion is used in the
x if each portion cannot be sold or leased out separately, then: production or supply of
 the entire property is classified as investment property if the goods or services and/or
for administration
owner-occupied portion is an insignificant portion; or if purposes (an owner-
 the entire property is classified as owner-occupied property occupied property).
IAS 40.10 (reworded)
(e.g. property, plant and equipment, or a right-of-use asset
or non-current asset held for sale) if the owner-occupied portion is the significant portion.
See IAS 40.10

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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 µarbitrary GHFLVLRQV¶. 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 SURSHUWLHVLQ'XUEDQ3RUW(OL]DEHWK&DSH7RZQDQG'¶$DU

Required: Briefly explain how Stunning should classify its properties in each of these areas, details of
which are as follows:
A Durban: Stunning owns two freestanding buildings on adjoining but separate sites in Durban, South
Africa: one is used by Stunning for administration purposes and the other is leased to Runofdamill
Limited under an operating lease.
B Port Elizabeth: Stunning owns a twenty-storey building in Port Elizabeth: it leases out nineteen floors (each
operating lease contract includes an option to purchase) and uses the top floor as its head office.
C Cape-Town: Stunning 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 '¶$DU6WXQQLQJRZQVD two-VWRUH\KRXVHLQ'¶$DUone IORRUKRXVHV6WXQQLQJ¶VHQWLUHEXVLQHVVDQGone 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 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 must classify the entire house as owner-occupied (i.e. as property, plant and equipment).

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D. There are 2 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.
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
DQGWKXVZHFDQQRWGHWHUPLQHµVLJQLILFDQFH¶SXUHO\RQSK\VLFDODUHD
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 (the lessee is a subsidiary How entities in a group
and the lessor is the parent company, or vice versa), is classified: account for investment
properties held under leases:
x in the lessor¶s financial statements: as an investment property x Lessor: Investment property (as
(but only if it is leased out under an operating lease); it earns rental income)
x in the OHVVHH¶V financial statements: either x Lessee: Right-of-use asset or an
expense (if lessee elects to
 as a right-of-use asset (with a lease liability); or recognise the lease as an expense)
 as an expense: if the lessee elects this option, the cost x Group: PPE (as it is owner-occupied)
of leasing the property is recognised as an 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 6PDOO/LPLWHG¶VDFFRXQWLQJSROLF\IRULQYHVWPHQWSURSHUWLHVLVWKHIDLUYDOXHPRGHO
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. 6PDOO/LPLWHG¶VFRPSDQ\ILQDQFLDOVWDWHPHQWV
B. %LJ/LPLWHG¶VFRPSDQ\ILQDQFLDOVWDWHPHQWV
C. %LJ/LPLWHG¶VJURXSILQDQFLDOVWDWHPHQWV

Solution 2: Group investment properties

A. In Small’s financial statements 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 model for investment properties is
Small¶V chosen accounting policy. Under this model, the property is not depreciated or tested for
impairment.

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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-RFFXSLHGIURP%LJ¶VSHUVSHFWLYHDQGWKXV
%LJ¶VULJKW-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
WKHEXLOGLQJ PXVWEHPHDVXUHGXVLQJ,)56¶VYHUVLRQRIWKHFRVWPRGHO
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)

Classification of investment
An entity may provide ancillary services to the tenants of properties when ancillary
its property (e.g. building maintenance or security). In services are provided:
such cases, the property may only be classified as an
x If services are insignificant:
investment property if these 'services are insignificant to Investment property
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 is no longer a passive investor and
thus 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.

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C. Hotel '¶$IULFD 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, 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 µlessor makes an
underlying asset available for use by a OHVVHH¶. See IAS 40.19A; IFRS 16.22 & IFRS 16 App A

There is an exception to IFRS ¶V general approach, where, instead of recognising the property as
a µright-of-use DVVHW¶ 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 always Measurement of IP:
at cost. This initial measurement and how to calculate x Initial: always cost
x Subsequent: either:
cost is explained in section 4.2.
 Cost model (CM) or
 FV model (FVM)
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 SURSHUW\¶V 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

We will need to measure
model and fair value model, the use of the cost model may fair value regardless of the
turn out to be compulsory for specific individual properties. model used:
This happens where, in certain scenarios, it is clear that x FV model: FV of the IP needed for
the SURSHUW\¶V fair value will not be reliably measurable on measurement of the IP
a continuing basis. In these specific scenarios, even if the x Cost model: FV of the IP needed for
entity has chosen to measure investment property using disclosure purposes
the fair value model, the individual property would have to be measured using 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. See 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 µreliable and more UHOHYDQW¶ information. In this regard, IAS 40 explains
that it would be µhighly 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)

4.2.1 Overview Cost is defined as:

An investment property is initially measured at its cost,
which is a defined term (see pop-up alongside). The
measurement of cost depends on whether the asset is
owned or held under a lease (as a right-of-use asset),
and if it was owned, whether it was acquired in an asset
exchange. See IAS 40.20; .27 & 29A
4.2.2 Initial cost of owned investment property (IAS 40.20 - 24)
x the amount of cash equivalents paid
(or FV of any other consideration
given) to acquire an asset
x determined at the time of its
acquisition or construction; or
x the amount at which the asset is
initially recognised in terms of
another IFRS. IAS 40.5 (reworded)

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

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Cost of owned IP, not

Directly attributable costs include, for example, legal fees. acquired in an exchange,
It also includes construction costs, if the investment property includes:
is self-constructed. It also includes borrowing costs if the x the purchase price; and
borrowing costs µare directly attributable to the acquisition, x any directly attributable costs
(including transaction costs e.g.
construction or SURGXFWLRQ¶ of a property that is a µqualifying legal fees and transfer taxes).
asset¶ and that is measured under the µcost model¶. A IAS 40.21 (reworded slightly)

µTXDOLI\LQJ DVVHW¶ LV µan asset that necessarily takes a

substantial period of time to get ready for its intended use or VDOH¶ (e.g. a building under
construction). If the property is measured under the µfair value model¶ (section 4.4), capitalisation of
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 µrecognised 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)
Cost of owned IP that is
In the case of an owned investment property that was acquired acquired in an exchange
by way of an asset exchange, the cost of the property for is measured at the:
purposes of initial recognition is measured at the fair value of x FV of the asset given up; or the
the asset given up, unless the fair value of the asset received x FV of the asset received, if this
is µmore clearly HYLGHQW¶. is ‘more clearly evident’; or the
x CA of the asset given up if:
If the fair value of neither asset is reliably measurable, then - 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 lease, Cost of a right-of-use
and which will be recognised as a right-of-use asset (i.e. asset is the sum of:
instead of the lease costs being expensed), will also be x lease liability (PV of future pmts);
measured on initial recognition at cost. However, this cost is x lease pmts made before/ at
measured in terms of IFRS 16 Leases. See IAS 40.29A commencement, less any
lease incentives received;
x initial direct costs; and
In this case, the leased SURSHUW\¶V cost will be:
x estimated future costs (e.g.
x the initial measurement of the lease liability; 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 occasions where costs are incurred 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 6 on derecognition), 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 7KHEXLOGLQJ¶VOLIWZDVGDPDJHGGXHWR 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
Bank/ Accounts payable (A/L) 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
IP: Building: flats (A) 10 000
Write-off of lift destroyed through vandalism (estimated fair value)
IP: Building: flats (A) 25 000
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
Investment property measured
Each of these situations are explained below. under the cost model is:

x initially measured at cost;

4.3.2 Property that is owned x depreciated;
x tested for impairments; and
If the entity uses the cost model for investment x can be classified as held for sale

property that is owned and does not meet the criteria to be classified as µheld for VDOH¶, the cost model
will be the same as the cost model used for property, plant and equipment. See IAS 40.56 (c)

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 for investment property that 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 terms of the cost model described in IFRS 16 Leases. This version of the cost model
(i.e. contained in IFRS 16 Leases) is very similar to the cost model described in IAS 16 Property,
plant and equipment in that the asset is measured at cost less any accumulated depreciation and
any accumulated impairment losses. However, there are two important differences, explained
below.

First difference: In the case of an investment property held under a lease, the right-of-use asset¶V
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 ).

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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
DVVHW¶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¶V 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¶V 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 property value model:
under the fair value model, the fair value model used is x is initially measured at cost;
x is re-measured to fair value at the
the same whether the investment property is owned or end of the reporting period;
held under a lease and even if it meets the criteria to be x any gains or losses arising from a
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 ¶V 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 µheld for VDOH¶ asset (in terms of IFRS 5 Non-current assets held for
sale and discontinued operations).

However, investment properties that had been measured using the fair value model would not be
measured in terms of IFRS 5, but instead, would continue to be measured under the fair value model
in terms of IAS 40 Investment properties. This fair value model is identical to the fair value model
used when measuring a straight-forward µowned SURSHUW\¶ (see section 4.4.2 above).
See IAS 40.33 and IFRS 5.5

4.4.4 Property that is held under a lease (IAS 40.33 & .40A and IFRS 16.34)

An investment property 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 µowned
SURSHUW\¶ (see section 4.4.2).

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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 is
of IFRS 13, which must reflect, amongst other things: defined as:
x rental incomes from current leases; and x the price that would be received to sell
x other assumptions that market participants would the property in an orderly transaction;
use when pricing investment property under current x between market participants;
market conditions. IAS 40.40 x at the measurement date. IFRS 13.9 (reworded)

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 µbuilding 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

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 µexceptional FDVHV¶, 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.

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If fair values are not reliably measurable on a continuing basis, or are difficult to measure under the current
circumstances, the method of accounting is affected by whether the property is under construction or not:

If fair values are not reliably measurable on a continuing basis,

. measurement depends on whether the property is:

Investment property that is not under construction 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 If the FV of ‘IP that is not
a rebuttable presumption that the fair value will be able to under construction’ is not
be reliably measured on a continuing basis. In fact, we reliably measurable and
must always assume the fair value to be reliably this is determined:
measurable on a continuing basis unless: x on initial recognition as IP: we can
rebut the presumption and thus use
x the market for comparable properties is inactive; and CM for that property (must use CM
x alternative reliable measurements of fair value are not until disposal & a RV of nil)
available. See IAS 40.53 x after initial recognition as IP: since
it would have been measured at FV
at least once by this stage, we may
However, if an entity concludes that the fair value of an not rebut the presumption and
investment property (that is not under construction) is not must thus use FVM until disposal.
See IAS 40.53 & .55
reliably measurable, the accounting treatment depends on
whether the entity has ever managed to measure this property at fair value in the past.
x If the entity has managed to measure the property at fair value in the past, then, in the case of
this property, the presumption that fair value is µreliably measurable on a continuing basis¶ may
never be rebutted. This applies even if it subsequently becomes difficult or even impossible to
PHDVXUHWKHSURSHUW\¶VIDLUYDOXH. In such cases, the property must remain measured at its last
known fair value. In other words, the fact that D SURSHUW\¶V fair value has become difficult or
impossible to determine is not an adequate reason to measure the asset under the cost model.
Thus, the only time a property such as this would cease to be measured at fair value is:
- if it ceases to meet the definition of investment property, requiring it to be transferred either:
- to property, plant and equipment, or
- inventory; or See IAS 40.55
- if there is a voluntary change in accounting policy from the fair value model to the cost
model, although, a change in accounting policy from the fair value model to the cost model
is highly unlikely to be possible (see section 4.1). See IAS 40.31
x 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 µreliably 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.
- We must measure this property using the cost model until disposal: we may never
subsequently change to the fair value model (even if fair values subsequently become
reliably measurable).
- We must always use a residual value of nil.
- We 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).

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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 value recognised in profit or loss).
If the FV of ‘IP that is
under construction’ is not
However, being able to determine a fair value during reliably measurable and
construction means that, when construction is complete, this is determined:
we will not be allowed to reassess the situation and rebut x during construction: measure at
the presumption that fair values will be reliably cost until FV becomes measurable
measurable on a continuing basis ± we will be forced to or until completion date,
continue to use the fair value model until the property is whichever is earlier
disposed of (or transferred out of investment property due x on completion:
to a change in use). - if still at cost, we can rebut the
presumption and use CM for that
In other words, if we are able to reliably measure the property (must use CM until
SURSHUW\¶V fair value during construction and thus began disposal & a RV of nil)
using the fair value model during construction, but then on - if already at FV, we cannot rebut
completion of construction, we decide that the fair value the presumption now, so must
will not be reliably measurable on a continuing basis, we continue to measure under the
will not be allowed to switch from the fair value model to FVM until disposal.
See IAS 40.53 & .55
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

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 2Q0DUFK;LWZDVXQFOHDULIWKHEXLOGLQJ¶VIDLUYDOXHZRXOGEHUHOLDEO\PHDVXUDEOHRQ
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 7KHFRPSDQ\¶VDFFRXQWLQJSROLF\LVWRmeasure 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.
Answer:
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.

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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)

Transfers in/out
When there is change in use of a property, it may result in the of investment
investment property definition: property occur if:
x ceasing to be met, in which case the property would need to be x there is evidence
transferred out of investment property into another classification x of a change in use,
(e.g. inventory); or x with the result that the:
x becoming met, in which case the property would need to be - IP def is now met :
transferred into investment property from another classification tfr into IP
- IP def is no longer met:
(e.g. inventory).
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 PDQDJHPHQW¶V 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 previously rented out under an operating lease (i.e. meeting the investment property
definition), could subsequently become used by the entity as its head office (i.e. subsequently
becoming owner-occupied and thus no longer meeting the investment property definition but
meeting the property, plant and equipment definition 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)
x A property previously rented out under an operating lease (i.e. meeting the investment property
definition), 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, the standard clarifies that evidence of a change
in use may not simply be based on management¶V change in intention. In this µKD]LHU¶ situation
of 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 begun.
Thus, in this case, an investment property that management simply states 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 that was owner-occupied (i.e. meeting the property, plant and equipment definition),
could subsequently cease to be owner-occupied and become rented out to third parties under
an operating lease instead (i.e. no longer meeting the property, plant and equipment definition
but meeting the investment property definition 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 previously available for sale in the ordinary course of business (i.e. meeting the
inventory definition), could subsequently be rented out under an operating lease instead (i.e. thus
no longer meeting the inventory definition but meeting the investment property definition instead).
In this case, the property would need to be transferred out of inventories and into investment
property. See IAS 40.57 (d)

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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. VHOOWKHEXLOGLQJµDVLV¶ 3LOORZ/LPLWHGVRPHWLPHVVHOOVEXLOGLQJVDVSDUWRILWVEXVLQHVVDFWLYLWLHV 
B. KROGWKHEXLOGLQJµDVLV¶IRUFDSLWDODSSUHFLDWLRQRU
C. borrow fURPWKHEDQNDQGFRPSOHWHWKHEXLOGLQJWKHQXVHLWDVWKHHQWLW\¶VKHDGRIILFH

Solution 6: Transfers in and out of investment property

Whilst the property was being developed, it should be classified as investment property since the HQWLW\¶V
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 a
transfer to LQYHQWRULHVFDQRQO\RFFXULIWKHUHLVDFKDQJHLQXVHµHYLGHQFHGE\FRPPHQFHPHQWRI
GHYHORSPHQWZLWKDYLHZWRVDOH¶DQGWKDWDQLQYHVWPHQWSURSHUW\WKDWLVWREHGLVSRVHGRIµZLWKRXW
GHYHORSPHQW¶PXVWUHPDLQFODVVLILHGDVLQYHVWPHQWSURSHUW\XQWLOGLVSRVal.
Thus, this property must not be reclassified to inventories (i.e. it remains investment property) because
LWLVEHLQJVROGµDVLV¶ LHLWLVQRWEHLQJGHYHORSHGZLWKWKHLQWHQWLRQWRVHOOLW 
B. If the intention is to keep the building for capital appreciation, the building remains classified as investment
property because it still meets the investment property definition. Pillow will then have the option to
measure it 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 investment property definition and
would, instead, meet the property, plant and equipment definition. It would thus 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 terms of IAS 23 Borrowing Costs)

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 it was
previously carried under the cost model in terms of IAS 16. This is explained in section 5.4.

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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 either in terms of IAS 16 Property, plant and equipment
or accounted for as a right-of-use asset in terms of
IFRS 16 Leases. Transferring from
owner-occupied property
to investment property (FVM):
When owner-occupied property is to be reclassified
to investment property that will then be measured x account for any depreciation and impairment
losses until the date of change in use; and
under the fair value model (FVM), the entity must
x revalue the property to fair value (even if the
revalue the property to its fair value immediately cost model has been used to measure PPE)
before making the transfer to investment property:
x any change from the carrying amount to fair 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 means that 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, we could no longer transfer this revaluation surplus to retained earnings over
the life of the asset (since it is longer depreciated). Thus, any revaluation surplus relating to a property
that is reclassified to investment property could only be transferred to retained earnings on its
eventual disposal.

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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 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 DVDµUHSODFHPHQW¶. 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.
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 )DQWDVWLF¶Vhead-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 PHDVXUHGXVLQJ,$6¶VFRVWPRGHOWKHSURSHUW\PXVWEHUHYDOXHG
to fair value in terms of IAS 16¶V revaluation model before being transferred to investment property. This is
because the entity uses the fair value model for its investment properties.

1 January 20X5 Debit Credit

PPE: Office building: carrying amount (A) 500 000
Bank/ Accounts payable (A/L) 500 000
Purchase of head-office building(owner-occupied)
30 June 20X5
Depreciation (E) (500 000 - 0) / 5 x 6 / 12 months 50 000
PPE: Office building: carrying amount (A) 50 000
Depreciation to date of change in use
PPE: Office building: carrying amount (A) 70 000
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
PPE: Office building: carrying amount (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
IP: Office building: fair value (A) 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)

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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 adjustment

Transferring from inventories to
should be made immediately before or after the investment property (FVM):
transfer. However, it makes sense to process the
adjustment after the transfer. In other words, transfer x transfer at the CA of the inventory; & then
the inventory to investment property at the carrying x revalue the property to fair value.
amount of the inventory (i.e. lower of cost or net x Recognise difference between CA & FV in P/L.
realisable value) and then remeasure the investment property to fair value.

The difference between the SURSHUW\¶V previous carrying amount and its fair value is recognised
immediately in profit or loss. See IAS 40.63

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 contract was then signed and became effective from 1 March 20X5.
x 2Q0DUFK;WKHEXLOGLQJ¶V
- fair value was C300 000 and
- net realisable value was C290 000.
x 2Q'HFHPEHU;WKHEXLOGLQJ¶VIDLUYDOXHKDGJURZQWR& 000.
x Chess Limited uses the fair value model for its investment properties.
Required: 3URYLGHWKHMRXUQDOVIRU&KHVV/LPLWHG¶V\HDUHQGHG'HFHPEHU;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.

1 January 20X5 Debit Credit

Inventory (A) 250 000
Bank/ Accounts payable (A/L) 250 000
Building purchased with the intention of selling
1 March 20X5
IP: Building: fair value (A) 250 000
Inventory (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) FV: 340 000 ± CA: 300 000 40 000
Fair value adjustment of investment property (P/L) 40 000
Investment property remeasured to fair value at year-end

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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 µRZQHG¶ 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

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.
'XULQJ D µIUHDN¶ HDUWKTXDNH 6XSHU /LPLWHG¶V 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.
6XSHU/LPLWHG¶VKHDGRIILFHPRYHGLQWRWKHse 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).

30 June 20X5 Debit Credit

IP: Office building: fair value (A) FV: 260 000 ± CA: 200 000 60 000
Fair value adjustment of investment property (P/L) 60 000
Investment property revalued to fair value on date of transfer
PPE: Office building: cost (A) 260 000
IP: Office building: fair value (A) 260 000
Transfer of investment property to property plant and equipment
Depreciation (E) (260 000 ± 0) / 10 x 6/12 13 000
PPE: Office building: accumulated depreciation (-A) 13 000
Depreciation for the year

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6. Derecognition (IAS 40.66 - 73)

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
derecognised on:
x permanent withdrawal from use (e.g. abandonment)
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 µFRQVLGHUDWLRQ¶) 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

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, disposal proceeds are measured in the same way that we determine the
transaction price in terms of IFRS 15 (see chapter 4 on revenue). This means, if a property is
disposed of by way of a sale but the receipt of these proceeds will be delayed, and this delay gives
the purchaser a significant financing benefit, these proceeds must be measured at the price the
customer would have paid for the investment property had it been disposed of for cash. The
difference between the price 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 (e.g. a roof destroyed
in a storm, a lift that needed 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

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Any compensation receivable from a claim made following an impairment or giving up of a property
is considered to be a separate economic transaction and is thus accounted for separately when the
compensation becomes receivable. The compensation will be 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) Proceeds: 100 000 ± CA: 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).

If the fair value model is used, the carrying amount of the investment property changes each time it
LVIDLUYDOXHGEXWWKHWD[EDVHGRHVQ¶WFKDQJHIRUWKHVHDGMXVWPHQWVThe 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). 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 (see chapter 6: section 4.3). The principle of exempting these temporary differences from
deferred tax is the same principle we applied when accounting for non-deductible property classified
as property plant and equipment in IAS 16.

However, there is a fundamental difference in the deferred tax journal entries depending on whether
the property is classified as an investment property and measured under the fair value model (in
terms of IAS 40) or is 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: any deferred tax relating to the revaluation surplus
will be debited or credited to the revaluation surplus account (OCI); but
x fair value adjustments on investment properties are all recognised in profit and loss: thus all
related deferred tax journals 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, we must build this into the measurement of our deferred tax balance (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).

536 Chapter 10
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However, if investment property is measured using the fair value model, the presumption is that
its carrying amount will be recovered entirely through the sale of the property rather than through
the use thereof. 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 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) and has a total useful life of 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).
The tax authorities:
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 it falls within a business
model the objective of which is to obtain substantially all 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.
Answer:
x The deferred tax balance at 31 December 20X6: C616 500, liability (see W1)
x The deferred tax journal during 20X6 will be as follows:
31 December 20X6 Debit Credit
Income tax expense (E) DT c/bal: 616 500 ± DT o/bal: 450 000 166 500
Deferred tax: income tax (L) Or: W1 166 500
Deferred tax on investment property

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W1: Deferred tax calculation on investment property: intention to sell

CA TB TD DT
Balance: 1/1/20X2 0 0 0 0
Purchase: 1/1/20X2 (1) 1 500 000 (4) 1 500 000 0 0
)9DGM¶VWD[GHGXFWLRQVX2/3/4/5 (3) 1 500 000 (3) (300 000) (1 800 000) (3) (450 000) Cr DT Dr TE

Balance: 1/1/20X6 (2) 3 000 000 (4) 1 200 000 (1 800 000) (5) (450 000) Liability

)9DGM¶VWD[deductions: X6 (3) 600 000 (3) (75 000) (675 000) (3) (166 500) Cr DT Dr TE

Balance: 31/12/20X6 (2) 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

Solution 11B: Presumed intention to sell is rebutted

Comment:
x In this scenario, the presumed intention 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.
Answer:
x The deferred tax balance at 31 December 20X6: C742 500, liability (see W1)
x The deferred tax journal during 20X6 will be as follows:
31 December 20X6 Debit Credit
Income tax expense (E) W1: (742 500 ± 540 000) 202 500
Deferred tax: income tax (L) 202 500
Deferred tax on investment property

W1: Deferred tax calculation: Investment property: intention to keep

CA TB TD DT
(1) (2) (4)
Balance: 1/1/20X6 3 000 000 1 200 000 (1 800 000) (540 000) Liability
Movement (6) 600 000 (6) (75 000) (675 000) (6) (202 500) Cr DT Dr TE
(1) (3) (5)
Balance: 31/12/20X6 3 600 000 1 125 000 (2 475 000) (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

538 Chapter 10
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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 The income tax rate is 30%.
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. How would your answer change if the building falls with a business model the objective of which is to
obtain substantially all 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.

Solution 12A: Presumed intention to sell and an exemption

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.

Answer:

x The deferred tax balance at 31 December 20X6: C504 000 liability (see W1)

x The deferred tax journal during 20X6 will be as follows:

31 December 20X6 Debit Credit

Income tax expense(E) W1 144 000
Deferred tax: income tax (L) 144 000
Deferred tax on investment property

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W1: Deferred tax calculation

Investment property: Carrying Tax Temporary Deferred taxation
intention to sell amount base difference
Balance: 1/1/20X2 0 0 0 0
Purchase: 1/1/20X2 (1) 1 500 000 (4) 0 (1 500 000) (5) 0 Exempt
)9DGM¶V;± 20X5 (3) 1 500 000 (4) 0 (1 500 000) (3) (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

)9DGM¶V; (3) 600 000 (4) 0 (600 000) (3) (144 000) Cr DT Dr TE

(2) (4) (7)

Balance: 31/12/20X6 3 600 000 0 (3 600 000) (504 000) Liability
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)

(2) Fair value (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 chapter 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

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.
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.

Answer:
x The deferred tax balance at 31 December 20X6: C630 000, liability (see W1)

x The deferred tax journal during 20X6 will be as follows:

31 December 20X6 Debit Credit

Income tax expense (E) W1 180 000
Deferred tax: income tax (L) 180 000
Deferred tax on investment property

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W1: Deferred tax calculation

Investment property: Carrying Tax Temporary Deferred
intention to keep amount base difference taxation

Balance: 1/1/20X2 0 0 0 0
Purchase: 1/1/20X2 (1) 1 500 000 (4) 0 (1 500 000) (5) 0 Exempt
)9DGM¶V;± 20X5 (3) 1 500 000 (4) 0 (1 500 000) (3) (450 000) Cr DT Dr TE

(2) (4) (6)

Balance: 1/1/20X6 3 000 000 0 (3 000 000) (450 000) 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) (450 000) Liability

)9DGM¶V; (3) 600 000 (4) 0 (600 000) (3) (180 000) Cr DT Dr TE

(2) (4) (7)

Balance: 31/12/20X6 3 600 000 0 (3 600 000) (630 000) Liability
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)

(2) Fair value (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 & chapter 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
economic benefits embodied in the property through use rather than sale.

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.

Tax-related information:
x The income tax rate is 30%.
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 or permanent differences 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.

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Solution 13: Presumed intentions (rebutted and not rebutted) and exemption
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 economic
benefits embodied in the property through use rather than sale.
The deferred tax is thus measured based on the actual intention to use this asset.

Answer:
x The deferred tax balance at 31 December 20X6: C647 100 liability (W1: 445 500 L + W2: 201 600 L)
x The deferred tax journal during 20X6 will be as follows:

31 December 20X6 Debit Credit

Income tax expense (E) (W1: 121 500 + W2: 57 600) 179 100
Deferred tax: income tax (L) 179 100
Deferred tax on investment property

W1: Deferred tax calculation: Investment property: Building (keep)

Carrying Tax Temporary Deferred

amount base difference taxation

(1) (3) (5)

Balance: 1/1/20X6 1 800 000 720 000 (1 080 000) (324 000) Liability
Movement 360 000 (45 000) (405 000) (7) (121 500) Cr DT Dr TE
(2) (4) (6)
Balance: 31/12/20X6 2 160 000 675 000 (1 485 000) (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)

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W2: Deferred tax calculation: Investment property: Land (assume sell)

Carrying Tax Temporary Deferred

amount base difference taxation
Balance: 1/1/20X2 0 0 0 0
Purchase: 1/1/20X2 (1) 600 000 (4) 0 (600 000) (5) 0 Exempt
)9DGM¶V;± 20X5 (3) 600 000 (4) 0 (600 000) (3) (144 000) Cr DT Dr TE

(2) (4) (6)

Balance: 31/12/20X5 1 200 000 0 (1 200 000) (144 000) Liability
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

)9DGM¶V: 20X6 (3) 240 000 (4) 0 (240 000) (3) (57 600) Cr DT Dr TE

(2) (4) (6 )
Balance: 31/12/20X6 1 440 000 0 (1 440 000) (201 600) Liability
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):
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

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.

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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).

31 December 20X6 Debit Credit

Income tax (E) W1 226 500
Current tax payable: income tax (L) 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)
Taxable profits 755 000
Current income tax 755 000 x 30% 226 500

9. Disclosure (IAS 40.74 - 79)

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; and
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)

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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 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)

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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;
IAS 40.79 (c) ± (d)
- other changes.
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; and
- 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

Entity Name
Statement of financial position 20X5 20X4
As at 31 December 20X5 (extracts) C C

ASSETS
Non-current assets Note
Investment property 27 xxx xxx

Entity Name
Notes to the financial statements
For the year ended 31 December 20X5 (extracts)

1. 6WDWHPHQWRIFRPSOLDQFH«
....

2. Accounting policies
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 «

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Entity Name
1RWHVWRWKHILQDQFLDOVWDWHPHQWVFRQWLQXHG«
For the year ended 31 December 20X5 (extracts)

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 DW«WKDWKDVEHHQRIIHUHGDVVHFXULW\IRUDORDQ VHH
NRWH«/RDQREOLJDWLRQV
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.

35. Profit before tax 20X5 20X4

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- x Held by owner or held by lessee as a right-
of-use asset of-use asset
x For use in supply of goods/ services or for x To earn rentals or for capital appreciation
admin purposes

Follow IAS 16 Follow IAS 40

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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

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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

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Measurement
Deferred tax

Cost model Fair value model

Deferred tax is the same as for property,
plant and equipment:
x the deferred tax balance is measured on all
temporary differences (at income tax rates)
x unless the asset is not tax deductible, in
which case the temporary differences will
be exempt from deferred tax (IAS 12.15)
Deferred tax is measured based on the
presumption that the intention is to sell
the investment property (IAS 12.51C)
This presumption is rebutted if the
investment property:
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 (i.e. through 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)

550 Chapter 10
Gripping GAAP Investment properties

Main disclosure
General
x Accounting policies
x Profit before tax:
 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
x 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)
x Profit before tax note:
 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/ saleability
x Contractual obligations

IP: Disclosure – for FV model

x Recon between CA at beginning and end of period
 Additions – acquisitions
 Additions – subsequent expenditure
 +/- assets classified as held for sale
 Gain/ loss from FV adjustments
 Transfers (to)/ from inventories/ PPE
 Other
x Show a separate recon for any property that HAD to be measured using CM and also:
 Describe this property
 Explain why the FV could not be measured reliably
 The range of estimates in which FV is highly likely to be
 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

x Recon between CA at beginning and end of period
 Additions – acquisitions
 Additions – subsequent expenditure
 +/- assets classified as held for sale
 Depreciation
 Impairments or impairments reversed
 + - transfers (to)/ from inventories/ PPE
 Other
x FV of the properties

Chapter 10 551
 Gripping GAAP Impairment of assets

Chapter 11
Impairment of Assets
Reference: IAS 36 and IFRS 13 (including amendments to 10 December 2021)

Contents: Page
1. Introduction 554
2. Indicator review 555
2.1 Overview 555
2.2 External information 555
2.3 Internal information 555
2.4 Materiality 555
2.5 Reassessment of the variables of depreciation 556
Example 1: Indicator review 556
Example 2: Indicator review 558
3. Recoverable amount 559
3.1 Overview 559
Example 3: Recoverable amount and impairment loss: basic 559
3.1.1 Recoverable amounts: indefinite useful life intangible assets 560
3.1.2 Recoverable amounts: all other assets 560
3.2 Fair value less costs of disposal 561
Example 4: Recoverable amount: fair value less costs of disposal 561
3.3 Value in use 562
3.3.1 Cash flows in general 563
3.3.1.1 Relevant cash flows 563
3.3.1.2 Assumptions 563
3.3.1.3 Period of the prediction 563
3.3.1.4 Growth rate 564
Worked example 1: Growth rate 564
3.3.1.5 General inflation 564
Worked example 2: General inflation 564
3.3.2 Cash flows from the use of the asset 565
3.3.2.1 Cash flows from use to be included 565
3.3.2.2 Cash flows from use to be excluded 565
3.3.3 Cash flows from the disposal of the asset 565
Example 5: Recoverable amount: value in use: cash flows 566
3.3.4 Discount rate and present valuing the cash flows 566
Example 6: Value in use: discounted (present) value 567
3.3.5 Foreign currency future cash flows 568
Example 7: Foreign currency future cash flows 568
4. Recognising and measuring an impairment loss 568
4.1 Overview 568
4.2 Impairments and the cost model 569
Example 8: Impairment loss journal: basic 569
4.3 Impairments and the revaluation model 570
Example 9: Impairment loss journal: with a revaluation surplus 571
Example 10: Fair value and recoverable amount ± disposal costs are negligible 572
Example 11: Fair value and recoverable amount ± disposal costs are not negligible 572

552 Chapter 11
Gripping GAAP Impairment of assets

Contents continued ...: Page

5. Recognising a reversal of a previous impairment loss 573
5.1 Overview 573
5.2 Impairment reversals and the cost model 573
5.3 Impairment reversals and the revaluation model 574
Example 12: Revaluation model and impairment loss reversed 574
6. Cash-generating units 577
6.1 Overview 577
Worked example 3: Individual asset or part of a cash-generating unit? 577
Worked example 4: Cash-generating unit ± asset has the potential to generate cash flows 578
Example 13: Scrapping of an asset within a cash-generating unit 578
6.2 Allocating an impairment loss to a cash-generating unit 579
6.2.1 Overview 579
Example 14: Allocation of impairment loss (no goodwill) 580
Example 15: Allocation of impairment loss (with goodwill) 580
6.2.2 ,IZHNQRZDQLQGLYLGXDODVVHW¶VUHFRYHUDEOHDPRXQW 581
6.2.3 ,IZHNQRZRQHRIWKHDPRXQWVUHODWLQJWRDQLQGLYLGXDODVVHW¶VUHFRYHUDEOHDPRXQW 581
Example 16: Allocation of impairment loss (no goodwill): multiple allocation 581
6.2.4 If the CGU contains scoped-out assets and liabilities 583
Example 17: Allocation of impairment loss (with goodwill) ± with scoped-out
assets and some individual recoverable amounts known 583
6.3 Impairment reversals relating to cash generating units 585
6.3.1. Calculating impairment loss reversals relating to CGUs 585
6.3.2. Impairment loss reversals relating to CGUs ± cost model 586
Worked example 5: Impairment loss reversals ± cost model 586
Example 18: Impairment and reversal thereof (no goodwill) ± cost model 586
Example 19: Impairment and reversal thereof (with goodwill) ± cost model 587
6.3.3. Impairment loss reversals relating to CGUs ± revaluation model 588
Example 20: Impairment reversal of a CGU (with goodwill) ± some individual
recoverable amounts known ± cost model and revaluation model 589
6.4 Goodwill and corporate assets 592
6.4.1 Overview 592
6.4.2 Goodwill and its allocation to a CGU 592
6.4.3 Corporate assets and their allocation to a CGU 593
Example 21: Corporate assets 594
7. Deferred tax consequences of impairment of assets 596
Example 22: Deferred tax consequences relating to impairment 596
8. Disclosure 597
8.1 In general 597
8.2 Impairment losses and reversals of previous impairment losses 597
8.3 Impairment testing: cash-generating units 597
9. Summary 599

Chapter 11 553
 Gripping GAAP Impairment of assets

1. Introduction

IAS 36 Impairment of assets is designed to ensure that an The purpose of IAS 36:
DVVHW¶V FDUU\LQJ DPRXQW GRHV QRW H[FHHG LWV UHFRYHUDEOH To ensure an asset’s CA is
amount, and thus that its value is not overstated. not overstated. See IAS 36.1

The carrying amount of an asset must reflect the economic Carrying amount is
benefits an entity expects it WR SURGXFH +RZHYHU DQ DVVHW¶V defined as:
carrying amount could end up being overstated. For example: a x the amount at which an asset
plant costing C100 000, that is depreciated to a nil residual value is recognised
x after deducting any
over 5 years, would have a carrying amount of C80 000 at the accumulated:
end of year 1. However, if it was damaged in a storm in year 1, it - depreciation (amortisation) &
is possible that the carrying amount is no longer a reasonable - impairment losses. See IAS 36.6
measurement of its expected economic benefits. In this case,
we must assess the amount we could truly obtain (recover) from this plant.

There are only ever two options for an asset: (a) dispose of it now or (b) continue using it and then
dispose of it. Thus, we calculate the net amount we could obtain from disposing of it (fair value less
cost of disposal) and the amount expected from continuing to using it (value in use). 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).
Recoverable amount is
If DQDVVHW¶V recoverable amount is found to be lower than its defined as:
FDUU\LQJ DPRXQW LW PHDQV WKH DVVHW¶V FDUU\LQJ DPRXQW LV x the higher of an asset’s:
overstated and must be reduced. In other words, our asset has - fair value less costs of
been impaired. This reduction is called an impairment loss and disposal (FV-CoD); and
is an expense that is generally recognised in profit or loss. - value in use (VIU). See IAS 36.6

+RZHYHUDIWHUUHGXFLQJDQDVVHW¶VFDUU\LQJDPRXQWGXHWRDQLPSDLUPHQWWKHXQIDYRXUDEOHFRQGLWLRQV
that caused this impairment loss could subsequently reverse (e.g. damage is repaired). If this
happens, the recoverable amount may now be higher than the DVVHW¶VFDUU\LQJDPRXQWDQGthus
we may need 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. However, if the asset is measured under
the revaluation model, the impairment and impairment reversal may need to be recognised partially
or totally in other comprehensive income instead of in profit or loss: see sections 4.3 and 5.3.

(QWLWLHVPXVWSHUIRUPDQµannual indicator review¶DWUHSRUWLQJ Scope of IAS 36

date, to assess whether an asset might be impaired. It is IAS 36 applies to all
generally only if this review suggests an asset may be impaired assets except for the
following scoped-out assets:
that the recoverable amount is calculated.
x inventories (IAS 2)
x investment properties
The µannual indicator review¶ and µrecoverable amount calculation¶ measured at fair value (IAS 40)
(when necessary), are helpful (although time consuming), as it x non-current assets classified
forces businesses to assess the most profitable future for the as held for sale (IFRS 5)
asset concerned (i.e. whether to use or dispose of the asset). x deferred tax assets (IAS 12)
x employee benefit assets (IAS 19)
IAS 36 does not apply to the impairment of all assets. x financial assets (IFRS 9)
Assets that are: x contract assets & costs to
obtain/ fulfil a contract that are
x excluded from the scope of IAS 36 (scoped-out assets: recognised as assets (IFRS 15)
see pop-up), are measured in terms of their own standards. x insurance contracts (IFRS 17)
x included in the scope of IAS 36 (scoped-in assets) are all x biological assets measured at
other assets (e.g. property, plant and equipment, intangible FV less costs to sell (IAS 41)
assets DQGµLQYHVWPHQWSURSHUW\XQGHUWKHFRVWPRGHO¶). See IAS 36.2

7KHWHUPµDVVHW¶LQWKLVFKDSWHUUHIHUVWRERWKµLQGLYLGXDODVVHWV¶DQGµFDVK-JHQHUDWLQJXQLWV¶ LH a group

of assets that cannot produce cash inflows independently of one another). We will first look at how to
account for impairments and impairment reversals in terms of individual assets and then apply these
principles to cash-generating units.

554 Chapter 11
 Gripping GAAP Impairment of assets

2. Indicator Review (IAS 36.8 - 17)

2.1 Overview (IAS 36.8 - 17) An indicator review is:

a procedure that involves
$QµLQGLFDWRUUHYLHZ¶PXVWEHSHUIRUPHGDWWKHHQGRIWKHUHSRUWLQJ looking for evidence that
an asset’s CA may be overstated
period in order to assess whether an impairment 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 cash we can still get the asset to generate
for us through either its use or its disposal (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 recoverable
amount is only
The µindicator review¶ should consider the following factors:
calculated if:
x external information; x the indicator review suggests a
x internal information; possible material impairment
x materiality; and x unless the asset is
x reassessment of the variables of depreciation. See IAS 36.12, 15 &17 - an intangible asset
- not yet available for use; or
The µrecoverable amount¶ only needs to be calculated if: - with an indefinite useful life;
- goodwill
x the indicator review suggests the asset may be impaired; in which case the RA must
x the asset is an intangible asset with an indefinite useful life*; ALWAYS be calculated.
x the asset is an intangible asset not yet available for use*; or See IAS 36.9 & .10

x the asset is goodwill acquired in a business combination*. See IAS 36.9 & .10
* These assets are subject to more stringent impairment testing because they are not amortised and
thus there is a greater risk that their carrying amounts are overstated (see section 3.1.1).

2.2 External information (IAS 36.12 (a)-(d) and .13-14)

There are many examples of information that could indicate an asset is impaired, but IAS 36 provides
a list of indicators involving external information that must, at a minimum, be considered. For example:
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 (e)-(h) and .13-14)

There are many examples of information that could indicate an asset is impaired, but IAS 36 provides
a list of indicators involving internal information that must, at a minimum, be considered. For example:
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,
- DSODQWRFHDVHPDQXIDFWXULQJDSURGXFWOLQHRUFORVHDIDFWRU\WKDWXVHVWKHDVVHWDQG
- WKHUHDVVHVVPHQWRIWKHXVHIXOOLIHRIDQDVVHWIURPµLQGHILQLWH¶WRµILQLWH¶
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 section 3.1.1). See IAS 36.10

Chapter 11 555
 Gripping GAAP Impairment of assets

2.5 Reassessment of the variables of depreciation (IAS 36.17)

If an indicator (internal or external) suggests that the asset¶V FDUU\LQJ DPRXQW LV PDWHULDOO\
overstated, this could mean that it may be materially impaired. If so, we would adjust the
carrying amount down to the recoverable amount DQGFDOOWKLVDGMXVWPHQWDQµLPSDLUPHQWORVV¶
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 (under-depreciated assets).
If the CA appears
To assess the reasonableness of the depreciation to date, overstated:
we must re-evaluate the three variables of depreciation: x before processing an
x estimated remaining useful life, impairment;
x residual value (used to calculate depreciable amount), & x we first check whether our
x depreciation (or amortisation) method. IAS 36.17 (reworded) depreciation variables need
to be re-estimated (e.g. we
Any change in the above three variables must be adjusted may need to process extra
depreciation)
in terms of the standard governing that type of asset. For
example, a change in the depreciation of property, plant and equipment is accounted for as a
change in accounting estimate (IAS 8).

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
IRU WKH SODQW¶V RXWSXW LV H[SHFWHG GXULQJ ; DIWHU ZKLFK it has been determined that, due to
LQWHQVLYHXVDJHLQWKHSODQW¶VHDUO\\HDUV, there is to be limited use beyond 20X9.
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 /LOJX\¶V net asset value is presented in its statement of financial position as C300 000 (Assets:
400 000 ± Liabilities: 100 000). This equates to a net asset value of C3 per share (C300 000 /
100 000 shares). However, the fact that the market perceives the value of Lilguy 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 µslight¶ 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.

556 Chapter 11
Gripping GAAP Impairment of assets

x The entity expects the usage of the plant to be limited to non-existent beyond 20X9, therefore the
useful life needs to re-assessed according to this change in expected usage. Thus, 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 useful life (TUL), from 10 yrs to 6 yrs (5 past yrs to the end of 20X8 + 1 more yr: 20X9)
 decrease in remaining useful life (RUL) 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 (420 000-0)/ 6; (70 000) (210 000) (140 000)
(420 000-0) / 2
Carrying amount: 31/12/20X8 350 000 210 000 (140 000)

After processing the extra depreciation (of C140 000) in 20X8, the SODQW¶V 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 C400 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 C160 000

7KH UHYLVHG QHW DVVHW YDOXH LV QRZ OHVV WKDQ WKH FRPSDQ\¶V PDUNHW YDOXH RI C220 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
FDVKLQIORZVSHUWKHPDQDJHPHQWDFFRXQWDQW¶VEXGJHW
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. The following journal would be processed:

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)

Chapter 11 557
Gripping GAAP Impairment of assets

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 two
years of usage, due to a decrease LQWKHPDUNHWGHPDQGIRUWKHSODQW¶VRXWSXW. Furthermore, due to
over usage in the earlier years, the plant is expected to no longer be functional 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 two 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)
Carrying amount: 1/1/20X5 420 000 420 000
Remaining useful life (10 ± 4); (1 + 3) 6 4
Depreciation: 20X5 (420 000-0)/ 6; (70 000) (105 000) (35 000)
(420 000-0)/ 4
Carrying amount: 31/12/20X5 350 000 315 000 (35 000)

558 Chapter 11
 Gripping GAAP Impairment of assets

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 WKDQWKHFRPSDQ\¶VPDUNHWYDOXHRI 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 following depreciation journal must be processed:

Debit Credit
Depreciation ± plant (P/L: E) 35 000
Plant: Acc depr (-A) 35 000
Extra depreciation on plant 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.

Chapter 11 559
 Gripping GAAP Impairment of assets

Solution 3A: Recoverable amount ± basic

C
Recoverable amount is the higher of the following: 170 000
Fair value less costs of disposal 170 000
Value in use 152 164

Solution 3B: Impairment loss ± basic

i) If the CA 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 CA is C150 000, the asset is not impaired, because RA exceeds CA: C
Carrying amount 150 000
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, intangible assets
not yet available for use and goodwill (IAS 36.10 & 24)

Goodwill, intangible assets with indefinite useful lives and intangible assets not yet available for use
are subject to more stringent impairment testing. This is because they are not amortised and, by
their nature, their expected economic benefits are subject to a greater level of uncertainty.

In the case of these three assets, the recoverable amount must be estimated annually (i.e. not
only when an indicator review suggests an impairment). This estimate may be made any time
during the year (i.e. the estimate does not have to made as at reporting date), but it must be
made at the same time each year (e.g. if the reporting date is 31 December, the recoverable
amount may be estimated during September). However, if the asset was acquired during the
current year (e.g. in October), the recoverable amount must be calculated before reporting date.

In the case of intangible assets with indefinite useful lives, there is an exception to the µDQQXDO
recoverable amount FDOFXODWLRQ¶UHTXLUHPHQW: 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 DVVHW¶V recoverable amount was substantially
greater than the carrying amount at that time; and
x events and circumstances subsequent to the previous calculation of the recoverable
amount suggest that there is only a remote chance that the DVVHW¶V current recoverable
amount would have dropped below its carrying amount. See IAS 36.24

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 µvalue in use¶ and µfair value less costs of
disposal¶, it is not always necessary (or possible) to calculate both these amounts. Consider
the following examples on the next page.

560 Chapter 11
 Gripping GAAP Impairment of assets

Situations where we would not have to calculate both amounts include, for example:
x If it is impossible to measure the µfair value less costs of disposal¶, then we will have no
option but to assume that the recoverable amount is its µvalue in use¶.
x If the first of the two amounts is calculated and found to be greater than carrying amount,
the other amount will not need to be calculated. This is because a recoverable amount is
the higher of these two amounts, and thus this situation would have already proved that
the recoverable amount exceeds the carrying amount, and thus the asset is not impaired.
x If there is no indication that µvalue in use¶ materially exceeds µfair value less costs of
disposal¶ WKLVRIWHQKDSSHQVif an asset is held for disposal), we can simply calculate the
µfair value less costs of disposal¶ (often easier to calculate than value in use). See IAS 36.19 - .21

Summary
Normal approach x calculate FV-COD; and then
x if FV-COD < CA then also calculate VIU (since 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 : only 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 36.6 and IAS 36.28-9 and IAS 36.53A)
Fair value is
Fair value less costs of disposal is a measure of the estimated
defined as:
net proceeds that would be received if we were to sell the asset,
x the price that would be
after taking into account disposal costs that we expect would be
 received to sell an asset
incurred. or
 paid to transfer a liability
By definition, fair value is a market-based measurement, x in an orderly transaction
because it takes into consideration only those assumptions that x between market
market participants would use when pricing the asset VHH µIDLU participants
YDOXH¶GHILQLWLRQLQWKHSRS-up). x at the measurement date.
IAS 36.6

Costs of disposal (see definition in the pop-up) are incremental

costs directly associated with the disposal (except those already Costs of disposal
recognised as liabilities) and may include, for example: are defined as:
x legal costs; x incremental costs
x costs of removal of the asset; x directly attributable to
the disposal of an asset
x costs incurred in bringing the asset to a saleable condition; or cash-generating unit,
x transaction taxes. x excluding finance costs
and income tax expense.
The fact that the cosWPXVWEHµLncremental¶PHDQVZHRQO\LQFOXGH IAS 36.6

it if it is a cost that will only be incurred if the asset is disposed of.

For example, the cost of advertising an asset for sale is not included in the disposal costs
because advertising costs will be incurred even if the asset is not sold. Conversely, a sales
commission payable to a sales agent is incremental, and thus included in the disposal costs,
because it would only be incurred if the asset is sold. %DVHGRQGHILQLWLRQRIµLQFUHPHQWDOFRVW¶ provided in IFRS 15

Termination benefits (as defined in IAS 19) and costs to restructure (re-organise) a business
must not be included as a disposal cost. IAS 36.28 (reworded)

Example 4: Recoverable amount ± fair value less costs of disposal

Apple Limited (a VAT vendor) owns an asset over which it has the following expectations as
at 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

Chapter 11 561
 Gripping GAAP Impairment of assets

x Costs to re-organise the layout of the factory due directly to the asset disposal C15 000
x If Apple were to sell the asset, it will result in a taxable recoupment of C150 000, on C45 000
which tax of C45 000 will be incurred (the income tax rate is 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

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 cost is not directly attributable to the disposal (it is only indirectly related).
x The income tax expense is excluded from the costs of disposal since IAS 36 specifically excludes
income tax from WKHGHILQLWLRQRIµFRVWVRIGLVSRVDO¶ See IAS 36.28
Expected selling price C230 000
Less the costs of disposal Delivery cost: 20 000 + Legal cost: 10 000 + VAT: 30 000 (60 000)
Fair value less costs of disposal 170 000

If the disposal of an asset requires the acquirer to assume a liability, then the DVVHW¶VFV would
effectively be determined on a net basis (FV of the asset ± FV of the liability), and the disposal
costs would be deducted from this. An example: the acquisition of a nuclear plant that requires
environmental restoration upon its decommission in 10 \HDUV¶WLPH. In this case, the FV-CoD
would equal: (FV of Plant ± FV of Restoration obligation) less disposal costs. See IAS 36.29
Value in use (VIU) is defined
3.3 Value in use (IAS 36.30 ± 57) as:
Value in use includes the net cash flows from DQDVVHW¶V: x the present value of the
x future cash flows expected to be
x use, and derived from
x disposal after usage. x an asset or cash-generating unit.
IAS 36.6

Value in use is an entity-specific measurement (whereas fair value is a market-based

measurement). It is entity-specific because it reflects the cash flows and discount rate based on the
nature of the asset and how the entity expects to use it. 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 (from use and disposal after use); 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 aspects involved in this process: VIU requires calculating:
the present value of the
a) estimate of future cash flows (inflows and outflows); expected annual cash flows:
b) time value of money; [FCF1/(1+Discount Rate)] +
c) uncertainties in the amount and timing of cash flows; [FCF2/(1+ Discount Rate)2] +
d) the cost of bearing the uncertainties; and ... [FCFn/(1+Discount Rate)n]
e) other factors that may affect the pricing of the cash etc
Where FCF1 = future cash flows in year 1 etc
flows (e.g. illiquidity). See IAS 36 Appendix A:A1

The time value of money is taken into consideration when estimating an appropriate discount
rate, which is the market risk-free rate (element b).

The last three elements (aspects c-e) may be considered either:

x when estimating the future cash flows (element a); or
x together with the time value of money (element (b) when estimating the discount rate.

562 Chapter 11
 Gripping GAAP Impairment of assets

Including these aspects (c-e) in the estimation of future cash flows and also in the estimation of
the discount rate would be double-counting. Thus, we must be careful to only take them into
account in either the estimation of future cash flows or estimation of the discount rate - not both.

We will now discuss the calculation of the value in use 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; Relevant cash flows
include inflows &
x general inflation.
outflows from:
x Usage &
3.3.1.1 Relevant cash flows (IAS 36.39)
x Disposal.

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 well as those cash outflows that are
necessary to create these cash inflows; and
x From eventual disposal: the net cash flows from the eventual disposal of the asset.
See IAS 36.39

3.3.1.2 Assumptions (IAS 36.33 (a), .34 and 38) Assumptions when
predicting cash flows
The assumptions used when making projections must be: must be:
x reasonable; x Reasonable
x Justifiable
x justifiable (e.g. an entity may justify a projection of, for x Mgmt’s best estimate
example, 500 units p.a. despite its normal output being x Based on past cash flows
only 100 units, if it had already expended cash outflows, x Based mainly on external evidence.
before year-end, on upgrading its plant);
x management’s best estimate (i.e. not the most optimistic or most pessimistic) of the future
economic 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 years Period of prediction:
since projections usually become increasingly unreliable.
However, they may extend beyond five years if management: x should ideally be 5 years/ shorter
x should be based on most recent
x is confident the projections are reliable; and & approved budgets and forecasts.
x can, based on past experience, demonstrate its ability to
forecast cash flows accurately over that longer period. See IAS 36.35

Chapter 11 563
 Gripping GAAP Impairment of assets

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).

Worked example 1: Growth rate

,PDJLQHWKDWRXUFXUUHQW\HDU¶VJURZWKUDWHLVZKLFKLVVLJQLILFDQWO\KLJKHUWKDQRXUDYHUDJH
growth rate over the last 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 the entity is either currently experiencing, or is expecting 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 µhigher 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
Similarly, in declining markets, simply basing projections on past sales that are just extrapolated, even at zero
growth rate, might be very inaccurate. Declining markets reflect higher uncertainties and not only could cash
inflows from sales decrease, but cash outflows from costs may increase.

3.3.1.5 General inflation (IAS 36.40) The discount rate and

cash flows must
The discount rate we use must either include general inflation ‘match’.
or exclude it, depending on whether have used nominal cash If the discount rate:
flows or real cash flows in our value in use calculation: x includes general inflation:
x Nominal cash flows are the current cash flow amounts that - use nominal cash flows

have been adjusted upwards for the effects of inflation (i.e. x excludes general inflation:
nominal amounts are the actual cash flows we expect); - use real cash flows

x Real FDVKIORZVDUHWKHQRPLQDOFDVKIORZVZHH[SHFWEURXJKWEDFNLQWRµUHDOWHUPV¶E\
reversing out general inflation and thus real cash flows must only include specific, non-inflation
related price increases or decreases.

In essence, nominal cash flows include general inflation, whereas real cash flows, exclude
general inflation. Thus:
x if we use nominal cash flows (i.e. including inflation), the discount rate must reflect the
effects of this inflation;
x if we use real cash flows (i.e. excluding general inflation), the discount rate must not reflect the
effects of this inflation.

Worked example 2: General inflation ± effect on discount rate and cash flows
If we currently pay rent of $100 and expect to pay $110 next year due to general inflation of
10%, then our nominal cash flow is $110 (actual amount we expect to pay) and our real cash
flow is $100 (nominal cash flow adjusted backwards to remove the inflation: 110 / 1.1 = $100).
x If we use nominal rent of $110, then our discount rate would be 10% (the PV factor for 10% after
one year is 0.9091 and thus the present value would be $110 x 0.9091 = $100).
x If we used real rent of $100, then our discount rate would be 0% (the PV factor for 0% after one
year is 1, and thus the present value would be $100 x 1 = $100).

564 Chapter 11
 Gripping GAAP Impairment of assets

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) & (b); IAS 36.41-42)

Cash inflows include:

x the inflows from the continuing use of the asset. Cash flows from use:

Cash outflows include all those cash outflows that are x Includes: cash flows relating
expected to be necessary: to continuing use in its
existing condition (plus costs
x for the continuing use of the asset in its current condition
needed to get asset to a
(and which can be directly attributed, or allocated on a
useable condition)
reasonable and consistent basis, to the asset); and
x Excludes: cash inflows re
x to bring an asset that is not yet available for use to a
other assets; cash outflows
usable condition. See IAS 36.39 & .41
already recognised as liabilities,
cash flows relating to
Cash flows represent the economic benefits resulting from a
enhancements, financing, tax.
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 & IAS 36.50-51)

)XWXUH FDVK IORZV DUH HVWLPDWHG EDVHG RQ WKH DVVHW¶V current Cash flows from
disposal:
condition. The following expected cash flows are thus excluded:
x cash inflows that relate to other assets, (since these will be x Expected proceeds
taken into account when assessing the value in use of these x Less expected disposal
costs
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
x cash inflows and outflows relating to future expenditure to enhance the asset in excess of
its current standard of performance at reporting date; See IAS 36.44 & .45
x cash inflows and outflows relating to a future restructuring to which the entity is not yet
committed; See IAS 36.44 & .45
x cash inflows and outflows from financing activities (since cash flows will be discounted to
present values using a discount rate that takes into account the time-value of money);
x cash flows in respect of tax (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:
x the amount the entity expects to receive from the disposal of the asset at the end of the
DVVHW¶VXVHIXOOLIHLQDQDUP¶VOHQJWKWUDQVDFWLRQEHWZHHQNQRZOHGJHDEOHZLOOLQJSDUWLHV
x less the estimated costs of the disposal. IAS 36.52 (slightly reworded)

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 (but only if general inflation was taken into account when estimating
both the cash flows from use and the discount factor); and
x for specific future price adjustments. See IAS 36.53

Chapter 11 565
 Gripping GAAP Impairment of assets

Example 5: Recoverable amount ± value in use ± cash flows

0DQDJHPHQW¶V PRVW UHFHQWO\ DSSURYHG EXGJHW VKRZV D PDFKLQH¶V future cash flows as
follows:
20X5 20X6 20X7
Future cash inflows/ (outflows): &¶ &¶ &¶
Maintenance costs (100) (120) (80)
Operational costs (electricity, water, labour etc) (200) (220) (240)
Interest on finance lease (60) (50) (40)
Income tax payments on profits (16) (20) (28)
Cost of LQFUHDVLQJWKHPDFKLQH¶VFDSDFLW\ (0) (220) (0)
Depreciation (80) (80) (80)
Expenses to be paid in respect of 20X4 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 20X4 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 20X4 assuming that a 5-year projection is considered to be appropriate.

Solution 5: Recoverable amount - value in use ± cash flows

20X5 20X6 20X7 20X8 20X9

Future cash inflows / (outflows) - Machine &¶ &¶ &¶ &¶ &¶
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 20X4 accruals (not a future expense ± - - -
already recognised in 20X4 financial statements as liability)
Basic inflows: (only 40% relates to machine) 400 480 560
Extra profits from the upgrade (always exclude) - - -
Net cash inflows (20X8: 240 x 1.08) (20X9: 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
\HDULVWKHQWRWDOOHGWRJLYHWKHµQHWSUHVHQWYDOXH¶RUµYDOXHLQXVH¶
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 7KHFXUUHQW\HDUJURZWKUDWHRIVHHPVXQXVXDOJLYHQWKHFRPSDQ\¶VDYHUDJHJURwth 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%.

3.3.4 Discount rate and 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 to a present value). This means multiplying the cash flows
by an appropriate discount factor (or using a financial calculator). Choosing an appropriate
discount rate requires professional judgement.

566 Chapter 11
 Gripping GAAP Impairment of assets

The discount rate is a pre-tax discount rate, which is estimated using the:
x current market assessment of the time value of money; and Discount rate should
x the risks specific to the asset for which the future cash be:
flows have yet to be adjusted. IAS 36.55 (reworded) x pre-tax
x market-related risk-free rate
When an asset-specific rate is not available, a surrogate rate
x Adjusted for risks specific to
is used. Guidance for estimating a surrogate rate is as follows: the asset for which future
x Estimate what the market assessment would be of: cash flows haven’t yet been
adjusted
- the time value of money for the asset over its
remaining useful life; PVF = 1 ÷ (1 + k) n
- the uncertainties regarding the timing and amount of the Where:
cash flows (where the cash flow has not been adjusted); k = discount rate and
- the cost of bearing the uncertainties relating to the asset n = number of periods to
(if the cash flow was not adjusted); cashflow

- other factors that the market might apply when pricing future cash flows (e.g. WKHHQWLW\¶V
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),
WKH HQWLW\¶V LQFUHPHQWDO ERUURZLQJ UDWH DQG RWKHU PDUNHW ERUURZLQJ UDWHV FRXOG EH
considered although these rates would need to be adjusted to reflect how the market would
assess the following risks in context of the expected cash flows (unless the cash flows have
already 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 (PVF) for year 1 1 / (1 + 0.1) 1; Or: 1 / 1.1 0.909
x Present value factor (PVF) for year 2 1 / (1 + 0.1) 2 ; Or: 0.909 / 1.1 0.826
x Present value factor (PVF) for year 3 1 / (1 + 0.1) 3; Or: 0.826 / 1.1 0.751
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
Present value 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 11 567
 Gripping GAAP Impairment of assets

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 calculated as:
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 (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
x PV factor for year 2 1/1.12 0.826
x PV factor for year 3 1/1.13 0.751
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 value in use is R764 088. We first calculate the PV of the cash flows in the foreign
currency ($127 348; rounded), and then convert it into the functional currency by applying the spot
exchange rate on reporting date (R764 088).
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
Present value 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:
If the recoverable amount of an individual asset is found to be CA > RA
less than its carrying amount, the carrying amount must be
reduced to the recoverable amount. This is an impairment.
An impairment loss is
After an impairment is processed, depreciation in subsequent defined as:
periods must be calculated using the new depreciable amount x the amount by which the
DQGXVLQJWKHDVVHW¶VUHPDLQLQJXVHIXOOLIH x carrying amount exceeds
x the recoverable amount. IAS 36.6

The new depreciable amount is:

x the reduced carrying amount of the asset (the recoverable amount),
x less its residual value.

568 Chapter 11
 Gripping GAAP Impairment of assets

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 journals 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, IAS 38 Intangible assets or IAS 40 Investment properties), 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:
(µaccumulated depreciation¶ is not required to be separately
disclosed IURPµDFFXPXODWHGLPSDLUPHQWORVVHV¶DQGthus the x Dr: Impairment loss
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) UHIOHFWVWKHDVVHW¶V
 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

31 December 20X9 Debit Credit
Impairment loss (P/L: E) 100 000 ± 40 000 60 000
Plant: Accumulated impairment losses (-A) 60 000
Impairment of plant

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 11 569
 Gripping GAAP Impairment of assets

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
Plant: Accumulated impairment losses (-A) xxx
Step 1: Impairment of PPE: first against existing RS balance

Impairment loss (E) xxx

Plant: Accumulated impairment losses (-A) 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.

570 Chapter 11
 Gripping GAAP Impairment of assets

x Continued …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 µimpairment loss¶. If not, then one must
first adjust the ACA to FV, accounting for this adjustment as a µrevaluation¶.

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.

31 December 20X9 Debit Credit

Revaluation surplus (OCI) Balance in this account: given 10 000
Impairment loss expense (P/L) Total decrease: 15 000 ± Debit to RS: 10 000 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
FDUULHGDWLWVµIDLUYDOXHDWWKHGDWHRIWKHUHYDOXDWLRQOHVVDQ\VXEVHTXHQWDFFXPXODWHGGHSUHFLDWLRQ
DQGLPSDLUPHQWORVVHV¶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 µcost 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 11 571
Gripping GAAP Impairment of assets

Example 10: Fair value and Recoverable amount ± disposal costs negligible
An asset is revalued to fair value on 31 December 20X5. The following measurements are
provided as at this date:
Scenario A Scenario B Scenario C
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 ± disposal costs negligible
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.

Scenario A Scenario B Scenario C

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 ± disposal costs not negligible
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 ± disposal costs not negligible
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)
x FV less costs of disposal 100 000 – 10 000 (90 000) (90 000) (90 000) (90 000)
x Value in use Given (100 000) (120 000) (60 000) (92 000)
Impairment loss 0 N/A 10 000 8 000

Chapter 8: example 12 is another example of impairment testing and the revaluation model

572 Chapter 11
 Gripping GAAP Impairment of assets

5. Recognising a Reversal of a Previous Impairment Loss (IAS 36.109 - 125)

5.1 Overview An impairment loss

reversal is
If an asset (other than goodwill) was once impaired but, at a later processed when:
stage, its recoverable amount now exceeds its actual carrying RA > CA
amount, the impairment loss previously recognised may be
reversed, but only if the circumstances that originally caused the impairment have reversed.
Impairment losses
However, an impairment loss relating to goodwill is never on goodwill:
reversed. The reason is that an increase in the recoverable May never be reversed!
amount of goodwill probably relates to internally generated
goodwill (rather than the purchased goodwill), which is not allowed to be recognised as an asset
(see chapter 9 on Intangible Assets). See IAS 36.124 & .125 and IAS 38.48

An impairment loss reversal will have the effect of increasing the carrying amount (carrying
amount before the reversal + impairment loss reversal = new carrying amount). Thus, the
depreciation after the reversal of an impairment loss will be calculated based on the:
x new depreciable amount (i.e. new carrying amount less residual value),
x GLYLGHGE\WKHDVVHW¶Vremaining useful life (RUL). 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 µchange
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)
Impairment loss
When reversing an impairment, we must never increase an reversals under the
DVVHW¶Vcarrying amount above the carrying amount it would have cost model:
had, had the asset never been impaired. Thus, in the case of the x Up to HCA (depreciated cost):
cost model, ZH PD\ QRW LQFUHDVH WKH DVVHW¶V FDUU\LQJ DPRXQW - Dr: Accum. impairment loss
above its historical carrying amount, which is its depreciated cost: - Cr: Impairment loss reversal
x original cost, x Above HCA (depreciated cost)
x less accumulated depreciation. See IAS 36.117 Not allowed (the ACA under
the cost model must never
If the cost model is used, the increase in carrying amount is exceed depreciated cost)
recognised in profit or loss as an impairment reversal (income), calculated as: 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

HCA: Historical carrying amount ACA: Actual carrying amount RA: Recoverable amount

Chapter 11 573
 Gripping GAAP Impairment of assets

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

impairment loss may be recognised in profit or loss, other reversal under the
revaluation model:
comprehensive income or a combination of both.
x Up to HCA:
Any reversal of an impairment loss that: - Dr Acc impairment loss
- Cr Impairment loss reversal (P/L)
x increases the carrying amount up towards historical
carrying amount (depreciated cost) is recognised in x Above HCA:
profit or loss as an impairment reversal(income); and - Dr Acc impairment loss
- Cr Revaluation surplus (OCI)
x increases the carrying amount above historical carrying
amount (depreciated cost) 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 7KHDVVHW¶VUHFRYHUDEOHDPRXQWGHFUHDVHGWR& 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 7KHUHYDOXDWLRQVXUSOXVLVWUDQVIHUUHGWRUHWDLQHGHDUQLQJVRYHUWKHDVVHW¶VXVHIXOlife.
Required: Show the journal entries assuming that:
A. 7KHDVVHW¶VUHFRYHUDEOHDPRXQWLQFUHDVHGWR& 000 at 31 December 20X5;
B. 7KHDVVHW¶VUHFRYHUDEOHDPRXQWLQFUHDVHGWR& 000 at 31 December 20X5.

Solution 12A: Revaluation model and impairment loss reversed (not limited)
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 µrevaluation incomH¶).
x The recoverable amount of C160 000 exceeds the historical carrying amount (depreciated cost) of
C120 000 (W1) and thus this portion of the increase (C40 000) 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.

574 Chapter 11
Gripping GAAP Impairment of assets

31 December 20X5 Debit Credit

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
Fair value: 01/01/20X3 Given 270 000
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 (limited)

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 XQGHU WKH UHYDOXDWLRQ PRGHO WKH DVVHW¶V FDUU\LQJ DPRXQW PD\ QRW EH
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).

Chapter 11 575
Gripping GAAP Impairment of assets

x On 31 December 20X5, the recoverable amount (RA) is C210 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.
%HFDXVHWKHDVVHW¶VFDUU\LQJDPRXQW & 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
LPSDLUPHQWUHYHUVDO LHLWLVQRWµUHYDOXDWLRQLQFRPH¶ 
x W1 and W2 from Part A apply to this question too.

31 December 20X5 Debit Credit

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
Fair value: 01/01/20X3 Given 270 000
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/ Not allowed/
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

HCA: Historical carrying amount ACA: Actual carrying amount RA: Recoverable amount

576 Chapter 11
 Gripping GAAP Impairment of assets

Continued…
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. Cash Generating Units (IAS 36.65 ± 108 and IAS 36.122 ± 123)

6.1 Overview
A cash generating unit
(CGU) is defined as:
When testing assets for impairment, the recoverable amount
should ideally be estimated for an individual asset. However, x the smallest identifiable group
it is often not possible to estimate the recoverable amount of of assets
the individual asset. In this case, we must decide to which x that generates cash inflows
that are
cash-generating unit (CGU) the asset belongs and test
the CGU for impairment instead. x largely independent of the cash
inflows from other assets or
groups of assets. IAS 36.6
The instances where the recoverable amount of an
individual asset cannot be estimated are:
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) and thus its individual value in
use cannot be measured; and
x its value in use cannot estimated to be close to its fair value less costs of disposal. See IAS 36.67

Worked example 3: Individual asset or part of a cash-generating unit?

Adaptation of example in IAS 36.6
We are a successful mining entity that owns a private railway for transporting coal. This
railway can only be sold as scrap metal of C1 000 (net of disposal costs).
x Since this railway does not generate its own cash inflows but works in tandem with the other
mining assets to help generate cash inflows from the sale of coal, we cannot calculate its individual
µvalue in use¶.
x Although the UDLOZD\¶V µfair value less costs to sell¶ reflects its scrap metal value, there is no
evidence that the entity plans to dispose of the railway and thus LWLVXQOLNHO\WKDWLWVµYDOXHLQXVH¶
would be similar to LWVµfair value less costs to sell¶.
6LQFHZHFDQQRWGLUHFWO\FDOFXODWHWKHUDLOZD\¶VLQGLYLGXDOµYDOXHLQXVH¶DQGZHFDQ¶WLQGLUHFWO\HVWLPDWH
LWE\FRQFOXGLQJWKDWLW¶VVLPLODUWRLWVµIDLUYDOXHOHVVFRVWVRIGLVSRVDO¶RI& 000, we cannot calculate
WKHUDLOZD\¶VUHFRYHUDEOHDPRXQW EHFDXse we need both amounts to do this). Thus, the railway must
be tested for impairment by including it in the cash-generating unit to which it belongs (i.e. the mine).

A cash-generating unit (CGU) is a grouping of assets ± the An active market is

smallest group of identifiable assets ± which together, as defined as:
a group of assets, generate cash inflows from continuing x A market in which transactions for
use (i.e. not from disposal) and where these cash inflows x the asset or liability
are generally not affected by or dependent upon other x take place with sufficient
assets or groups of assets. IAS 36.6 (reworded) frequency and volume
x to provide pricing information on
Please note that we identify separate CGUs based on the an ongoing basis. IFRS 13, Appendix A
ability of the asset, or group of assets, to generate cash
inflows that are independent of other assets, or groups of assets. In other words, we do not
consider whether cash outflows are independent.

Chapter 11 577
 Gripping GAAP Impairment of assets

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 (e.g. plant A produces widgets that are then used by
plant B). In this situation, it may seem that the cash inflows from this asset, or group of assets,
are not independent of one another and should thus be considered as one single CGU (e.g.
plant A and plant B may be considered dependent on one another and thus accounted for as a
single CGU). However, IAS 36 states that if it is simply possible for the output to be sold on an
active market, then this asset, or group of assets, is classified as a CGU even though its output
is being used internally by another asset or group of assets. See IAS 36.70

Worked example 4: Cash-generating unit ± asset has the potential to generate cash flows
If plant A produces widgets that are then used by plant B, but these widgets could be
sold on an active market, then, even though this is not currently happening and thus it
is not currently producing independent cash inflows, plant A is WUHDWHGDVLILW¶VDseparate CGU.
In this case, budgets relating to this asset or group of assets may need to be adjusted to reflect
the market prices that would be achievable if the output was sold on the active market instead
of the internal prices currently achieved by using the output internally. See IAS 36.70
When testing a CGU for impairment, we must compare:
x the recoverable amount for the CGU as a whole, with
x the carrying amount of the CGU as a whole: CA of all assets (including scoped-out assets!)
less CA of all liabilities that make up the unit (with a few exceptions ± see below).

When calculating the carrying amount and the recoverable amount (greater of fair value less
costs of disposal and value in use) of a CGU:
x we 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 that will generate the future
cash flows used in determining the &*8¶V value in use; IAS 36.76 (a)
x we 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

If we know the recoverable amount of one of the individual assets within a CGU, we first test
that individual asset for impairment. Incidentally, if one of the individual assets within a CGU is
to be scrapped, then:
x its µIDLUYDOXHOHVVFRVWVRIGLVSRVDO¶ FV-CoD) will reflect the expected net proceeds from
scrapping, and
x since there would be zero, or negligible, cash inflows expected from use, then its µvalue in use¶
(VIU) would also roughly equal the cash inflows from the expected net proceeds on scrapping.
This means that, if one of the individual assets within a CGU is to be scrapped, its recoverable
amount will be known (RA = FV-CoD = VIU = proceeds from scrapping) and thus assets to be
scrapped should always be tested for impairment as an individual asset before impairment
testing the CGU to which it belongs. See IAS 36.21 and .66

Example 13: Scrapping of an asset within a cash-generating unit

A machine (carrying amount of C40 000) in an assembly line suffered damage due to a power
surge and, for safety reasons, it was immediately physically removed from the assembly line.
x The assembly line, which is a CGU, is still operating, although at 80% capacity.
x 7KHDVVHPEO\OLQH¶VUHFRYHUDEOHDPRXQWLV& 000 (which takes into account that this
machine is damaged) and its carrying amount is C240 000 (this carrying amount includes
the damaged machine although the machine has not been impaired).

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

578 Chapter 11
 Gripping GAAP Impairment of assets

The machine remains part of the cash-generating unit (CGU):

x 6LQFHZHGRQRWNQRZWKHPDFKLQH¶V5$WKLVPDFKLQHFDQQRWEHLQGLYLGXDOO\WHVWHGIRULPSDLUPHQW
x Since the cash-JHQHUDWLQJ XQLW¶V UHFRYHUDEOH DPRXQW H[FHHGV LWV FDUU\LQJ DPRXQW WKH FDVK-
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. This means we know the
PDFKLQH¶VLQGLYLGXDO5$ VHHH[SODQDWLRQEHORZ DQGWKXVLWPXVWEHWHVWHGIRULPSDLUPHQWRQLWVRZQ
before testing the CGU for impairment. See IAS 36.21 and IAS 36.66.
x Since the machine is to be scrapped, its fair value less costs of disposal is the disposal proceeds
of C1 000 (assuming no costs of disposal).
x Since the machine has already been taken out of use, its value in use will consist of only the net
disposal proceeds of C1 000 (there are no future cash flows from continuing use).
x 7KXVLQWKLVFDVHWKHPDFKLQH¶VYDOXHLQXVHHTXDOVLWVIDLUYDOXHOHVVFosts of disposal of C1 000
and thus its recoverable amount is determinable (C1 000).
x $IWHUWKHPDFKLQH¶V&$RI& KDVEHHQLPSDLUHGWRLWV5$RI&WKHFDVKJHQHUDWLQJXQLW¶V
carrying amount is reduced to C201 000 (C300 000 ± impairment C39 000), which is then compared to
the RA of C300 000. (Alternatively, because the asset is being scrapped and removed from the
assembly line, we could remove this machine from the CGU impairment test altogether, thus comparing
the CA of C200 000 with the RA of C299 000). Since the cash-JHQHUDWLQJXQLW¶VUHFRYHUDEOHDPRXQW
exceeds its carrying amount (by C99 000), the cash generating unit is not impaired.

The machine is therefore impaired as follows: C

Carrying amount 40 000
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 Allocating an impairment loss to a cash-generating unit (IAS 36.104-105)

6.2.1 Overview Allocating a CGU
impairment loss to its
If a cash generating unit is impaired, the impairment loss individual assets
must be allocated to the relevant individual assets within the x first allocate the IL to goodwill;
group.
x then allocate any remaining IL
to the other assets on a pro
The allocation of an impairment of a cash-generating unit to rata basis based on their
the relevant individual assets is as follows: carrying amounts
x the impairment is first allocated to goodwill, if any; and
x any remaining impairment is allocated on a pro rata basis based on the relative carrying
amounts of the individual scoped-in assets within the group (see section 6.2.4 for more
about scoped-in and scoped-out assets). See IAS 36.104

However, when allocating a &*8¶V impairment loss, 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 (if measurable);
x value in use
x value in use (if determinable); or x zero. IAS 36.105
x zero. IAS 36.105 (slightly reworded)

Chapter 11 579
Gripping GAAP Impairment of assets

Example 14 shows the impairment of a CGU that does not contain goodwill whereas example 15 (and
example 17) shows the impairment of a CGU that does contain goodwill.

Example 14: Allocation of impairment loss (no goodwill)

A cash-generating unit, with a recoverable amount of C5 000, includes the following assets,
all measured under the cost model:
Carrying amount Recoverable amount
x Equipment C6 000 unknown
x Vehicles 2 000 unknown
Required: Journalise the impairments.

Solution 14: Allocation of impairment loss (no goodwill)

Comment:
In this example, the impairment loss expense is shown as one single debit entry, but note that the credit to
accumulated impairment loss (-A) must be recognised for each individual asset.

Journals at year-end Debit Credit

Impairment loss (P/L: E) W1 3 000
Equipment: accumulated impairment loss (-A) W2 2 250
Vehicles: accumulated impairment loss (-A) W2 750
Impairment of assets within the cash-generating unit

W1: Impairment loss of cash-generating unit C

Carrying amount 6 000 + 2 000 8 000

Recoverable amount Given (5 000)
Impairment loss 3 000

CA before Impairment CA after

W2: Impairment loss allocated to individual assets imp allocated imp
Calculation C C C
Equipment 6 000/ 8 000 x C3 000 impairment 6 000 (2 250) 3 750
Vehicles 2 000/ 8 000 x C3 000 impairment 2 000 (750) 1 250
8 000 (3 000) 5 000

Example 15: Allocation of impairment loss (with goodwill)

A cash-generating unit, with a recoverable amount of C3 000, includes the following assets,
all measured under the cost model:
Carrying amount Recoverable amount
x Equipment C6 000 unknown
x Vehicles 2 000 unknown
x Goodwill 4 000 unknown
Required: Journalise the impairments.

Solution 15: Allocation of impairment loss (with goodwill)

Journals at year-end Debit Credit

Impairment loss (P/L: E) W1 9 000
Goodwill: accumulated impairment loss (-A) W2 4 000
Equipment: accumulated impairment loss (-A) W2 2 250
Vehicles: accumulated impairment loss (-A) W2 750
Impairment of assets within the cash-generating unit

W1: Impairment loss of CGU C

CA of CGU 6 000 + 2 000 + 4 000 12 000

RA of CGU Given (3 000)
Impairment loss of CGU 9 000

580 Chapter 11
 Gripping GAAP Impairment of assets

CA Impairment CA
W2: Impairment loss allocated to individual assets before IL allocated after IL
Calculation C C C
Goodwill Goodwill is impaired first 4 000 (4 000) 0
Equipment 6 000/ 8 000 x 5 000 remaining impairment 6 000 (3 750) 2 250
Vehicles 2 000/ 8 000 x 5 000 remaining impairment 2 000 (1 250) 750
Remaining impairment = 9 000 ± 4 000
12 000 (9 000) 3 000

Notes:
x If a CGU contains goodwill, the first round of impairment allocations is always against this goodwill.
x After impairing the goodwill, there was still a remaining impairment (C9 000 ± C4 000 = C5 000) that needed to
be allocated to the remaining scoped-in assets. All assets in this example were scoped-in assets.

6.2.2 If we know an individual asset’s recoverable amount

If one (or more) of the individual assets within a CGU show signs of being impaired, the entity must
try to determine its recoverable amount. If this individual asset's recoverable amount is determinable
and found to be less than its carrying amount, this individual asset must be impaired.
See IAS 36.66

If this CGU:
x does not contain goodwill, it is not essential to process the impairment on this individual asset
before calculating and allocating any impairment loss on the CGU; but if it
x does contain goodwill, it is essential to process the impairment on this individual asset before
calculating and allocating any impairment loss on the CGU. See IAS 36.97-8

For consistency, all solutions to the examples in this chapter will be approached in a way that first
processes the individual asset impairments (if any), before any impairment on the cash-
generating unit is calculated and allocated. See IAS 36.97-98

6.2.3 If we know one of the amounts relating to an individual asset’s recoverable amount

Recoverable amount is the higher of value in use and fair value less cost of disposal. The nature
of CGUs means that 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 16: Allocation of impairment loss (no goodwill):

± some individual recoverable amounts known ± multiple allocation
The following details apply to a cash- generating unit, in which all individual assets were
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

Chapter 11 581
Gripping GAAP Impairment of assets

Although the recoverable amount of the building is unknown, we know that its fair value less costs of
disposal (FV-CoD) is C3 600.
Required: For each asset in the CGU, calculate its impairment loss and its final carrying amount.

Solution 16: 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, this example shows the plant being impaired before
calculating and allocating the impairment on the CGU.
x We are given the building's FV-CoD of C3 600. We will thus need to make sure that the building's
CA does not drop below this amount. This limitation led us to have a second round of allocations.
Answer:
The plant is impaired by C1 000, leaving it with a carrying amount of C5 000 (W1 and W3)
The equipment is impaired by C960 (667 + 293), leaving it with a carrying amount of C2 040 (W3)
The vehicles are impaired by C640 (444 + 196), leaving it with a carrying amount of C1 360 (W3)
The building is impaired by C400, leaving it with a carrying amount of C3 600 (W3).

W1: Impair individual assets where RA is known CA RA Impairment of individual assets

Plant C6 000 C5 000 C1 000

W2: Impairment loss on CGU C

CA of CGU, after individual asset impairments Prior CA: 15 000 ± IL: 1 000 14 000
RA of CGU Given (12 000)
Impairment loss (IL) of CGU 2 000

W3: Allocation of the CGU impairment loss (2 000) to the individual assets

CA before Impairment CA after

First round of allocation IL on CGU loss allocation IL on CGU
CGU impairment to be allocated W2 2 000
Assets already fully impaired / not impaired 5 000 N/A 5 000
x Plant 6 000 ± 1 000«VHH: 5 000 N/A NOTE 1 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
x Building 4 000 / 9 000 x 2 000; but limited to 400 4 000 (400) NOTE 2 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

x Plant 6 000 ± 1 000 «VHH: 5 000 N/A NOTE 1 5 000
x Building 4 000 ± 400 «VHHDOORFDWLRQDERYH 3 600 N/A NOTE 2 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
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

582 Chapter 11
 Gripping GAAP Impairment of assets

2. Although we did not know the RA of the building, we know 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), and since we know we may not reduce its
CA to below C3 600, we must limit the IL allocation to C400.
As a result of this limitation, there needs 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 building, the building is fully impaired and thus
the second round of allocations now also excludes the building (i.e. the plant and the building are
excluded in the second round of allocations).

6.2.4 If the CGU contains scoped-out assets and liabilities

IAS 36 Impairment of assets applies to all assets except certain scoped-out assets (see
section 1) and liabilities:
x These scoped-out assets (and liabilities) are included in
A CGU may include
WKHFDOFXODWLRQRIWKH&*8¶VFDUU\LQJDPRXQWZKLFKLV scoped-out assets.
WKHQFRPSDUHGZLWKWKH&*8¶VUHFRYHUDEOHDPRXQWWR
x A CGU's CA and RA includes any
determine whether the CGU is impaired.
scoped-out assets; but
x However, an impairment of a scoped-out asset is not x A CGU impairment is never
measured in terms of IAS 36 but in terms of its own allocated to a scoped-out asset
VWDQGDUGLQVWHDG HJLQYHQWRU\LVPHDVXUHGDWµWKHORZHURIFRVWDQGQHWUHDOLVDEOHYDOXH¶
in terms of IAS 2 Inventory) and thus any impairment (or impairment reversal) relating to
the CGU must not be allocated to these assets (or liabilities).

Example 17: Allocation of impairment loss (with goodwill)

- with scoped out assets and some individual RAs known
A cash-generating unit (CGU) 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 (none of the individual
assets have been revalued), 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

Solution 17: Allocation of impairment loss (with goodwill)

± with scoped out assets; some individual RAs known
Comments:
x The RA of the vehicle was known and was less than its CA and was thus impaired. Since the CGU
contains goodwill, it is essential that we impaired this vehicle first. See W1.
x $IWHULPSDLULQJWKHYHKLFOHZHUHFDOFXODWHWKH&*8¶VFDUU\LQJDPRXQWDQGFRPSDUHLWWRWKH&*8¶V
recoverable amount. This CGU was found to be impaired. See W2.
x We first allocate the CGU's impairment against goodwill, if it exists. See W3, first round.
x Only if there is a remaining unallocated CGU impairment do we allocate it against the remaining
scoped-in assets in the CGU. This CGU included scoped-out assets (inventory). Although the CA
and RA of a CGU is calculated by including scoped-out assets, we do not allocate a CGU's
impairment to scoped-out assets (see section 1 for the scoped-out assets). See W3, second round.
Impairments of
W1: Impair individual assets where necessary CA RA individual assets
Vehicle C4 000 C2 800 C1 200

W2: Impairment loss on CGU

CA of CGU, after individual asset impairments Prior CA: 12 000 ± IL: 1 200 (W1) C10 800
RA of CGU Given (8 000)
Impairment loss of CGU 2 800

Chapter 11 583
 Gripping GAAP Impairment of assets

W3: Allocation of the CGU impairment loss (2 800) to the individual assets

CA Impairment loss CA
before IL allocation after IL

First round of allocation:

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 2 2 800
x Building 5 000 / 5 000 x 800 5 000 (800) NOTE 2 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 does not involve an allocation of the impairment:
a) against goodwill, because it was already fully impaired.
b) against inventory, because it is a scoped-out asset.
c) against vehicles, because it has already been impaired to its recoverable amount (see W1).
The remaining impairment is thus entirely allocated to the building.

Remember that intangible assets with indefinite useful lives, intangible assets not yet available
for use, and goodwill must be tested every year for possible impairments, even if there is no
indication that it is impaired. They may be tested at any stage during the year so long as they
are tested at the same time every year (see section 3.1.1).

The fact that they must be tested every year is important when deciding when to test a CGU
for impairment because, if the CGU contains one or more of these assets, it means the CGU
will have to be tested annually in the same way, assuming the individual recoverable amounts
for these assets cannot be calculated (P.S. the recoverable amount for goodwill can never be
calculated individually). See IAS 36.66

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

If the CGU contains intangible asset with an indefinite useful life, then it is possible that a prior
recent, detailed recoverable amount calculation could be used, assuming three criteria are met
(see section 3.1.1). See IAS 36.24

Similarly, 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 WKHXQLW¶V
current recoverable amount is less than its current carrying amount is remote. IAS 36.99

584 Chapter 11
 Gripping GAAP Impairment of assets

6.3 Impairment reversals relating to cash generating units (IAS 36.119 & 122-125)
6.3.1 Calculating impairment loss reversals relating to CGUs
Allocating an
If we find we need to reverse an impairment loss relating to a
impairment loss
cash-generating unit (CGU), we start by calculating the total reversal:
impairment loss reversal that we think we need to recognise. x Allocate first to all assets
We do this by subtracting the recoverable amount of the CGU on a pro rata basis (but
from the carrying amount of the CGU (we may not necessarily making sure that the new
CA doesn’t exceed the lower
be able to recognise this total impairment reversal due to the of HCA & RA)
limitation, which will be explained below). x Never allocate to goodwill!

After calculating the total impairment loss reversal that we expect to recognise, we then allocate
this total to each of the scoped-in 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 scoped-in assets relative to the
carrying amount of the CGU in total. However, we leave goodwill out of this allocation
calculation entirely because an impairment of goodwill may never be reversed. See IAS 36.124 - .125

Now, when allocating the total impairment loss to the individual scoped-in 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:
An IL reversal is
x Recoverable amount; and recognised:
x Carrying amount, had no impairment loss been recognised x in P/L if cost model is used;
in prior years. x in P/L, and possibly also in OCI
- if the cost model is used, this is 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. ThiVLVGRQHDVDµVHFRQGURXQGDOORFDWLRQ¶ ZKLFK
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 XSSHUOLPLWRQWKLVDVVHW¶VFDUU\LQJDPRXQWZHFRXOGRQO\DOORFDWHDQLPSDLUPHQW
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 (see
section 5) also apply to a CGU (see section 6.3.2). These principles are that, when we use the:
x cost model (see section 5.2)
- the impairment reversal is always recognised in profit or loss as income.
x revaluation model (see section 5.3)
- 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 further impairment reversal is then recognised as income in other comprehensive
income (i.e. the portion that increases the carrying amount above depreciated cost«
WKRXJKQHYHUDERYHµGHSUHFLDWHGIDLUYDOXH¶).

Chapter 11 585
 Gripping GAAP Impairment of assets

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 about IL reversals:
of 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 a prior year (historical carrying
amount): in the case of the cost model, this historical 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).
Worked example 5: Impairment loss reversals ± cost model
If our actual carrying amount before the reversal is C80 and the recoverable amount is C110,
we have a potential impairment loss of C30, but:
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).

ACA: 80 Increase (20): allowed HCA: 100 Increase (10): disallowed RA: 110

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).

ACA: 80 Increase (30): allowed RA: 110 Not applicable HCA: 120

When 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 18: Impairment and reversal thereof (no goodwill) ± cost model
On 31 December 20X4, as a result of a government ban on a product produced by Outlaw 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 18: 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

CA before Impairment CA after
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

586 Chapter 11
Gripping GAAP Impairment of assets

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)
W5: 31 December 20X5: Allocation of reversal of impairment to individual assets
CA before Impairment CA after
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 had it not
previously been impaired i.e. it is limited to its 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 (TXLSPHQW¶VHCA (depreciated cost) is C800 000 (given), but the CA after the imp. reversal was only C750 000 (W5)
x Plant¶VHCA (depreciated cost) is C2 400 000 (given), but the CA after imp. reversal was only C2 250 000 (W5).

Example 19: 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.
This was the first time that there had ever been an indication of an impairment.
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:
a) Calculate the impairment in 20X4 and how much should be allocated to each asset.
b) Calculate the impairment reversal in 20X5 and how much should be allocated to each asset.

Solution 19: Impairment and reversal thereof (with goodwill) ± cost model

a) The impairment in 20X4 is C8 000 000 (W1), of which C2 000 000 should be allocated to goodwill,
C2 250 000 to plant and C3 750 000 to buildings (W2).

b) The impairment loss reversal in 20X5 is C2 400 000 (W4), of which C900 000 is allocated to plant and
C1 500 000 is allocated to buildings (W5).

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

Chapter 11 587
 Gripping GAAP Impairment of assets

W2: 31 December 20X4: Allocation of CGU impairment loss to individual assets

CA before Impairment CA after
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

W3: 31 December 20X5: Carrying amount (before reversal of impairment) C

Goodwill Impaired to nil end 20X4 (W1) 0
Plant Impaired to 750 000 end 20X4 (W1), so: 750 000 ± (750 000 ± 0) / 5 x 1 year 600 000
Building Impaired to 1 250 000 end 20X4 (W1), so: (1 250 000 ± 0) / 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 on cash-generating unit
Carrying amount Given or W3 1 600 000
Less recoverable amount Given (4 000 000)
Impairment reversal (income) (2 400 000)

W5: 31 December 20X5: Allocation of CGU's impairment reversal to individual assets

CA before Impairment CA after
reversal reversed reversal
Goodwill Prior goodwill impairments may never be reversed 0 0 Note 1 0
Plant 0.6mil/1.6mil x 2 400 000 impairment reversal 600 000 900 000 Note 2 1 500 000
Building 1.0mil/1.6mil x 2 400 000 impairment reversal 1 000 000 1 500 000 Note 2 2 500 000
1 600 000 2 400 000 Note 2 4 000 000
Notes (W3) (W4)

1. Impairments of goodwill may never be reversed.

2. Impairments of all other scoped-in assets may be reversed, but the reversal is limited on an individual asset
basis to what its CA would have been had it not previously been impaired i.e. HCA (depreciated cost). In this
example, the reversal was not limited because the reversal did not increase the CA above the HCA
(depreciated cost) .
x 3ODQW¶V HCA was: (3 000 000 ± 0) / 5 x 4 = 2 400 000, but the CA after imp. reversal was only
C1 500 000 (W5)
x %XLOGLQJ¶VHCA was: (5 000 000 ± 0) / 5 x 4 = 4 000 000, but the CA after imp. reversal was only
C2 500 000 (W5).

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 a 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 or may
not be higher than historical carrying amount (depreciated cost).

588 Chapter 11
 Gripping GAAP Impairment of assets

When using the revaluation model, an impairment loss reversal may be recognised in profit or loss
(P/L) and in other comprehensive income (OCI):
x as income in profit or loss to the extent that it increases the DVVHW¶V carrying amount (actual
carrying amount) up to its historical carrying amount (depreciated cost):
Debit accumulated impairment losses & Credit impairment loss reversal income (P/L)
x as income in other comprehensive income (i.e. the revaluation surplus account) to the extent that
it increases the carrying amount above historical carrying amount (depreciated cost):
Debit accumulated impairment losses & Credit revaluation surplus (OCI).

Notice in the above journals that any increase above historical carrying amount (i.e. depreciated
cost) is recognised in other comprehensive income as a credit to revaluation surplus. Please
also note that we debit the accumulated impairment loss account instead of debiting the cost
account. This is EHFDXVHWKHFRVWDFFRXQWZRXOGFXUUHQWO\UHIOHFWWKHDVVHW¶VIDLUYDOXHDQGWKXV
a debit to this account would result in it reflecting an arbitrary balance.
Example 20: Impairment reversal 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 (RUL)
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
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 DVVHW¶Vuseful 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 20A: 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).

Chapter 11 589
Gripping GAAP Impairment of assets

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

Notes:
(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 RA 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
CA before impairment Imp reversal CA after impairment
reversal allocation reversal
(W1)
1
Goodwill N/A N/A N/A
2
Machine (152/592 = 25.7% 6) 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
592 000 108 000 5 700 000
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 20B: 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

590 Chapter 11
Gripping GAAP Impairment of assets

Solution 20C: 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.

1/1/20X1 Debit Credit

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: Accumulated depreciation (-A) 135 000
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
31/12/20X4
Depreciation ± factory (P/L: E) (CA: 350 000-0) / 7 remaining yrs x 1 50 000
Factory: Accumulated depreciation (-A) 50 000
Factory building depreciated annually
Revaluation surplus (OCI) 35 000 / 7 remaining yrs x 1 5 000
Retained earnings (Equity) 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: Accumulated depreciation (-A) 40 000
Factory building depreciated annually
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
Revaluation surplus (OCI) 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)

Chapter 11 591
 Gripping GAAP Impairment of assets

Note: If you scribble down the ledger accounts (posting these 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
ORVVUHYHUVDOWRµFRVW¶HYHQWKRXJKSDUWRIWKHUHYHUVDOLVFUHGLWHGWRUHYDOXDWLRQVXUSOXV± the entire reversal is
GHELWHGWRµ$FF,/¶ 
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 Goodwill and corporate assets

6.4.1 Overview

The previous sections in this chapter have referred to CGUs as being the smallest grouping of
assets generating independent cash inflows. CGUs include a variety of assets (and sometimes
liabilities), including goodwill and corporate assets. The previous sections referred to the
existence of goodwill in the CGU and how its existence affects the allocation of a CGU impairment
or CGU impairment reversal. However, these previous sections have not yet explained how
goodwill or corporate assets come to be included in the CGU. Let us now consider this.
x Goodwill and its allocation to a CGU is explained in section 6.4.2; and
x Corporate assets and their allocation to a CGU is explained in section 6.4.3.

6.4.2 Goodwill and its allocation to a CGU

When testing a cash-generating unit (CGU) for impairment, one must include any goodwill asset
that the CGU benefits from.

Goodwill can be internally generated, or it can be purchased (e.g. goodwill arising from a
business combination). It is only purchased goodwill that may be recognised as an asset
(internally generated goodwill is always expensed). This goodwill asset reflects the economic
benefits expected from the assets that were acquired in the business combination but were not
able to be separately recognised ± it is often described as reflecting the value of the synergies
arising from the related business combination. Goodwill is not able to generate cash flows
independently of other assets, but it may improve the cash inflows of one or more CGU.

If a goodwill asset is recognised, it must be allocated to the CGU or CGUs that are expected to
benefit from the synergies arising from the acquisition. Where more than one CGU benefits from
the goodwill, the goodwill allocation could be done based on the relative carrying amounts of the
affected CGUs, or using whatever method best reflects the extent to which we think the goodwill
benefits the various CGUs.

In some cases, it is not possible to allocate goodwill to one of more of the individual CGUs
without the allocation being arbitrary, in which case the goodwill must be allocated to the smallest
group of CGUs where such an allocation makes sense and is not considered to be an arbitrary
allocation. In such cases, the group of CGUs to which goodwill has been allocated gets tested
for impairment (i.e. rather than the individual CGUs).

Sometimes, by the end of the period in which the acquisition (e.g. business combination)
occurred, the fair value of the identifiable assets and liabilities acquired have not yet all been
confirmed. This would mean that, at this reporting date, these acquired assets and liabilities would
all still be measured at provisional fair values and thus the goodwill (a balancing figure), would
also be provisional. These provisional values must be finalised within 12 months of acquisition
date (IFRS 3.45). This delay may mean that the allocation of goodwill to the CGUs is only possible
when these values are finalised. See IAS 36.85 and IFRS 3.45

592 Chapter 11
 Gripping GAAP Impairment of assets

6.4.3 Corporate assets and their allocation to a CGU (IAS 36.100 - 102)

When testing a cash-generating unit (CGU) for impairment, one must include any corporate
assets that are capable of being allocated on a reasonable and consistent basis to that unit.

Like goodwill, a corporate asset cannot generate cash flows independently of other assets.
However, whereas goodwill may improve the cash inflows of either a single or multiple CGUs,
corporate assets are, by definition (see pop-up), assets that affect the cash inflows of multiple CGUs.

Thus, the primary characteristics of corporate assets (e.g. head

Corporate assets are
office buildings) are that:
defined as:
x µWKH\ GR QRW JHQHUDWH FDVK IORZV LQGHSHQGHQWO\ RI RWKHU x assets other than goodwill
assets or groups of assets; and
x that contribute to the
x their carrying amounts cannot be fully attributed to the CGU future cash flows
XQGHUUHYLHZ¶IAS 36.100 (extract) x of both the:
- cash generating unit
Examples of corporate assets include research and
under review and
development centres and head office assets, such as a head
- other cash generating
office building, IT software, computer and telephone systems.
units. IAS 36.6

A head office building, for example, does not generate cash inflows on its own, but if used by
both a manufacturing CGU and retail CGU, then we would call it a corporate asset because it
affects the cash inflows of multiple CGUs.

Corporate assets thus have the following primary characteristics:

x µWKH\GRQRWJHQHUDWHFDVKIORZVLQGHSHQGHQWO\RIRWKHUDVVHWVRUJURXSVRIDVVHWVDQG
x their carrying amounts cannot be fully DWWULEXWHGWRWKH&*8XQGHUUHYLHZ¶IAS 36.100 (extract)

Since a corporate asset does not generate its own cash inflows, we are unable to determine its
value in use and therefore we are unable to determine its recoverable amount (RA = higher of VIU
and FV-CoD). Thus, if we believe the corporate asset may be impaired, the only way we can check
is by comparing the carrying amount and recoverable amount of the CGUs to which it belongs. In
order to do this, we would need to have allocated the corporate asset to these CGUs.

Corporate assets are allocated to the CGUs to which they relate on a EDVLVWKDWLVµUHDVRQDEOH
DQGFRQVLVWHQW¶7KLVFRXOGLQYROYHDOORFDWLQJWKHFRUSRUDWHDVVHWWRLWVUHODWHG&*8VEDVHGRQ:
x their relative carrying amounts, or
x on some other basis (e.g. we might choose to allocate the corporate asset evenly across
the CGUs that use it, if these CGUs all use the corporate asset to an equal extent).

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 the recoverable
amount of the CGU. IAS 36.102 (reworded)

If the entity owns corporate assets that are unable to be allocated to its cash-generating units
RQDµUHDVRQDEOHDQGFRQVLVWHQWEDVLV¶WKHLPSDLUPHQWWHVWVZLOOVLPSO\EHSHUIRUPHGIURPWKH
bottom-up.

Essentially this means that we will do the impairment testing as follows:

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

Chapter 11 593
Gripping GAAP Impairment of assets

Example 21: Corporate assets

Elliot Limited has assets with a carrying amount of C9 100 000 at 31 December 20X5,
constituted by 3 cash-generating units and 2 corporate assets, details of which are as follows:
Carrying Recoverable
amount amount
Cash-generating units excluding corporate assets: C7 000 000 C5 300 000
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
Corporate assets: C2 100 000
x Head-office building 700 000 Unknown
x Computer platform 1 400 000 Unknown
Total assets C9 100 000

The head-office building supports all cash-generating units while the computer platform supports the
toothpaste and wire-brush units only.

Required: Calculate the amount of the impairment to be allocated to each CGU, assuming that:
A. the corporate assets can be allocated to the relevant cash-generating units: the building is to be allocated
WRWKH&*8¶VEDVHGRQWKHLUUHODWLYHFDUU\LQJDPRXQWVZKHUHDVWKHFRPSXWHUSODWIRUPLVXVHGHTXDOO\
by the toothpaste and wire-brush CGUs and should thus be allocated evenly between them.
B. the corporate assets cannot be allocated to the relevant cash-generating units.

Solution 21A: Corporate assets that are able to be allocated

Journals at year-end Debit Credit

Impairment loss (P/L: E) (a) 3 800 000
Building: accum. impairment loss (-A) (b) 272 310
Computer platform: accum. impairment loss (-A) (c) 804 598
Other assets: accum. impairment loss (-A) (d) See note below 2 723 092
Impairment of assets within the cash-generating unit
(a) W1: Total impairment: 1 200K + 1 400K + 1 200K = 3 800 000
(b) W2: Impairment of building: 66 667 + 96 552 + 109 091 = 272 310
(c) W2: Impairment of computer platform: 466 667 + 337 931 + 0 = 804 598
(d) W2: Impairment of other assets: 666 666 + 965 517 + 1 090 909 = 2 723 092

Note
This impairment of C2 723 092 relates to all the other assets contained in the three CGUs. However, in reality,
this impairment would be broken down further and journalised against each of the individual assets, but
insufficient information was given to do this. Had we known what the individual assets in the CGUs were, we
would have allocated the impairment to each in the usual way, based on their relative carrying amounts (see
section 6.2).

W1. Calculation of impairment loss per CGU CGU - T CGU - W CGU - R

Carrying amount of µother assets¶, 1 000 000 2 000 000 4 000 000
excl. corporate assets
Corporate assets:
x Building T: 700 000 x 1 000K / 7 000K * 100 000 200 000 400 000
W: 700 000 x 2 000K / 7 000K *
R: 700 000 x 4 000K / 7 000K *
x Computer platform T & W: 1 400 000 x 50%** 700 000 700 000 0
Total 1 800 000 2 900 000 4 400 000
Recoverable amount (600 000) (1 500 000) (3 200 000)
Impairment 1 200 000 1 400 000 1 200 000

*: 1 000 000 + 2 000 000 + 4 000 000 = 7 000 000

**: The computer platform was used equally by only the toothpaste and wire-brush CGUs, so 50% split.

594 Chapter 11
Gripping GAAP Impairment of assets

W2. Allocation of impairment loss per CGU

W2.1 Allocation of IL relating to CGU-T IL of CGU - T

To other assets 1 200K x 1 000K / 1800K 666 666
To corporate assets
x Building 1 200K x 100K / 1800K 66 667
x Computer platform 1 200K x 700K / 1800K 466 667
Total impairment of CGU-T 1 200 000

W2.2 Allocation of IL relating to CGU-W IL of CGU - W

To other assets 1 400K x 2000K / 2900K 965 517
To corporate assets
x Building 1 400K x 200K / 2900K 96 552
x Computer platform 1 400K x 700K / 2900K 337 931
Total impairment of CGU-W 1 400 000

W2.3 Allocation of IL relating to CGU-W IL of CGU - R

To other assets 1 200K x 4 000K / 4400K 1 090 909
To corporate assets
x Building 1 200K x 400K / 4400K 109 091
x Computer platform 1 200K x 0 / 4400K 0
Total impairment of CGU-R 1 200 000

Solution 21B: Corporate assets that are not able to be allocated

7KH LPSDLUPHQW WHVWLQJ RI WKLV HQWLW\¶V DVVHWV ZKHUH LWV FRUSRUDWH DVVHWV ZHUH LQFDSDEOH RI EHLQJ
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 ± 1 050K 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

Chapter 11 595
 Gripping GAAP Impairment of assets

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 22: 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
HVWLPDWHGWKHSODQW¶VUHFRYHUDEOHDPRXQWDW'HFHPEHU;WREH& 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
HVWLPDWHGWKHSODQW¶VUHFRYHUDEOHDPRXQWDW'HFHPEHU;WREH& 000.
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 22: Deferred tax consequences relating to impairment

31 December 20X4 Debit Credit
Deferred tax: income tax (A) W1: 1 400 (cr) ± 5 040 (dr) 3 640
Income tax expense (P/L: E) 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

Opening balance: 20X4 0 0 0 0
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)

596 Chapter 11
 Gripping GAAP Impairment of assets

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 PD\EHLQFOXGHGLQDQRWHVXSSRUWLQJWKHFDOFXODWLRQRISURILWRUORVV HJµSURILW

EHIRUHWD[¶QRWH RULQWKHQRWHVXSSRUWLQJWKHDVVHW HJWKHµSURSHUW\SODQWDQGHTXLSPHQW¶QRWH
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);
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)

$GGLWLRQDOGLVFORVXUHLVUHTXLUHGZKHQLPSDLUPHQWWHVWLQJLVSHUIRUPHGRQµFDVK-JHQHUDWLQJXQLWV¶
LQVWHDGRIµLQGLYLGXDODVVHWV¶. 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-JHQHUDWLQJ XQLW¶V UHFRYHUDEOH DPRXQW D GHVFULSWLRQ RI WKH
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;

Chapter 11 597
 Gripping GAAP Impairment of assets

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;
- 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 FRPSDUHGZLWKWKHHQWLW\¶VWRWDOFDUU\LQJDPRXQWof 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; and
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)

598 Chapter 11
Gripping GAAP Impairment of assets

9. Summary

The big picture – the chapter addresses the following questions:

x what is an indicator review? (See section 2)
x how do we calculate the recoverable amount? (See section 3)
x how do we process an impairment loss? (See section 4)
x how do we calculate and process an impairment loss reversal? (See section 5)
x how does this change if we are dealing with a cash-generating unit instead of an asset? (See section 6)
x What are the deferred tax consequences of impairments and reversals (See section 7)
x what are the disclosure requirements when there is an impairment loss or reversal thereof? (See section 8)

Indicator Review

Should occur annually, with the purpose of

identifying impairments

External information Internal information

x Significant decrease in value
x Significant adverse current/ future changes in
the market in which the asset is used
x Increase in market interest rates (decreases
value in use)
x Carrying amount of business net assets >
market capitalisation etc
x Obsolescence
x Physical damage
x Adverse current/ future changes in asset usage
x Actual profits/ cash flows worse than budgeted
x Net cash outflows or losses become apparent
when 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 SOFP: Greater of: ACA – RA:
x cost or fair value x value in use or x first debit RS: ACA>HCA
x less ‘accumulated x fair value less costs of disposal x then debit IL: HCA>RA
depreciation and Calculated if:
impairment losses’ x indicator review suggests
material impairment
x intangible asset that:
- has indefinite useful life
- is not yet available for use
- is goodwill

Fair value less costs of disposal Value in use

x The price that would be received to sell an
asset (or paid to transfer a liability)
x in an orderly transaction
x between market participants
x at the measurement date
x Less Disposal costs (excluding termination
benefits (IAS 19), finance costs and income
tax expense and restructuring costs)
The present value of estimated future cash
flows(pre-tax) from:
x Use and
x Disposal at end of useful life
Exclude the following cash flows:
x financing
x tax
x outflows in respect of obligations already
recognised as liabilities
x that relate to enhancements/restructurings
the entity is not yet committed to

Chapter 11 599
Gripping GAAP Impairment of assets

Value in use

Estimated future cash flows Appropriate discount rate

Use cash flows based on managements’ best
estimated projections:
x Short-term projections (less than 5 yrs):
approved budgets only
x Long-term projections (beyond 5 years):
extrapolate the approved budget using a
justifiable growth rate (generally stable/
declining growth rate below long-term average)
x Pre-tax
x Market-related risk-free rate
x Adjusted for risks specific to the asset
Foreign cash flows
x Discount using rate appropriate to that
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 Increasing CA up to HCA:
surplus) Debit:
Debit: Asset: accumulated impairment losses
Revaluation surplus (to the extent of the balance Credit:
therein) (OCI) Reversal of impairment loss (income: P/L)
Credit:
Asset: accumulated impairment losses Increasing CA above HCA:
Debit:
Decreasing CA below HCA: Asset: accumulated impairment losses
(e.g. if there was no RS bal or the RS bal has now Credit:
been reduced to nil because of the jnl above) Revaluation surplus (OCI)
Debit: Limit to 'Depreciated FV' (FV – AD)*
Impairment loss (expense: P/L) *
Credit:
Asset: accumulated impairment losses
*An increase above 'Depreciated FV' is possible
*When reducing the CA to RA under the RM, be but it would not be an impairment reversal. This
careful: Because, when using the RM, the CA should would be a revaluation increase, so although
already reflect the FV, we should only ever debit an the jnl would still involve a credit to
impairment loss expense if the costs of disposal are 'Revaluation surplus', the debit would be to
'not negligible'. If CA has not yet been adjusted to 'Asset: cost' (not 'Asset: accumulated
reflect FV, we must first reduce the CA to FV by 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
deducting the accumulated impairment loss).
This must be depreciated over the remaining
useful life of the asset.
A new depreciable amount is calculated (after
deducting the accumulated impairment loss, if
any).
This must be depreciated over the remaining
useful life of the asset

600 Chapter 11
 Gripping GAAP Impairment of assets

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 should be taken into account unless
the RA of the CGU cannot be measured
without taking the liabilities into account)
x Calc the CA of the CGU
x If the CA > RA = Imp loss
x The imp loss is allocated as follows:
 First to GW
 Then to each A in the CGU based on
their relative CAs within the CGU (ie
pro-rata)
But make sure the CA of each A in the CGU
does not drop below the greater of:
 FV-CoD
 VIU
 Zero
x If the allocation of the IL to certain assets
is limited, this excess unallocated IL must
be allocated in a 2nd/3rd etc round of
allocations until it has been completed
allocated
x Journals processed for each A in the CGU:
Follow the same approach used for
individual assets (see prior page)
x Calc the RA of the CGU (only the As in the
CGU should be taken into account unless
the RA of the CGU cannot be measured
without taking the liabilities into account)
x Calc the CA of the CGU
x If the CA < RA = Imp loss Reversal (if the
CGU had previously been impaired)
x The imp loss reversal is allocated as follows
 Never to GW
 Then to each scoped-in A in the CGU
based on their relative CAs within the
CGU (ie pro-rata)
But make sure the CA of each asset in the
CGU does not increase above:
 If CM used: its depreciated cost
 If RM used: its depreciated fair value
x If the allocation of an IL reversal to
certain assets is limited, the excess
unallocated IL reversal is allocated in a
2nd/3rd round
x Journals processed for each A in the CGU:
Follow the same approach used for
individual assets (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

If allocated to individual CGUs on If not able to be allocated to individual

reasonable basis
x Impairment test: compare ACA of CGU (incl.
portion of allocated corporate asset) to RA
CGUs on a reasonable basis
x Step 1: test individual CGUs for
impairment
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.

Abbreviations:
ACA = actual carrying amount
CA = carrying amount
CGU = cash generating unit
FV-CoD = fair value less costs of disposal
GW = goodwill
HCA = historical carrying amount
IL = impairment loss
OCI = other comprehensive income
P/L = profit or loss
RA = recoverable amount
RS = revaluation surplus
VIU = value-in-use

Chapter 11 601
 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 2021)

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 604
PART B: Discontinued operations 654

PART A:
Non-Current Assets Held for Sale
Contents: Page
A: 1 Overview 604
A: 2 Scope 605
A: 2.1 Non-current assets held for sale: scoped-out non-current assets 605
A: 2.2 Disposal groups held for sale: scoped-out items 606
A: 3 &ODVVLILFDWLRQDVµKHOGIRUVDOH¶RUµKHOGIRUGLVWULEXWLRQ¶ 606
A: 3.1 :KDWKDSSHQVLIVRPHWKLQJLVFODVVLILHGDVµKHOGIRUVDOH¶ +)6 RUµKHOGIRUGLVSRVDO¶ +)' " 606
A: 3.2 The classification criteria in general 606
A: 3.2.1 Overview 606
A: 3.2.2 Classification as held for sale 606
A: 3.2.2.1 The core criterion 606
A: 3.2.2.2 The further supporting criteria 607
A: 3.2.2.3 Meeting the criteria 607
A: 3.2.2.4 An intention to sell may be an indication of a possible impairment 608
A: 3.2.3 Classification as held for distribution 608
A: 3.2.4 Comparison of the classification as held for sale and held for distribution 608
A: 3.3 Criteria when a completed sale is expected within one year 609
A: 3.4 Criteria when a completed sale is not expected within one year 610
A: 3.5 Criteria when an NCA or DG is acquired with the intention to sell 610
A: 4 Measurement: individual non-current assets held for sale 611
A: 4.1 Overview 611
A: 4.2 Measurement if the sale is expected within one year 612
A: 4.3 Measurement when the NCA is not expected to be sold within one year 612
A: 4.4 Measurement when the NCA is acquired with the intention to sell 612
A: 4.5 Initial and subsequent measurement of a NCAHFS or NCAHFD 613
A: 4.5.1 Initial measurement (on the date of classification) 613
A: 4.5.2 Subsequent measurement (after the date of classification as held for sale) 613
A: 4.6 Measurement principles specific to the cost model 614
A: 4.6.1 The basic principles when the cost model was used 614
Example 1: Measurement on date classified as HFS (previously: 615
cost model)
Example 2: Re-measurement after classified as HFS (previously: cost 616
model): impairment loss reversal is limited
Example 3: Measurement on date classified as a NCAHFS and Re- 618
measurement of NCAHFS: reversal of impairment loss
with limitation (previously: cost model)
A: 4.6.2 The tax effect when the cost model was used 622
Example 4: Tax effects of classification as NCAHFS and the cost model 622

602 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

A: 4.7 Measurement principles specific to the revaluation model 623

A: 4.7.1 The basic principles when the revaluation model was used 623
Example 5: Measurement on date classified as HFS (was revaluation model) 624
Example 6: Re-measurement of a NCAHFS (was revaluation model): 626
further impairments and reversals of impairments
Example 7: Re-measurement of a NCAHFS (was revaluation model): 628
prior revaluation expenses may not be reversed
A: 4.7.2 The tax effect when the revaluation model was used 630
Example 8: Tax effect of reclassification and the revaluation model 630
A: 4.8 Measurement implications of a change to a plan to sell / distribute 634
A: 4.8.1 Overview 634
A: 4.8.2 If a NCAHFS subsequently fails to meet the HFS or HFD classification criteria 634
A: 4.8.3 If a NCAHFS subsequently becomes a NCAHFD, or vice versa 634
Example 9: Re-PHDVXUHPHQWRIDVVHWVQRORQJHUFODVVLILHGDVµKHOGIRUVDOH¶ 635
A: 4.9 0HDVXUHPHQWLQYROYLQJµVFRSHG-out non-FXUUHQWDVVHWV¶ 635
Example 10: Asset falling outside the measurement scope of IFRS 5 636
A: 5 Disposal groups held for sale 636
A: 5.1 Overview of disposal groups 636
A: 5.2 Identification of disposal groups 637
A: 5.3 Classification, presentation and disclosure of disposal groups held for sale or distribution 637
A: 5.4 Measurement of disposal groups held for sale in general 637
A: 5.4.1 Initial measurement of disposal groups held for sale 638
Example 11: Disposal group held for sale ± impairment allocation 639
Example 12: Disposal group held for sale ± initial impairment 640
A: 5.4.2 Subsequent measurement of a disposal group held for sale 642
Example 13: Disposal group held for sale ± subsequent impairment 643
Example 14: Disposal group held for sale ± subsequent impairment reversal 644
A: 5.5 Measurement of disposal groups not expected to be sold within one year 645
A: 5.6 Measurement of disposal groups acquired with the intention to sell 646
A: 5.7 Measurement of disposal groups when there is a change to the plan to sell or distribute 646
A: 5.7.1 Overview 646
A: 5.7.2 If a DG subsequently fails to meet the HFS or HFD classification criteria 646
A: 5.7.3 If a DGHFS subsequently becomes a DGHFD, or vice versa 647
A: 6 Presentation and disclosure: non-current assets (or disposal groups) held for sale or distribution 647
A: 6.1 Overview 647
A: 6.2 In the statement of financial position 648
A: 6.3 In the statement of financial position or notes thereto 648
A: 6.4 In the statement of other comprehensive income and statement of changes in equity 648
A: 6.5 Comparative figures 648
A: 6.6 Other note disclosure 649
A: 6.6.1 General note 649
A: 6.6.2 Change to a plan of sale 649
A: 6.6.3 Events after the reporting date 649
Example 15: Disclosure of non-current assets held for sale 649
A Summary 651
PART B:
Discontinued Operations
B: 1 Introduction to discontinued operations 654
B: 2 Identification of a discontinued operation 654
B: 3 Measurement of a discontinued operation 655
B: 4 Disclosure of a discontinued operation 655
B: 4.1 Profit or loss from discontinued operation 655
B: 4.2 Cash flows relating to a discontinued operation 657
B: 4.3 Comparative figures 657
B: 4.4 Changes in estimates 657
B: 4.5 Other note disclosure 657
B: 4.5.1 Components no longer held for sale 657
B: 4.5.2 If the discontinued operation also meets the definition of µKHOGIRUVDOH¶ 658
B Summary 658

Chapter 12 603
 Gripping GAAP Non-current assets held for sale and discontinued operations

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 µnon-current Part A explains how to
assets held for sale’, this term actually refers to: classify, measure,
x individual µQRQ-current assets KHOGIRUVDOH¶ NCAHFS); present and disclose:

x a group of items held for sale, where this group
sometimes includes not only non-current assets but
also current assets and directly related liabilities,
called DµGLVSRVDOJURXSKHOGIRUVDOH¶ '*+)6 ; and
x Individual assets held for sale
(NCAHFS); and
x Disposal groups held for sale
(DGHFS) … these are just groups
of assets held for sale.

x individual µnon-current assets held for distribution WR RZQHUV¶ RU µdisposal groups held for
distribution WRRZQHUV¶ DVRSSRVHGWREHLQJKHOGIRUsale) (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 individual assets (and disposal Important definitions:
groups) classified as held for sale is almost identical to the
A non-current asset (NCA) is
method of accounting for those held for distribution. For
defined as:
this reason, we will not discuss individual non-current x an asset that is not a CA. IFRS 5 App A
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)
wherever this chapter refers to something as being held See IFRS 5 Appendix A

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
 to be disposed of,
When we talk about how to account for items that are held
 by sale/ otherwise,
for sale (or held for distribution), we are talking about their:
 together as a group in a single
x Classification; transaction,
x Measurement; x and liabilities directly associated
x Presentation and disclosure. with those assets that will be
transferred in the transaction.
Classification: See IFRS 5 Appendix A

We apply certain criteria when deciding if an asset or disposal group should be classified as µheld for
sale¶ (HFS) and there is a similar set of criteria when deciding if an asset or disposal group should
be classified as µheld for distribution¶ +)' . These criteria will be the same whether we are
considering how to classify an individual non-current asset or a disposal group. See section A:3.

604 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

Measurement:
Assets/disposal groups µheld for sale¶ are measured at the lower of carrying amount and fair value
less costs to sell. Assets/disposal groups µheld for distribution¶ are measured, in a similar way, at
the lower of carrying amount and fair value less costs to distribute. See section A:4.

However, some non-current assets that are held for sale (or distribution) are not affected by the
measurement requirements stipulated in IFRS 5. We will call these non-current assets the µVFRSHG-
out non-FXUUHQWDVVHWV¶7KHVHDUHOLVWHGLQVHFWLRQ$

Sometimes we have a µdisposal group’ (rather than an individual non-current asset) that is held for
sale (or distribution). This would also be measured at the lower of carrying amount and fair value
less costs to sell (or to distribute). However, when measuring this disposal group, we will need to
remember that the items in our disposal groups 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.
IFRS 5’s measurement
The mixture of items in our disposal groups makes it slightly requirements only apply
more complex because the IFRS 5 measurement requirements to certain NCAs.
only apply to certain non-current assets ± they do not apply to They do not apply to:
current assets, liabilities or to scoped-out non-current assets. x Certain scoped-out NCAs
Due to this slight complexity, we will first study the measurement x Current assets
of individual non-current assets held for sale/ distribution x Liabilities
(section A:4) and then study disposal groups held for sale/ distribution section A:5.

Presentation and disclosure:

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. See section A:6

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/ distribution;
x Section A: 4 explains how we measure individual NCAs held for sale/ distribution;
x Section A: 5 explains how we measure disposal groups (DGs) held for sale/ 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 model x Investment property measured
under the FV model (IAS 40)
(IAS 40 Investment property) x Agricultural NCAs measured at
x Agricultural non-current assets measured at fair value less ‘FV less costs to sell’ (IAS 41)
x Assets for which FV may be difficult
costs to sell (IAS 41 Agriculture) to determine (e.g. DT assets)
See IFRS 5.5
x Assets for which fair values may be difficult to 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

Please note that these non-current assets are scoped-out only from the measurement requirements of
IFRS 5. Thus, a non-current asset held for sale would still be subject to the classification, presentation
and disclosure requirements of IFRS 5. See IFRS 5.2

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 Gripping GAAP Non-current assets held for sale and discontinued operations

A: 2.2 Disposal groups held for sale: scoped-out items

Disposal groups are simply groups of assets, or groups of The IFRS 5 measurement
requirements do not apply
assets and related liabilities, that are to be disposed of in a
to (scoped-out items):
single transaction. This means that some disposal groups may
actually not contain any non-current assets (e.g. the disposal x Scoped-out non-current assets
x Current assets
group could be made up of entirely current assets, or current x Liabilities.
assets with liabilities). However, IFRS 5 will only apply if the
disposal group contains at least one non-current asset.

This means that if the disposal group contains at least one non-current asset, IFRS 5¶VFODVVLILFDWLRQ
measurement, presentation and disclosure requirements would then apply. However, ,)56 ¶V
measurement requirements will not apply to items in the group that represent liabilities, current assets
and specific non-current assets that are scoped out from the IFRS 5 measurement requirements
(see section A: 2.1). /HW¶VFDOOWKHVHWKUHHWKHµscoped-out items¶

Please note that these µscoped-out items¶ (scoped-out non-current assets, all current assets and
all liabilities) are scoped-out only from the measurement requirements of IFRS 5. In other words,
the measurement requirements do not apply to these µscoped-out items¶ ... but the classification,
presentation and disclosure requirements of IFRS 5 will still apply to them.

A: 3 &ODVVLILFDWLRQDVµHeld fRU6DOH¶ RUµ+HOGIRU'LVWULEXWLRQ¶(IFRS 5.6-14)

A: 3.1 What happens if something is classified as µHeld for Sale¶ (HFS) or

µHeld for Disposal¶ +)' ? (IFRS 5.6-14)
If a non-current asset (NCA) or disposal group (DG) meets the criteria to be classified as µKHOGIRU
VDOH¶ (HFS) RUµKHOGIRUGLVWULEXWLRQ¶ +)' , this individual NCA or DG must be:
x measured LQWHUPVRI,)56 XQOHVVLWLVDµVFRSHG-RXWDVVHW¶± see section A: 2);
x presented separately in the statement of financial position DV µKHOG IRU VDOH¶ DQG SUHVHQWHG XQGHU
µFXUUHQWDVVHWV¶ (i.e. a plant held for sale will no longer be included in property, plant and equipment);
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 µheld for sale¶ depends on
whether certain criteria are met. Similarly, when to classify a non-current asset (NCA) or disposal
group (DG) as µheld 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 them separately (see section A:3.2.4 for a
summary that compares these two set of criteria).
A NCA/ DG is classified as
A: 3.2.2 Classification as held for sale HFS when we expect that:
x its carrying amount
A: 3.2.2.1 The core criterion x will be recovered principally through
x a sale transaction rather than
The core criterion driving the classification of a non-current asset through continuing use. IFRS 5.6
1&$ RUGLVSRVDOJURXS '* DVµKHOGIRUVDOH¶LVWKDWLWPD\RQO\ P.S. There are more criteria to be met
be classified as held for sale when most of its carrying amount before we can say we expect the CA
is expected to be recovered through the inflows from the sale of to be recovered mainly through sale.
the NCA or DG rather than from the use thereof. See IFRS 5.6

If we look at this criterion carefully, we can see that a non-current asset (NCA) or disposal group
(DG) may continue to be used E\WKHHQWLW\DQG\HWVWLOOEHFODVVLILHGDVµKHOGIRUVDOH¶7KHLPSRUWDQW
issue is whether the inflows from the sale thereof are greater than from the use thereof: if the inflows
from the sale thereof are greater, then it is classified as µheld for sale¶.

606 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

If we look at this criterion again, we can also see that a non-current asset (NCA) or disposal group (DG)
that is to be abandoned FRXOGQRWSRVVLEO\EHFODVVLILHGDVµKHOGIRUVDOH¶EHFDXVHDQDEDQGRQPHQWPHDQV
no sale would take place and thus none of its carrying amount would be recovered through a sale.

Abandonment means just that ± the non-current asset (NCA) or An abandoned asset
disposal group (DG) will be discarded, dumped, ditched, can never be classified
discontinued, closed down etc. In other words, there is no future as HFS because:
sale involved. Its carrying amount will therefore be recovered x it is not going to be sold, thus
through future use (until date of abandonment) after which it will x its CA will be recovered principally
through continuing use. See IFRS 5.13
not be sold but will be thrown away instead. See IFRS 5.13

Please note that assets that have been permanently taken out
Abandoned assets include
of use and for which there is no plan to sell (e.g. the entity plans
NCAs or DGs that are to be:
to drop it off at the local dump) are treated as abandoned.
However, assets that have simply been temporarily taken out of x used to the end of their economic life,
or
use are not accounted for as abandoned assets. See IFRS 5.14
x closed rather than sold. IFRS 5.13

A: 3.2.2.2 The further supporting criteria

Now, look at the core criterion again (see above). Before we conclude that the carrying amount of
the NCA or DG is expected to be recovered mainly through a sale rather than through usage, the
following two criteria must also be met:
The CA of the NCA/DG will
x the asset must be available for sale immediately, in its
be said to be recovered
present condition and based on normal terms, and mainly through a sale
x the sale must highly probable of occurring. See IFRS 5.7 transaction if:
x it is available for immediate sale
To prove that the sale is highly probable, a further five criteria - in its present condition
must be met: - subject only to terms that are
x the appropriate level of management must be committed usual and customary for sales of
such NCAs (or DGs) and
to the plan to sell;
x its sale must be highly probable.
x an active programme to try and sell the asset has begun; IFRS 5.7

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

A: 3.2.2.3 Meeting the criteria

It is quite difficult to meet all these supporting criteria and thus a non-current asset (NCA) or disposal
JURXS '* WKDWLVLQWHQGHGWREHVROGZLOORIWHQIDLOWREHFODVVLILHGDVµKHOGIRUVDOH¶

However, if all these criteria are met before reporting date, the non-current asset (NCA) or disposal
group (DG) must be FODVVLILHGDVµKHOGIRUVDOH¶ in those financial statements.

If these criteria are met after the reporting date, but before the financial statements are issued, the
non-FXUUHQWDVVHW 1&$  RU GLVSRVDOJURXS '*  LV QRW FODVVLILHGDV µKHOG IRU VDOH¶ LQ WKDW VHW RI
financial statements, but certain disclosures are still required (see section A:6.6.3). 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 µheld 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.

Chapter 12 607
 Gripping GAAP Non-current assets held for sale and discontinued operations

A: 3.2.2.4 An intention to sell may be an indication of a possible impairment

The mere intention to sell a non-current asset ± even if it is The mere intention to sell a
not classified as µKHOGIRUVDOH¶ ± may be an indication that NCA or DG could be:
the asset could be impaired (see chapter 11). x an indication of a possible impairment
x If the intention to sell is considered an indication of a
possible impairment, we would need to calculate the recoverable amount. See IAS 36.9
x 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) that is to A NCA/ DG is classified as HFD
EHGLVWULEXWHGWRWKHHQWLW\¶VRZQHUVmay only be classified as when:
µKHOGIRUGLVWULEXWLRQ¶LIWKHHQWLW\LVFRPPLWWHGWRthis plan. x the entity is committed
x to distribute the NCA/DG
x to the owners. IFRS 5.12A (slightly reworded)
To prove the entity is committed to the distribution :
P.S. There are more criteria to be met
x the NCA or DG must be µDOUHDG\DYDLODEOHIRU immediate before we can say the entity is
GLVWULEXWLRQ¶LQLWVµpresent condition¶ and committed to the distribution.

x it must be highly probable the distribution will occur.

The entity is committed to the
distribution if the:
A distribution is highly probable if:
x NCA/DG is available for immediate
x Actions taken to complete the distribution have begun; and distribution in its present condition;
and
x Remaining actions to complete the distribution: x the distribution is highly probable.
 are expected to be completed within a year of the IFRS 5.12A (slightly reworded)

classification as held for distribution; and

 suggest that it is unlikely that:
- the distribution will be withdrawn, or that
- there will be any significant changes to the distribution.

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:
A NCA/DG is classified as HFS if its CA will be recovered
mainly through its sale rather than through its use.
This is the case if the following criteria are met:
x it is available for immediate sale (in its
present condition and at normal terms); &
x the sale thereof is highly probable.
Held for distribution:
A NCA/DG is classified as HFD if the entity is
committed to distributing it to the owners.
This is the case if the following criteria are met:
x it is available for immediate distribution
(in its present condition); &
x the distribution thereof is highly probable.

See IFRS 5.8 See IFRS 5.12A

Highly probable sale:
A sale is highly probable if (5 criteria):
x appropriate level of mgmt is committed to a plan to sell;
x an active programme to sell has begun;
x it must be actively marketed at a reasonable
price relative to its FV;
x the sale is expected within 1 yr of date of classification
as HFS (unless longer period is permitted per IFRS 5.9)
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.
Highly probable distribution:
A distribution is highly probable if (3 criteria):
x actions to complete the distribution have begun
x the distribution is expected to occur within 1
yr of the date of classification as HFD
x actions required to complete the distribution
should suggest that it is unlikely that:
- significant changes to the distribution will
be made; or that
- the distribution will be withdrawn

608 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

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
EHFODVVLILHGDVµKHOGIRUVDOH¶WKHFDUU\LQJDPRXQWRIWKH recovered mainly via a
asset is to be recovered mainly through a sale sale, ALL the following
transaction than through continuing use. See IFRS 5.6 criteria must be met:
x the NCA is immediately available
for sale in its present condition
In order to prove this, we must meet all of the following and on 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 commitment to the sale
must be available for immediate sale: from appropriate level of mgmt,
- in its present condition, - Active programme to find a buyer &
complete the sale must’ve begun,
- subject only to terms that are usual and - Sale expected within 1 year of
customary for sales of such asset. IFRS 5.7 classification,
- Selling price reasonable
For an asset to be available for immediate sale, the compared to its FV, and
- Unlikely to be significant changes
entity must currently have both the intention and made to the plan of sale
ability to transfer the NCA (or DG) to a buyer in its 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
Highly probable is
x The sale must be highly probable: IFRS 5.7 defined as:
For the sale to be considered highly probable, there are five x significantly more likely than
sub-criteria to be met: x probable. IFRS 5 App A

- The appropriate level of management must have Probable is defined as:

x more likely than not IFRS 5 App A
committed itself to a sales plan:
Management, with the necessary authority to approve 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 µheld 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
VHSDUDWHO\FODVVLILHGDVDµQon-FXUUHQWDVVHWKHOGIRUVDOH¶

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 WKH VXEVLGLDU\¶V 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)

Chapter 12 609
 Gripping GAAP Non-current assets held for sale and discontinued operations

A: 3.4 Criteria when a completed sale is not expected within one year (IFRS 5.9 & App B)

On occasion, we might FODVVLI\VRPHWKLQJDVµKHOGIRUVDOH¶HYHQ A NCA/ DG may still be

though the sale is not expected to be completed and recognised classified as HFS even if
as a sale within one year. This happens when: the sale is not expected
within 1 year on condition that:
x the expected delay is caused by events or circumstances
x the delay is beyond the entity’s
EH\RQGWKHHQWLW\¶VFRQWURODQG control; and
x there is sufficient evidence that the entity remains committed x there is sufficient evidence that the
to its plan to sell the asset. entity is still committed to the sale.
Certain extra criteria must be met
depending on the scenario.
There are three different scenarios that IFRS 5 identifies as See IFRS 5.9 & IFRS 5 App B
possibly leading to a sale taking longer than one year. For each
scenario, certain extra criteria will need to be met for the one-year requirement to fall away. See IFRS 5 App B
A firm purchase
Scenario 1: The entity initially commits to selling a non-current commitment is defined as:
asset (or disposal group), but it has a reasonable expectation x an agreement with an unrelated party,
that someone other than the buyer will impose conditions that x binding on both parties and usually
will delay the completion of the sale. legally enforceable, that:
- specifies all significant terms,
In this scenario, the NCA (or DG) is classified as µheld for sale¶ if: (incl. the price and timing); and
- includes a disincentive for non-
x the entity is unable to respond to these expected conditions µuntil performance that is large
a firm purchase commitment is actually obtained’, and enough that performance is
highly probable. IFRS 5 Appendix A (reworded)
x µa firm purchase commitment is highly probable within one year¶.
See IFRS 5.B1(a)

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 µheld for sale¶ if:
x the entity has timeously taken the necessary actions to respond to the changed conditions, and
x the entity expects that the delaying conditions will be µfavourably resolved¶. See IFRS 5.B1(b)

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 µreasonable price¶
bearing in mind the µchange in circumstances¶, and
x the asset must be available for immediate sale in its present condition and at normal terms and
the sale must be highly probable (i.e. para 7 and 8 must be met). See IFRS 5.B1(c)

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 (or

A NCA/ DG acquired with
disposal group) exclusively with the view to its subsequent the intention to sell must
disposal. In this case, the non-current asset must be classified be classified as HFS if:
DVµKHOGIRUVDOH¶LPPHGLDWHO\RQDFTXLVLWLRQGDWHLI x the sale is expected within 1 yr; and
x the one-year requirement is met (unless a longer period is x any criteria in para 7 & para 8 that
allowed by paragraph 9 and the related appendix B ± see aren’t met on date of acquisition will
be met within a short period (+-3m).
section A: 3.4 above); and See IFRS 5.11

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.

610 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

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 in the life of an individual non-current follows:
asset (NCA) that is classified as µheld for sale¶ (HFS): x before classification:
x before the date of classification (clearly irrelevant to - measured in terms of its previous standard
newly acquired assets) when it is measured in terms of x on or after the classification date:
its previous relevant standard (e.g. IAS 16); and - measured in terms of IFRS 5:
- initial measurement
x on and after the date of classification when it is measured
- subsequent measurement.
in terms of IFRS 5.

Before the NCA is classified as µheld for sale¶, it 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 means that:
x on initial acquisition, the asset would have been recorded at cost; and
x subsequently, the asset would have been measured under either 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.

On and after the date that the NCA is classified as µheld for sale¶, the measurement principles in IFRS 5
must be followed. These measurement principles can be separated into:
x initial measurement; and
Fair value is defined as:
x subsequent measurement.
x the price that would be received to sell
Essentially, initial measurement of a NCA that is classified an asset (or paid to transfer a liability)
as µheld for sale¶ (i.e. on the date that it is classified as such) x in an orderly transaction
is at the lower of its: x between market participants
x at the measurement date. IFRS 5 App A
x carrying amount (CA), and its
x fair value less costs to sell (FV-CtS). See IFRS 5.15

Please QRWHWKDWµIDLUYDOXH¶DQGµFRVWVWRVHOO¶DUHERWKGHILQHGWHUPV VHHSRS-ups).

The subsequent measurement of a NCA from the date that it is classified as µheld for sale¶ 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).

The principles described above apply equally to NCA that is Costs to sell are defined as:
classified as µheld for distribution¶ with the only difference x the incremental costs
being that we measure it at the lower of its: x directly attributable to the disposal
x carrying amount (CA), and its of an asset (or disposal group),
x fair value less costs to distribute (FV-CtD). See IFRS 5.15A x excluding finance costs and income
tax expense. IFRS 5 Appendix A

We will first explain the basic measurement principles in terms of the normal situation where the
asset is expected to be sold within one year.

After this we will look at how these principles may need to be modified if the asset µheld for sale¶ is:
x expected sell later than one year from date of classification, or
x acquired with the intention to sell.

Thereafter, we will look at the detailed steps involved in the initial measurement and subsequent
measurement of a non-current asset held for sale.

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A: 4.2 Measurement if the sale is expected within one year (IFRS 5.15; .20-21 & .25)

Non-current assets that are classified as µheld for sale¶ are measured on date of classification
and then on subsequent reporting dates at the lower of its:
x carrying amount (CA), and
Measurement of a NCAHFS:
x fair value less costs to sell (FV-CtS). See IFRS 5.15
x the lower of:
Assets that are µheld for sale¶ are not depreciated (or - carrying amount; and
- FV less costs to sell.
amortised). This is because their carrying amount is
x depreciation/ amortisation ceases.
principally made up of the future income from the sale of See IFRS 5.15 & .25

the asset rather than the use thereof (note: depreciation is

a reflection of 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 µheld for sale¶ after the date on which it was classified
as µheld 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

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
it may be necessary (depending on materiality) to measure the expected within 1 year:
µFRVWVWRVHOO¶DWWKHLUSUHVHQWYDOXH7KHJUDGXDOLQFUHDVHLQWKH
x the costs to sell may need to be
present value due to the passage of time shall be recognised present valued. See IFRS 5.17
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 a NCA that is acquired with the intention NCAs acquired with the
of it being sold follows similar principles as above, but with a intention of being sold are
measured:
slight modification. The modification is explained below.
x using the same principles = lower of:
- carrying amount; and
Normally, the acquisition of a NCA would first be classified as, - FV less costs to sell.
for example, an item of property, plant and equipment, initially x where the CA is what it would have
measured at cost and subsequently depreciated and tested for been if it wasn’t classified as HFS.
impairment, after which it would then being reclassified and Thus, generally, it will be
remeasured DVµKHOGIRUVDOH¶. effectively measured at:
x FV-CtS. See IFRS 5.15 & .16

However, in the case of a NCA acquired with the express intention of it being sold, the NCA is
immediately classified and measured as a µheld for sale¶ asset.

This LQLWLDOPHDVXUHPHQWRID1&$WKDWLVLPPHGLDWHO\FODVVLILHGDVµKHOGIRUVDOH¶LVWKHORZHURILWV
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)

Interestingly, tKLVPHDVXUHPHQWSULQFLSOHQRUPDOO\UHVXOWVLQWKH1&$EHLQJLQLWLDOO\PHDVXUHGDWµIDLU
YDOXHOHVVFRVWVWRVHOO¶, because this will normally be lower than the carrying amount it would have
KDGLILWKDGQRWEHHQFODVVLILHGDVµKHOGIRUVDOH¶ This can be explained as follows:
x The normal approach is to initially measure a NCA at cost. This means that, on initial recognition,
WKH1&$ZRXOGKDYHKDGDFDUU\LQJDPRXQWHTXDOWRFRVWLIKDGQRWEHHQFODVVLILHGDVµKHOGIRUVDOH¶
x The µFRVW¶RIDFTXLULQJa NCA normally reflects LWVµIDLUYDOXH¶RQSXUFKDVHGDWH. If this is the
case, since selling costs are normally expected to be incurred when selling a NCA, its fair value
less costs to sell would normally be less than fair value and thus less than its cost (i.e. the
µcarrying amount on date of purchase had the item not been classified as HFS¶ = µcost¶ = µfair
value¶«and thus µfair value less costs to sell’ will be the lower amount).

612 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

A: 4.5 Initial and subsequent measurement of a NCAHFS or NCAHFD (IFRS 5.18-21 & 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 UHFODVVLI\LQJWKHDVVHWWRµKHOGIRUVDOHGLVWULEXWLRQ¶ asset one last time in terms of its
(i.e. before transferring it to a HFS/ HFD account): Measure previous IFRS
the asset one last time in terms of its previous IFRS. x Reclassify (i.e. transfer this asset
to a new HFS (or HFD) account)
For example: An asset that was previously an item of x On reclassification date: measure
property, plant and equipment (PPE), would be measured the asset to the lower of:
- CA and
XVLQJ,$6¶V cost model or revaluation model, as follows: - FV-CtS (or FV – CtD)
- Cost model: depreciate it to date of classification
and then check for any indication of an impairment; or
- Revaluation model: depreciate it 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 WKHDVVHWIURPLWVSUHYLRXVFODVVLILFDWLRQWRµKHOGIRUVDOH¶
)RUH[DPSOHWUDQVIHUWKHDVVHWIURPSURSHUW\SODQWDQGHTXLSPHQWWRµKHOGIRUVDOH¶
x After WUDQVIHUULQJ LHFODVVLI\LQJ WRµKHOGIRUVDOH¶
Measure the asset in terms of IFRS 5, which requires measuring it to the lower of:
- Carrying amount (CA) (measured according to its previous standard, e.g. IAS 16), 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 ¶V measurement
requirements. These are referred to as the scoped-out non-current assets (See section A:2.1).

Worked example: Measurement of µscoped-out¶ non-current assets

If the non-current asset held for sale was previously investment property that was measured
under the fair value model:
x LWZLOOEHUHFODVVLILHGWRµKHOGIRUVDOH¶DQG
x LWZLOOEHSUHVHQWHGDQGGLVFORVHGDVµKHOGIRUVDOH¶EXW
x investment property measured under the fair value model is one of the scoped-out non-
current assets and thus ,)56¶VPHDVXUHPHQWSULQFLSOHVZLOOQRWDSSO\WRWKLVSURSHUW\, which
means that LWZLOOFRQWLQXHWREHPHDVXUHGXQGHU,$6¶VIDLUYDOXHPRGHO See IFRS 5.5

A: 4.5.2 Subsequent measurement (after the date of classification as held for sale)

7KHPHDVXUHPHQW SULQFLSOHV DIWHU FODVVLILFDWLRQ DV µKHOG IRU Steps to subsequent

VDOH¶DUHTXLWHVLPSOH measurement:

x The asset is no longer depreciated or amortised. x Stop depreciating/ amortising

x Re-measure to lower of
x The asset continues to be periodically re-measured to - CA and
the lower of carrying amount and its latest fair value less - FV-CtS
costs to sell. See IFRS 5.1; .15 & .25 Subsequent re-measurement may result in
x impairment loss; or
x impairment loss reversal.
The re-measurements may result in either:
x an impairment loss, or Impairment losses reversed
x an impairment loss reversal. See IFRS 5.20-21 are limited to:
x the cumulative impairment
The impairment loss reversed may need to be limited since losses recognised in terms of:
impairment losses reversed must not exceed the cumulative - IAS 36 (i.e. prior to
impairment losses that have previously been recognised: classification as HFS); plus
- IFRS 5. See IFRS 5.21
x in terms of IAS 36 Impairment of assets; and
x in terms of IFRS 5 Non-current assets held for sale and Discontinued operations. See IFRS 5.21

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What is meant by ‘carrying amount’?

See IAS Plus Guide on IFRS 5: 2008, example 4.1F
https://www.iasplus.com/en/publications/global/guides/pub1923 accessed 9 October 2019
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 been recognised under IAS 36’. See IAS Plus Guide Example 4.1F
(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 of µSURSHUW\SODQWDQGHTXLSPHQW¶WKDWare to

EHUHFODVVLILHGDVµKHOGIRUVDOH¶8QGHUIAS 16 Property, plant and equipment, these assets would
have been measured using either the cost model or revaluation model and thus we will separately
discuss the implication of the IFRS 5 measurement principles on each of these models.

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 LVFODVVLILHGDVµKHOGIRUVDOH¶

x immediately before FODVVLI\LQJ WKH DVVHW DV µKHOG IRU VDOH¶ measure the asset in terms of its
previous standard «LQWKLVFDVHXVLQJWKHcost 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 (i.e. reclassify it);
x immediately after reclassifying WKHDVVHWDVµKHOGIRUVDOH¶measure the asset in terms of IFRS 5:
x Measure it to the lower of:
- Carrying amount (CA), and
- 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 µIDLU YDOXH OHVV FRVWV WR VHOO¶ ZKHQHYHU DSSURSULDWH. This may
require the recognition of an impairment loss or an impairment loss reversal. See IFRS 5.20-22

Impairment losses are always recognised as expenses in profit or loss whereas impairment losses
reversed are recognised as income in profit or loss. See IFRS 5.37

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 the 'HORLWWH¶V
interpretation explained in section A:4.5.2) and its FV-CtS. See IFRS 5.15

Furthermore, impairment loss reversals are limited WRWKHDVVHW¶Vcumulative 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

Selling costs (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).

614 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

Example 1: Measurement on date classified as HFS (previously: cost model)

$OOFULWHULDIRUFODVVLILFDWLRQRIDSODQWDVDµKHOGIRUVDOH¶ 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 NCAHFS 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 under IFRS 5) are a fair
indication of expected costs of disposal (used for measuring PPE under IAS 36).

Solution 1: Measurement on date classified as HFS (previously: cost model)

Comment: Remember the following:
x Before reclassifying PPE to NCAHFS, the PPE¶VFDUU\LQJDPRXQW &$ PXVWEHFKHFNHGIRULPSDLUPHQWVE\
comparing it to its recoverable amount (RA). This impairment test is per IAS 36 Impairment of assets.
The 33(¶V recoverable amount (RA) is the greater of:
- value in use (VIU); and
- fair value less costs of disposal (FV-CoD).
If the 33(¶VCA is greater than its RA, then the PPE is impaired in terms of IAS 36 Impairment of assets (i.e.
we process an impairment loss to reduce the 33(¶VCA to its RA).
x On reclassification as NCAHFS, the asset may need to be impaired again, this time in terms of IFRS 5, which
requires the NCAHFS to be immediately remeasured to the lower of its CA and FV-CtS.
This extra impairment would be needed if the PPE was transferred into NCAHFS at a CA that had been
LPSDLUHGWRD5$UHIOHFWLQJ9,8 HJ,IWKH33(¶V&$ZDVDQGLWV9,8ZDVDQG)9-CoD was 75, then
WKH33(¶V&$ZRXOGEHLPSDLUHGWREHLQJLWV5$UHSUHVHQWHGE\9,8%XWWKLVDVVHWRQFHFODVVLILHGDV
NCAHFS, would then need to be impaired again, under IFRS 5, to 75, being its FV-CtS).
x Compare A, B and C: These examples show how an impairment may need to be recognised under IAS 36
(while still classified as 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 36.
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 IAS 36.
This CA transferred to NCAHFS is greater than 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 IAS36.
The CA transferred to NCAHFS equalled its FV-CtS and thus the NCAHFS is not impaired under IFRS 5.

A B C
W1: Measurement of plant before reclassification: (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 &:
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
IAS 36
PPE: Impairment Impairment of PPE on 1 January 20X3 0 8 000 15 000
PPE: Carrying amount just A: CA 80 000 ±IL 0 80 000 72 000 65 000
before transfer B: CA: 80 000 ± IL: 8 000
C: CA: 80 000 ± IL: 15 000

W2: Measurement of plant on reclassification: (i.e. measured as NCAHFS: IFRS 5)

NCAHFS: CA Transfer from 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
NCAHFS: Carrying amount just after reclassification 65 000 65 000 65 000

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Journals: A B C
1 January 20X3 Dr/(Cr) Dr/(Cr) Dr/(Cr)

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 impairment loss (-A) O/bal : 0 + Impairment loss (W1) N/A 8 000 15 000
NCAHFS: Plant: acc impairment 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: Plant: acc impairment loss (-A) (15 000) (7 000) N/A
Impairment loss after classification as ‘held for sale’
Explanatory notes:
x Depreciation stops from the date it is classified as NCAHFS (i.e. it is now measured in terms of IFRS 5).
x The journals above make use of two separate NCAHFS accounts showing:
x its carrying amount, FDOFXODWHGDVµFRVW± DFFXPXODWHGGHSUHFLDWLRQ¶ (NCAHFS: Plant: Cost-AD),
x any accumulated impairment losses relating to the asset (NCAHFS: Plant: Accumulated imp losses)
IFRS 5 does not require us to do this, but having a separate account for accumulated impairment losses is useful
because future impairment loss reversals on a NCAHFS are limited to total accumulated impairment losses
(accumulated impairment losses in terms of IAS 36 + accumulated impairment losses in terms of 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
This example follows on from example 1B, where a plant met aOOFULWHULDIRUFODVVLILFDWLRQDVµKHOGIRU
VDOH¶RQ January 20X3, on which date it had a carrying amount of C80 000, measured under the cost model:
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 UHFRJQLVHDµUHYHUVDORILPSDLUPHQWORVV¶ LQFRPH ± but remember 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 ,)56 OHW¶VFDOOWKLVWKHµILUVWOLPLW¶ ,
- the new carrying amount of the NCAHFS must continue to be measured at the lower of the CA and
FV-CtS OHW¶VFDOOWKLVWKHµVHFRQGOLPLW¶ 

616 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

Journal: A B
Dr/(Cr) Dr/(Cr)
30 June 20X3
NCAHFS: accumulated impairment losses (-A) W1.3 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’

W1: Subsequent measurement after reclassification as NCAHFS (see above 1B): See IFRS 5.15 and 5.20-.21

W1.1: Remeasurement to FV-CtS on reporting date: See IFRS 5.20-.21

A B
Latest FV-CtS: 30/06/X3 A: 70 000 ± 2 000 = 68 000 68 000 85 000
B: 90 000 ± 5 000 = 85 000
Less: Prior carrying amount: 01/01/X3 Lower of CA & FV-CtS: 01/01/X3 (65 000) (65 000)
CA 72 000 vs FV-CtS 65 000
(See example 1B W2)
Impairment loss reversal (proposed) 3 000 20 000

W1.2: First limit:

Impairment loss reversal: limited to prior accumulated impairment losses: See IFRS 5.21

A B
Impairment loss reversal (proposed) W1.1 3 000 20 000
Limited to: prior accumulated PPE imp loss: 8 000 (ex 1B: W1) + (15 000) (15 000)
impairment losses NCAHFS imp loss: 7 000 (ex 1B: W2)

Excess disallowed N/A 5 000

Impairment loss reversal (proposed) A: not limited (3 000 ± excess: N/A)* 3 000 15 000
after first limitation: * B: limited (20 000 ± excess: 5 000)
(20 000 Increase > 15 000 AIL) *
* Explanatory notes regarding the first limitation:
The prior accumulated impairment loss recognised on this asset, before the reversal, was 15 000. Thus:
A. The reversal of 3 000 is not limited (because the accumulated 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 (accumulated impairment loss 15 000 ± reversal of impairment loss 3 000).
B. The reversal of 20 000 is limited (because the accumulated impairment loss before the reversal
is 15 000, which is less than 20 000, and thus the potential reversal of 20 000 is limited to 15 000).
No further reversals are possible in the future.

W1.3: Second limit:

New carrying amount: limited to carrying amount of PPE on date of reclassification: See IFRS 5.15
A B
NCAHFS: CA on 01/01/X3 was: See example 1B 65 000 65 000
Plus: proposed 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 reclassified, i.e. Depreciated cost: (80 000) (80 000)
ignoring imp losses: 01/01/X3 Cost: 100 000 ± AD: 20 000
Excess disallowed There is no excess N/A N/A

Therefore, impairment loss reversal is: Not limited * 3 000 15 000

Overview of what we did in W1.1, W1.2 and W1.3:

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).

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The following working is an alternative working that combines the previous W1.1, W1.2 and W1.3:

W1 (Alternative): Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 &.20-.21
A B
Latest measurement of NCAHFS on reporting date (30/06/X3), at the lower of: 68 000 80 000
x Latest FV - CtS: 30/06/X3 A: 70 000 ± 2 000 = 68 000 68 000 85 000
B: 90 000 ± 5 000 = 85 000
x CA on date reclassified, but ignoring i.e. Depreciated cost on 01/01/X3 80 000 80 000
impairment losses: 01/01/X3 A&B: Cost: 100 000 ± AD: 20 000

Less: Prior carrying amount: 01/01/X3 Lower of CA & FV-CtS: 01/01/X3 (65 000) (65 000)
CA 72 000 vs FV-CtS 65 000
(See example 1B W2)
Impairment loss reversal 3 000 15 000

Check: 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 accumulated PPE AIL: 8 000 + (15 000) (15 000)
impairment losses (AIL) NCAHFS AIL: 7 000 (See example 1B)
Excessive reversal disallowed N/A N/A

P.S. 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
LPSDLUPHQWORVVHVLQWKHDERYHWDEOHLVRQO\DµFKHFN¶ on your workings.

Example 3: Measurement on date classified as a NCAHFS and

Re-measurement of NCAHFS (previously: cost model):
 reversal of impairment loss with 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: C100 000 (purchased on 1 January 20X1)
x Accumulated impairment loss: C18 000 (processed on 31 December 20X1)
x Accumulated depreciation: C18 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.

AlOFULWHULDIRUFODVVLILFDWLRQDVDµQRQ-FXUUHQWDVVHWKHOGIRUVDOH¶DUHPHW on 8 January 20X3 on which date

the following values were established:
x Value in use: C75 000
x Fair value less costs to sell (IFRS 5) & Fair value less costs of disposal (IAS 36): C60 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 Part A shows the initial measurement of a non-current asset held for sale (NCAHFS).
x Parts B, C and D show the subsequent measurement of a non-current asset held for sale (NCAHFS),
explaining, under three different scenarios, the limit placed on impairment loss reversals.
x The previous example (example 2) also showed how to limit an impairment loss reversal, but example 3 differs
in that it now shows how to apply the limit to an impairment loss reversal when the item of PPE already had a
balance on its accumulated impairment loss account (i.e. from impairments processed in terms of IAS 36 during
the years before it was classified as held for sale).

618 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

x Part B, C and D show that an impairment loss reversal on a NCAHFS is limited in two ways:
 it is limited to the total of all prior cumulative impairment losses (IAS 36 impairments + IFRS 5 impairments), and
 the carrying amount of a NCAHFS may not exceed the carrying amount calculated as if it had never been
impaired/ classified as HFS.
The first limit is based on IFRS 5.21.
The second limit is based on IFRS 5.15, which requires a NCAHFS to be measured at the lower of:
 carrying amount (interpreted to mean CA as at reclassification date, ignoring impairment losses, thus, when
using the cost model, is calculated as: cost ± accumulated depreciation on reclassification date); and
 fair value less costs to sell.

Solution 3A: Measurement on date classified as HFS (previously: cost model)

Comments on Part A:
This example shows the 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).
x Immediately before the transfer to NCAHFS (8 Jan 20X3), the plant is measured one last time as PPE (i.e.
per IAS 16 and IAS 36): the CA of C64 000 is less than its RA of C75 000 (VIU: C75 000 > FV-CoD: C60 000)
and thus there is no further impairment of the plant whilst it is classified as PPE.
However, since the plant had previously been impaired (by C18 000) in terms of IAS 36, the fact that RA
exceeds its CA means an impairment loss reversal must be processed. This PPE was measured under the
cost model and thus the reversal may need to be limited (i.e. 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.

Journals: 8 January 20X3 Debit Credit

PPE: Plant: accum. imp. loss (-A) W1 11 000
Impairment loss reversal ± PPE (I) 11 000
Impairment on plant is reversed

PPE: Plant: acc imp. loss (-A) O/bal (given): 18 000 ± IL reversal: 11 000 (W1) 7 000
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)

W1: Measurement of plant before classification as NCAHFS: (IAS 16 & IAS 36) C
PPE: CA: 08/01/X3 Cost: 100 000 ± AD: 18 000 ± AIL: 18 000 Note 1
64 000
PPE: RA: 08/01/X3 Higher of VIU: 75 000 and FV-CoD: 60 000 (75 000)
PPE: Impairment reversal 08/01/X3 RA > CA: In terms of IAS 36, there is no further impairment, 11 000
but there is an impairment loss reversal

PPE: Carrying amount just before transfer CA: 64 000 + ILR: 11 000 (i.e. measured in terms of IAS 16) 75 000
Note 1: depreciation between 01/01/X3 to 08/01/X3 was ignored because immaterial

W2: Measurement of plant on classification as NCAHFS: (IFRS 5) C

NCAHFS: CA 08/01/X3 Transfer from PPE: CA calculated in W1 75 000
NCAHFS: FV ± CtS 08/01/X3 Given (60 000)
NCAHFS: Impairment 08/01/X3 Balancing (Impairment under IFRS 5) 15 000
NCAHFS: CA after impairment CA: 75 000 ± IL: 15 000 60 000

Chapter 12 619
Gripping GAAP Non-current assets held for sale and discontinued operations

Solution 3B, 3C & 3D: Re-measurement of NCAHFS: reversal of impairment loss, with a
limitation (previously: cost model)
Comment:
x The solutions to Part B, C and D show 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 33(¶V
carrying amount, where this carrying amount is interpreted to mean the carrying amount on date of
reclassification, ignoring prior impairment losses (i.e. when using the cost model, µFRVW± accumulated
GHSUHFLDWLRQ¶ ± RULQRWKHUZRUGVµdepreciated cost¶) ± this limit is shown in W1.3. See IFRS 5.15
x Part B shows an impairment reversal that is not limited at all. (first limit and second limit)
x Part 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).
x Part D shows an impairment reversal that is limited by both the first and second limit.

Journals: B C D
Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
30 June 20X3
NCAHFS: Plant: acc impairment loss (-A) W1.3 or W1 (alternative) 15 000 20 000 20 000
Impairment loss reversal ± NCAHFS (I) (15 000) (20 000) (20 000)
Reversal of impairment loss when re-measuring the NCAHFS

W1: Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 and 5.20 -.21

W1.1: Remeasurement to FV-CtS on reporting date: See IFRS 5.20-.21

B C D
Latest FV-CtS: 30/06/X3 Given 75 000 82 000 85 000
Less Prior carrying amount: 08/01/X3 Lower of CA & FV-CtS: 08/01/X3 (60 000) (60 000) (60 000)
CA 75 000 vs FV-CtS 60 000
(See example 3A: W2)
Impairment loss reversal (proposed) 15 000 22 000 25 000

W1.2: First limit:

Impairment loss reversal: limited to prior accumulated impairment losses: See IFRS 5.21
B C D
Impairment loss reversal (proposed) W1.1 15 000 22 000 25 000
Limited to: prior accumulated PPE AIL: 7 000 (Calc 1) + (22 000) (22 000) (22 000)
impairment losses (AIL) NCAHFS AIL: 15 000 (Ex 3A W2)
Excess disallowed N/A N/A 3 000

Impairment loss reversal (proposed), See explanatory notes below: * 15 000 22 000 22 000
after first limitation: *See notes A: not limited (15 000 ± excess: 0)
B: not limited (22 000 ± excess: 0)
C: limited (25 000 ± excess: 3 000)

Calculation 1: PPE imp loss = AIL: 18 000 (given) ± IL: 11 000 (Ex 3A W1) = 7 000

* Explanatory notes regarding the first limitation:

The cumulative impairment loss recognised on this asset is 22 000 before the impairment loss reversal, thus:
B: The intended impairment loss reversal 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.
C: The intended impairment loss 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.
D: The intended impairment loss 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.

620 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

W1.3: Second limit:

New carrying amount: limited to carrying amount of PPE on date of reclassification See IFRS 5.15
B C D
NCAHFS: CA on 08/01/X3 was: Lower of CA 75 000 & FV-CtS 60 000 60 000 60 000 60 000
(Example 3A: W2)
Plus: Proposed imp 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 PPE on date i.e. Depreciated cost: (80 000) (80 000) (80 000)
reclassified, ignoring Cost: 100 000 ± AD: (100 000 ± 0) x
imp losses: 01/01/X3 10% x 2yrs
Excess disallowed B: Not limited N/A 2 000 2 000
See notes below
C & D: Limited
Thus, impairment loss reversal* B: IL reversal 22 000 ± 0 (not limited) 15 000 20 000 20 000
C & D: IL reversal of 22 000 ± excess
disallowed 2 000

* Explanatory 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 was limited by the second limit (W1.3).
x D was limited by both the first limit (W1.2) and also the second limit (W1.3).

The following is an alternative working that combines the previous W1.1 and W1.2 and W1.3:
W1 (Alternative): Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 &20-21

B C D
Latest measurement of NCAHFS on reporting date (30/06/X3), at 75 000 80 000 80 000
the lower of:
x Latest FV-CtS: 30/06/X3 Given 75 000 82 000 85 000
x CA on date reclassified, but i.e. Depreciated cost: 80 000 80 000 80 000
ignoring imp losses: 08/01/X3 Cost: 100 000 ± AD: (100 000 - 0)
x 10% x 2 yrs Note 1

Less Prior carrying amount Lower of CA and FV-CtS: 08/01/X3 (60 000) (60 000) (60 000)
(See Example 3A: W2)
Impairment loss reversal 15 000 20 000 20 000
Note 1: depreciation between 01/01/X3 to 08/01/X3 was ignored because immaterial
See IFRS 5.21
Check: The impairment loss reversal may not exceed prior cumulative impairment losses
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 IL Reversal disallowed See note below * N/A N/A N/A

P.S. 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
SULRUFXPXODWLYHLPSDLUPHQWORVVHVLQWKHDERYHWDEOHLVRQO\DSURRIRUDµcheck’ on your workings.

Further comments on example 3B, 3C and 3D:

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: C7 000 (AIL was 22 000 ± IL Reversal 15 000). However, WKHPD[LPXPµ,/ reversal¶that will be possible in
future is only C5 000. This is because the current CA of NCAHFS is C75 000, and thus a reversal in excess of
C5 000 would increase the CA above depreciated cost on date of classification of C80 000, which is not allowed
(i.e. the CA of PPE on date of classification calculated ignoring any impairment losses = Cost: 100 000 ± AD on
date of classification: 20 000).
 C&D: C2 000 (AIL was 22 000 ± IL Reversal 20 000). However, no further µ,/ reversal¶ is possible. This is
because the current CA of NCAHFS is C80 000, which equals its depreciated cost on date of classification (we
may not increase the CA of a NCAHFS above the CA of the PPE on date of classification = Cost: 100 000 ± AD
on date of classification: 20 000).

Chapter 12 621
 Gripping GAAP Non-current assets held for sale and discontinued operations

A: 4.6.2 The tax effect when the cost model was used

As soon as an asset is classified as held for sale, we stop depreciating it. However, the tax
authorities generally do not stop allowing tax deductions (assuming the cost of the asset was tax
deductible) simply because you have decided to sell the asset.

7KLV PHDQV WKDW WHPSRUDU\ GLIIHUHQFHV ZLOO DULVH GXH WR D FRPELQDWLRQ RI WKH DFFRXQWDQW¶V QLO
depreciation and any impairment losses or reversals FRPSDUHGZLWKWKHWD[DXWKRULW\¶VFRQWLQXHG
tax deductions (assuming the DVVHW¶V cost is tax deductible). When temporary differences arise,
we will need to recognise deferred tax.

The principles affecting the current tax payable and deferred tax balances are therefore exactly
the same as for any other non-current asset.

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 µKHOGIRUVDOH¶DUHPHWRQ-DQXDU\;IROORZLQJDGHFLVLRQ
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.
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%.
Required:
A. Calculate the current tax charge for 20X3 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

Answer:
x The current tax charge for 20X3 = C58 500 (W1)
x The deferred tax balance at 31 December 20X3 = C4 500 (W2)

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)
Taxable profits 195 000
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

(CA: 70 000 – FV-CtS: 65 000) (5 000) (1 500) Cr DT,
Dr TE
Depreciation/ tax allowance 0 (10 000)
Balance ± 31 December 20X3 65 000 80 000 15 000 4 500 Asset

622 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

Solution 4B: Journals

31 December 20X3 Debit Credit

Income tax expense (E) W1 58 500
Current tax payable: income tax (L) 58 500
Current tax payable (estimated)
Income tax expense (E) W2 1 500
Deferred tax: income tax (Asset is reduced) 1 500
Deferred tax adjustment

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 LV FODVVLILHG DV µKHOG IRU VDOH¶, we need to
follow these steps:
x Step 1: immediately before reclassifying WKH DVVHW DV µKHOG IRU VDOH¶ WKH DVVHW PXVW EH
measured using its previous revaluation model in terms of IAS 16:
- GHSUHFLDWHLWWRGDWHRIFODVVLILFDWLRQDVµKHOGIRUVDOH¶
- 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 WKH DVVHW DV µKHOG IRU VDOH¶ WKH DVVHW PXVW EH
measured in terms of IFRS 5:
- Measure it to the lower of:
- Carrying amount (CA), and
- 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-PHDVXUHWRµIDLUYDOXHOHVVFRVWVWRVHOO¶ZKHQHYHUDSSURSULDWH: this
may necessitate the recognition of an impairment loss or an impairment loss reversal.

An impairment loss recognised in terms of IFRS 5 is An impairment loss is

always recognised as an expense in profit or loss, even if always expensed in P/L
there is a related revaluation surplus balance (i.e. from a even if there is a
prior revaluation in terms of IAS 16). A revaluation surplus revaluation surplus!
balance existing on the date of reclassification to µheld 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 reversal is always an
recognised as income in profit or loss. See IFRS 5.37 income in P/L.
But it is limited in 2 ways:
7KH DPRXQW RI WKH UHYHUVDO LV OLPLWHG WR WKH DVVHW¶V  The IL reversal must never exceed
cumulative impairment losses recognised. See IFRS 5.21 the cumulative IL recognised in
terms of IAS 36 & IFRS 5

A further limitation is possible in that, when reversing an  The CA after the IL reversal must
never exceed the lower of CA (if the
impairment loss, the NCAHFS must always be measured at reval model was used, the CA is the
the lower of ‘depreciated FV’) and FV-CtS (see
interpretation in section A: 4.5.2)
x its µcarrying amount¶, and
x µfair value less costs to sell¶ See IFRS 5.15

The µcarrying amount¶ XVHG LQ WKH DERYH µIXUWKHU OLPLWDWLRQ¶ is measured on reclassification date,
calculated as if the asset had never been impaired (see interpretation explained in section A: 4.5.2).
:KHQWKHFRVWPRGHOZDVXVHGWKLVFDUU\LQJDPRXQWLVWKHµGHSUHFLDWHGFRVW¶RQUHFODVVLILFDWLRQGDWH
EXWZKHQXVLQJWKHUHYDOXDWLRQPRGHOLWLVWKHµGHSUHFLDWHGIDLUYDOXH¶RQUHFODVVLILFDWLRQGDWH See IFRS 5.15

Chapter 12 623
Gripping GAAP Non-current assets held for sale and discontinued operations

Example 5: Measurement on date classified as HFS

x previously: revaluation model
$QLWHPRISODQWPHDVXUHGXQGHU,$6¶VUHYDOXDWLRQPRGHOPHWDOOFULWHULDIRUFODVVLILFDWLRQDV
µKHOGIRUVDOH¶RQ-DQXDU\;7KHIROORZLQJinformation 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 7KHYDOXHLQXVHKDVDOZD\VEHHQJUHDWHUWKDQWKHSODQW¶VFDUU\LQJDPRXQWDQGWKHUHIRUHWKH
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.

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 when 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. on or after the asset has been classified as a NCAHFS), this
impairment loss is expensed, even if there is a revaluation surplus balance (see parts A and B).

Journals:
A B C
1 January 20X4 Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
PPE: Plant: acc. depreciation (-A) W1.1: Acc depr to 31/12/X3 15 000 15 000 15 000
PPE: Plant: cost (A) 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
Notice: There is no further depreciation on this asset.
Notes:
Note 1. We calculate the revaluation surplus balance (W3) immediately before WKH33(¶VILQDOUHYDOXDWLRQWRIDLU
value on 1/1/X4, since any drop in its value must first be set-off against this revaluation surplus 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.

624 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

Note 3. Even though a revaluation surplus balance remains after the revaluation on 1/1/X4 (see W3: A & B), any
subsequent impairment losses after the plant is reclassified as NCAHFS must be expensed (i.e.
impairments in terms of IFRS 5 are always expensed). See note 5 below.
Note 4. While the plant is PPE, we transferred the revaluation surplus to retained earnings over its useful life (i.e.
at the same rate as the asset is depreciated) but once the plant is a NCAHFS (from 1/1/X4), both
depreciation and this transfer must cease.
Note 5. The balance in the revaluation surplus on date of classification as a NCAHFS remains there until the
asset is disposed of, at which point it will be transferred to retained earnings.

W1: Measurement of plant before reclassification as NCAHFS (i.e. measured as PPE: IAS 16 & IAS 36)

W1.1 Revaluation in terms of IAS 16 A B C

PPE: CA: 01/01/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: 01/01/X3 Given 120 000 120 000 120 000
PPE: Acc. depr: 31/12/X3 (FV 120 000 ± RV: 0) / 8 remaining years (15 000) (15 000) (15 000)
PPE: CA: 01/01/X4 FV 120 000 ± AD 15 000 105 000 105 000 105 000
PPE: Incr/(decr): 01/01/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 (latest FV) 100 000 150 000 60 000

W1.2 Check for impairments in terms of IAS 16 & IAS 36 A B C

PPE: Carrying amt before impairment FV at 01/01/X4 (Given/ W1.1) 100 000 150 000 60 000
PPE: Recoverable amount: Higher 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: Impairment loss expense (IAS 36) RA is greater than CA N/A N/A N/A

Therefore, the CA just before the transfer on 01/01/X4

PPE: Carrying amt before impairment: FV at 01/01/X4 (Given/ W1.1) 100 000 150 000 60 000
Less: Impairment loss expense (IAS 36) See W1.2 (none were impaired) (0) (0) (0)
PPE: Carrying amt after impairment, just before transfer: 01/01/X4 100 000 150 000 60 000

W2: Measurement of plant on reclassification (i.e. measured as NCAHFS: IFRS 5)

(/RZHURIWKH33(¶V&$DQG)9-CtS) See IFRS 5.15 A B C
NCAHFS: CA: 01/01/X4 Tfr from PPE: W1.2 100 000 150 000 60 000
NCAHFS: FV-CtS: 01/01/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
NCAHFS: Impairment 01/01/X4 IFRS 5 Balancing see Note 3 & 5 above 9 000 20 000 20 000

NCAHFS: Carrying amount after impairment : 01/01/X4 CA - IL 91 000 130 000 40 000

W3: Revaluation surplus roll-forward A B C

Balance: 01/01/X3 Opening balance 0 0 0
Revaluation to FV: 01/01/X3 W1: FV 120 000 ± CA 80 000 40 000 40 000 40 000
Transfer to ret. earnings: 31/12/X3 40 000 / 8 yrs remaining (5 000) (5 000) (5 000)
Balance: 01/01/X4 Before transfer see Note 1 above 35 000 35 000 35 000
Revaluation to FV: 01/01/X4 W1 (5 000) 45 000 (35 000)
Balance: 01/01/X4 After transfer see Note 4 & 5 above 30 000 80 000 0

Chapter 12 625
Gripping GAAP Non-current assets held for sale and discontinued operations

Example 6: Re-measurement of a NCAHFS: (previously revaluation model):

x further impairments and reversals of impairments

This example is based on example $¶VSODQWZKLFKZDVPHDVXUHGXVLQJWKHUHYDOXDWLRQPRGHO.

The following information is repeated here for your convenience:
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 suUSOXVLVWUDQVIHUUHGWRUHWDLQHGHDUQLQJVRYHUWKHDVVHW¶VXVHIXOOLIH
x The recoverable amount had always exceeded the carrying amount.
x 7KLVSODQWPHWDOOFULWHULDIRUFODVVLILFDWLRQDVµKHOGIRUVDOH¶RQ-DQXDU\;RQZKLFKGDWHWKHfollowing
values applied:
- Fair value of C100 000 and expected selling costs of C9 000 (equal to expected disposal costs);
- Value in use of C105 000.
Required: Journalise the remeasurement 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 The prior example (example 5A) showed the journals on reclassification date (1 January 20X4, the date
the PPE was reclassified as a NCAHFS). They show how to initially measure a NCAHFS.
x This example (example 6) shows the journals that occur on a subsequent reporting date (30 June 20X4).
These journals show how to subsequently measure a NCAHFS after the date it was classified as a NCAHFS.
x This example shows that when remeasuring 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: (per IAS 36) plus impairments when the asset was NCAHFS (per IFRS 5)).
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 (when using the revaluation model, this CA equals the depreciated fair value):
- 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 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.

Journals: A B C
30 June 20X4 Dr/(Cr) Dr/(Cr) Dr/(Cr)
NCAHFS: acc impairment loss (-A) W1 or W1.3 4 000 9 000 N/A
Reversal of impairment loss ± NCAHFS (I) (4 000) (9 000) N/A
Remeasurement of NCAHFS: increase in FV-CtS
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)
Remeasurement of NCAHFS: decrease in FV-CtS
*Note 1: Notice that the impairment (in Part C) is recognised in P/L even though there is a balance of
C30 000 in the revaluation surplus (see example 5A: W3).

W1: Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 & 5.20-21

W1.1: Remeasurement to FV-CtS on reporting date: See IFRS 5.20-21 A B C

Latest 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: Prior carrying amount: 01/01/X4 Lower of CA: 100 000 and FV-CtS: (91 000) (91 000) (91 000)
91 000 (FV: 100 000 ± CtS: 9 000) (see
Ex 5A: W2)
Impairment loss reversal - proposed/ (Impairment loss) 4 000 16 000 (4 000)

626 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

W1.2: First limit:

Impairment loss reversal: limited to prior accumulated impairment losses: See IFRS 5.21

A B C
Impairment loss reversal (proposed) W1.1 4 000 16 000 N/A
Limited to: prior accumulated PPE AIL: 0 (Ex 5A W1.2) + 9 000 9 000 N/A
impairment losses (AIL) NCAHFS AIL: 9 000 (Ex 5A: W2)
Impairment loss reversal (proposed), A: 4 000 is not limited by the 9 000 4 000 9 000 N/A
after first limitation * B: 16 000 is limited by the 9 000
C: N/A: there was no IL Reversal
* Explanatory notes re the first limitation:
A: The proposed IL reversal of 4 000 is not limited by the first limitation (because the accumulated
impairment losses before the reversal is 9 000, which is bigger than 4 000). P.S. after this reversal, a
further 5 000 may be reversed in future (accumulated impairment loss 9 000 ± IL reversal 4 000).
B: The proposed IL reversal of 16 000 is limited by the first limitation (because the accumulated impairment
losses before the reversal is 9 000, which is less than 16 000). P.S. after this reversal, no further IL reversals
will be possible as the accumulated impairment loss balance will be nil (AIL 9 000 ± IL reversal 9 000).
C: The asset decreased in value and thus there is obviously no proposed impairment loss reversal. The latest
accumulated impairment loss has now increased to 13 000:
- the NCAHFS impairment on classification date (See Ex 5A: W2): 9 000, plus
- the NCAHFS impairment after classification date (See Ex 6C: W1.1): 4 000.
P.S. Since the AIL balance has grown to 13 000, future impairment loss reversals of 13 000 are possible.

W1.3: Second limit:

New carrying amount: limited to carrying amount of PPE on date of reclassification: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: Proposed imp 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 PPE on date reclassified, Depreciated fair value: 100 000 100 000 N/A
ignoring imp losses: 01/01/X4 FV: 100 000 ± AD: 0
(AD is nil as it was immediately
reclassified after revaluation)
Excess disallowed A, B & C: not limited N/A N/A N/A

Thus, impairment loss reversal is: See calculations below 4 000 9 000 N/A

Calculations:
x A: Proposed reversal of 4 000 (W1.2) ± excess disallowed 0 (W1.3) = 4 000 reversal of imp loss
x B: Proposed 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.

The following is an alternative working that combines the previous W1.1 and W1.2 and W1.3:
W1 (Alternative): Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 & 20-21

A B C
Latest measurement of NCAHFS on reporting date (30/06/X4), 95 000 100 000 87 000
at the lower of:
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

x CA on date reclassified, but ignoring i.e. Depreciated fair value 100 000 100 000 100 000
impairment losses: 01/01/X4 FV: 100 000 ± AD: 0
Less: Prior carrying amount (01/01/X3) Lower of CA (100 000) and (91 000) (91 000) (91 000)
FV-CtS (91 000) (Ex5A W2)
Impairment loss reversal / (impairment loss) 4 000 9 000 (4 000)

Chapter 12 627
Gripping GAAP Non-current assets held for sale and discontinued operations

See IFRS 5.21

Check: The impairment loss reversal may not exceed the prior cumulative impairment losses
A B C
Impairment loss reversal W1 4 000 9 000 N/A
Limited to prior accum. imp. losses (AIL) See calculation (1) below 9 000 9 000 N/A
Excessive reversal disallowed See note below N/A N/A N/A

Calculation (1): PPE AIL (IAS 36): 0 (See Ex 5A: W1.2) + NCAHFS AIL (IFRS 5): 9 000 (See Ex 5A: W2) = 9 000

Note: This alternative layout of W1 will automatically limit any impairment loss reversal to prior accumulated
impairment losses and thus the comparison of the proposed impairment loss reversal to prior accumulated
impairment losses in the above table is only a µFKHFN¶ on your workings.

Example 7: Re-measurement of a NCAHFS (previously: revaluation model):

x prior revaluation expenses may not be reversed

7KLVH[DPSOHLVEDVHGRQH[DPSOH&¶VSODQWZKLFKZDVPHDVXUHGXVLQJWKHUHYDOXDWLRQPRGHO
The following information is repeated here for your convenience:
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.
x 7KLVSODQWPHWDOOFULWHULDIRUFODVVLILFDWLRQDVµKHOGIRUVDOH¶RQ-DQXDU\;RQZKLFKGDWH
the following values applied:
- Fair value of C60 000 and expected selling costs of C20 000 and
- 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, which showed the journals relating to the initial measurement
of the NCAHFS on the date it was classified as a NCAHFS (1 January 20X4).
x This example (example 7) shows the subsequent measurement of the NCAHFS on reporting date.
It highlights that:
- prior impairment loss expenses may be reversed, but that
- prior revaluation expenses may not be reversed.

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: Subsequent measurement of plant after reclassification as NCAHFS: See IFRS 5.15 & 5.20-21

W1.1: Remeasurement to FV-CtS on reporting date: See IFRS 5..20-21 C

Latest FV less costs to sell: 30/06/X4 FV: 80 000 ± CtS: 10 000 70 000

Less: Prior carrying amount: 01/01/X4 Lower of CA & FV-CtS (01/01/X4) (40 000)
x CA: 60 000 (FV: given) vs
x FV-CtS: 40 000 (60 000 - 20 000)
(See example 5C W1)

Impairment loss reversal (proposed) 30 000

628 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

W1.2: First limit: C

Impairment loss reversal: limited to prior accumulated impairment losses: See IFRS 5.21

Impairment loss reversal (proposed) W1.1 30 000

Limited to: prior accumulated impairment losses Calculation (1) (20 000)
Excess disallowed 10 000

Impairment loss reversal (proposed), after first limitation* IL Reversal 30 000 – 10 000 20 000

Calculation 1:
PPE impairment (IAS 36) before reclassification date: Given 0
PPE impairment (IAS 36) on reclassification date: See Ex 5C: W1.2 0
NCAHFS impairment (IFRS 5) on reclassification date: See Ex 5C: W2 20 000
20 000
* Explanatory notes regarding the first limitation:
x The proposed impairment loss reversal of C30 000 on 30/6/X4 is limited by the first limitation
(because the total accumulated impairment losses recognised on this asset was C20 000 on 1/1/X4,
which is less than C30 000). P.S. after this reversal, no further IL reversals will be possible as the
accumulated impairment loss balance will be nil (AIL 20 000 ± IL reversal 20 000).
x Please notice that:
- on the last day that the asset was classified as PPE, its CA of C105 000 was devalued to a FV of
C60 000 (in terms of IAS 16): a decrease of C45 000 (see example 5C W1.1); and then
- on this same day, when the asset was reclassified as a NCAHFS, WKH33(¶V&$RI& 000 (FV)
was decreased to its FV-CtS of C40 000 (in terms of IFRS 5): a decrease of C20 000.
Thus, on the day of reclassification, the CA was decreased by a total of C65 000 (45 000 + 20 000).
However, the decrease of C45 000 (from its CA of C105 000 to its FV of C60 000) is a µdevaluation to
fair value¶ and not an µimpairment to FV-CtS¶.
This decrease of C45 000, being a devaluation, would have been FUHGLWHGWRWKHDVVHW¶VFRVWDQGdebited to:
- revaluation surplus (35 000) and
- revaluation expense (10 000) (see example 5C: W1.1 and the journals).
The remaining decrease of C20 000, being an impairment, would have been FUHGLWHGWR WKH DVVHW¶V
accumulated impairment loss and debited to impairment loss expense.
Only impairment losses may be reversed and thus only the decrease of C20 000 that was recognised
as an impairment loss may be reversed.

W1.3: Second limit: C

New carrying amount: limited to carrying amount of PPE on date of reclassification: See IFRS 5.15
NCAHFS: CA on 01/01/X4 was: See Example 5C: W2 40 000
Plus proposed imp loss reversal: 30/06/X4 W1.2 20 000
NCAHFS: CA on 30/06/X4 would be: 60 000
Limited to: CA of PPE on reclassification date, i.e. Depreciated fair value: (60 000)
ignoring imp losses: 01/01/X4 FV: 60 000 ± AD: 0 (immediately reclassified,
thus no depreciation)
Excess disallowed Not limited N/A
Thus, impairment loss reversal Proposed IL reversal 20 000 (W1.2) ± excess 20 000
disallowed: 0 = 20 000

The following is an alternative working that combines the previous W1.1 and W1.2 and W1.3:

W1 (Alternative): Subsequent measurement of plant after reclassification as NCAHFS C

Latest measurement of NCAHFS on reporting 60 000
date (30/06/X4), at the lower of:
x Latest FV-CtS: 30/06/X4 FV: 80 000 ± CtS: 10 000 70 000
x CA on date reclassified, but ignoring Depreciated fair value: 60 000
impairment losses: 01/01/X4 x FV: 60 000 ± Acc depr: 0
Less: Prior carrying amount (01/01/X4) Lower of CA & FV-CtS: 01/01/X4 (40 000)
x CA (60 000) and
x FV-CtS (40 000) (See Example 5C W2)
Impairment loss reversal / (impairment loss) 20 000

Chapter 12 629
 Gripping GAAP Non-current assets held for sale and discontinued operations

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 accumulated imp losses (AIL) See calculation 1 (below) (20 000)
Excessive reversal disallowed N/A
Calculation (1): PPE AIL (IAS 36): 0 (See Ex 5C: W1.2) + NCAHFS AIL (IFRS 5): 20 000 (See Ex 5C: W2) = 9 000

A: 4.7.2 The tax effect when the revaluation model was used

Depreciation stops as soon as an asset is classified as µheld for sale¶. However, the tax authorities
generally do not stop granting the tax deductions relating to the cost of the asset (assuming the cost
of the asset is tax deductible) simply because you have decided to sell the asset.

Thus, there will generally be a difference between the DFFRXQWDQW¶V expenses relating to the asset
(depreciation, which will be nil from the date of classification, and any impairment losses or reversals)
and the WD[ DXWKRULW\¶V GHGXFWLRQV relating to the asset (assuming the DVVHW¶V cost was tax
deductible)7KXVIURPWKHµincome statement perspective’WKHDFFRXQWDQW¶VµSURILWEHIRUHWD[¶DQG
WKHWD[DXWKRULW\¶VµWD[DEOHSURILWV¶ZLOOGLIIHUThis means, when converting profit before tax to taxable
profit, we would need to reverse any impairments (or impairment reversals) as well as any
GHSUHFLDWLRQWKDWKDGEHHQLQFXUUHGEHIRUHFODVVLILFDWLRQDVµKHOGIRUVDOH¶DQGWKHQVXEWUDFWWKHWD[
deductLRQV6LPLODUO\IURPWKHµbalance sheet perspective’WKHDVVHW¶VFDUU\LQJDPRXQWDQGWD[EDVH
will differ, thus causing a temporary difference on which deferred tax must be recognised.

The principles affecting the current tax payable and deferred tax balances are thus exactly the same
as for any other non-current asset. However, 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 are sometimes referred to as trading
profits or 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. commonly referred to as the 'normal' tax rate).

However, when an asset is UHFODVVLILHG DV µKHOG IRU VDOH¶ it means the future benefits are now
expected to come from the sale of the asset rather than the use thereof. Profits from the sale of the
asset involve capital profits if one expects to sell the asset at a price that exceeds original cost.
Depending on the country, the tax legislation may apply tax methods and tax rates to capital profits
that differ from the tax methods and tax rates that apply to normal trading profits. If this is the case,
the deferred tax balance will need to be adjusted to take into account WKHHQWLW\¶VFKDQJHLQLQWHQWLRQ
and the resultant different tax calculations. In South Africa, the Income Tax Act has specific
provisions relating to capital gains (commonly referred to as capital gains tax legislation).

As a result, UHFODVVLI\LQJDQDVVHWLQWRWKHµKHOGIRUVDOH¶FODVVLILFDWLRQZLOO, at a minimum, generally

result in an adjustment to deferred tax in order to remeasure the deferred tax balance using the
µcapital gains tax legislation¶ rather than the 'normal tax legislation¶.

Example 8: Tax effect of reclassification and the revaluation model

$QLWHPRISODQWPHWDOOFULWHULDIRUFODVVLILFDWLRQDVµKHOGIRUVDOH¶RQ-DQXDU\;
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

630 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

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;
- Only 80% of the capital gain (proceeds - base cost) is taxable;
- The base cost is 120 000;
- The tax rate is 30%.
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
31 December 20X2 Debit Credit

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

Deferred tax (A/L) 12 000
Tax on revaluation: tax rates based on usage (i.e. non-capital profits)

Income tax expense (E) W2 3 000

Deferred tax (A/L) 3 000
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

Deferred tax (A/L) 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
Transfer of revaluation surplus to retained earnings

Chapter 12 631
Gripping GAAP Non-current assets held for sale and discontinued operations

1 January 20X4 Debit Credit

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
Deferred tax balance is adjusted: CA and tax base changed (deferred 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

Deferred tax (A/L) 3 600
Deferred tax balance is adjusted: CA and tax base changed (deferred tax
measured based on intention to sell)

Income tax expense (E) W1 63 000

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 WKHSODQW¶VSUHYLRXVO\DSSOLFDEOHVWDQGDUG ,$6 KDGEHHQGRQH
on the previous reporting date, 31 December 20X3, which was one day before the asset was
UHFODVVLILHGDVµKHOGIRUVDOH¶WKHSODQWLVQRWUHYDOXHGagain in terms of IAS 16 on date of reclassification,
1 January 20X4.
,QRWKHUZRUGVWKHSODQW¶VFDUU\LQJDPRXQWRQGDWHRIUHFODVVLILFDWLRQ ; was its latest fair value
and thus was already µup-to-date¶ in terms of IAS 16.
Note 3. The plant was not impaired on either of the reporting dates (31 December 20X2 or 31 December 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 of plant Assets held for sale are not depreciated 0
Add back impairment of plant Impairment on the NCAHFS: 20 000 + 10 000 30 000
Less tax deduction on plant 100 000 x 20% (20 000)
Taxable profits 210 000

Current income tax 210 000 x 30% 63 000

632 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

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
(10 000) (20 000) (10 000) (3 000)
Tax allowance: 100 000 x 20% x 1yr Dr TE
Balance: 31/12/X1 The asset is PPE 90 000 80 000 (10 000) (3 000) Liability
Depreciation: (100 000 ± 0)/ 10 x 1yr Cr DT
(10 000) (20 000) (10 000) (3 000)
Tax allowance: 100 000 x 20% x 1yr Dr TE
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
Balance: 31/12/X2 The asset is PPE 120 000 60 000 (60 000) (18 000) Liability
Depreciation: (120 000 ± 0)/ 8 x 1yr Cr DT
(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
Balance: 31/12/X3 The asset is PPE 150 000 40 000 (110 000) (33 000) Liability
Tfr out of PPE (150 000)
Dr DT
Trf into NCAHFS W3 150 000 7 800*
Cr RS
*DT adjustment 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 (20 000) 0 20 000 4 800
Cr TE
Subtotal: FV ± CtS: 150 000 ± 20 000 W3 130 000 40 000 (90 000) (20 400)
Impairment (IFRS 5): 31/12/X4 (10 000)
Subtotal: FV ± CtS: 140 000 ± 20 000 W3 120 000 Cr DT
(10 000) (3 600)
Dr TE
Depreciation: No depreciation
0 (20 000)
Tax allowance: 100 000 x 20% x 1yr
Balance: 31/12/X4 The asset is NCAHFS 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 (i.e. future tax) 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% Taxable capital gain x 30% (A) 7 200 2 400 0

DT (i.e. future tax) on the recoupment

Selling price limited to cost CA (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% Recoupment x 30% (B) 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)
DT Adjustment needed 7 800 4 800 (3 600)
Dr DT; Cr RS Dr DT; Cr TE Cr DT; Dr TE

Chapter 12 633
 Gripping GAAP Non-current assets held for sale and discontinued operations

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 into 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-FXUUHQW DVVHW WKDW ZDV SUHYLRXVO\ FODVVLILHG DV µKHOG IRU VDOH¶ (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 RIµKHOGIRUVDOH¶ RUµKHOGIRUGLVWULEXWLRQ¶ , the asset must be remeasured 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 asset had never been classified as µKHOGIRUVDOH¶(i.e. take the
DVVHW¶VFDUU\LQJDPRXQWEHIRUHUHFODVVLILFDWLRQDQGDGMXVWLW for any depreciation, amortisation,
impairments, impairment reversals and/or revaluations that would have been recognised had the
asset not been reclassified as held for sale/ distribution); and
x its recoverable amount. See IFRS 5.27

An adjustment to the DVVHW¶Vcarrying 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 µheld for sale¶ (HFS) may become µheld for distribution¶ (HFD)
instead (or vice versa). In this case, the asset would simply be transferred from the HFS classification
to the HFD classification (or vice versa).

This non-current asset, which was previously HFS (or HFD) would then effectively be classified,
measured and presented as HFD (or HFS ).

A measurement adjustment may be needed since the two classifications are measured slightly differently:
x the HFS classification is measured at the lower of carrying amount and fair value less costs to
sell, whereas
x the HFD classification is measured at the lower of carrying amount and fair value less costs to
distribute.

When remeasuring the asset, we simply follow the normal rules for initial measurement on
reclassification date (IFRS 5.15) and subsequent measurement after reclassification (IFRS 5.20-25).
The adjustments would simply be accounted for as an impairment loss or impairment loss reversal.

Since a reclassification from HFS to HFD (or vice versa) does not change the fact that the non-
current asset 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.

634 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

Example 9: Re-PHDVXUHPHQWRIDVVHWVQRORQJHUFODVVLILHGDVµKHOGIRUVDOH¶
Plant measured under the cost model was classified as held for sale on 31 December 20X2 when its:
x Carrying amount was C80 000:
 Cost: C100 000 on 1 January 20X1 and
 Accumulated depreciation: C20 000 on 31 December 20X2
- 10% straight-line
- to nil residual values;
x Recoverable amount was C65 000:
 Fair value less costs of disposal: of C65 000
 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
µKHOGIRUVDOH¶2QWKLVGDWHLWVUHFRYHUDEOHDPRXQWZDV& 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-PHDVXUHPHQWRIDVVHWVQRORQJHUFODVVLILHGDVµKHOGIRUVDOH¶
30 June 20X3 Debit Credit

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

Plant: acc. depreciation (-A) 5 000
Depreciation of plant for 6 months from 1 July 20X3

W1: Impairment loss reversal C

New carrying amount (30 June 20X3) to be lower of: 75 000
x Carrying amount had the asset never Cost 100 000 ± AD (100 000-0) x 10% x 2.5 yrs * 75 000
EHHQFODVVLILHGDVµKHOGIRUVDOH¶
x Recoverable amount Given 85 000

Current carrying amount (30 June 20X3) Fair value ± costs to sell (Given) (65 000)
Impairment loss reversal 10 000

*: Please note depreciation on this asset is backdated (i.e. calculated as if it had never ceased).

A: 4.9 Measurement LQYROYLQJµVFRSHG-out non-current assets¶

As mentioned in section A: 2, the measurement provisions of IFRS 5 do not apply to the following
non-current assets:
x Deferred tax assets (IAS 12 Income tax);
x Assets relating to employee benefits (IAS 19 Employee benefits);
x Financial assets (IFRS 9 Financial instruments);
x Investment properties measured under the fair value model (IAS 40 Investment property);
x Non-current assets measured at fair value less point-of-sale costs (IAS 41 Agriculture);
x Contractual rights under insurance contracts (IFRS 4 Insurance contracts). See IFRS 5.5

Chapter 12 635
 Gripping GAAP Non-current assets held for sale and discontinued operations

The scope exclusion simply means that, even though these non-current assets PD\EHµheld for
sale¶ (or µKHOG IRU GLVSRVDO¶), they will not be measured in terms of IFRS 5. For example: a
financial asset that meets the criteria for FODVVLILFDWLRQDVµ+)6¶ will not be remeasured on initial
reclassification to the lower of its carrying amount and fair value less cost to sell and would not
be subsequently remeasured to its latest fair value less costs to sell. However, IFRS 5 still
requires them to be classified, presented and disclosed as µ+)6¶ RU+)' .

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
DOOFULWHULDIRUVHSDUDWHFODVVLILFDWLRQDVµKHOGIRUVDOH¶DUHPHWRQZKLFKGDWHWKH
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
PHDVXUHPHQWUHTXLUHPHQWVDQGWKXVFRQWLQXHWREHPHDVXUHGDWµIDLUYDOXH¶7KH\DUHWKXVQRWUH-
PHDVXUHGWRµIDLUYDOXHOHVVFRVWVWRVHOO¶DQGWKXVWKHVHOOLQJFRVWVDUHLJQRUHG
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 would have been remeasured 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
Transfer of land to non-current asset held for sale
NCAHFS: Land: CA (A) W1 70 000
Investment property: Land (A) 70 000
Transfer of land to non-current asset held for sale

W1: Measurement of investment property before reclassification (i.e. measured as IP: IAS 40)
C
Investment property at fair value on 1 January 20X3 Given 80 000
Investment property at 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 earlier (see section A:1), IFRS 5 refers not only to individual non-current assets
held for sale (or distribution), but also to disposal groups held for sale (or distribution).

First we have to identify if we have a disposal group, as defined (see section A:5.2).

If we have a disposal group as defined, we will then need to apply the same criteria to decide if
we must classify this disposal group as µheld for sale¶ (or distribution) (previously discussed in
section A:3). If we have a disposal group that should be classified as µheld for sale¶ RUGLVWULEXWLRQ ,
we will then have to measure, present and disclose LWDVµKHOGIRUVDOH¶ RUGLVWULEXWLRQ 

The classification, presentation and disclosure of individual non-current assets held for sale
(or distribution) is the same for disposal groups µKHOGIRUVDOH¶ RUGLVWULEXWLRQ VHHVHFWLRQ$

636 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

When measuring a disposal group held for sale (or distribution), we use the same basic
measurement principles used for individual non-current assets held for sale (or distribution)
(previously discussed in section A:4). However, because a disposal group includes a variety of items
(non-current assets and current assets and possibly even liabilities), some of which might be scoped-
out items, measuring a disposal group held for sale is slightly more complex than measuring an
individual non-current asset held for sale. This is explained in section A:5.4.

A: 5.2 Identification of disposal groups

A disposal group is simply a group of assets that are to be disposed of by sale or by some other
means. +RZHYHU IRU LW WR EHD µGLVSRVDO JURXS¶ WKH SODQPXVW EH IRU DOO the assets in the group
(together with any directly related liabilities) to be disposed of together in a single transaction.

Notice there is a difference between a µdisposal group¶ and

A disposal group is defined as:
a µdisposal group held for sale¶. If we look carefully at the
definition of a µdisposal group’, the group can be disposed of x a group of assets (and liabilities
through a sale or by any other means. However, for the directly associated with those
assets that will be transferred in the
disposal group to meet the criteria for classification as µheld transaction)
for sale’, its carrying amount must be expected to be x to be disposed of:
recovered mainly through a sale transaction. Thus, for - by sale or
example, a group of assets that we plan to abandon may meet - otherwise,
the definition of a µdisposal group’, but would not be classified x as a group in a single transaction.
as a µdisposal group held for sale’. IFRS 5 Appendix A (slightly reworded)

A: 5.3 Classification, presentation and disclosure of disposal groups held for

sale or distribution
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.
x 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.
x For presentation and disclosure of a disposal group held for sale, please see the principles
explained in section A:6.

A: 5.4 Measurement of disposal groups held for sale in general

Measurement of DGs that
The measurement of a µdisposal group held for sale¶ (or
are HFS or HFD:
distribution) is interesting because it could include all sorts of
Disposal groups are
assets and even liabilities. However, it is important to measured at the lower of:
remember that IFRS 5 measurement requirements do not x Its CA, and
apply to all items. Instead, ,)56µVFRSHVRXW¶DQXPEHURILWHPV x Its FV – CtS.
from the measurement requirements (see section A:2) resulting in Scoped-in NCAs in the DG are:
them only applying to certain non-current assets. The scoped-out x Not depreciated or amortised.
items include: Only those items in the DG that are
scoped-in NCAs are affected by the
x Liabilities; measurement requirements in IFRS 5.
x Current assets; and
x Scoped-out non-current assets:
 Financial assets within the scope of IFRS 9 Financial instruments;
 Investment property measured under the fair value model in terms of IAS 40 Investment property;
 Non-FXUUHQWDVVHWVPHDVXUHGDWµIDLUYDOXHOHVVFRVWVWRVHOO¶LQWHUPVRIIAS 41 Agriculture; and
 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

Chapter 12 637
 Gripping GAAP Non-current assets held for sale and discontinued operations

We will refer to those assets that the IFRS 5 measurement requirements do apply to DVµVFRSHG-
in non-FXUUHQWDVVHWV¶.

If the disposal group includes at least one µscoped-in non-current asset¶, the disposal group as
a whole will be subject to the IFRS 5 measurement requirements (as well as the classification,
presentation and disclosure requirements).

If the disposal group does not contain any µscoped-in non-current assets¶, then the disposal
group will not be subject to the IFRS 5 measurement requirements at all (although it will still be
subject to ,)56¶V classification, presentation and disclosure requirements).

If the disposal group includes at least one µVFRSHG-in non- A disposal group may include
FXUUHQW DVVHW¶ WKH GLVSRVDO JURXS as a whole is thus goodwill acquired in a
measured in terms of IFRS 5 at: 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 held for sale (IFRS 5.4 & .15-18 & .20 & .23
& IAS 36.104)
The process to be followed on initial measurement is:
Initial measurement of a
x Immediately before reclassification, all individual assets DGHFS (or DGHFD):
and liabilities within the disposal group (DG) must be
x Before reclassification:
measured one last time in terms of their own standards.
Measure each item in the
For example: a plant measured under the cost model DGHFS using its own IFRSs;
must be depreciated to reclassification date and x After reclassification:
checked for impairments, whereas inventory must be Measure DGHFS at lower of CA and
measured to the lower of cost and net realisable value FV-CtS (could lead to an imp loss).
on reclassification date.
x The individual assets and liabilities must then be
An impairment loss on
transferred to the disposal group held for sale (DGHFS)
the initial measurement
or the disposal group held for distribution (DGHFD). of a DGHFS is allocated:
x The disposal group, as a whole, is then remeasured on x First to: goodwill, if applicable;
reclassification date in terms of IFRS 5 as follows: x Then to: Scoped-in NCAs.
 for a DG held for sale, to the lower of its:
- carrying amount; or
- fair value less costs to sell.
 for a DG held for distribution, to the lower of its:
- carrying amount; or
- fair value less costs to distribute.
Any impairment loss is then allocated to those assets in the disposal group that fall within
the measurement scope of IFRS 5 (i.e. allocated to the scoped-in non-current assets):
 If goodwill is present, any impairment loss is first allocated to goodwill; and
 Any remaining impairment loss is then allocated proportionately to the other assets in the
disposal group that fall within the IFRS 5 measurement requirements (i.e. to the other
scoped-in non-current assets) based on their relative carrying amounts. See IAS 36.104

638 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

In other words, none of the impairment loss must be allocated to current assets, 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 recODVVLILFDWLRQDVDµGLVSRVDOJURXSKHOGIRUVDOH¶DUHPHW
,PPHGLDWHO\EHIRUHWKHDVVHWVDUHFODVVLILHGDVµKHOGIRUVDOH¶WKH\ZHUH 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.

Answer: The impairment loss is C100 000. The allocation thereof is shown in the table below.

CA immediately before Impairment loss CA immediately after

classification as HFS allocation classification as HFS
Inventory 70 000 N/A Note 2 70 000
Property, plant and equipment 150 000 (52 500) Note 4 & 5 97 500
Investment property (FV model) 80 000 N/A Note 2 80 000
Investment property (cost model) 50 000 (17 500) Note 4 & 5 32 500
Goodwill 30 000 (30 000) Note 3 0
Trade payables (10 000) N/A Note 2 (10 000)
Net assets 370 000 (100 000) Note 1 270 000

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. 7KH PHDVXUHPHQW UHTXLUHPHQWV RI,)56  RQO\ DSSO\ WR µVFRSHG-in non-FXUUHQW DVVHWV¶ DQG
thus no part of the impairment loss on the measurement of the disposal group is allocated to
the following scoped-out items:
- inventory (because it is a current asset),
- trade payables (because it is a liability) or
- the investment property under the fair value model (because it is a scoped-out non-current asset).

Chapter 12 639
Gripping GAAP Non-current assets held for sale and discontinued operations

Note 3. The impairment loss is first set-off against any goodwill, and any impairment loss remaining is
then allocDWHG WR WKH UHPDLQLQJ µVFRSHG-in non-FXUUHQW DVVHWV¶ RQ WKH EDVLV RI WKH UHODWLYH
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 amounts 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 it 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 -XQH;XSRQZKLFKGDWHDOOFULWHULDIRUVHSDUDWHFODVVLILFDWLRQDVµKHOGIRUVDOH¶DUH
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 reclassification 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 )RU ,)56 ¶V PHDVXUHPHQW UHTXLUHPHQWV WR DSSO\ WKH GLVSRVDO JURXS PXVW FRQWDLQ DW OHDVW RQH
scoped-in non-current asset. In this example, there were:
- two scoped-in non-current assets (a plant and a building); and
- one scoped-out non-current asset (an investment property measured under the fair value model).
x All items in the disposal group must first be remeasured in terms of their own standards (i.e. scoped-
in non-current assets, scoped-out non-current assets, current assets and any liabilities).
x Since the intention to sell is an indication of a possible impairment, all items of property, plant and
equipment (i.e. the plant and building) must be checked for impairment. Note that investment property
under the fair value model is not subject to impairment testing and thus some information given is ignored.
The higher of the value in use (VIU) and fair value less costs of disposal (FV-CoD) is the recoverable
amount (RA). If WKHDVVHW¶V RA is less than its CA (before reclassification), then that individual asset
must first be impaired in terms of IAS 36.
x Once the individual assets in the disposal group have been remeasured in terms of their own
standards, the carrying amount of the disposal group is determined. The disposal group must then be
measured to the lower of this carrying amount and its fair value less costs to sell. 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.

640 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

Answer: The impairment loss of the disposal group is C35 000, of which:
x C10 500 is allocated to plant and
x C24 500 is allocated to the factory building.

W1: Measurement of plant before reclassification: 30/06/20X3 C

(i.e. still PPE, measured in terms of IAS 16):
Plant: Carrying amount 80 000 ± Depreciation for 6 months (100 000 -0) x 10% x 6/12 75 000
Plant: Recoverable amt Higher of VIU: 90 000 and FV-CoD: 65 000 (70 000 ± 5 000) (90 000)
Impairment loss Plant is not impaired 0

Plant: CA after impairment CA: 75 000 ± Impairment loss: 0 75 000

W2: Measurement of factory building before reclassification: 30/06/20X3 C

(i.e. still PPE, measured in terms of IAS 16):
Building: Carrying amount 180 000 ± Depreciation for 6 months (200 000 ± 0) x 5% x 6/12 175 000
Building: Recoverable amt Higher of VIU: 210 000 and FV-CoD: 155 000 (170 000±15 000) (210 000)
Impairment loss Factory building is not impaired 0

Building: CA after impairment CA: 175 000 ± Impairment loss: 0 175 000

W3: Measurement of investment property before reclassifying: 30/06/X3 C

(i.e. still Investment Property, measured in terms of IAS 40):
Investment property: Fair value on 1 January 20X3 Given 80 000
Investment property: Fair value on 30 June 20X3 Given (70 000)
Fair value loss 10 000

Investment property: CA after FV loss CA: 80 000 ± FV loss: 10 000 70 000

W4: Measurement of disposal group after reclassification C

(i.e. now NCAHFS, measured in terms of IFRS 5):
Plant: carrying amount W1: 75 000 ± Imp loss: 0 75 000
Building: carrying amount W2: 175 000 ± Imp loss: 0 175 000
Investment property: carrying amount W3: 80 000 ± FV loss: 10 000 70 000
Carrying amount of disposal group 320 000
Fair value less costs to sell of disposal group Given (285 000)
Impairment loss (relating to the whole disposal group) 35 000

Disposal group: CA after impairment CA: 320 000 ± 35 000 285 000

W5: Allocation of impairment of disposal group 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
W6: (Alternative): Measurement of disposal group and allocation of impairment
(instead of W4 and W5):
CA immediately before Impairment loss CA immediately after
classification as HFS allocation classification as HFS
Plant (cost model) 75 000 (10 500) Note 3 64 500
Building (cost model) 175 000 (24 500) Note 3 150 500
Investment property (FV model) 70 000 N/A Note 2 70 000
Net assets 320 000 (35 000) Note 1 285 000

Note 1. The total impairment loss of 35 000 is calculated as:

CA: 320 000 (per table in W6 above) ± FV-CtS (given): 285 000 = 35 000
Note 2. 7KH PHDVXUHPHQW UHTXLUHPHQWV RI ,)56  RQO\ DSSO\ WR µVFRSHG-in non-FXUUHQW DVVHWV¶
Investment property at fair value is a scoped-out non-current asset and thus none of the
GLVSRVDOJURXS¶VLPSDLUPHQWORVVLVDOORFDWHGWRLQYHVWPHQWSURSHUW\

Chapter 12 641
 Gripping GAAP Non-current assets held for sale and discontinued operations

Note 3. The impairment loss is first set-off against any goodwill in the disposal group:
Total impairment loss: 35 000 ± Goodwill: 0 = IL still to be allocated: 35 000
Any impairment loss remaining after first setting it off against goodwill (i.e. C35 000 in this case), is
WKHQDOORFDWHGWRWKHRWKHUµVFRSHG-in non-FXUUHQWDVVHWV¶RQWKHEDVLVRIWKHUHODWLYHcarrying amounts:
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

A: 5.4.2 Subsequent measurement of a disposal group held for sale (IFRS 5.4; 5.15; 5.19-
20; 5.23; IAS 36.122)

As with an individual asset, a disposal group would need to be remeasured to its latest µIDLUYDOXH
OHVVFRVWVWRVHOO¶ 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 requirements of IFRS 5 (i.e.
if it includes scoped-out items), please remember that the carrying amounts of these items must be
measured in terms of their own relevant IFRS before the disposal group is remeasured to its latest
µIDLUYDOXHOHVVFRVWVWRVHOO¶,QRWKHUZRUGV
Subsequent
x A disposal group might contain two categories of items:
measurement of a
- Scoped-in non-current assets (measured in terms of IFRS 5); DGHFS or DGHFD:
- Scoped-out items (not measured in terms of IFRS 5): x Before remeasurement:
these items could include current assets, scoped-out Scoped-in NCAs in the DG: do
non-current assets and liabilities, all of which continue to not depreciate or amortise
be measured in terms of their own relevant standards. All other items in the DG:
measure using their own IFRSs;
x The total carrying amount of the disposal group is recalculated x Remeasurement:
to reflect any changes to the individual carrying amounts of the Measure the DG at its latest FV-CtS
scoped-out items, measured in terms of their own standards. (or FV-CtD)…which could lead to an:
- impairment loss
x 7KH GLVSRVDO JURXS¶V latest carrying amount (calculated
- impairment loss reversal.
above) is then compared to its latest fair value less costs to
sell (or costs to distribute), and appropriate adjustments may
be necessary, involving either: An impairment loss on
subsequent measurement
- a further impairment loss; or of a DG is allocated:
- an impairment loss reversal. x First to: goodwill, if applicable;
x Then to: scoped-in NCAs.
An impairment loss is recognised if the latest µcarrying amount¶ (i.e. same as for initial measurement).
of the disposal group, as a whole, is greater than the latest µfair
value less costs to 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 of the disposal group was allocated.
In other words, the impairment loss is:
x first allocated against any goodwill that may be included in the disposal group, 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 on subsequent
An impairment loss reversal is recognised if the latest µcarrying
measurement of a DG is:
amount¶ of the disposal group, taken as a whole, is less than the
x allocated to scoped-in NCAs
latest µfair value less costs to sell¶ (or fair value less costs to (there is no limit to the amount
distribute). However, an impairment loss reversal is limited in allocated to these items);
that it may only be recognised to the extent that: x never allocated to goodwill or
x It has not been recognised in the remeasurement of any current any of the other items in the DG.
See IAS 36.122
assets, scoped-out non-current assets or liabilities; and
x It does not exceed the accumulated impairment losses in terms of IAS 36 Impairment of assets and/
or IFRS 5. IFRS 5.22 & See IAS 36.117

This impairment loss reversal would then be allocated to scoped-in non-current assets based on
their relative carrying amounts but may never be allocated to goodwill (this is because an
impairment of goodwill may never be reversed). See IAS 36.122-123

642 Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

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 two scoped-in non-current assets and 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 reclassification date (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
FODVVLILFDWLRQDVµKHOGIRUVDOH¶2QWKLVGDWHWKHLQYHVWPHQWSURSHUW\KDVDIDLUYDOXHRI& 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 that a subsequent impairment loss on a disposal group is recognised and
allocated in the same way as an initial impairment loss.

Answer: The impairment loss of the disposal group is C14 000 (W2), allocated as follows:
x C4 200 is allocated to plant; and
x C9 800 is allocated to the building (W3 or W4).

W1: Measurement of investment property at reporting date (as IP, in terms of IAS 40 C
Carrying amount is currently Example 12 (W3 and W5; or W6) 70 000
Fair value is currently Given (69 000)
Fair value loss 1 000
Investment property: CA after FV loss CA: 70 000 ± FV loss: 1 000 69 000

W2: Measurement of disposal group at reporting date (as a DGHFS, in terms of IFRS 5) C
Plant Ex 12 (W6) 64 500
Building Ex 12 (W6) 150 500
Investment property Given, Or W1 above 69 000
Carrying amount: 31/12/X3 284 000
FV - Costs to sell: 31/12/X3 Given (270 000)
Impairment loss (relating to the whole disposal group) 14 000
Disposal group: CA after impairment CA: 284 000 ± 14 000 270 000

W3: Allocation of impairment of disposal group 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 µVFRSHG-RXW¶from IFRS 5 0
measurement requirements See IFRS 5.5
Total impairment loss W7 14 000

W4: An alternative layout of workings (instead of W2 and W3)

CA immediately before Impairment loss CA immediately after
remeasurement allocation remeasurement
Plant (cost model) 64 500 (4 200) Note 3 60 300
Building (cost model) 150 500 (9 800) Note 3 140 700
Investment property (FV model) 69 000 N/A Note 2 69 000
Net assets 284 000 (14 000) Note 1 270 000
Note 1. The total impairment loss of C14 000 is calculated as:
CA: 284 000 (per table above) ± FV-CtS (given): 270 000 = 14 000
Note 2. 7KHPHDVXUHPHQWUHTXLUHPHQWVRI,)56RQO\DSSO\WRµVFRSHG-in non-FXUUHQWDVVHWV¶
Investment property at fair value is a scoped-out non-current asset and thus none of the
GLVSRVDOJURXS¶VLPSDLUPHQWORVVLVDOORFDWHGWRLQYHVWPHQWSURSHUW\

Chapter 12 643
Gripping GAAP Non-current assets held for sale and discontinued operations

Note 3. The impairment loss is first set-off against any goodwill:

Total impairment loss: 14 000 ± Goodwill: 0 = IL still to be allocated: 14 000
Any impairment loss remaining after first setting it off against goodwill (i.e. C14 000), is then
DOORFDWHGWRWKHRWKHUµVFRSHG-in non-FXUUHQWDVVHWV¶EDVHGRQWKHUHODWLYHFDUU\LQJDPRXQWV
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
5HVFXH/LPLWHGKDVDGLVSRVDOJURXSWKDWPHWWKHFULWHULDIRUFODVVLILFDWLRQDVµKHOGIRUVDOH¶
on 5 May 20X2. The disposal group contained three items (inventory, plant and goodwill).
x Carrying amounts immediately before the reclassification on 5 May 20X2:
- Inventory: C30 000 (inventory cost C90 000 but was written down to its net realisable value of C30 000);
- Plant: C50 000 (cost: C120 000, accumulated depreciation: C70 000);
- Goodwill: C5 000 (at cost).
x The fair value less costs to sell of the disposal group was estimated as follows:
- 5 May 20X2: C70 000;
- 31 December 20X2: C150 000.
x 2Q'HFHPEHU;WKHLQYHQWRU\¶VQHWUHDOLVDEOHYDOXHKDGLQFUHDVHGWR& 000.
Required: Calculate all carrying amounts relating to the disposal group on 5 May and 31 December 20X2
and show all journals from reclassification date (5 May 20X2) to reporting date (31 December 20X2).

Solution 14: Disposal group held for sale ± subsequent impairment reversal
Comment:
x This example shows a disposal group held for sale (DGHFS) involving:
- An initial impairment on reclassification date; and
- A subsequent impairment loss reversal on reporting date.
x This example also involves goodwill and thus shows how any impairment is first allocated to goodwill
and that goodwill impairments are never reversed.
x The example shows that subsequent impairment loss reversals relating to a DGHFS may be limited.
Answer:
The carrying amount of the DG is C70 000 on 31 May 20X2 (W1) and C125 000 on 31 December 20X2 (W2).
The carrying amounts of the individual assets in the DG on these dates are shown in W1 and W2, respectively.

5 May 20X2 (reclassification date) Debit Credit

DGHFS: Inventory (A) Given 30 000
Inventory (A) 30 000
DGHFS: Plant: Cost-AD (A) Given 50 000
Plant: acc depreciation (-A) Given 70 000
Plant: cost (A) Given 120 000
DGHFS: Goodwill (A) Given 5 000
Goodwill (A) 5 000
Reclassification of items belonging to disposal group held for sale
Impairment ± goodwill (E) W1 5 000
DGHFS: Goodwill: Accumulated impairment loss (-A) 5 000
Impairment ± plant (E) W1 10 000
DGHFS: Plant: Accumulated impairment loss (-A) 10 000
Remeasurement of scoped-in items belonging to disposal group held
for sale – impairment of goodwill and plant
31 December 20X2 (reporting date)
DGHFS: Inventory (A) W1 45 000
Write-back of inventory (I) 45 000
Inventory write back to lower of cost and net realisable value
DGHFS: Plant: Accumulated impairment loss (-A) 10 000
Impairment loss reversal ± plant (I) W1 10 000
Remeasurement of scoped-in items belonging to disposal group held
for sale – impairment reversal of plant

644 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

W1: CA on 5 May 20X2 CA immediately before Impairment loss CA immediately after

classification as HFS allocation classification as HFS
30 000 Note 1 N/A Note 3 30 000
Inventory (scoped-out)
50 000 Note 1 (10 000) Note 3 40 000
Plant (scoped-in)
5 000 Note 1 (5 000) Note 3 0
Goodwill (scoped-in)
Net assets 85 000 (15 000) 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 (85 000)
and fair value less costs to sell (70 000). An impairment loss of 15 000 must be processed.
Note 3. The impairment loss must first be allocated to goodwill (5 000) and then any remaining
impairment loss (15 000 ± 5 000 allocated to goodwill = 10 000) must then be allocated to
the scoped-in non-current assets based on their relative carrying amounts. There was only
one such item (plant) and thus the remaining impairment loss of C10 000 is allocated
entirely to the plant. None is allocated to inventory because inventory is scoped-out.

W2: CA on 31 December 20X2 CA immediately before Impairment loss CA immediately after

re-measurement reversal re-measurement
allocation
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
Goodwill (scoped-in) 0 Note 2 0 Note 4 0
Net assets 115 000 10 000 Note 3 125 000
Note 1. All scoped-out items must first be remeasured in terms of their own relevant standards.
Inventory is a current asset (thus scoped-out) and must thus first be measured in terms of
IAS 2 Inventory to C75 000 (lower of cost, C90 000, and net realisable value, C75 000).
Note 2. Plant and goodwill are scoped-in non-current assets, thus they are measured in terms of
,)56IURPWKHGDWHWKHGLVSRVDOJURXSWRZKLFKWKH\EHORQJLVFODVVLILHGDVµKHOGIRUVDOH¶
This means their carrying amounts would not have changed since reclassification date
(C40 000). Notice that although plant is normally a depreciable asset, depreciation stops
when the asset is measured under IFRS 5.
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 remeasuring 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 had not been impaired whilst it was classified as PPE (i.e. it had not been impaired
in terms of IAS 36) but was impaired by C10 000 when it was classified as NCAHFS (i.e. it
was impaired in terms of IFRS 5 ± see W1). The increase of C35 000 is thus further limited
to the accumulated impairment losses 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. The entire
impairment reversal is allocated to plant as it is the only scoped-in asset.

A: 5.5 Measurement of disposal groups 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
REYLRXVO\µXQZLQG¶RYHUWLPH LHWKHSUHVHQWYDOXHZLOOLQFUHDVHRYHUWLPH DQGWKLVLQFUHDVHLQ
the present value must be recognised in profit or loss. See IFRS 5.17

Chapter 12 645
 Gripping GAAP Non-current assets held for sale and discontinued operations

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.

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 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 WKDWZDVSUHYLRXVO\FODVVLILHGDVµKHOGIRUVDOH¶(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
WKHGLVSRVDOJURXS ZLOOKDYHWREHWUDQVIHUUHGRXWRIWKHFODVVLILFDWLRQDVµKHOGIRUVDOH¶ RUµKHOGIRU
GLVWULEXWLRQ¶ DQGEDFNLQWRLWVSUHYLRXVFODVVification (e.g. property, plant and equipment). See IFRS 5.26

%HIRUH WUDQVIHUULQJ WKH GLVSRVDO JURXS RXW RI WKH FODVVLILFDWLRQ DV µKHOG IRU VDOH¶ RU µKHOG IRU
GLVWULEXWLRQ¶ WKHGLVSRVDOJURXSPXVWEHUH-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 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

646 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

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
criteria necessary for it to be classified as held for sale (or distribution). 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.

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 (HFS) classification to the held for distribution (HFD)
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, SUHVHQWDWLRQLVPRUHµVXUIDFHOHYHO¶ZKHUHDVGLVFORVXUHUHIHUVWRWKHµGHWDLO¶RU

µGHHSHUOHYHO¶LQIRUPDWLRQ

Chapter 12 647
 Gripping GAAP Non-current assets held for sale and discontinued operations

When talking about presentation of a non-current asset (or disposal group) held for sale, the key
ZRUGWRUHPHPEHULVµVHSDUDWH¶

Extra disclosure will be required where the financial statements include either:
x DµQRQ-current asset (or disposal group) KHOGIRUVDOH¶RU
x DµVDOHRIDQRQ-FXUUHQWDVVHW¶

Please note that the classification of a non-FXUUHQWDVVHW RUGLVSRVDOJURXS DVµKHOGIRUVDOH¶

will only affect WKHSHULRGGXULQJZKLFKLWZDVFODVVLILHGDVµKHOGIRUVDOH¶7KLVPHDQVWKDWQR
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.

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 µKHOG IRU
VDOH¶PXVWEHpresented 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.

/LDELOLWLHVDQGDVVHWVZLWKLQDµGLVSRVDOJURXSKHOGIRUVDOH¶PD\QRWEHset-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
See IFRS 5.3
A non-current asset (or disposal group) held for sale is presented as a current asset.

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, this means that 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 that is classified as held for sale and major class of liability that is
classified as held for sale are each 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

&RPSDUDWLYHILJXUHVDUHQRWUHVWDWHGWRUHIOHFWDUHFODVVLILFDWLRQWRµKHOGIRUVDOH¶In other words,

this would mean that, for example, if an item of property, plant and equipment is reclassified to
µheld for sale¶ during the current period, the asset remains presented as property, plant and
equipment in the comparative period.

648 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

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

A: 6.6.3 Events after the reporting date (IFRS 5.12 and 5.41)

,IWKHFULWHULDIRUFODVVLILFDWLRQDVµKHOGIRUVDOH¶DUHPHWafter the year-end, the non-current asset

must not be classified as held for sale in that reporting period (no re-measurements should be
SHUIRUPHGDQGQRUHFODVVLILFDWLRQRIWKHDVVHWWRµKHOGIRUVDOH¶VKRXOGWDNHSODFH . 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:

Entity name
Notes to the financial statements
For the year ended 31 December 20X3 (extracts)
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

x An entity owns only the following non-current assets: factory buildings and 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.
x The entity 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 reporting date. The factory
building is expected to be sold for cash.
x )DFWRU\EXLOGLQJVZHUHUHFODVVLILHGDVµKHOGIRUVDOH¶RQ;RQZKLFKGDWHLWVIDLUYDOXHless
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.

Chapter 12 649
Gripping GAAP Non-current assets held for sale and discontinued operations

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 3ODQWZDVUHFODVVLILHGDVµKHOGIRUVDOH¶RQ;RQZKLFKGDWH
- 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 (6 months later), plant ceased to meet all criteria needed IRUFODVVLILFDWLRQDVµKHOGIRUVDOH¶:
x On this date its recoverable amount is C85 000 (fair value less costs to sell were still C65 000).
x TKHSODQWLVQRORQJHUFODVVLILHGDVµKHOGIRUVDOH¶VLQFHWKHLQWHQWLRQLVQRZWRUHGHSOR\LWWRRWKHU
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.

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.

Entity name
Statement of financial position 20X3 20X2
At 31 December 20X3 C C
Non-current assets
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

Entity name
Notes to the financial statements 20X3 20X2
For the year ended 31 December 20X3 C C
26. Property, plant and equipment
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-FXUUHQWDVVHWQRZFODVVLILHGDVµKHOGIRUVDOH¶ (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-FXUUHQWDVVHWQRORQJHUFODVVLILHGDVµKHOGIRUVDOH¶ 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-FXUUHQWDVVHWQRZFODVVLILHGDVµKHOGIRUVDOH¶ 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

650 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

Entity name
Notes to the financial statements 20X3 20X2
For the year ended 31 December 20X3 C C
27. Non-current assets held for sale
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.
3ODQWLVQRORQJHUFODVVLILHGDVµKHOGIRUVDOH¶VLQFHLWLVQRZLQWHQGHGWREHPRYHGWRRWKHUH[LVWLQJIDFWRULHV
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 ± depreciation:5 000) 5 000
- Tax (1 500)
- Net 3 500

35. Profit before tax

Profit before tax is stated after taking into account the following items:
- 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
Comment 1: The NCAHFS is transferred back to PPE on 30 June 20X3: It is remeasured as if it had always
been measured in terms of IAS 16. Thus, its CA of 65 000 is remeasured to 75 000, being the
lower of its RA: 85 000 and historical CA: 75 000 (100 000 ± 100 000 x 10% x 2,5 years).
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. 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:
A NCA/DG is classified as HFS if its CA is expected
to be recovered mainly through a sale of the asset
than through use of the asset.
We prove the above if these criteria are met:
x the asset is available for immediate sale (in
its present condition and at normal terms); &
x the sale thereof is highly probable.
Held for distribution:
A NCA/DG is classified as HFD if the entity is
committed to distributing it to the owners.
We prove the above if these criteria are met:
x the asset is available for immediate
distribution (in its present condition); &
x the distribution thereof is highly probable.

See IFRS 5.8

Highly probable sale:
A sale is highly probable if:
x the appropriate level of mgmt is committed to it;
x an active programme to sell has begun;
x it must be actively marketed at a reasonable
price relative to its FV;
x the sale is expected to be concluded within 1 yr
of the date of classification as HFS (unless a
longer period is permitted in terms of IFRS 5.9)
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.
Highly probable distribution:
A distribution is highly probable if:
x actions to complete the distribution have begun
x the distribution is expected to be concluded
within 1 yr of the date of classification as HFD
x actions required to complete the distribution
should suggest that it is unlikely that:
- significant changes to the distribution will
be made; or that
- the distribution will be withdrawn

Chapter 12 651
Gripping GAAP
Non-current assets (or disposal groups) held for sale
Classification: as held for sale
General
Normal 6 criteria
Measurement: Non-current asset held for sale
Cost model
Initially: at cost
Subsequently:
Before reclassification:
Depreciate and impair (if
necessary and material)
Reclassify:
Transfer to NCAHFS
On reclassification:
x Remeasure to lower of
- CA (on reclassification
date, ignoring imp losses)
or
- FV – CtS
After reclassification:
x Stop depreciating
x Remeasure to latest FV – CtS
at subsequent reporting
dates
(IL reversals limited to
accumulated IL’s & revised
CA not to exceed Cost - AD)
Transfer back to PPE
652
Non-current assets held for sale and discontinued operations
If asset not expected to be Assets acquired with
sold within 1 yr intention to sell
x 3 scenarios and related criteria Normal 6 criteria, except, apart
x Costs to sell to be from the 1-yr requirement that
discounted (IFRS 5.17) must be met on acquisition date,
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
Revaluation model Assets acquired with
intention to sell
Initially: at cost Initially: Lower of
Subsequently: - CA (cost) and
- FV – CtS
Before reclassification:
Subsequently:
Depreciate; revalue (if FV
materially different to CA) and x Never depreciate
impair (if necessary and x Remeasure to latest FV – CtS
material) at subsequent reporting dates
Reclassify: (reversals of IL limited to
Transfer to NCAHFS accumulated IL’s & never
exceed Cost)
On reclassification:
x Remeasure to lower of
- CA (on reclassification date,
ignoring imp losses) or
- FV – CtS
After reclassification:
x Stop depreciating
x Remeasure to latest FV –
CtS at subsequent reporting
dates
(IL reversals limited to
accumulated IL’s & revised
CA not to exceed FV - AD)
x ILs are always expensed –
never debited to a RS bal.
If no longer held for sale
Remeasure to lower of:
x CA (had asset never been classified as NCAHFS); &
x RA
Resume depreciation
Chapter 12
Gripping GAAP Non-current assets held for sale and discontinued operations

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-in
non-current asset
The disposal group as a whole will be measured
in terms of IFRS 5
The disposal group will be classified and
disclosed in terms of IFRS 5
If the DG does not include any scoped-in
non-current assets
The disposal group as a whole will not be
measured in terms of IFRS 5
The disposal group will be classified and
disclosed 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-

classification as HFS classification as HFS measurement of a DGHFS

Re-measure each item in the
DG based on their own
standards
Measure the DG to the lower of: x Measure each of the items
x Cost or excluding the scoped-in NCAs
using their own standards.
x FV-CtS.
x Calculate the DG’s new CA.

An impairment loss is first x Measure the DG to its latest

allocated to goodwill (if any) FV-CtS.

and any further IL is x Calculate the difference: New

allocated to the scoped-in
NCAs, pro-rata based on their
relative carrying amts.
CA less latest FV-CtS
x An impairment loss is first
allocated to goodwill (if any)
and any further IL is allocated
to 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 12 653
 Gripping GAAP Non-current assets held for sale and discontinued operations

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
look at how to account for a discontinued operation. distinguished, 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

A component of an entity is either:
presentation and disclosure requirements will need to be x 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
JURXSRI&*8¶V , 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
either classified as held for sale or is disposed of would has 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:
- is a separate major line of
sale. In this case, these operations would qualify as a
business or geographical area
discontinued operation. of operations; or
- is part of a single co-
However, if only some of the outlets in KwaZulu-Natal are ordinated plan to dispose of
to be disposed of, this would not represent a separate a separate major line of
business or geographical area
geographical area. If one then concluded that it was also of operations; 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.

654 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

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, jXVWDVZLWKµGLVSRVDOJURXSVKHOGIRUVDOH¶ '* µGLVFRQWLQXHGRSHUDWLRQV¶ '2 FRXOG
also involve all sorts of assets as well as directly related liabilities.

Whereas the classification and presentation UHTXLUHPHQWV RI ,)56  DSSOLHV WR DOO µGLVFRQWLQued
RSHUDWLRQV¶WKHmeasurement requirements apply only to those non-current assets that are included
in the discontinued operation and which DUHµnot scoped-RXW¶IURPWKHPHDVXUHPHQWUHTXLUHPHQWV

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
EHSUHVHQWHGµIRUDOOSHULRGVSUHVHQWHG¶7KLVVLQJOHDPRXQW 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 GLVFRQWLQXHGRSHUDWLRQ¶Vassets/disposal groups; IFRS 5.33 (b) (iii)
x tax effects of gain/ loss on re-measurement or disposal. IFRS 5.33 (b) (iv)

The analysis of this single amount must be provided µIRUDOOSHULRGVSUHVHQWHG¶ IFRS 5.34

The analysis of this single amount may be provided on the face of the statement of comprehensive
income (see option A) or in the notes (see option B). IFRS 5.33 (b)

Chapter 12 655
Gripping GAAP Non-current assets held for sale and discontinued operations

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):

Entity name
Statement of comprehensive income
For the year ended 31 December 20X3 (extracts)
20X3 20X3 20X3 20X2 20X2 20X2
&¶ &¶ &¶ &¶ &¶ &¶
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): remeasurement 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)

Profit for the period 350 58 408 220 200 420

Other comprehensive income 0 0 0 0 0 0
Total comprehensive income 350 58 408 220 200 420

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):
Entity name
Statement of comprehensive income
For the year ended 31 December 20X3 (extracts)
20X3 20X2
Note &¶ &¶
Revenue 800 800
Expenses (300) (400)
Profit before tax 500 400
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
Other comprehensive income 0 0
Total comprehensive income 408 420

Entity name
Notes to the financial statements
For the year ended 31 December 20X3 (extracts)
20X3 20X2
&¶ &¶
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)
Profit for the period 58 200

656 Chapter 12
 Gripping GAAP Non-current assets held for sale and discontinued operations

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 µIRUDOOSHULRGVSUHVHQWHG¶
x net cash flows from operating activities;
x net cash flows from investing activities; and
x net cash flows from financing activities.
Entity name
Notes to the statement of cash flows
For the year ended 31 December 20X3 (extracts)
20X3 20X2
4. Discontinued operation: analysis of cash flows C¶ C¶
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)
:KHUH WKH FRPSRQHQW LV QR ORQJHU µKHOG IRU VDOH¶ WKH DPRXQWV SUHYLRXVO\ GLVFORVHG DV
µGLVFRQWLQXHG RSHUDWLRQV¶ LQ WKH SULRU SHULRGV PXVW EH UHFODVVLILHG DQG LQFOXGHG LQ µFRQWLQXLQJ
RSHUDWLRQV¶The prior period amounts must be described as having been re-presented. This will
facilitate better comparability.
See the examples of disclosure provided in section B: 4.1 and assume that the discontinued
operation was first classified as such in 20X2, but that during 20X3 the criteria for classification
DVµGLVFRQWLQXHG¶ZHUHQRORQJHUPHW Now look at the example disclosure below , which shows
the statement of comprehensive income for 20X3 (using option B as the preferred layout i.e.
where the detail would be given in the notes). Notice that the prior year 20X2 figures shown
EHORZZKHUHDVSUHYLRXVO\VSOLWLQWRµFRQWLQXLQJ¶µGLVFRQWLQXed¶DQGµWRWDO¶ see section B: 4¶V
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
DSUHYLRXVO\FODVVLILHGµGLVFRQWLQXHGRSHUDWLRQ¶KDVEHHQUHDEVRUEHGLQWRWKHILJXUHVUHSUHVHQWLQJWKH
µFRQWLQXLQJRSHUDWLRQV¶RIWKHHQWLW\WKXVH[SOaining 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 12 657
 Gripping GAAP Non-current assets held for sale and discontinued operations

Entity name
Statement of comprehensive income
For the year ended 31 December 20X3 (extracts)
20X3 20X2
&¶ &¶
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
Profit before tax 600 700
Tax expense X2: 180 + DO taxes (97 + 3) (192) (280)
X3: 150 + DO taxes (32 + 10)
Profit for the period 408 420
Other comprehensive income 0 0
Total comprehensive income 408 420

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
IURPWKHHQWLW\¶VRWKHUDVVHWV. 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. 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

658 Chapter 12
 Gripping GAAP Inventories

Chapter 13
Inventories
Main references: IAS 2; IFRS 13; IFRS 15, IAS 16 (incl. amendments to 10 December 2021)
Contents: Page
1. Introduction 661
2. Scope 662
3. The recognition and classification of inventory 662
4. Recording inventory movement: periodic versus perpetual systems 663
4.1 Overview 663
4.2 Perpetual system 664
4.3 Periodic system 664
Example 1: Perpetual versus periodic system 666
4.4 Stock counts, inventory balances and missing inventory 667
4.4.1 The perpetual system and the use of stock counts 667
4.4.2 The periodic system and the use of stock counts 667
Example 2: Perpetual versus periodic system and missing inventory 668
Example 3: Perpetual and periodic system: stock loss due to theft ± profits 669
4.4.3 Presenting inventory losses 671
5. Initial measurement: cost 672
5.1 Overview 672
5.2 Purchase costs 672
5.2.1 Overview 672
5.2.2 Transaction taxes and import duties 672
Example 4: Transaction taxes and import duties 673
5.2.3 Transport costs 673
5.2.3.1 Overview 673
5.2.3.2 Transport/carriage inwards 673
5.2.3.3 Transport/carriage outwards 674
Example 5: Transport costs 674
5.2.4 Rebates 674
Example 6: Rebates 674
5.2.5 Discount received 675
Example 7: Discounts 676
5.2.6 Finance costs 677
Example 8: Deferred settlement terms 678
5.2.7 Imported inventory 679
5.2.7.1 Spot rates 679
Example 9: How to convert foreign currency into a local currency 679
5.2.7.2 Transaction Dates 679
Example 10: Imported inventory ± transaction dates 679
5.3 Conversion costs (manufactured inventory) 680
5.3.1 Overview 680
5.3.2 Conversion costs are split into direct costs and indirect costs 680
Example 11: Conversion costs 682
5.3.3 The ledger accounts used by a manufacturer 683
5.3.3.1 Overview 683
5.3.3.2 Accounting for the movements: two systems 684
5.3.3.3 Calculating the amount to transfer: three cost formulae 684
Example 12: Manufacturing journal entries 685
5.3.4 Manufacturing cost per unit 687

Chapter 13 659
Gripping GAAP Inventories

Contents continued: Page

5.3.5 Variable manufacturing costs (costs that vary directly with production) 688
Example 13: Variable manufacturing costs 688
5.3.6 Fixed manufacturing costs (costs that do not vary directly with production) 689
Example 14: Fixed manufacturing costs & the use of a suspense account 690
Example 15: Fixed manufacturing cost suspense account ± 3 scenarios 691
5.3.6.1 Under-production leads to under-absorption of FMCs 693
Example 16: FMC application rate ± under-absorption 693
5.3.6.2 Over-production leads to over-absorption of FMCs 694
Example 17: FMC application rate ± over-absorption 695
5.3.6.3 Budgeted versus actual fixed manufacturing rates summarised 696
Example 18: Fixed manufacturing costs ± over-absorption 696
Example 19: Fixed manufacturing costs ± under-absorption 697
5.3.7 Joint and by-products 699
Example 20: Joint and by-products 699
5.4 Other costs 700
5.4.1 General rule for capitalisation of other costs 700
5.4.2 Capitalisation of borrowing costs 700
5.4.3 Other costs that may never be capitalised 701
Example 21: All manufacturing costs, including µother costs¶ 701
6. Subsequent measurement: inventory movements (cost formulae) 702
6.1 Overview 702
6.2 Specific identification formula (SI) 702
Example 22: SI purchases and sales 703
6.3 First-in, first-out formula (FIFO) 703
Example 23: FIFO purchases 703
Example 24: FIFO sales 703
6.4 Weighted average formula (WA) 704
Example 25: WA purchases 704
Example 26: WA sales 705
6.5 The cost formula in a manufacturing environment 705
Example 27: Manufacturing ledger accounts ± FIFO vs WA formulae 706
7. Subsequent measurement: year-end 708
7.1 Overview 708
7.2 Net realisable value 709
Example 28: Net realisable value and events after reporting period 710
Example 29: Net realisable value based on purpose of the inventory 711
7.3 Inventory write-downs 711
Example 30: Lower of cost or net realisable value: write-downs 711
7.4 Reversals of inventory write-downs 712
Example 31: Lower of cost or net realisable value: reversal of write-downs 712
7.5 Presenting inventory write-downs and reversals of write-downs 714
Example 32: Lower of cost or net realisable value ± raw materials 715
8. Disclosure 716
8.1 Accounting policies 716
8.2 Statement of financial position and supporting notes 716
8.3 Statement of comprehensive income and supporting notes 716
Example 33: Disclosure ± comparing the nature and function method 716
Example 34: Disclosure ± cost of sales and inventory related depreciation 718
Example 35: Disclosure ± inventory asset and accounting policies 719
9. Summary 720

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 Gripping GAAP Inventories

1. Introduction

Inventory is an asset, whether tangible or intangible, How we account for inventory

that the entity intends to sell or to use in providing is explained in IAS 2 Inventory
services to its customers. This means that, classifying an
asset as µinventories¶, as with all other asset classifications, is affected by intentions. For
example, the following 3 purchased properties, all identical, would be classified and accounted
for differently depending on our intentions:
x Property we intend to use as our factory: this would be classified as property in terms of
IAS 16 Property, plant and equipment;
x Property we intend to hold for capital appreciation: this would be classified as investment
property in terms of IAS 40 Investment property; and
x Property we intend to sell in the ordinary course of business: this would be classified as
inventories in terms of IAS 2 Inventories.

So, in terms of inventory, what kind of item are we looking at? Well, for starters, it depends on what
type of business it is. For example, an entity could buy or make its own inventory, in which case it
would be called a retailer or manufacturer, respectively. In the latter case, for example, an entity
making its own inventory would normally include final products (finished goods), half-finished goods
(work-in-progress) and raw materials. It would also include any supplies used in the manufacturing
process (e.g. cleaning materials). Similarly, entities providing services to customers (called service
providers) would include in their inventory any µsupplies¶ WKH\XVHLQSURYLGLQJWKHVHUYLFHµSXSSOLHV¶
DUHRIWHQFDOOHGµFRQVXPDEOHVWRUHV¶ Typical categories of inventory items are summarised below:

Categories of inventory according to business-type:

Retailer: Manufacturer: Service-provider

x Merchandise x Finished goods x Consumable stores 1
RUµPHUFKDQGLVHIRUVDOH¶
x Work-in-progress
x Raw materials
x Consumable stores 1
(1) These are µPDWHULDOVDQGVXSSOLHV¶an entity intends using in the manufacturing process or in providing a service

In the case of retailers and manufacturers, inventories often represent a significant portion of
the HQWLW\¶V 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, where this expense is generally called cost of sales.
This expense is often the biggest expense that a retailer or manufacturer has, thus it also
VLJQLILFDQWO\DIIHFWVDQHQWLW\¶V profit or loss.

The principles regarding inventories that we need to consider (for which we will need to use a
combination of IAS 1 Inventory and the Conceptual Framework) 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).

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 Gripping GAAP Inventories

The main focus of IAS 2 Inventories is on the determination of the cost of the inventories, and
when to recognise this cost as an inventory expense (e.g. which happens when it is sold or
when it needs to be written-down). This is interesting because, unlike other standards, 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. Thus, we will need to use the Conceptual
Framework in deciding when to recognise a cost as an inventory asset (see section 3).

2. Scope

Even if it meets the definition

IAS 2 applies to all assets that meet the definition of
of inventory, some assets are
inventories except for the following: entirely scoped-out from inventory (i.e.
x Financial instruments 1 they won’t be considered inventory)
x Biological assets related to agricultural activity2; and e.g.
x Agricultural produce at point of harvest
x Agricultural produce at the point of harvest.2 IAS 2.2 (reworded)
However, some assets are inventory
1. These are accounted for in terms of IFRS 9 Financial but are scoped-out from IAS 2’s
instruments and IAS 32 Financial instruments: Presentation measurement requirements:
e.g.
2. These are accounted for in terms of IAS 41 Agriculture. x Agricultural produce after harvest

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 (extract)
*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.

Some costs may need to be accounted for in terms of IFRS 15 (see chapter 4)

Costs that are not able to be accounted for in terms of IAS 2 Inventories or any other
standard (e.g. IAS 16 Property, plant and equipment) must, instead, be accounted for in
terms of IFRS 15 Revenue from contracts with customers. 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
x Recognised: when it meets the asset
subsequently be recognised as an expense «LWGRHVQRW definition and recognition criteria
explain when it should be recognised as an inventory asset. x Classified as inventory: when it
meets the definition of inventory
However, IAS ¶VGHILQLWLRQof inventory (see pop-up on
the next page) states, amongst other things, that inventory is an asset. Thus, we look to the
Conceptual Framework (CF) because this document provides guidance on when to recognise
an asset.
x The CF states we must initially recognise an item as an asset when both the following are met:
 the &)¶V definition of an asset and
 7KH&)¶V recognition criteria (see chapter 2).

In this regard, it is classified as an inventory asset if it meets the inventory definition given in
IAS 2 (see pop-up on the next page). So, if an item meets the asset definition and recognition
criteria, per the CF, we recognise it as an asset. When recognising it as an asset, we then
decide what type of asset to classify it as (inventory, investment property, plant etc).

662 Chapter 13
 Gripping GAAP Inventories

Inventory is defined as:

If we look carefully at this definition of inventory, we see
x an asset
that it essentially includes what:
x that is:
x retailers commonly call merchandise; - held for sale in the ordinary course
of business; or
x manufacturers commonly call raw materials, work in - in the process of production for
progress and finished goods; & such sale; or
x service entities commonly call consumable stores. - in the form of materials or supplies to
be consumed in the production process
Looking at the inventory definition again, we also see that or in the rendering of services. IAS 2.6
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.
For example: If our ordinary business involves buying and selling properties, we would classify these
properties as inventories. However, if our ordinary business does not involve buying and selling
properties, but 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 will 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 perpetual and periodic

systems are NOT mentioned
The movement of inventory refers to the purchase, and in IAS 2 Inventory
subsequent sale of inventory. Purchasing inventory Perpetual = continual update for sales
results in the recognition of an asset whereas selling the Periodic = occasional update for sales
inventory results in the recognition of an expense.
However, the focus of this section is the sale of inventory and thus the recognition of the
expense. 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, a 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 sales under these two systems differ slightly from entity to entity. Essentially,
however, the difference between these two systems is simply that:
x Using the perpetual system, we perpetually (i.e. continually) update our ledger to account
for the cost of each µLQYHQWRU\purchase WUDQVDFWLRQ¶DQGIRUWKHFRVWRIeach µLQYHQWRU\sale
WUDQVDFWLRQ¶ZKHUHDV
x Using the periodic system, although we update our ledger to account for the cost of each
µLQYHQWRU\purchase WUDQVDFWLRQ¶ZHGRnot XSGDWHLWWRDFFRXQWIRUWKHFRVWRIHDFKµLQYHQWRU\
sale WUDQVDFWLRQ¶. Instead, we record the total cost RI DOO µLQYHQWRU\ VDOH WUDQVDFWLRQV¶ for a
period (e.g. a month or a year) as a single transaction (i.e. it is updated occasionally).

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.

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 Gripping GAAP Inventories

4.2 Perpetual system

The perpetual system is used by entities that have complex needs (e.g. manufacturing concerns), or
KDYHDFFHVVWRFRPSXWHULVHGDFFRXQWLQJV\VWHPVWKDWFDQDFFRPPRGDWHWKLVµUHDO-WLPH¶SURFHVVLQJ

The perpetual system uses two accounts: The perpetual system:

x an inventory account (an asset); and x is used by bigger entities
x a cost of sales account (an expense).
x uses the following ledger accounts,
which are continously updated:
Both accounts are perpetually (constantly) updated for - inventory account &
each purchase and each sale of inventory, as and when - cost of sales account
these occur. Thus, the balance in: x can detect missing stock e.g. from theft.
x the inventory account, on any one day, shows what we should physically have on hand; and
x the cost of sales account shows the latest cumulative cost of sales.

Since our inventory account shows what the closing balance should be, a physical stock count can then
be used to check our closing balance. This stock count is done at the end of the period (e.g. year-end).
We compare the µclosing balance in the inventory account¶ and the results of the µphysical count¶, to
identify any missing inventory, which is then recorded as an expense (e.g. inventory loss due to theft).

4.3 Periodic system The periodic system:

x is used by smaller entities

Computerised accounting packages have made the
perpetual system far more popular among businesses. x uses the following ledger
accounts, which are not all
However, small businesses, which may not have access continously updated:
to these packages, will use the periodic system. Thus, - purchases account
the 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 calculate the inventory c/ balance
we do not continually update our ledger accounts for the cost x we use the inventory c/balance to
of each item of inventory sold. Instead, we process one calculate the cost of sales
single journal to account for the total cost of all inventory sold x cannot identify lost stock (e.g. theft)
during the period. This amount (cost of inventory sold) is calculated as a balancing figure by subtracting
the cost of the inventory still on hand, determined from the stock count.
x This stock count is done periodically, generally at year-end. It involves physically counting the
number of units of µinventory on hand¶. We then calculate the total cost of the µinventory on hand¶,
which is what we refer to as RXUµLQYHQWRU\FORVLQJEDODQFH¶. We calculate this by multiplying the
µnumber of units¶ counted by the µcost per unit¶.
Number of units on hand x Cost per unit = Inventory closing balance
x After calculating the µinventory closing balance¶ per the stock count, we balance back to µcost of sales¶.
We do this by comparing this µinventory closing balance¶ with the total of our µinventory opening
balance plus the µcost of our inventory purchased during the year¶
Opening balance + Purchases ± Closing balance = Cost of sales
In other words, aOOLQYHQWRU\WKDWLVµPLVVLQJ¶LVDVVXPHGWRKDYHEHHQVROGDQGWKXVWKHFRVWRIWKH
µPLVVLQJLQYHQWRU\¶LVUHFRJQLVHGE\ZD\RIRQHVLQJOHjournal, as the total µcost RIVDOHV¶ (i.e. the total
of DOOWKHµLQYHQWRU\VDOHWUDQVDFWLRQV¶GXULQJWKHSHULRG).
This system overlooks the possibility that some of this inventory may not have been sold but could,
for example, have been stolen instead. The periodic system cannot detect and separately record
stock theft, and is thus not as accurate as the perpetual system (i.e. the cost of sales is overstated
because it includes the cost of theft). See section 4.4.2 for more on this issue.

An example: A n entity with C100 of inventory on hand at the beginning of a year, records each of the
inventory purchases during the year, where these purchases totalled C200. The entity then counts the
inventory on hand at year-end and calculates the cost thereof to be C50. In this case, the entity will
record the difference of C250 as the cost of sales for the year. See overleaf for the calculation.

664 Chapter 13
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Example solution: Using a stock count to work out cost of goods sold for the year

Opening balance of inventory
Purchases of inventory
Subtotal
Less Closing balance of inventory
Cost of goods sold
Cost of purchases from prior year that were unsold at beginning of year C100
Cost of purchases during the current year (multiple journals) 200
Cost of inventory purchased to date that is still on hand at end of year 300
Cost of inventory still on hand (per the stock count) (one journal) (50)
Cost of inventory sold (also called cost of sales) C250

The periodic system uses three ledger 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).

The journals that are processed under the periodic system will now be explained. Journal 1 is
a journal that is processed for each and every purchase transaction, whereas journals 2, 3 and 4
are all processed once during the reporting period, after physically counting the inventory on
hand at reporting date and calculating the cost of this inventory:

Journal 1: Process a journal to record each and every purchase of inventory

We do QRWGHELWWKHSXUFKDVHVWRWKHµLQYHQWRU\DVVHW¶DFFRXQWEXWto DµSXUFKDVHV¶DFFRXQW
instead ± this account is simply a temporary account (T) the total of which will eventually
EHWUDQVIHUUHGWRWKHµFRVWRIVDOHV¶DFFRXQW
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 purchased
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 prior 2 journals assume we had sold all the opening
inventory plus all the inventory purchased during the year. But if we have any closing inventory, it
means these assumptions were not correct: we clearly did not sell everything, and thus expensing
all the opening inventory and all the purchases was a little too optimistic. This journal thus reverses
an amount out of cost of sales and back into inventory to reflect the inventory still on hand.

The above periodic journals are illustrated below:

Journal 1 Debit Credit

Purchases (T) xxx
Bank/ accounts payable xxx
Purchase of inventories
Journal 2
Cost of sales (E) xxx
Inventory (A) xxx
Transfer of the inventory opening balance to cost of sales
Journal 3
Cost of sales (E) xxx
Purchases (T) xxx
Transfer of the inventory purchases to cost of sales
Journal RYHUOHDI«

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 Gripping GAAP Inventories

Journal 4 Debit Credit

Inventory (A) xxx
Cost of sales (E) xxx
Recognition of the results of the stock count as the new inventory closing
balance, with the contra entry being to cost of sales

After posting the journals, our µcost of sales¶ ledger account will appear as follows:

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 (i.e. the cost of sales) xxx

Example 1: Perpetual versus periodic system

Opening inventory balance C55 000
Purchases during the year (cash) C100 000
The year-end stock count 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 1: Perpetual versus periodic system
In this example, cost of sales & inventory are not affected by whether the periodic or perpetual system is used (i.e.
cost of sales is C65 000 & inventory is C90 000 in both parts A & B). This is because there was no missing inventory.

Solution 1A: Using the periodic system

Purchases (Temporary) Cost of sales (Expense)
Bank (2) 100 000 Inventory o/b(3) 55 000 Inventory c/b(5) 90 000
Cost of sales (4) 100 000 Purchases (4) 100 000 Total c/f (6) 65 000
100 000 100 000 155 000 155 000
Total b/f (6) 65 000
Inventory (Asset)
O/ bal (1) 55 000 Cost of sales (3) 55 000
Cost of sales(5) 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 year (dr purchases and cr bank/ payable).
(3) The inventory opening balance (C55 000) is reversed so that we can later record the new closing
balance. We do this by transferring it to the cost of sales account (dr cost of sales & cr inventory). To
understand this journal, think about it like this ± we are assuming the entire opening balance was sold.
(4) The total of the purchases during the period is transferred to the cost of sales account. To
understand this journal, think about it like this ± ZHDUHDVVXPLQJDOOWKLVSHULRG¶VSXUFKDVHVZHUHVROG
(5) The inventory closing balance is determined at reporting date by physically counting the inventory
on hand and calculating its cost (given as C90 000). This cost is recorded in the inventory account,
while simultaneously reducing the cost of sales account (dr inventory & cr cost of sales). To
understand this journal, think about it like this ± we are now reversing part/all of jnls 3 & 4 on the basis
that clearly we were wrong to assume that everything was sold.
(6) Notice how the balance on the cost of sales account now reflects the final 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/ balance (3) 90 000

666 Chapter 13
 Gripping GAAP Inventories

Notes to the ledger accounts:

(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). This journal reflects the total cost of sales for the year, but the cost of sales
would have actually been processed as many individual journals, as and when each sale occurred.
(3) The inventory closing balance 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.
In this case, since the balance and the stock count both reflected C90 000, no adjustment was needed.
If the stock count reflected actual inventory less than C90 000, suggesting a theft may have
occurred, we would need to process a journal to account for the theft (cr inventory dr theft expense)

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). 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 x uses stock counts as a check; & thus
theft). When using the perpetual system, the accountant x can detect stock losses
calculates the balance of the inventory account without
the 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:

Debit Credit
Inventory loss (E) xxx
Inventory (A) xxx
Inventory loss recognised due to missing stock (e.g. theft of inventories)

If a physical count reflects more stock than appears in the inventory account, then it suggests that
an error occurred either in recording the purchases or sales during the period, or in the physical
stock count. Further investigation would be needed to decide what adjustments to process.

4.4.2 The periodic system and the use of stock counts

When using the periodic system, the accountant does The periodic system
not know what either his inventory balance is or what his
x requires a stock count in order to
cost of sales are, until the inventory on hand is physically calculate the closing inventory
counted and its cost calculated. This cost of the inventory balance & to balance back to the
physically on hand is recorded as the inventory closing cost of sales; & thus it
balance, and is used to calculate the cost of sales. x cannot detect stock losses.

This system, where we do not balance to the closing balance, means there is no way of knowing what
the inventory closing balance should be. Thus, when using the periodic system, any missing inventory
(e.g. due to theft) is µKLGGHQ¶LQWKHFRVWRIVDOHVFor example, if thefts occurred during the period and
thus the stock count reflected a low number of units, this would cause a lower inventory closing
balance. 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.

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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 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 and thus, when we did our stock count, we only
found C5 worth of inventory (not C20). In this case our cost of sales would reflect C95:
Opening inventory: C0 + Purchases: C100 ± Closing inventory: C5 = Cost of sales: C95
Notice:
x The cost of sales is higher than it should have been because it includes the theft of C15.
x It is correct 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 happen to identify a loss at the time it occurs (e.g. we are unfortunate enough to experience a
significant robbery where it is clear exactly what has been stolen), then we process the following:
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: The total expense remains C95 (same as in worked example 2), but is now reflected in two separate
expense accounts and thus more accurately reflects the situation:
Cost of sales expense: C80 + Cost of theft expense (inventory loss): C15 = C95

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 (Part A) suggests that cost of sales is C88 000, whereas the perpetual system
(Part B) more accurately suggests cost of sales is C80 000 and cost of lost stock is 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

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Solution 2A: The periodic system does not identify missing inventory
Purchases (Temporary) Cost of sales (Expense)
Bank (2) 96 000 Inventory o/b(3) 24 000 Inventory c/b(5) 32 000
Cost of sales (4) 96 000 Purchases (4) 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

Inventory (Asset) Bank

O/ bal (1) 24 000 Cost of sales (3) 24 000 Purchases (2) 96 000
Cost of sales(5) 32 000
Notes to the ledger accounts:
(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 inventory opening balance (C24 000)
first needs to be removed from this account. This is done by transferring it out of the inventory
asset and into the cost of sales expense account.
(4) The total of the purchases during the period is transferred to the cost of sales account.
(5) 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.
(6) After processing all entries, the balance on the cost of sales account reflects an expense of C88 000.

Solution 2B: The perpetual system does identify missing inventory

Inventory (Asset) Cost of sales (Expense)
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/ balance (5) 32 000
Notes to the ledger accounts:
(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 THUS 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

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Required: Assuming we prefer to present our inventory losses separately to our cost of sales:
A. Show the ledger accounts using the perpetual system (including closing accounts): we 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 there were no other income and expenses during the year.

Solution 3A: Perpetual system: stock loss due to theft and profits
Inventory (Asset) Cost of sales (Expense)
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/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)

Cost of sales (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
Notes to the ledger accounts:
(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 ( 55 000 TA (6) 95 000 Bank (1) 95 000
Cost of sales (4) 80 000

Purchases (Temporary) Cost of sales (Expense)

Bank (1) 100 000 Cost of sales (100 000 Inventory o/b (2) 55 000 Inventory c/b (4) 80 000
(3)
Purchases 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
P/L (7) 20 000
95 000 95 000

Notes to the ledger accounts:

(1) Amounts given
(2) Transfer inventory opening balance to cost of sales (assumption: all opening inventory is sold during the year).
(3) Transfer all purchases to cost of sales (assumption: all purchases are sold during the period).

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(4) 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) Balance to the amount of C75 000, which is the cost of sales expense, and close it off to the trading account.
(6) Sales are closed off to the trading account (TA).
(7) The balance on the trading account shows the gross profit (GP). This is transferred to the profit or
loss account (P/L). All other income and expense accounts are then also transferred to (closed off
to) the P/L account. The P/L account thus converts gross profit into the final µprofit for the period¶.

Solution 3C: Disclosure ± perpetual versus periodic

Entity name
Statement of comprehensive income Perpetual Periodic
For the period ended 31 December 20X1 (extracts) 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 (2) 20 000 20 000

Comment: Whereas the final µSURILWIRUWKHSHULRG¶LQERWKFDVHVLV unaffected, at C20 000, the gross profits differ
and where the perpetual system¶VJURVVSURILt of C30 000 is a more accurate reflection of what happened.

4.4.3 Presenting inventory losses (IAS 2.34 and .38)

Inventory losses arise due to many reasons (e.g. theft of stock or damage). Whatever the reason
for the loss, inventory WKDWLVQRORQJHUDYDLODEOHIRUVDOH HJLW¶VEHHQVWROHQ PXVt be expensed.

As we now know, 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 (see section 4.4.1).

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).
Cost of inventory
Irrespective of whether the periodic or perpetual system is expense (also called cost
used, if a loss of inventory has been identified, we must decide of sales) includes:
how to present this loss. However, the standard does not state
x the cost of inventory sold;
whether an inventory loss (an expense) should be presented
x unallocated manufacturing overheads;
x separately from µcost of inventory expense¶; or x any abnormal production costs
x included with the µcost of inventory expense¶. (e.g. wastage);
x other costs depending on the
See IAS 2.38
7KH VWDQGDUG VWDWHV WKDW WKH µFRVW RI LQYHQWRU\ H[SHQVH¶ circumstances.
(often called µcost of sales 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
µHQWLW\¶VFLUFXPVWDQFHV¶FRXOGDOVRMXVWLI\LQFOXGLQJother amounts LQWKLVµFRVWRILQYHQWRU\H[SHQVH¶
(e.g. distribution costs). See IAS 2.38

Thus, an inventory loss (e.g. cost of stolen inventory or an impairment due to damage) could, under certain
circumstances, be included in the µcost of inventory expense¶ DVDQµother amount¶3rofessional 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 µcost of inventory expense¶ (cost of sales expense);
x if the loss is abnormal (e.g. robberies are not frequent), the inventory loss expense should not be included
in the µcost of inventory expense¶ (cost of sales); but rather a separate µLQYHQWRU\ORVV expense¶.

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The reason ZK\RQHZRXOGZDQWWRH[FOXGHWKHFRVWRIDQµabnormal loss¶RILQYHQWRU\IURPWKH

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.

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
x other costs required in order to bring the inventory x FV less costs to sell
See IAS 2.20

See IAS 2.10

to its present location and condition (section 5.4).

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¶VEducational 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).

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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.

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 FRXQWU\¶V&XVWRPV'HSDUWPHQW& 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 this equals the net amount paid per the
bank account: Payments: (C9 200 + C5 000) ± Receipts: (C1 200 + C5 000).

Solution 4B: Non-refundable taxes and import duties

Inventory (Asset) Bank
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) Transport costs:

x Inwards: capitalise to inventory

5.2.3.1 Overview
x Outwards: expense.
There are two types of transport (carriage) costs, each 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
WKHVXSSOLHUWRWKHSXUFKDVHU¶VEXVLQHVVSUHPLVHV

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,W LV D FRVW WKDW ZDV LQFXUUHG LQ µEULQJLQJ WKH LQYHQWRU\ WR LWV SUHVHQW ORFDWLRQ¶ DQG VKRXOG
therefore be capitalised to (i.e. included in) the cost of inventory asset.

5.2.3.3 Transport/carriage outwards

)UHTXHQWO\ZKHQDEXVLQHVVVHOOVLWVLQYHQWRU\LWRIIHUVWRGHOLYHUWKHJRRGVWRWKHFXVWRPHU¶V
SUHPLVHV7KHFRVWRIWKLVGHOLYHU\LVUHIHUUHGWRDVµWUDQVSRUWRXWZDUGV¶

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 DFRVWWKDWZDVLQFXUUHGLQµEULQJLQJWKHLQYHQWRU\WRLWVSUHVHQW
ORFDWLRQ¶ 7UDQVSRUWRXWZDUGVVKRXOGWKXVEHUHFRUGHGDVDVHOOLQJH[SHQVHLQWKHVWDWHPHQWRI
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
Inventory (A) 100 000
Trade payable (L) 100 000
Cost of inventory purchased on credit
Inventory (A) 10 000
Transport (E) 15 000
Trade payable (L) 25 000
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
Inventory (A) 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 essentially the rebate received could be designed:
x to reduce the purchase price; or
x WRUHIXQGFHUWDLQRIWKHHQWLW\¶Vselling expenses. Rebates received are set-
off:
The purpose of the rebate affects how we account for it: x against purchase cost: cr inventory
x if the rebate was essentially a reduction in the x against selling costs: cr income
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:
x Invoice price (no VAT is charged on these goods): C9 000
x Rebate offered to the entity by the supplier: C1 000

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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. ZDVDUHIXQGRIWKHHQWLW\¶VH[SHFWHGVHOOLQJFRVWV

Solution 6A: Rebate reducing cost of inventory

Comments: The rebate reduces the cost of inventory: 9 000 ± 1 000 = 8 000

Inventory (Asset) Bank

Bank (1) 8 000 Inv (1) 8 000

Solution 6B: Rebate not reducing cost of inventory

Comments:
(1) The cost of inventory is C9 000 even though only C8 000 is paid. This is because the rebate of C1 000
LVQRWUHODWHGWRWKHLQYHQWRU\SXUFKDVHFRVWEXWWKHHQWLW\¶V IXWXUHH[SHFWHGVHOOLQJFRVWV7KXVWKH
rebate is recognised as income, (this rebate income will be matched with the related selling expenses).
Inventory (Asset) Bank
Bank/RR (1) 9 000 Inv (1) 8 000

Rebate received (RR) (Income)

Inv (1) 1 000

5.2.5 Discount received (IAS 2.11 & IAS 2.11E3&E4) All discounts received:
x are credited to inventory
There are a variety of discounts that you could receive 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 discountWKLVLVVRPHWLPHVUHFHLYHGDVDµUHZDUG¶IRUSD\LQJLQFDVK
x settlement discountWKLVLVVRPHWLPHVUHFHLYHGDVDµUHZDUG¶IRUSD\LQJSURPSWO\

Trade, bulk and cash discounts are generally agreed to on transaction date. Settlement
discounts, however, are estimated by the entity, on transaction date, based on when it 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, bulk, and cash discounts are straight-forward, settlement discounts require more
explanation. As mentioned above, when purchasing inventory when 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 RIWKHµLQYHQWRU\¶will need to be increased by the amount of this
forfeited discount. When journalising this (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.
Explanatory example: We buy inventory for C1 000 and are offered a C200 settlement discount:
Option 1:
x When processing the purchase, we could recognise the µtrade payable¶ measured at the
net amount after deducting the expected discount (debit inventory and credit payable: 800);
x When processing the payment, we will either have paid on time or not:
 If we pay on time, we process the payment of 800 (debit payable and credit bank: 800).
 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 DµSD\DEOH¶PHDVXUHGDWWKHgross amount (we credit this): 1 000, and
x DµGHIHUUHGGLVFRXQW¶PHDVXUHGDWWKHDPRXQWRIWKHSRVVLEOHGLVFRXQW 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 RIGLVFRXQW GHELWµLQYHQWRU\¶
FUHGLWµSD\DEOH¶ DQGGHELWµGHIHUUHGGLVFRXQW¶

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 realisedLWLVQRORQJHUGHIHUUHGVRZHUHYHUVHWKHµGHIHUUHGGLVFRXQW¶
and set it off against the payable GHELWµSD\DEOH¶DQGFUHGLWµGHIHUUHGGLVFRXQW¶ ± 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 forfeitedLWLVQRORQJHUGHIHUUHGVRZHUHYHUVHWKHµGHIHUUHG
GLVFRXQW¶ DQG DGG LW WR WKH FRVW RI inventory GHELW µLQYHQWRU\¶ DQG FUHGLW µGHIHUUHG
GLVFRXQW¶ ± 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

Inventory (Asset) Bank
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 measure the inventory and trade payable at the amount net of discount: 7 600 (9 000 ± 1 000 - 400)
(2) Since we µUHFHLYH¶WKHGLVFRXQW, 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)
Inventory (Asset) Trade payables (Liability)
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 measure the inventory and trade payable at the amount net of the discount: 7 600 (8 000 ± 400)
(2) :HµIRUIHLW¶WKHGLVFRXQWDQGWKXVZLOOQHHGWRSD\ 000, (i.e. the inventory actually costs C8 000).
Thus, we must increase both the inventory cost and the payable with the forfeited discount of 400.
(3) 6LQFHZHµIRUIHLW¶WKHGLVFRXQWZHPDNH a payment based on the gross amount: 8 000.

Solution 7D: Trade discounts and settlement discounts ± payment on time (using option 2)
Inventory (Asset) Trade payables (Liability)
TP & DD (1) 7 600 Inventory (1) 8 000
Def Discount (2) 400
Bank (3) 7 600
Bank Deferred discount (DD)
Trade Payable (3) 7 600 Inventory (1) 400
Trade Payable (2)
400
Comments:
1. We recognise both the inventory and payable at the net amount of 7 600, but we recognise the
SD\DEOHXVLQJWZRDFFRXQWVFUHGLWµWUDGHSD\DEOH¶ZLWK DQGGHELWµGHIHUUHGGLVFRXQW¶ZLWK
2. :HSD\RQWLPHDQGWKXVµUHFHLYH¶RXUGLVFRXQW:HUHFRUGWKLVE\WUDQVIHUULQJWKHGHIHUUHGGLVFRXQW
(DD) to the payable account, thus reducing the payable balance. The discount is no longer deferred.
3. 6LQFHZHµUHFHLYH¶WKHGLVFRXQWZHPDNHDSD\PHQWRIthe net amount of only 7 600 (8 000 ± 400)

Solution 7E: Trade discounts and settlement discounts ± payment late (using option 2)
Inventory (Asset) Trade payables (Liability)
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 inventory, the
contra entry involves two accounts: credit µWUDGHSD\DEOH¶ZLWK 000 and debit µGHIHUUHGGLVFRXQW¶ZLWK
(2) We pay late and thus µforfeit¶RXUGLVFRXQW:HUHFRUGWKLVE\WUDQVIHUULQJWKHGHIHUUHGGLVFRXQW (DD)
to the inventory account. There is no longer any deferred discount and the inventory is now measured
at its cost of C8 000.
(3) 6LQFHZHµforfeited¶WKHGLVFRXQWwe 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

1 January 20X1 Debit Credit
Inventory (A) 6 050
Trade payable (L) 6 050
Cost of inventory purchased on credit (cost of financing is immaterial)
31 December 20X2
Trade payable (L) 6 050
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.
1 January 20X1 Debit Credit
Inventory (A) 5 000
Trade payable (L) 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,
JRRGVDUHUHIHUUHGWRDVµLPSRUWHG¶ 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 LQWRWKHUHSRUWLQJHQWLW\¶VIXQFWLRQDOFXUUHQF\ JHQHUDOO\KLVORFDOFXUUHQF\ 
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.

7KHµWUDQVDFWLRQGDWH¶LVQRWDGHILQHGWHUPEXWit 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 µIUHHRQERDUG¶ )2% and µGHOLYHUHGDWWHUPLQDO¶ '$7 
x if goods are purchased on a FOB basis, risks are transferred to the purchaser as soon as
WKHJRRGVDUHGHOLYHUHGRYHUWKHVKLS¶VUDLODWWKHIRUHLJQSRUW (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

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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 LQDQµDOUHDG\FRPSOHWH¶VWDWH (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 µUHDG\-to-VHOO¶VWDWH (merchandise) is often referred to simply
as the µpurchase cost¶. The cost of goods that are manufactured include both µpurchase costs¶ (i.e. the
cost of purchasing raw materials), and µconversion FRVWV¶. µConversion 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 Conversion costs include:
raw materials into a finished product. It is also called the
x Direct manuf. costs (e.g. wages)
production or manufacturing process. Conversion costs x Indirect manuf. costs (overheads)
are thus part of the production costs (i.e. part of the - Variable manuf. overheads
manufacturing costs). Please note the difference: raw (e.g. cleaning)
material is being converted, and thus raw material is not - Fixed manuf. overheads (e.g. rent)
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
are defined as:
The indirect conversion costs (i.e. manufacturing x indirect costs of production that
overheads) can be further categorised into costs that are: x vary directly or nearly directly
x with the volume of production. IAS 2.12
x Variable: Indirect conversion costs that are variable are
also called variable manufacturing overheads, and are
the indirect costs that increase or decrease as Fixed manuf. overheads
are defined as:
production increases or decreases (e.g. cleaning
x indirect costs of production that
materials); and
x remain relatively constant
x Fixed: Indirect conversion costs that are fixed are x regardless of the volume of
IAS 2.12
also called fixed manufacturing overheads. These production.
are the indirect costs that remain relatively unchanged despite the number of items
produced (e.g. factory rent; administration costs relating to the factory; depreciation and
maintenance of factory buildings and equipment; and the depreciation and maintenance
FRVWVRIOHDVHGDVVHWVFDOOHGµULJKW-of-XVHDVVHWV¶WKDWDUHXVHGLQSURGXFWLRQ). 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 µconversion costs¶ and how
conversion costs µILWLQWR¶WKHWRWDOPDQXIDFWXULQJFRVW.

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 µraw 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 µwork-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 µfinished goods¶ inventory account, (section 5.3.3).

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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-SURJUHVVDFFRXQWDUHµPDQXIDFWXULQJFRVWV¶+RZHYHU
not all of these costs are called µconversion 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 is being manufactured is capitalised to the inventory account
DVSDUWRIWKHµFRVWVGLUHFWO\UHODWHGWRWKHXQLWVRISURGXFWLRQ¶>,$6@
- while the machinery is idle is expensed [costs while idle must not be capitalised: see IAS 2.13].
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 office equipment that relates to the management/ administration of the factory
qualifies to be capitalised to the cost of inventory, but the depreciation on 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

Imagine the following scene: Manufacturing process

x Raw materials are purchased. They are delivered to our x Raw materials account (RM)
premises and put in a storeroom. The accountant shows - In: purchases
raw materials stored in the storeroom in the raw materials - Out: transfers to WIP:
account (an inventory asset). x Work-in-progress account (WIP)
- In: transfers from RM plus
x Some of the raw materials are now loaded onto a truck and conversion costs
- Out: transfers to FG: completed item
driven out of the storeroom to the factory building, 100
x Finished goods account (FG)
metres away. The accountant shows this scene by moving - In: transfers from WIP
an amount out of the raw materials account and into the - Out: transfers to CoS: items sold
work-in-progress account (an inventory asset). x Cost of sales account (CoS)
- In: transfers from FG
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 ± LW¶VWKHFRQYHUVLRQFRVWVWRR: 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 x Periodic system
accounts 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 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 (50 + 100 ± 30) must have been transferred
from the store-room to the factory in order to be used. Thus, at the end of the period, we record
this movement by transferring 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% of the electricity
relates 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)

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Journals continued … Debit Credit

Inventory: work-in-progress (A) (o/b 20 000 + purchase: 40 000) x 40% 24 000
Inventory: raw materials (A) 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
Inventory: work-in-progress (A) 28 000
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 4
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 5
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 6
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, first-in first-out 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: wages for the factory workers (80 000) is direct labour whereas wages for the factory cleaners (6 000)
is indirect labour: both are necessary in 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.
However, 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 may not be capitalised to
inventory [IAS 2.13]. Thus, although depreciation (straight-line basis) was C28 000, had the machine been idle
for 10% of the period, we would have only capitalised C25 200 (C28 000 x 90%) to inventory.
(4) Depreciation on office equipment is expensed (nothing is subsequently capitalised to inventory) because it
was not used in the manufacturing process.

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(5) Transfer from WIP to FG: Items of work-in-SURJUHVV :,3 WKDWDUHQRORQJHUµLQSURJUHVV¶EXWDUHQRZ

finished (completed) must be transferred from WIP to finished goods (FG).
Since all WIP was completed, we simply transfer the entire balance on the WIP account to the FG account.
This example was kept simple in that all WIP was started and completed in the same month.
Had there been some WIP incomplete 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 the cost of the amount to be transferred to FG (i.e. the cost of the finished items).
These three formulae are explained in section 6.
(6) 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 per x Fixed costs / unit (indirect)
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 LWµWRLWVSUHVHQWORFDWLRQDQGFRQGLWLRQ¶ (section 5.4). See IAS 2.10

It is important, when calculating the total manufacturing cost per unit, to assess each manufacturing
cost as either:
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:Tthe 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

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Diagram 4: Manufacturing costs

Manufacturing costs

Variable manufacturing costs Fixed manufacturing costs

Includes, for example:
x Purchase cost of raw materials
x Direct conversion costs that vary
with production (e.g. direct labour)
x Indirect conversion costs that vary
with production (e.g. electricity)
(variable manufacturing overhead)
Includes, for example:
x Direct conversion costs that do not vary
with production (e.g. wages that do not
increase/decrease with production levels)
x Indirect conversion costs that don’t vary
with production (e.g. factory rent)
(fixed manufacturing overhead)

5.3.5 Variable manufacturing costs (costs that vary directly with production)
The variable manuf. cost per
Variable manufacturing costs are simply costs that vary
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

Solution 13B: Journals

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

Inventory: work-in-progress (A) 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). - Inventory: no. of units x fixed
manufacturing cost per unit
However, as was explained, even direct costs may actually
- Expense: Any remaining
turn out to be fixed in nature. unallocated balance is expensed
For example, factory wages that are considered to be core
production costs, 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. (DFKWLPHDXQLWLVZRUNHGRQZHWUDQVIHUWKLVµSHUXQLWFRVW¶out
of the suspense account to the work-in-progress account. This fixed manufacturing cost per
unit is often referred to as the µfixed 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
(AFMCAR). rate 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
as for the purposes of quoting, budgeting and interim x expected average production levels
x under normal conditions
reporting). This means that a budgeted rate (BFMCAR), x after taking into account
using budgeted normal production level (also known as expected loss of capacity during
normal capacity IAS 2.13) as the denominator, is needed as an planned maintenance See IAS 2.13

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
Comment:
x We do not have an actual fixed rate per unit yet since our year has not yet ended and thus we do not yet
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.

Calculation: Budgeted fixed manufacturing cost per unit (BFMCAR):

= Fixed manufacturing costs
Normal production level
= C100 000
50 000 units
= C2 per unit
Journals: Debit Credit
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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Notes to the ledger accounts:

(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.

Since we are processing journals using a budgeted rate during the year, there are three possible
outcomes (see example 15). These 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):
= Fixed manufacturing costs
Normal production level
= C100 000
50 000 units
= C2 per unit

Solution 15A: Fixed manufacturing cost suspense account ± no balance (AP = BP)
Comment:
Notice 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).
Journals: Debit Credit
Fixed manufacturing costs (Suspense a/c) Given 100 000
Bank (A) 100 000
Fixed manufacturing costs are first allocated to the suspense account
Inventory: work-in-progress (A) 50 000u x C2 (BFMCAR) 100 000
Fixed manufacturing costs (Suspense a/c) 100 000
Allocation of fixed manufacturing costs to the number of units of inventory
actually produced during the year

Ledger accounts:
Bank Fixed manufacturing costs (Suspense)
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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Notes to the ledger accounts:

(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.

Solution 15B: Fixed manufacturing cost suspense account ± a debit balance (AP < BP)
Comment:
Notice that, when actual production is less than normal production, fixed manufacturing costs are under-
absorbed into the inventory account (i.e. a debit balance remains in the suspense account).

Journals: Debit Credit

Fixed manufacturing costs (Suspense a/c) Given 100 000
Bank (A) 100 000
Fixed manufacturing costs are first allocated to the suspense account
Inventory: work-in-progress (A) 40 000u x C2 (BFMCAR) 80 000
Fixed manufacturing costs (Suspense a/c) 80 000
Allocation of fixed manufacturing costs to the number of units of
inventory actually produced during the year

Ledger accounts:

Bank Fixed manufacturing costs (Suspense)

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

Inventory: work-in-progress (Asset)

FMCS (2) 80 000

Notes to the ledger accounts:

(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.

Solution 15C: Fixed manufacturing cost suspense account ± a credit balance (AP >BP)
Comment:
Notice that, when actual production exceeds normal production, the fixed manufacturing costs are over-
absorbed into the inventory account (i.e. a credit balance remains in the suspense account).

Journals: Debit Credit

Fixed manufacturing costs (Suspense a/c) Given 100 000

Bank (A) 100 000
Fixed manufacturing costs are first allocated to the suspense account
Inventory: work-in-progress (A) 60 000u x C2 (BFMCAR) 120 000
Fixed manufacturing costs (Suspense a/c) 120 000
Allocation of fixed manufacturing costs to the number of units of inventory
actually produced during the year

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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
Balance (3) 20 000
120 000 120 000
Balance (3) 20 000

Inventory: work-in-progress (Asset)

FMCS (2) 120 000

Notes to the ledger accounts:

(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.

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

Annual fixed 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):

= Fixed manufacturing costs
Normal production level
= 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) 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):
= Fixed manufacturing costs
Greater of: normal (100 000u) and actual (50 000u) production
= C100 000
100 000 units
= C1 per unit *
*: This is the actual fixed manufacturing cost per unit that ends up being allocated to inventory. 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

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
UHIHUUHGWRDVWKHµDFWXDOUDWH¶ (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, because we would have effectively capitalised inefficiency: capitalising fixed
costs of C2 per unit instead of the normal C1 per unit GRHVQ¶WPDNHVHQVHJLYHQWKDWWKHRQO\UHDVRQIRUWKH
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) SXUHO\GXHWRWKHFRPSDQ\¶VLQHIILFLHQF\

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)

= Fixed manufacturing costs

Normal production level
= 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) ± 100 000
Inventory: work-in-progress (A) C200 000 (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

= Fixed manufacturing costs

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).

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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 =
Normal production level

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 actual fixed overheads 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)
= Fixed manufacturing costs
Normal production level

= 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
FMC (4) 60 000 Balance c/d 58 000
78 000 78 000
Balance (6) 58 000

Notes to the ledger accounts:

(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 has been
debited to inventory (Allocated: C60 000 ± Incurred: C40 000): 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:
= Fixed manufacturing costs
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)

= Fixed manufacturing costs

Normal production level

= 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

Notes to the ledger accounts:

(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: 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: 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:

= Fixed manufacturing costs

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 VXJDULVµVSOLWXS¶LQWRWKHTXDQWLW\WKDWZLOOEHVROGDVZKLWHVXJDUDQGWKH
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 VKDUHGSURFHVV« WKH 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 µphysical methods measure¶, the µselling price at split-off method¶
and the µrelative 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 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 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.

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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
(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) 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
(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) This method allocates joint costs on a net realisable value method i.e. µselling price¶ less µfurther
processing costs¶. The further processing cost of C20/ cake includes the cost of icing 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 LQFOXGHG LQ WKH LQYHQWRU\¶V FRVW LH
capitalised) but only if they are incurred in the process of bringing the inventory to its µpresent 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 LVµDQDVVHWWKDW
necessarily takes a substantial period of time to get ready for LWVLQWHQGHGXVHRUVDOH¶
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
WLPHZRXOGPHHW WKH GHILQLWLRQ RIDµTXDOLI\LQJ DVVHW¶LQZKLFK FDVHDQ\UHODWHGILQDQFLQJ FRVWV
recognised as an interest expense must now be capitalised to that inventory
Debit Interest expense xxx
Credit Interest payable / bank xxx
Interest expense is incurred
Debit Inventory xxx
Credit Interest expense xxx
Interest expense is capitalised
For example, the process of manufacturing cheese can involve a substantially long period of time,
in which case the inventory of cheese would be 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

We determine how much, if any, of a borrowing cost must be capitalised by using IAS 23 Borrowing
costs (see chapter 14).

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5.4.3 Other costs that may never be capitalised

There are many types of µRWKHUFRVWV¶ 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«KRZHYHUWKHFRVWRIVWRUDJHQHFHVVDU\between
one production process and another production process must be capitalised); and
x selling costs.

Example 21: All manufacturing costs including µother 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 µother costs¶

Debit Credit
Inventory expense: raw material write-off (E) 500 000 x (20% + 2%) 110 000
Inventory: raw materials (A) 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
Inventory: raw materials (A) 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
Note 1 and Note 2
Rent paid: storeroom, factory building and shop
Advertising (E) 100 000
Bank (A) 100 000
Advertising costs paid for relating to the sale of goods Note 3

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&RQWLQXHG« 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 is thus expensed.
The rent relating to storage while the concrete dries is capitalised because there is still a further production
process after the concrete dries (i.e. 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 (i.e. credit suspense account & debit inventory work-in-progress account) using the
budgeted fixed manufacturing cost allocation rate. This budgeted 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 (selling costs may never be capitalised).

6. Subsequent Measurement: Inventory Movements (Cost Formulae)

6.1 Overview (IAS 2.23 - 27)

Cost formulae:
Inventory movements include purchases and subsequent sales
x SI/ FIFO/ WA
thereof and, if applicable, the conversion into another type of inventory
x If SIM doesn’t apply, you can
or asset (i.e. in the case of a manufacturer, the conversion from a raw choose between FIFO and WA
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 suitable, 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 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 differ 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)

The use of the specific identification formula is not a choice - Specific identification is
it must be used if inventories: used for:
x FRQVLVWRIµLWHPVWKDWDUHQRWRUGLQDULO\LQWHUFKDQJHDEOH¶; or x Items that are not interchangeable; or
x DUH µJRRGV RU VHUYLFHV SURGXFHG DQG segregated for x Goods/ services produced & segregated
for specific projects
specific projects.¶See IAS 2.23

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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 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 50 000
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)

Inventories (A) Bank
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.

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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 thus 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)

Inventories (A) Cost of Sales (E)
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:
As with the first-in-first-out formula, the weighted average
we average the costs per unit
formula is suitable only when the goods are similar in value.
The WA cost per unit will change
Whenever goods are sold or converted, the cost of the when more goods are purchased at
a new price per unit.
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 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

Inventories (A) Bank
1 Jan 100 1 Jan 100
2 Jan 220 2 Jan 220
Balance 320 320

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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

The ledger accounts will look as follows:

Inventories (A) Cost of Sales (E)

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:
x If the selling price was C150, then the gross profit would be C150 ± C106,67 = C43,33.
x 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 formulae 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.

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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
C/ balance b/f Balancing 120 000

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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)

= Fixed manufacturing costs
Normal production level
= 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 to the ledger accounts:

1. The contra entry is depreciation expense. This is 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.
We do it this way because we need to GLVFORVHWKHµWRWDOGHSUHFLDWLRQ¶DVZHOODVWKHµGHSUHFLDWLRQ
H[SHQVH¶. Thus, if we had not debited the µdepreciation expense¶DFFRXQW first, this account would
not have sufficient detail for us to be able to determine what the µtotal depreciation¶ was.

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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
C/ balance b/f Balancing 31 636

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
C/ balance b/f Balancing 117 364

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
units C C/unit units Calculation C
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.

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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 value that is higher than cost is not allowed.
Subsequent measurement
of inventories:
Inventory write-downs are recognised as expenses (i.e. cr
x Lower of:
inventory asset, dr write-down expense). Write-downs may - Cost; or
subsequently be reversed, in which case they will be - Net realisable value. See IAS 2.9

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 Net realisable value is

x WKHHQWLW\¶VHVWLPDWion RIWKHLQYHQWRU\¶Vselling price in the defined as:

ordinary course of business x Estimated selling price in the

ordinary course of business
x less the costs the entity estimates it will still need to incur
x Less:
in order to make such a sale. These costs include: - estimated costs of completion &
 any costs that may still need to be incurred in order to - estimated selling costs. IAS 2.6 (reworded)
make it saleable; (costs of completion) and
 any costs that may need to be incurred in order to secure the sale (selling costs). See IAS 2.6

It is important to differentiate between net realisable value (used to subsequently measure

inventory), and fair value less cost of disposal (used in IAS 36 Impairment of assets) and fair value
less cost to sell (used in IFRS 5 Non-current assets held for sale and discontinued operations).

Since µnet realisable value¶ is the net amount an entity expects to receive when it sells inventory in
the ordinary course of business, it is an entity-specific measurement, which means that different
entities may have different net realisable values for the same item of inventory. +RZHYHUµIair value¶
is measured in terms of IFRS 13, which means it is not entity-specific but is, instead, the price the
item would sell for in the most advantageous/principal market. See IAS 2.7

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

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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
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.
C
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

This 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)
C
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)
Net realisable value 405 000

This 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 undamaged inventory at year-end would thus be NIL (CA: C270 000 - NRV: C405 000 =N/A)

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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)
Net realisable value 399 000

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)
Net realisable value 50 50

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

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iv) Disclosure

Entity name
Statement of comprehensive income
For the year ended 31 December 20X2 (extracts)
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)

Entity name
Notes to the financial statements
For the year ended 31 December 20X2
Part A Part B
3. Profit before tax C C
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
RIWKHHQWLW\¶VRWKHUH[SHQVHV± 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

An entity 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)
31 December 20X1 Debit Credit
Inventory write-down (E) 20
Inventories (A) 20
Write-down of inventories to net realisable value: W1

31 December 20X2
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

Carrying amount 50 70
Lower of cost or net realisable value (20X2: 70 or 55) (20X1: 70 or 50) (55) (50)
Write-down/ (reversal of previous write-down) (5) 20

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Disclosure

Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 (extracts) C C
Note
Revenue x x
Cost of inventory expense (x) (x)
Other costs Comment 1 (20X2: x - 5) (20X1: x + 20) Comment 2 (x - 5) (x + 20)
Profit before tax 7 (x) (x)

Comments:
1. ‘Other costs¶ would need to be disclosed either by function or by nature.
2. Instead of including the inventory write-down and reversal LQµRWKHUFRVWV¶LWcould have been included
in cost of inventory expense. This choice is based on professional judgement.

Entity name
Notes to the financial statements 20X2 20X1
For the year ended 31 December 20X2 C C
7. Profit before tax
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

31 December 20X1 Debit Credit

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

Carrying amount 50 70
Lower of cost or net realisable value (20X2: 70 or 75) (20X1: 70 or 50) (70) (50)
Write-down/ (reversal of previous write-down) (20) 20

Disclosure

Entity name
Statement of comprehensive income 20X2 20X1
For the year ended 31 December 20X2 (extracts) C C
Note
Revenue x x
Cost of inventory expense (x) (x)
Other costs Comment 1 (20X2: x - 20) (20X1: x + 20) Comment 2 (x - 20) (x + 20)
Profit before tax 5 (x) (x)

Comments:
1. ‘Other costs¶ would need to be disclosed either by function or by nature.
2. The inventory write-down and reversal could be included in cost of inventory expense RULQWKHHQWLW\¶V
other expenses ± this is a choice based on professional judgement (see section 7.5).

Chapter 13 713
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Entity name
Notes to the financial statements 20X2 20X1
For the year ended 31 December 20X2 C C
5. Profit before tax
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 µLQYHQWRU\write-down¶ expense and µreversal 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.
Cost of inventory expense
With respect to presentation, IAS 2 does not state
(also called cost of sales)
where we must present an inventory write-down includes:
expense (or reversal of write-down income). Thus, we
x the cost of inventory sold;
could present it as part of the line item 'cost of inventory
x unallocated manufacturing overheads;
expense' (often called cost of sales), or we could
x any abnormal production costs
include it in the line item 'other costs' or we could (e.g. wastage);
present it as a separate line item altogether, such as x other costs depending on the
See IAS 2.38
'inventory write-down'. There are many possibilities. circumstances.

However, IAS 2 describes the µcost 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 µcost 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 µcost of
inventory expense¶OLQH-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 µcost 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 µcost of inventory expense¶ line-item (cost of sales). See IAS 2.34 and IAS 2.38

Sometimes write-GRZQVDUH VLPSO\D QRUPDO SDUWRIDQ HQWLW\¶VEXVLQHVV)RUH[DPSOHLQYHQWRU\

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
new technology was released resulting in certain inventory may be 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 be presented).
rather be presented as an entirely separate line-item.

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.

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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 ± raw materials

A bookkeeper provided you with the following working papers regarding inventory on hand
at 31 December 20X2. The entity manufactures 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 ± raw materials

Comments:
x A write-down of the raw material of motorbike parts is necessary because the NRV of the complete
motorbikes has dropped below cost.
x No write-down of the raw material of bicycle parts is processed since the NRV of the complete
bicycles remained above cost.
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

Chapter 13 715
 Gripping GAAP Inventories

8. Disclosure (IAS 2.36 - .39)

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
- RWKHUFRVWVGHSHQGLQJRQµWKHFLUFXPVWDQFHVRIWKHHQWLW\  IAS 2.38
x Write-down of inventories. See IAS 2.36 (e)
- Write-GRZQVPD\EHLQFOXGHGLQFRVWRIVDOHVGHSHQGLQJRQµWKHFLUFXPVWDQFHVRI
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

716 Chapter 13
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x Work-in-progress: - Balance: 1 January 20X2: C40 000

- Balance: 31 December 20X2: C30 000
x Finished goods: - Balance: 1 January 20X2: C60 000
- Balance: 31 December 20X2: C80 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
Statement of comprehensive income
For the year ended 31 December 20X2 (extracts)
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)
Profit before tax 50 000
Taxation (20 000)
Profit for the year 30 000
Other comprehensive income 0
Total comprehensive income 30 000

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

40 000 W4 190 000 (200 000) 30 000
(balancing)

W3. Finished Goods O/bal + Finished goods - Cost of sales = C/bal

60 000 W2 200 000 (180 000) 80 000
(balancing)
W4. Production costs C
Wages 60 000
Depreciation 80 000
RM used W1 50 000

190 000

Chapter 13 717
Gripping GAAP Inventories

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)
Profit before tax 50 000
Taxation (20 000)
Profit for the year 30 000
Other comprehensive income 0
Total comprehensive income 30 000

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
Statement of comprehensive income
For the year ended 31 December 20X2 (extracts)
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

718 Chapter 13
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Entity name
Notes to the financial statements
For the year ended 31 December 20X2 (extracts)
20X2
3. Profit before tax
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.

Solution 35: Disclosure of the inventory asset and related accounting policies

Entity name
Statement of financial position
As at 31 December 20X2 (extracts)
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
Notes to the financial statements
For the year ended 31 December 20X2 (extracts)
20X2 20X1
Note C C
2. Accounting policies

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 µnote [[[¶for further details).

Chapter 13 719
Gripping GAAP Inventories

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
- Abnormal wastage;
order to bring the asset to its present
location and condition: - Storage costs (unless necessary mid-
- purchase cost (e.g. of raw material – production);
a 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 production
- If AP < NP, then some of the FMC will not
be capitalised and will be included as part
of the cost of inventory expense
(considered to be abnormal wastage)
- If AP = NP, then all FMC’s are capitalised
Actual production > Normal production
- If AP > NP, then all of the FMC will be
capitalised (if normal production was
used as the base instead of actual
production, then more costs would be
capitalised than 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

720 Chapter 13
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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.
Purchases during the period are debited to
purchases account. This is transferred out at
year-end.
x Inventory account (and any sub-
accounts such as Raw Materials, WIP,
Finished Goods etc); and
x Cost of sales account.

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 and

related notes 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

Note 1
- Per class of inventory: - + cost of write-downs
Note 1
- finished goods, - - reversals of write-downs
Note 1
- work in progress, - + inventory losses

- raw materials, - + fixed manuf costs expensed

- consumables
- Of inventory carried at fair value less
costs to sell (this applies to
commodity brokers only)
- Of inventory pledged as security
x Profit before tax note:
(under-absorbed)
- + abnormal wastage
Note 1: these costs could be included in
cost of inventory expense if we
believed they were a normal part of our
trading activities – 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 13 721
 Gripping GAAP Borrowing costs

Chapter 14
Borrowing Costs
Reference: IAS 23 (including amendments to 10 December 2021)

Contents: Page
1. Introduction 723
2. Scope 723
3. Understanding the terms: borrowing costs and qualifying assets 723
3.1 Borrowing costs 723
3.2 Qualifying assets 724
4. Expensing borrowing costs 724
4.1 Recognition as an expense 724
4.2 Measurement of the expense 725
Example 1: Expensing borrowing costs 725
5. Capitalising borrowing costs 725
5.1 Recognition as an asset 725
5.1.1 Commencement of capitalisation 726
Example 2: Capitalisation of borrowing costs: all criteria met same time 726
Example 3: Commencement of capitalisation: criteria met different times 727
Example 4: Commencement of capitalisation: criteria met different times 727
5.1.2 Suspension of capitalisation 728
Example 5: Suspension of capitalisation: delays in construction 728
5.1.3 Cessation of capitalisation 729
Example 6: Cessation of capitalisation: end of construction 729
5.2 Measurement of the amount capitalised 730
5.2.1 Measurement: specific loans 730
Example 7: Specific loans 730
Example 8: Specific loans: costs paid on specific days 731
Example 9: Specific loans: costs paid evenly over a period 732
Example 10: Specific loans: loan raised before construction begins 733
5.2.2 Measurement: general loans 733
Example 11: General loan: the effect of when payments are made 734
Example 12: General loan: more than one general loan 737
5.2.3 Measurement: Foreign exchange differences 739
Example 13: Foreign exchange differences 739
6. Deferred tax effects of capitalisation of borrowing costs 741
Example 14: Deferred tax on a qualifying asset (cost model): deductible 741
Example 15: Deferred tax on a qualifying asset (cost model): non-deductible 742
7. Disclosure 744
8. Summary 745

722 Chapter 14
 Gripping GAAP Borrowing costs

1. Introduction (IAS 23.1)

How we account for borrowing costs is explained in If borrowing costs meet specified
standard IAS 23. If borrowing costs are directly attributable criteria, they must be capitalised
to the acquisition, construction or production of a qualifying to the cost of the related asset.
asset¶they must be capitalised as part of the cost of that There are only 2 exceptions (see scope).
asset. All other borrowing costs are expensed when they are incurred. There are two exceptions
where an entity may choose not to capitalise the borrowing costs (see section 2). See IAS 23.1 and 4
x Before we capitalise borrowing costs as part of the cost of that asset, we must be sure:
 that the borrowing costs do indeed meet the definition of borrowing costs (µinterest and
other costs that an entity incurs in connection with the borrowing of funds¶); and
 that the asset meets the definition of a qualifying asset (µan asset that necessarily takes
a VXEVWDQWLDOSHULRGRIWLPHWRJHWUHDG\IRULWVLQWHQGHGXVHRUVDOH¶ 
Both terms are explained in more detail in section 3.
x Capitalisation of the borrowing costs incurred takes place from commencement date, ends
on cessation date and must be suspended GXULQJµH[WHQGHGSHULRGV¶GXULQJZKLFKWKHHQWLW\
µVXVSHQGVDFWLYHGHYHORSPHQW¶RIWKHDVVHW7KLVLVH[SODLQHGLQmore detail in section 5.1.
x 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
VLPSO\WDSSHGLQWRWKHHQWLW\¶VDYDLODEOHERUURZLQJV 7KLVLVH[SODLQHGLQVHFtion 5.2.
x 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 them 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.
x 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 UHODWHWRWKHµDFTXLVLWLRQFRQVWUXFWLRQRU

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 µPHDVXUHGDWIDLUYDOXH¶RULV
x LQYHQWRU\WKDWLVSURGXFHGµLQODUJHTXDQWLWLHVRQDUHSHWLWLYHEDVLV¶ 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 first be
capitalised and then would be remeasured 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 23.5-6)

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:
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 14 723
 Gripping GAAP Borrowing costs

Notice that this above list does not mention certain costs associated with raising funds or
otherwise financing a qualifying asset. This suggests that these 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 x to the acquisition, construction or
meets the definition of a qualifying asset, these costs production
x of a qualifying asset. IAS 23.8 (reworded)
must be 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

7KHVHLVVXHVDUHH[SDQGHGXSRQLQWKHVHFWLRQHQWLWOHGµPHDVXUHPHQW¶

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
property or investment property, intangible assets and x a substantial period of time
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 µready for their intended use or sale¶ on acquisition,
x financial assets (e.g. an investment in shares), and
x LQYHQWRULHVWKDWWDNHDµVKRUWSHULRGRIWLPH¶WRPDQXIDFWXUHSee 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).

724 Chapter 14
 Gripping GAAP Borrowing costs

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: -RXUQDOLVHWKHLQWHUHVWLQ<D\/LPLWHG¶VERRNVIRUWKH\HDUHQGHG'HFHPEHU;

Solution 1: Expensing borrowing costs

Comment: This example shows:
x When to recognise interest on a non-qualifying asset as an expense: when it is incurred.
x How much to expense: the amount of interest calculated using the effective interest rate method.
Journal: Debit Credit
Finance costs (E) 1 000 000 x 10% x 6/12 50 000
Bank/ liability 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 the:
To capitalise borrowing costs simply means to include them x definition of borrowing costs, &
in the cost of the related qualifying assets. In other words, x recognition criteria per IAS 23
- inflow of future economic
the borrowing costs are recognised as an asset. benefits are probable, and
- cost is reliably measurable.
See IAS 23.8-9
Costs that meet the definition of borrowing costs and that
are 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 met:
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 14 725
 Gripping GAAP Borrowing costs

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 P.S. 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 DVVHW¶V carrying amount is obviously increased.
However, these borrowing costs will eventually be expensed, thus reducing profits, when the
qualifying asset affects profit or loss. For example, if the qualifying asset is an item of property,
plant and equipment, the borrowing costs will be included in the depreciation expense.

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 begun;
x expenditure is being incurred by the entity in x Borrowing costs are incurred; and
preparing the asset; 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 be the
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: -RXUQDOLVHWKHLQWHUHVWLQ<LSSHH/LPLWHG¶VERRNVIRUWKH\HDUHQGHG'HFHPEHU;

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.

726 Chapter 14
Gripping GAAP Borrowing costs

Journals Debit Credit

Finance costs (E) 100 000 x 12 / 12 100 000

Bank/ liability 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 LQ+RRUDK¶Vbooks 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:
1 January 20X5 Debit Credit

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
Bank/ liability 100 000
Interest on loan incurred first expensed: total interest incurred

Building: cost (A) 100 000 x 11 / 12 91 667

Finance costs (E) 91 667
Interest on the loan capitalised to the cost of the building; measured
from commencement date (1 February 20X5)

Chapter 14 727
 Gripping GAAP Borrowing costs

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 development be suspended during:
of a qualifying asset is suspended (i.e. interrupted or x extended periods during which
delayed) IRU D ORQJ SHULRG RI WLPH  /HW¶V FDOO WKLV WKH x active development is suspended.
IAS 23.20 (reworded)
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
ZRUGV µH[WHQGHG SHULRGV¶ VHH JUH\ SRS-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
continue to be capitalised despite a delay is a wine farm asset ready for its intended use;
that has to wait for its inventory of wine to mature in order x is not for substantial technical or
administrative work. See IAS 23.20-.21
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 GXULQJ +DOW ,QQ¶V \HDU HQGHG
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.

728 Chapter 14
 Gripping GAAP Borrowing costs

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 cease when:
substantially ready for its intended use or sale. x substantially all activities necessary
x to prepare the qualifying asset for
For example, capitalisation would cease if the only work its 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.

Journals in 20X5 Debit Credit

Finance costs (E) Given 200 000
Bank/ liability 200 000
Interest incurred

Building: cost (A) 200 000 x 9 / 12 150 000

Finance costs (E) 150 000
Interest capitalised until completion date: 30/9/20X5

Chapter 14 729
 Gripping GAAP Borrowing costs

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: x the borrowings are general.

x WKH µVSHFLILF SXUSRVH¶ RI IXQGLQJ WKH FRQVWUXFWLRQ

acquisition or production of a qualifying asset (called specific borrowings) or;
x DµJHQHUDOSXUSRVH¶VXFKDVIRUEX\LQJLQYHQWRU\SD\LQJRIIFUHGLWRUVDQGDPXOWLWXGHRI
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 the borrowing costs incurred on a specific loan during Borrowing costs to be
the construction period (period between commencement capitalised on specific
date and cessation date, and excluding any suspension loans are measured as:
period; these dates are explained above) are capitalised x Borrowing costs incurred during
the construction period
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.

730 Chapter 14
 Gripping GAAP Borrowing costs

Journals in 20X5 Debit Credit

Finance costs (E) Given 50 000
Bank/ liability 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
Finance costs (E) 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 14 731
Gripping GAAP Borrowing costs

Journals in 20X5 Debit Credit

Finance costs (E) 50 000
Bank/ liability 50 000
Interest incurred on the loan is first expensed
Bank/ debtors W1 10 000
Interest income (I) 10 000
Interest income earned on investment of surplus loan funds
Building: cost (A) W1 40 000
Finance costs (E) 40 000
Portion of interest on the loan capitalised to the cost of the building
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 The interest rate payable on the loan was 10%.
x Construction began on 1 January 20X5, when all criteria for capitalisation of borrowing
costs were met.
x Although Hooray incurred construction costs from 1 January 20X5, Hooray only began
making construction payments from 1 March 20X5. The total construction costs, which
equalled C400 000, were paid evenly between 1 March 20X5 and 31 December 20X5.
x Surplus funds are invested in a fixed deposit and earned interest at 6% per annum. No
principal portion of the loan was repaid during the year ended 31 December 20X5.
Required: Show the interest-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 are required. These surplus funds are invested for January
and February and the balance on this account for these 2 months remains stable at C500 000.
From 1 March 20X5, 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).

Journals in 20X5: Debit Credit

Finance costs (E) W1 50 000
Bank/ liability 50 000
Interest incurred on the loan is first expensed
Bank/ debtors W1 20 000
Interest income (I) 20 000
Interest income earned on investment of surplus loan funds
Building: cost (A) W1 30 000
Finance costs (E) 30 000
Portion of interest on the loan capitalised to the cost of the building
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
Capitalised borrowing costs 30 000

732 Chapter 14
 Gripping GAAP Borrowing costs

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 principal 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: In this example (unlike example 8, where the loan was raised and construction began at the same
time: 1 January 20X5), 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 when calculating the portion of interest to be capitalised.

Journals Debit Credit

Finance costs (E) 500 000 x 10% x 12/ 12 50 000
Bank/Loan 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
Interest income earned on investment of surplus loan funds
Building: cost (A) W1 38 333
Finance costs (E) 38 333
Portion of interest on the loan capitalised to the cost of the building

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)
Capitalised borrowing costs 38 333

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
qualifying asset, we cannot simply capitalise all the loans are measured as:
interest incurred on this loan because not all the interest x Expenditures incurred
ZLOOEHµGLUHFWO\DWWULEXWDEOHWRWKHTXDOLI\LQJDVVHW¶ 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 (QA): 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 14 733
 Gripping GAAP Borrowing costs

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 µthe period¶,$6GRHVQRWFODULI\ZKDWLVPHDQWE\µthe period¶ and thus
its meaning is open to interpretation. It LVVXEPLWWHGWKDWZKLOVWµWKHSHULRG¶FRXOGPHDQWKH
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 WKDWµWKHSHULRG¶UHIHUVWRthe 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: µ&DSLWDOLVDWLRQUDWH[([SHQGLWXUHV¶
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) 50 000 x 7 + 30 000 x 4 + 100 000 x 1 570 000
Bank/ liability 570 000
Construction costs incurred: See Note 1
Finance costs (E) 500 000 x 7% + 600 000 x 12.5% 110 000
Bank/ liability 110 000
Finance costs incurred

734 Chapter 14
Gripping GAAP Borrowing costs

Journals continued ... Debit Credit

Building: cost (A) W1 28 208
Finance costs (E) 28 208
Finance costs capitalised
Note 1: This journal would actually be processed separately for each and every payment but is
VKRZQKHUHDVDFXPXODWLYHMRXUQDOIRUHDVHRIXQGHUVWDQGLQJWKHµELJSLFWXUH¶

W1: Calculation of borrowing costs to be capitalised:

Period Accumulated Expenses Average Interest Accumulated

expenses: incurred cumulative capitalised expenses:
opening bal during the expenses @ 10% closing bal
period
A B C D E
(A + B/2) or (A+B) C x % x m/12 = A + B + D (2)
or (A+ 0) (1)
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) This example involved even payments and thus B is divided by 2
x B is divided by 2 if the payments occur evenly during the period
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 not added if the payments occur at the end of the period
(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).

Journals in 20X5: Debit Credit

Building: cost (A) 50 000 x 7 + 30 000 x 4 + 100 000 x 1 570 000
Bank/ liability 570 000
Construction costs incurred Note 1
Finance costs (E) 500 000 x 7% + 600 000 x 12.5% 110 000
Bank/ liability 110 000
Finance costs incurred
Building: cost (A) W2 25 835
Finance costs (E) 25 835
Finance costs capitalised

Note 1: This journal would actually be processed separately for each and every payment but is shown
KHUHDVDFXPXODWLYHMRXUQDOIRUHDVHRIXQGHUVWDQGLQJWKHµELJSLFWXUH¶.

Chapter 14 735
Gripping GAAP Borrowing costs

W1: Calculation of borrowing costs to be capitalised:

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) or (A+B) C x % x m/12 = A + B + D (2)
or (A+ 0) (1)

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)
(2) D is only added when the interest is compounded in terms of the loan agreement (31 Dec 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.

Journals in 20X5: Debit Credit

Building: cost (A) 50 000 x 7 + 30 000 x 4 + 100 000 x 1 570 000
Bank/ liability 570 000
Construction costs incurred
Finance costs (E) 500 000 x 7% + 600 000 x 12.5% 110 000
Bank/ liability 110 000
Finance costs incurred
Building: cost (A) W2 30 585
Finance costs (E) 30 585
Finance costs capitalised

Note 1: This journal would actually be processed separately for each and every payment but is shown here
DVDFXPXODWLYHMRXUQDOIRUHDVHRIXQGHUVWDQGLQJWKHµELJSLFWXUH¶

736 Chapter 14
Gripping GAAP Borrowing costs

W1: Calculation of borrowing costs to be capitalised:

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) or (A+B) C x % x m/12 = A + B + D (2)
or (A+ 0) (1)
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 14 737
Gripping GAAP Borrowing costs

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 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) or (A+B) C x % x m/12 = A + B + D (2)
or (A+ 0) (1)
0 60 000 (3) 60 000 (6) 676 (9) 60 000
1 January
60 000 150 000 (4) 210 000 (7) 2 367 (10) 210 000
1 February
1 Mar ± 31 Dec 210 000 300 000 (5) 375 000 (8) 42 273 (11) 552 273
510 000 45 316
Calculations:
(1) This example involved a combination of payments at the beginning of the month (January and February),
(thus, C = A + B) and payments incurred evenly over the period (in which case, C = A + B/2)
x B is divided by 2 if the payments occur evenly during the period.
x B is added in full if the payments occur at the beginning of the period (i.e. B is not divided by 2) /
x B is not added if the payments occur at the end of the period.
(2) D is only added when the interest is compounded in terms of the loan agreement (31 Dec in this example)
(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

Journals in 20X5: Debit Credit

Building: cost (A) 60 000 + 120 000 + 30 000 x 11 510 000
Bank/ liability Note 1 510 000
Construction costs incurred

738 Chapter 14
 Gripping GAAP Borrowing costs

Journals continued ... Debit Credit

Finance costs (E) Part (a) 62 000
Bank/ liability 62 000
Finance costs incurred
Building: cost (A) Part (c) 45 316
Finance costs (E) 45 316
Finance costs capitalised
Note 1: This journal would actually be processed separately for each and every payment but is shown here
DVDFXPXODWLYHMRXUQDOIRUHDVHRIXQGHUVWDQGLQJWKHµELJSLFWXUH¶.

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 FRVWV PD\ LQFOXGH µH[FKDQJH GLIIHUHQFHV x the closing rate.
arising from foreign currency borrowings to the extent
WKDWWKH\DUHUHJDUGHGDVDQDGMXVWPHQWWRLQWHUHVWFRVWV¶ 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 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 µ,)5,&8SGDWH-DQXDU\¶):
µ6RPH 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 thHERUURZLQJ¶

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 two 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 WKDWµKRZDQHQWLW\DSSOLHV,$6WRIRUHLJQFXUUHQF\ERUURZLQJVLVD

PDWWHURIDFFRXQWLQJSROLF\UHTXLULQJWKHH[HUFLVHRIMXGJHPHQW¶7KLVPHDQVWKDWZhether 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.

Total construction costs equalled LC8 000 000 during 20X0.

Chapter 14 739
 Gripping GAAP Borrowing costs

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
1 January 20X0 Debit Credit
Building: cost (A) Given 8 000 000
Bank/ liability 8 000 000
Construction costs incurred
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 300 000
Interest payable (Average rate over period of interest) 300 000
Finance costs incurred
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)
Capitalisation of a portion of the forex loss on the loan principal: 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 the
total of 2 350 000 [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 = 500 000 (Loan amt: 5 000 000 x local interest rate at the time we raised the loan: 10%).
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)

740 Chapter 14
 Gripping GAAP Borrowing costs

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
GLIIHUHQFHEHWZHHQWKHDVVHW¶VFDUU\LQJDPRXQW ZKLFKLQFOXGHVWKHERUURZLQJFRVW DQGLWVWD[
base (which will not include the borrowing costs) will arise in the year in which the asset is
brought into use. This difference will gradually reverse over the life of the qualifying asset.

It will have completely reversed :

x once WKHTXDOLI\LQJDVVHW¶VFDUU\LQJDPRXQW ZKLFKwill include the construction costs and
borrowing costs) is reduced to nil via depreciation; and
x RQFH WKH TXDOLI\LQJ DVVHW¶V WD[ EDVH ZKLFK ZLOO LQFOXGH RQO\ WKH FRQVWUXFWLRQ FRVWV  LV
reduced to nil via annual tax-deductions (e.g. wear and tear allowance) and once a tax-
deduction has been granted for the borrowing costs (normally in the period it is incurred).

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, earning 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:

31 December 20X1 Debit Credit

Income tax expense (E) W3 208 500
Current tax payable: income tax (L) 208 500
Current tax expense for 20X1
Income tax expense (E) W2 26 220
Deferred tax: income tax (L) 26 220
Deferred tax expense for 20X1

W1. Calculation of amount to be capitalised during the construction period C

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
Total to be capitalised 92 000

Chapter 14 741
Gripping GAAP Borrowing costs

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)
(26 220)
Depreciation 392 000 x 20% x3/12 (19 600) 0 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. 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)
Profit before tax 782 400
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)
Taxable profits 695 000
Current income tax 695 000 x 30% 208 500
Proof: 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 tax where borrowing costs are capitalised to a non-deductible asset.

31 December 20X1 Debit Credit

Income tax expense (E) W3 213 000
Current tax payable: income tax (L) 213 000
Current tax expense for 20X1

742 Chapter 14
Gripping GAAP Borrowing costs

31 December 20X1 continued« Debit Credit

Income tax expense (E) W2: 27 600 ± 1 380 26 220
Deferred tax: income tax (L) 26 220
Deferred tax expense for 20X1

W1. Calculation of amount to be capitalised during the construction period C

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)
Total to be capitalised 92 000

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 1. 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 2: 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)
Profit before tax 782 400
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)
Taxable profits 710 000
Current income tax 710 000 x 30% 213 000

Chapter 14 743
 Gripping GAAP Borrowing costs

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)

Entity name
Notes to the financial statements (extracts)
For the year ended 31 December 20X5
20X5 20X4
C C
3. Finance costs

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%.

33. Property, plant and equipment

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)

Entity name
Statement of comprehensive income (extracts)
For the year ended 31 December 20X5
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

744 Chapter 14
Gripping GAAP Borrowing costs

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 x Capitalise the total amount of
the construction period using the borrowing costs actually incurred
following formula: during the construction period
- capitalisation rate (CR) x x Less any investment income earned
- the construction costs; on 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
(an official IAS 23 term):
When:
x Activities are in progress
x Borrowing costs (e.g. interest
are being incurred);
x Expenditure on
constructing the asset is
being incurred.
The suspension period (not
a defined term):
When construction is:
x actively suspended
x for a long period;
P.S. Do not pause if the
delay is short, or if it is
long but yet necessary
The cessation date
(not a defined term):
When:
x substantially all the
activities are complete
and
x the asset is thus
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 14 745
 Gripping GAAP Borrowing costs

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 static 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 static amount), you will use the principal 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.

746 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 2021)

Contents: Page
1. Introduction 749
2. Scope 749
3. Recognition, measurement and presentation of government grants 750
3.1 Overview 750
3.2 Grants related to immediate financial support or past expenses 751
3.2.1 Overview 751
3.2.2 Recognition 751
3.2.3 Measurement 752
3.2.4 Presentation 752
Example 1: Grant for past expenses 752
3.3 Grant related to future expenses 753
3.3.1 Overview 753
3.3.2 Recognition 753
3.3.3 Measurement 753
3.3.4 Presentation 753
Example 2: Grant for future expenses - conditions met over two years 753
3.4 Grants involving assets 754
3.4.1 Overview 754
3.4.2 Recognition and measurement of a grant of a non-monetary asset 755
3.4.2.1 Initial recognition and measurement of a non-monetary asset 755
Example 3: Grant is a non-monetary asset: measurement: fair 755
value or nominal amount
3.4.2.2 Subsequent recognition and measurement related to a non- 755
monetary asset
3.4.3 Recognition and measurement of a grant of a monetary asset 756
3.4.3.1 Initial recognition and measurement of a monetary asset 756
3.4.3.2 Subsequent recognition and measurement of a monetary asset 756
Example 4: Monetary grant related to a depreciable asset ± 757
credit to income or asset
Example 5: Monetary grant is a package involving a non- 758
depreciable asset and future costs that are not
measurable
Example 6: Monetary grant is a package involving a non- 759
depreciable asset and future costs that are
measurable
Example 7: Monetary grant is a package involving a non- 760
depreciable asset and a depreciable asset
3.4.4 Presentation of a grant related to assets 761

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Gripping GAAP Government grants and government assistance

Contents continued « Page

3.5 Grants related to loans 761
3.5.1 Overview of grants related to loans 761
3.5.2 Recognition of grants related to loans 761
3.5.3 Measurement of grants related to loans 761
3.5.4 Presentation of grants related to loans 762
Example 8: Grant related to a forgivable loan 762
Example 9: Grant related to a low-interest loan 762
3.6 Grants received as a package 764
Example 10: Grant is a package deal 765
4. Changes in estimates and repayments 765
Example 11: Grant related to expenses ± repaid 766
Example 12: Grant related to assets ± repaid 767
5. Deferred tax 769
5.1 Overview 769
5.2 Grants related to income 769
5.2.1 Grant for immediate financial support or past expenses: taxable 769
5.2.2 Grant for immediate financial support or past expenses: not taxable (i.e. exempt) 769
5.2.3 Grant to assist with future expenses: taxable 769
Example 13: Deferred tax: grant relating to future expenses: taxable 770
5.2.4 Grant to assist with future expenses: not taxable (i.e. exempt) 771
Example 14: Deferred tax: grant relating to future expenses: exempt 771
5.3 Grants related to assets 772
5.3.1 Grants related to assets: taxable 772
Example 15: Deferred tax: cash grant relating to asset ± taxable 772
5.3.2 Grants related to assets: not taxable (i.e. exempt) 774
Example 16: Deferred tax: Cash grant relating to asset ± not taxable 774
6. Disclosure 775
Example 17: Disclosure of government grants 776
Example 18: Disclosure of government grants related to assets: the asset note 777
Example 19: Disclosure of government grants and assistance: a general note 777
7. Summary 778

748 Chapter 15
Gripping GAAP Government grants and government assistance

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 x designed to provide an
are often referred to by other names such as subsidies, economic benefit to
subventions and premiums. x a specific entity (or range of
entities) that
From an accounting perspective, we split government xx qualifies under certain criteria
excluding indirect benefits
assistance into: provided through action
x µgovernment grants¶ (e.g. a grant of cash or another affecting general trading
asset); and conditions. IAS 20.3 (reworded)

x µother government assistance¶ (e.g. the receipt of government advice).

Whereas government grants are recognised and disclosed, Government grants are
other government assistance (i.e. µgovernment assistance¶ defined as:
that does not meet the definition of a µgovernment grant¶) will x government assistance that is a
x transfer of resources
only be disclosed.
x in exchange for compliance
with conditions (past/ future)
IAS 20, however, does not cover: government actions that relating to operating activities
result in indirect benefits received by an entity. For instance, of the entity
a government may construct roads and provide electricity x excluding government
assistance that cannot be
and water to areas that were previously underdeveloped: reasonably valued and
these actions benefit the trading conditions of all entities transactions that cannot be
operating businesses in that area and are not provided to a separated from the entity’s
normal trading transactions.
specific entity. See IAS 20.3 IAS 20.3 (reworded)

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
µgovernment 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 µadvice 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)

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3. Recognition, Measurement and Presentation of Government Grants

(IAS 20.7 - 38)

Government assistance is
3.1 Overview (IAS 20.7 ± 29) split into two categories:
x government grants:
Government grants are effectively a form of income recognised
- recognised and disclosed
in profit or loss. However, please note:
x other government assistance:
x Only government assistance that meets the definition of a - not recognised but disclosed.
µgovernment grant¶ would potentially be recognised:
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 µgovernment grant¶, as defined, will only be recognised in profit or loss if it is µreasonably
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 we can Government grants are only
recognise the grant as income because we normally have to recognised when there is:
meet certain FRQGLWLRQVWRµHDUQ¶WKHJUant. Conversely, meeting x reasonable assurance that
the pre-requisite conditions doeVQ¶WDOZD\VPHan the grant will - the entity will comply with
ever be received. Thus, there must be reasonable assurance the conditions; and
- the grants will be received.See IAS 20.7
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
means that the grant must be recognised in profit or loss on income approach:
a rational basis over the same periods in which the entity x in profit or loss (directly/ indirectly
x on a rational basis
recognises as expenses the costs that the grant was
x in the same period/s in which
intended to compensate. See IAS 20.12 the costs that the grant was
intended to reduce are
There are two ways in which the grant could be recognised expensed. See IAS 20.12
in profit or loss. Either by:
We can recognise a
x recognising it directly as ‘grant income’, or grant in P/L by either:
x recognising it indirectly as income, by way of a x crediting income (direct income); or
µreduced expense’, through crediting the cost that the x crediting asset/ expense
See IAS 20.24 & .29
grant was intended to subsidise (i.e. an asset, such as (indirect income).
plant, or an expense, such as wages) See IAS 20.24 and .29
Grants related to assets
are defined as: IAS 20.3 reworded
IAS 20 refers to three categories of government grants: x a government grant
x A grant related to an asset: This is a grant of either: x with a primary condition requiring:
- a long-term (i.e. non-monetary) asset (e.g. a tangible - the qualifying entity to
building or an intangible right); or - purchase, construct or otherwise
acquire long-term assets;
- cash (i.e. monetary asset) that must be used to acquire
x and may have a secondary
some sort of long-term asset.
condition/s restricting:
x A grant related to income: This is a grant of cash that - the type or location of the
does not involve the acquisition of an asset, but is assets, and/ or
simply received as either: - the periods during which the
assets are to be acquired or held.
- immediate financial support or compensation for
past expenses; or as
A grant related to income
- compensation for future expenses to be incurred. is defined as: IAS 20.3 reworded
x A grant related to a loan: This is a grant that could either be: x a government grant that is
- a forgivable loan (i.e. we might not pay back); or a x not a grant related to an asset.
- low-interest loan.

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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, or presentation of government
grants depends on whether:
a nominal amount; See IAS 20.23
x the grant relates to income, for:
x cash is measured at its cash amount. - 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 x the grant relates to loans; or
of 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 combination 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 on a retrospective basis
(i.e. the entity having already met all conditions, in the past). In other words, 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 - as a credit to expense; or
that the grant will be received and thus the grant transaction - as a credit to grant income
must be recognised. See IAS 20.7 x when the grant is receivable.
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 µimmediate financial support¶, or relating to µrelief
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«even though we were being granted relief from
a wage bill that was incurred in a prior year). 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 15 751
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3.2.3 Measurement (IAS 20.20) Grants for immediate

financial support/ past
Measurement of government grants related to income (or expenses are measured:
assets) is not specifically addressed by IAS 20, and grants are x at the amount
x received/ receivable. See IAS 20.20
thus simply measured at the amount received or receivable.

3.2.4 Presentation (IAS 20.29)

The benefit of the grant that relates to immediate financial support or to compensate for past
expenses must be presented in profit or loss, either as:
x income, presented either as:
Grants for immediate
- a separate line item for grant income; or financial support/ past
- SDUWRIµRWKHULQFRPH¶RUDVD expenses are presented:
x reduction of the related expense. See IAS 20.29 x in P/L,
x either as
- income (separate income line-
A grant for immediate financial support does not relate to any item or part of ‘other income’); or
particular expense and is thus presented as income. - reduction of the expense. See IAS 20.29

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

A government promised 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 the requisite audited statement of expenses on 31 March 20X1 as proof.

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

Comment:
x In this example, and in both Part A and Part B, the grant is received in relation to past expenses
and is therefore classified as µDJUant related to immediate financial support or pDVWH[SHQVHV¶DQG
is thus recognised as grant income as soon as it becomes receivable.
x In both Part A and Part B, the grant is recognised in profit or loss.
x 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).
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

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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 Grants for future expenses
x in profit or loss are recognised:
x on a systematic basis over the periods in which x in profit or loss Note
x the entity expenses the costs that the grant intends - as a credit to expense; or
IAS 20.12 reworded as a credit to grant income
to compensate. -
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
costs are incurred, credit deferred
when that related expenditure is incurred. IAS 20.12 & .17 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.

3.3.3 Measurement (IAS 20.12 & .17) Grants for future expenses
are measured as follows:
The entire grant for future expenses is measured at the x The portion of the amount
total amount of cash received, but the portion of this grant received/receivable to be
recognised in P/L is measured
that is recognised as income in profit or loss is measured
x systematically
on a basis that reflects the pattern in which the expenses
x over the period/s
are expected to be recognised. See IAS 20.12 & .17
x that these future costs are
expensed. See IAS 20.12
3.3.4 Presentation (IAS 20.29)
Grants for future expenses
The benefit of a grant that relates to future expenses are 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’);
- part oIµother iQFRPH¶RU
or
x as a reduction of the related expense. See IAS 20.29 - reduction of the 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.

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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
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.
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 (E) 20 000 20 000
Bank/ Wages payable (20 000) (20 000)
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
Wage expenditure (E) N/A (2 000)
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 (E) 80 000 80 000
Bank/ Wages payable (80 000) (80 000)
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
Wage expenditure (E) N/A (8 000)
Recognising 80% of the grant in P/L since 80% of the costs that the
grant was intended to compensate have been incurred

3.4 Grants involving assets Grants relating to an asset

can come in different forms:
3.4.1 Overview x a non-monetary asset
x a monetary asset that is to be
A grant involving an asset could take the form of the used to acquire a long-term
receipt of the actual non-monetary asset itself or could be asset, that is:
in the form of a monetary asset (e.g. cash) that is to be - depreciable; or
used to acquire a non-monetary asset. If we receive a - non-depreciable.
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 dHILQLWLRQRIDµJUDQWUHlated to an DVVHW¶. 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.

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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 is:
asset, we may measure it at the fair value of the asset or
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 (debit) and
x The initial jnl, if at a nominal
x deferred grant income (credit). 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
fair value), it is submitted that we may need to account for the transaction by immediately recognising
the grant income in profit or loss (not recognising it first as deferred grant income). This is because
deferred grant income must 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, and 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 income 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 aVVHW¶Vfair 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.

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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 P/L as follows:
receipt of the asset would be recognised as grant income If the asset is depreciable,
in 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 If the asset is non-depreciable,
recognised as grant income in profit or loss and the recognise in P/L as:
balance would remain deferred until the remaining x grant income
conditions are met. 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 is measured as follows:
asset (e.g. to acquire or maintain a non-monetary asset), x the cash amount
this 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 a grant related to an asset
credited to that non-monetary asset because the receipt then either journalise as:
of this grant must eventually be recognised as income in x Dr Cash; Cr Deferred income (L),
or
profit or loss: if the non-monetary asset is not x Dr Cash; Cr Asset: cost (but only
depreciable and yet the grant is recognised as a credit if the asset is depreciable).
See IAS 20.24
against the DVVHW¶Vcost, this grant will remain outside of
profit or loss forever (i.e. it will remain as a reduction to the DVVHW¶Vcost). 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.

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However, if the monetary asset was initially recognised as A grant of a monetary asset
deferred grant income, it will need to be subsequently is 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, If the related asset is depreciable,

and the grant was initially
then we would recognise the deferred grant income credited to deferred grant income,
as grant income over the useful life of the asset (e.g. subsequently recognise in P/L as:
the amount of grant income recognised in profit or x grant income or reduced
loss each year would match the rate of depreciation). expense (e.g. lower depreciation)
x over the useful life of the asset.
x If the related non-monetary asset is non-depreciable,
If the grant was initially recognised
then any deferred grant income initially recognised as a credit to the asset’s cost, then
must be subsequently recognised and measured as no journal would be needed to
grant income in profit or loss as and when the achieve the above.
conditions related to the grant are met. If the asset is non-depreciable,
recognise in P/L as:
This subsequent recognition of the grant as income in x grant income
profit or loss can be done either: x as and when conditions are met.
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
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
Bank (A) 12 000 12 000
Deferred grant income (L) (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)
Depreciation on plant
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

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Part A Part B
31 December 20X2 Dr/ (Cr) Dr/ (Cr)
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)
Depreciation on plant
Deferred grant income (L) 12 000 / 3 years 4 000 N/A
Grant income (I)/ Depreciation (E) (4 000)
Grant income recognised on the same basis as plant depreciation
31 December 20X3
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 yrs (30 000) (26 000)
Depreciation on plant
Deferred grant income (L) 12 000 / 3 years 4 000 N/A
Grant income (I)/ Depreciation (E) (4 000)
Grant income recognised on the same basis as plant depreciation
Comment:
x This example involves recording the receipt of a grant before we can recognise it in profit or loss. Thus, it
shows that we initially recognise the receipt as deferred income (liability) until the conditions are met.
x Then the example shows that, once we are reasonably assured 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 the plant is available for use (i.e. as the cost of
the plant is 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 the entity 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 to this grant is 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
Comment: 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.
Answer:
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 is not possible to choose between these two methods. Instead, the grant
received must first be recognised as deferred income, and then as income when the costs of meeting the condition
are recognised in profit or loss. This means that, since the condition relating to acquiring land has been met, the
portion of the grant relating to the land acquisition may, technically, now be recognised as income.

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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, which 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.
The journals for a grant for a non-depreciable asset and future expenses that are not reliably measurable:

1 January 20X1 Debit Credit

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 farmland
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

Example 6: Monetary grant is a package involving a non-depreciable asset and

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 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: purchasing land and clearing vegetation.
IAS 20 also states that we must take care µin identifying the conditions giving rise to costs and expenses
which determine the periods over which the grant will be earned¶. It also states that µit 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 cost associated with one of the conditions (future employee costs) were immeasurable.
- Since land is non-depreciable, the portion of the grant relating to it (C510 000) would be recognised as
grant income immediately (assuming this portion of the grant did not become repayable if the second
condition was not met). Although the entit\¶VDFFRXQWing 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.
- The portion of the grant relating to clearing vegetation (C90 000) would be deferred and recognised as
grant income when the related costs are incurred.

1 October 20X1 Debit Credit

Bank (A) 600 000
Deferred grant income (L) 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

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14 November 20X1 contLQXHG« Debit Credit

Deferred grant income (L) C600 000 x C1 700 000 / C2 000 000 510 000
Grant income (I) 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
Grant income (I) 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
Grant income (I) 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)

Example 7: Monetary grant is a package involving a non-depreciable asset and

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 DecembeU;DVVXPLQJWKDWWKHFRPSDQ\¶V
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

1 January 20X1 Debit Credit

Bank (A) 120 000
Deferred grant income (L) 120 000
Government grant received to assist in the acquisition of land
1 January 20X1
Land: cost (A) 200 000
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

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31 December 20X1 Debit Credit

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
Grant income (I) 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 can either be on a gross or net basis, IAS 20 prefers the deferred
grant income and asset to be presented 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

Grants need not be in the form of an asset ± the grant A forgivable loan is defined
as 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 µthe
conditions and obligations that have been, or must be, met when identifying the costs for
which the benefit of the loan is intended to compensaWH¶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 the
a grant is measured at the amount that is reasonably amount that is reasonably
assured of being forgiven (waived). See IAS 20.10 assured of being waived.
x Low-interest loan: measured as
A low-interest loan received from government must be the 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, measured at the difference between the carrying amount (measured in terms
of IFRS 9) and the actual loan proceeds received. See IAS 20.10A

The amRXQW RI WKH JUDQW LV WKHQ µUHFRJQLVHG LQ 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
FRPSHQVDWH¶ See IAS 20.16

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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: Show the journals for the year ended 31 December 20X1 assuming:
A. all conditions were met by 1 January 20X1.
B. all conditions were 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.
1 January 20X1 Debit Credit
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.

1 January 20X1 Debit Credit

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
Grant income (I) 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)

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.

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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: Show the journal entries for the year ended 31 December 20X1 assuming:
A. the low interest rate was granted on certain conditions, which were all met by 1 January 20X1.
B. the low interest rate was granted to meet general running costs over a 2-year period and the company
policy is to recognise grants as a credit to income.
C. the low interest rate was granted to meet salary costs over a 2-year period and 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. Instalment due on 31 December 20X3

Effective interest rate table using the actual rate of interest: 8%
Year Opening balance Interest charged @ 8% Repayment Closing balance
20X1 100 000 8 000 108 000
20X2 108 000 8 640 116 640
20X3 116 640 9 331
31/12/20X3 (125 971) 0
25 971 (125 971)

W2. 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 Opening balance Interest charged @ 10% Repayment Closing 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

1 January 20X1 Debit Credit
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
31 December 20X1
Interest expense (E) W3 9 464
Loan: government (L) 9 464
Interest on the government loan calculated at the market interest rate

Notice:
x The effect on profit or loss over the 3 years will be: 25 971
Interest expense: over 3 years (20X1-20X3) 9 464 + 10 411 + 11 452 (W3) 31 327
Grant income: recognised in full in first year (20X1) 20X1: 5 356 (Jnl) (5 356)

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Solution 9B: Grant related to a low-interest loan: conditions met later: credit to income
1 January 20X1 Debit Credit
Bank Given 100 000
Loan: government (L) W2 94 644
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
31 December 20X1
Interest expense (E) W3 9 464
Loan: government (L) 9 464
Interest on the government loan calculated at the market interest rate
Deferred grant income (L) 5 356 / 2 years 2 678
Grant income (I) 2 678
Grant credited to income over the 2-year condition: first year met
Notice:
x The effect on profit or loss over the 3 years will be: 25 971
Interest expense: over 3 years (20X1-20X3) 9 464 + 10 411 + 11 452 (W3) 31 327
Grant income: recognised over 2 years (20X1±20X2) 20X1: 2 678 + 20X2: 2 678 (5 356)

Solution 9C: Grant related to a low-interest loan: conditions met later: credit to expense
1 January 20X1 Debit Credit
Bank Given 100 000
Loan: government (L) W2 94 644
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
31 December 20X1
Interest expense (E) W3 9 464
Loan: government (L) 9 464
Interest on the government loan calculated at the market interest rate
Deferred grant income (L) 5 356 / 2 years 2 678
Salary expense (E) 2 678
Grant credited to related expense over the 2 yr condition: first year met
Notice:
x The effect on profit or loss over the 3 years will be: 25 971
Interest expense: over 3 years (20X1-20X3) 9 464 + 10 411 + 11 452 31 327
Salary expense: decrease over 2 years (20X1-20X2) 20X1: 2 678 + 20X2: 2 678 (5 356)

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).

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Each portion of a grant package is 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, to be used as follows:
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.
Other than the purchase of vehicles, all other conditions 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

1 January 20X1 Debit Credit

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 relating to immediate financial support with no
conditions attached: recognise income immediately: 30 000
x Portion of the grant relating to acquiring an asset: defer: 90 000
2 January 20X1
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
Deferred grant income (L) 90 000 / 3 years 30 000
Grant income (I) 30 000
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
assHW¶VFRVt 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.

Chapter 15 765
Gripping GAAP Government grants and government assistance

Where a change in estimate is caused by having to Repayments of government

repay some of the grant, or the entire grant, the change grants are accounted for as:
in estimate must be accounted for using IAS 8. x changes in estimates (IAS 8)
x using the cumulative catch-up
If the grant relates to a depreciable non-monetary asset, method to account for any
the cumulative additional depreciation on this asset that additional depreciation that
would have been recognised to date had the grant not would have been recognised had
there been no grant. See IAS 20.32
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 WKHDVVHW¶VFDUU\LQJDPRXQWhas 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

Example 11: Grant related to expenses ± repaid

The local government granted an entity C10 000 on 1 January 20X1 to assist in the financing of
mining expenses. The grant was conditional upon the entity mining for a period of at least 2 years.
The entity 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 entity¶s year-end is 31 December.
Required: Show the journal entries in 20X1 and 20X2 assuming:
A. the entity chose to recognise grants as deferred grant income.
B. the entity chose to recognise grants 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

Deferred grant income (L) (10 000) (10 000)
Recognising a government grant intended to reduce future expenses

766 Chapter 15
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Journals conWLQXHG« Part A Part B

Dr (Cr) Dr (Cr)
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
Grant income (I) (3 750)
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)
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 an entity C10 000 on 1 January 20X1 to assist in the purchase
of a manufacturing plant.
The grant was conditional upon the entity:
x purchasing the plant, and
x manufacturing for a period of at least two unbroken years.
If the conditions of the grant are not met, the grant will need to be immediately repaid, in full.

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 entity ceased manufacturing on 30 September 20X2 due to unforeseen circumstances.
x The asset was not considered impaired and the entity intended to resume manufacturing in the next year.

Chapter 15 767
Gripping GAAP Government grants and government assistance

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. Thus, 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
µGHIHUUHd grant income DFF¶ UHYHUVLng any balance in this account) and any excess payment is then
debiteGWRDµJUDQWLQFRPHUHYHUVHGH[SHQVHDFFRXQW¶
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.

Part A Part B
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
Bank 10 000 10 000
Deferred grant income (L) (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
Plant: cost (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
Grant income (I) (2 500)
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)
Depreciation of plant
30 September 20X2
Deferred grant income (L) A: 10 000 / 4 years x 9 / 12 1 875 N/A
Grant income (I) (1 875)
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

768 Chapter 15
Gripping GAAP Government grants and government assistance

Journals conWLQXHG« Part A Part B

Dr (Cr) Dr (Cr)
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.

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.

Chapter 15 769
Gripping GAAP Government grants and government assistance

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.

31 December 20X1 Debit Credit

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

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
Taxable profit 108 000

Current income tax 32 400

W2: Deferred income tax

Carrying Tax Temporary Deferred
Deferred grant income
amount base difference taxation
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) 0
Balance: 31/12/20X1 (8 000) 8 000 2 400 A

(1) TB = CA ± any amount that will not be taxable in future periods

Since the entire carrying amount is taxable now, none of it will be taxable in future periods« or, put in
other words, µall of it will be not taxable in the future¶.
Thus, TB = 8 000 ± 8 000 = 0

770 Chapter 15
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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 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

31 December 20X1 Debit Credit

Income tax expense: income tax (E) W1 29 400
Current tax payable (L) 29 400
Current income tax for 20X1 estimated

W1: Current income tax 20X1

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
Taxable profit 98 000

Current income tax 29 400

W2: Deferred income tax

Carrying Tax Temporary Deferred
Deferred grant income
amount base difference taxation
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) 0
Balance: 31/12/20X1 (8 000) 8 000 0 Exempt: IAS 12.15

(1) TB = CA ± the amount that will not be taxed in future periods

Since the entire carrying amount represents future income that is exempt from tax, none of it will be
taxable in future periods« or, put in other words, µall of it will be not taxable in the future¶.
Thus, TB = 8 000 ± 8 000 = 0

Notice:
In the prior example, example 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

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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
evident from the information provided.
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.

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.

Part A Part B
31 December 20X1 Dr/ (Cr) Dr/ (Cr)
Tax expense: income tax (E) W1 36 000 36 000
Current income tax payable (L) (36 000) (36 000)
Current tax
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 on deferred grant income
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

772 Chapter 15
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Entity name
Notes to the financial statements (extracts)
For the year ended 31 December 20X1
Part A Part B
5. Income taxation expense C C
x Current W1 or journals 36 000 36 000
x Deferred 15A: W2 & 15B: W3; or journals (6 000) (6 000)
Tax expense per the statement of comprehensive income 30 000 30 000
Tax rate reconciliation
Applicable tax rate 30% 30%
Tax effects of:
x Profit before tax 100 000 x 30% 30 000 30 000
x Reconciling items 0 0
Tax expense per statement of comprehensive income 30 000 30 000
Effective tax rate 30 000 / 100 000 30% 30%

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 example 15A only:Comment:

In example 15A, there are 2 deferred tax workings that will be required because there are two
balances affected by the grant:
1) the 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)
Balance: 31/12/20X1 (8 000) (2) 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
Since the entire carrying amount is taxable now, none of it will be taxable in future periods« or, put in
other words, µall of it will be not taxable in the future¶.
Thus, TB = 8 000 ± 8 000 = 0
P.S. the fact that it is taxable obviously means it affects taxable profit and thus the closing 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
Depreciation/ deduction (1) (30 000) (2) (18 000) 12 000 3 600 Dr DT Cr TE
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) Tax deduction (wear and tear): 90 000 / 5 years = 18 000

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Gripping GAAP Government grants and government assistance

W3: Deferred tax for example 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)
6 000
Depreciation/ deduction (26 000) (18 000) 8 000 Dr DT Cr TE
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) Tax deduction (wear and tear): 90 000 / 5 years = 18 000

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.

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:
Assuming we recognise government grants as a credit to the related asset (i.e. following on from
example 15B), show the tax journals and tax expense note for the year ended 31 December 20X1.

Solution 16: Deferred tax: cash grant relating to asset ± not taxable

31 December 20X1 Debit Credit

Tax expense: income tax (E) W1 32 400
Current income tax payable (L) 32 400
Deferred tax on deferred grant income
Deferred tax: income tax (A) W2 3 600
Tax expense: income tax (E) 3 600
Deferred tax on deferred grant income

774 Chapter 15
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Entity name
Notes to the financial statements (extracts) 20X1
For the year ended 31 December 20X1 C
5. Income taxation expense
x Current W1 32 400
x Deferred W2 (3 600)
Tax expense per the statement of comprehensive income 28 800
Tax rate reconciliation
Applicable tax rate 30%
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 per statement of comprehensive income 28 800
Effective tax rate 28 800 / 100 000 28.8%

W1: Current income tax 20X1

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
Taxable profit 108 000
Current income tax 32 400

W2: Deferred tax: 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) 0 Exempt
Depreciation/ deduction (2) (26 000) (2) (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

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) Depreciation on cost, net of grant received = (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 OR Depr would have been 30 000 ± Depr is 26 000 = 4 000
(5) The reduction in depreciation of 4 000, caused by the grant, results in a further exemption in the opposite
direction (it is simply WKHµXQwinding¶RIWKHRULJLQDl 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.

Chapter 15 775
Gripping GAAP Government grants and government assistance

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
WKHµRWKHULQFRPH¶OLQHitem 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
Statement of comprehensive income 20X5 20X4
For the year ended 31 December 20X5 C C
Notes
Revenue x x
Other income 40 150 000 170 000
Cost of Sales/Admin/Distribution/Other 41 x x
Finance costs 42 x x
Profit before tax 43 x x

Entity name
Notes to the financial statements
For the year ended 31 December 20X5
2. Accounting policies
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 C
Rent income 25 000 45 000
Government grant 50 125 000 125 000
Other income per the statement of comprehensive income 150 000 170 000

Solution 17B: Grant credited to expense ± SOCI note disclosure

Entity name
Notes to the financial statement 20X5 20X4
For the year ended 31 December 20X5 C¶ C¶
41. Costs by function
Cost of sales 800 900
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 LQWKHµRWKHULQFRPHQRWH¶
x The last line of tKHµDFFRunting policy nRWH¶ Vee Ex 17A) would read the following instead:
 Government grants are presented as a reduction of the related expense/ asset.

776 Chapter 15
Gripping GAAP Government grants and government assistance

Solution 17C: Grant credited to expense ± SOFP disclosure

The following disclosure applies whether the grant is presented as a reduction in expenses or as grant income.

Entity name
Statement of financial position 20X5 20X4
As at year ended 31 December 20X5 C¶00 C¶
LIABILITIES
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¶Vaccumulated depreciation is C300 000 at 01/01/20X4 (cost: C900 000).
x The plant is depreciated straight-line over its remaining life of 2 years to a nil residual value.
x Depreciation is provided on the straight-line method.
Required: Show the property, plant and equipment note for the year ended 31 December 20X5 assuming
the entity recognises grants as a reduction of the related asset.

Solution 18: Disclosure of a grant related to assets ± the asset note

Entity name
Notes to the financial statements 20X5 20X4
For the year ended 31 December 20X5 C¶ C¶000
20. Property, plant and equipment
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 µskeleton note¶ HQWLWOHGµJRYHUnment grants and assiVWDQFH¶that provides a
checklist or structure that you believe will ensure all general disclosure requirements will be met.

Solution 19: Disclosure of government grants and assistance ± a general note

Entity name
Notes to the financial statements
For the year ended 31 December 20X5
50. Government grants & assistance
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 SOCI)
 as a deduction against the «H[SHnse VHHQRWH«
 as a deduction against WKH«DVVHWLQ property, plant and equipment VHHQRWH« 
Unfulfilled conditions: The unfulfilled conditions at reporting date include: «HJµWe must mine for a further 12 yrs'.
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 we have directly
benefited LQFOXGHV« (e.g. a government procurement policy requiring the government to buy 50% of DOO« from us).
Contingent liabilities: If we fail to meet the conditions of the grant recognLVHGLQQRWH«we will be liable to repay
Cxxx. These conditions must be PHWRYHUWKHQH[W«\HDUVDIWHUZKLch we will no longer be exposed to this risk.

Chapter 15 777
Gripping GAAP Government grants and government assistance

7. Summary

Government assistance

Government grants Other government assistance

Monetary grants, for example:
Forgivable loans, or cash to be used to:
x Purchase an asset
x Pay for current/future expenses
x Reimbursement of past costs/ losses
x Financial assistance (e.g. low-interest loan)
Non-monetary grants, for example:
x Land, or
x Licence to operate
Where value cannot be reasonably allocated, for
example:
x Free technical advice
Transactions that can’t be separated from normal
trading activities, for example:
x Government procurement policy that
accounts for a portion of sales
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

778 Chapter 15
Gripping GAAP Government grants and government assistance

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
x Grant income (deferred or realised): realised) OR
acquired
(fair value – nominal amount) x Asset
OR
Credit: x Income (deferred/
realised) OR Future
x Expense expenses
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

Chapter 15 779
Gripping GAAP Leases: lessee accounting

Chapter 16
Leases: Lessee Accounting
Main References: IFRS 16 (with any updates to 10 December 2021)

Contents: Page
1. Introduction 782
2. Scope 782
3. Identifying whether we have a lease 782
3.1 Overview 782
3.2 Is the asset identified? 783
3.2.1 Identification can be explicit or implicit 783
Example 1: Identified asset ± explicit or implicit 783
3.2.2 $VVHWVDUHQRWµLGHQWLILHG¶LIVXSSOLHUKDVVXEVWDQWLYHULJKWRIVXEVWLWXWLRQ 784
Example 2: Identified asset ± substantive right of substitution 784
3.2.3 Portions of assets can be identified 785
Example 3: Identified asset ± capacity portions 785
3.3 'RZHKDYHWKHULJKWWRµFRQWUROWKHXVH¶RIWKH identified asset? 785
3.3.1 Overview 785
3.3.2 The right to obtain substantially all the economic benefits 786
Example 4: Substantially all the economic benefits ± primary & by-products 786
Example 5: Substantially all the economic benefits ± portion payable to lessor 787
3.3.3 The right to direct the use 788
3.3.3.1 Overview 788
Example 6: Right to direct the use ± µKRZand for whaWSXUSRVH¶LV
predetermined 788
Example 7: Right to GLUHFWWKHXVHµKRZDQGIRUZKDWSXUSRVH¶LV
predetermined 789
3.3.3.2 Decisions restricted to operations and maintenance 790
3.3.3.3 Protective rights 790
Example 8: Right to control the use with protective rights and maintenance 790
3.4 Flowchart: analysing the lease definition 792
4. Separating the lease components in a contract 792
Example 9: Allocating consideration to the lease and non-lease components 794
5. Combining contracts 794
6. Recognition exemptions (optional simplified approach) 795
6.1 Overview 795
6.2 Low-value asset leases and the simplified approach 795
Example 10: Exemptions and low-value assets 796
6.3 Short-term leases and the simplified approach 797
Example 11: Exemptions and short-term leases 797
7. Recognition and measurement ± necessary terminology 798
7.1 Overview 798
7.2 Lease term 798
Example 12: Lease term ± basic application 799
Example 13: Lease term ± option to extend: theory 800
7.3 Lease payments 802
7.3.1 Overview 802
7.3.2 Fixed payments 803
7.3.3 Variable lease payments 803
7.3.4 Exercise price of purchase options 804
7.3.5 Termination penalties 804
7.3.6 Residual value guarantees 804
7.3.7 Summary of the calculation of lease payment 804
7.4 Discount rate 805

780 Chapter 16
Gripping GAAP Leases: lessee accounting

Contents continued: Page

8. Recognition and measurement ± the simplified approach 805
Example 14: Leases under the recognition exemption (simplified approach) 805
9. Recognition and measurement ± the general approach 806
9.1 Overview 806
9.2 Initial recognition and measurement 806
Example 15: Initial measurement of lease liability and right-of-use asset 808
9.3 Subsequent measurement ± a summary overview 809
9.4 Subsequent measurement of the lease liability 810
9.4.1 Overview 810
9.4.2 The effective interest rate method 810
Example 16: Lease liability ± subsequent measurement 810
Example 17: Lease liability ± initial and subsequent measurement (advance pmts) 812
9.5 Subsequent measurement of the right-of-use asset 813
9.5.1 Overview 813
9.5.2 Subsequent measurement of the right-of-use asset: in terms of the cost model 813
Example 18: Right-of-use asset ± subsequent measurement: depreciation 814
Example 19: Right-of-use asset ± subsequent measurement: impairments 815
9.5.3 Subsequent measurement of the right-of-use asset: in terms of revaluation model 816
9.5.4 Subsequent measurement of the right-of-use asset: in terms of fair value model 816
9.6 Subsequent measurement - changing lease payments 816
Example 20: Remeasurement - change in lease term 817
9.7 Subsequent measurement - lease modifications 818
Example 21: Lease modification ± scope decreases resulting in partial termination 819
10. Tax consequences 820
10.1 Overview 820
10.2 Tax treatment of leases 820
10.3 Accounting for the tax consequences: lease accounted for using the simplified approach 821
10.3.1 From a tax-perspective, the lessee is renting the asset (the lease meets the
GHILQLWLRQRIµUHQWDODJUHHPHQW¶RUµSDUW E RIWKH,&$GHILQLWLRQ¶) 821
Example 22: Lease under simplified approach ± tax consequences 822
10.3.2 From a tax-perspective, the lessee owns the asset (the lease meets the
definition RIµSDUW D) of the ICA definiWLRQ¶ 824
10.4 Accounting for tax consequence: lease accounted for using the general approach 824
10.4.1 From a tax-perspective, the lessee is renting the asset (the lease meets the
GHILQLWLRQRIµUHQWDODJUHHPHQW¶RU µSDUW E RIWKH,&$GHILQLWLRQ¶ 824
Example 23: Lease under general approach ± tax consequences 825
10.4.2 From a tax-perspective, the lessee owns the asset (the lease meets the
GHILQLWLRQRIµSDUW D RIWKH,&$GHILQLWLRQ¶) 827
10.5 Accounting for the tax consequences involving transaction taxes (VAT): lease meets
µSDUW (b) RIWKH,&$¶GHILQition 827
10.5.1 Overview 827
10.5.2 VAT and the effect on the right-of-use asset 828
10.5.3 VAT and the effect on the lease liability 828
10.5.4 VAT and the effect on taxable profits and current income tax 828
10.5.5 VAT and the effect on deferred income tax 829
Example 24: Lease under general approach - with VAT (basic) 830
Example 25: Lease under general approach - with VAT 830
10.6 Accounting for the tax consequences involving transaction taxes (VAT): lease meets the
GHILQLWLRQRIDµUHQWDODJUHHPHQW¶ 832
11. Presentation and disclosure requirements 833
11.1 Presentation 833
11.1.1 Presentation in the statement of financial position 833
11.1.2 Presentation in the statement of comprehensive income 834
11.1.3 Presentation in the statement of cash flows 835
11.2 Disclosure 835
12. Summary 838

Chapter 16 781
 Gripping GAAP Leases: lessee accounting

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
FKDSWHUUHIHUHQFHWRWKHµHQWLW\¶PD\EHDVVXPHGWRUHIHUWRthe lessee.

IFRS 16 requires that, unless the scope exclusions apply (see section 2) or the optional
simplifications involving short-term leases and low-value asset leases apply (see section 6), the
lessee must recognise the lease by recognising: IFRS 16 accounts for
leases of a lessee ‘on
x Dµright-of-XVH¶asset; and balance sheet’ (i.e. leased
x a lease liability. See IFRS 16.22 assets + lease liabilities)

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 OHVVHH¶V statement of financial
position (i.e. the lease is recognised µRQEDODQFHVKHHW¶ 

2. 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.

3. Identifying whether we have a lease (IFRS 16.9-16 and B9-B33)

3.1 Overview Contract inception is

the earlier of the:
Before we apply IFRS 16, we must be sure that a lease exists. In x Date of a lease agreement; &
order for a lease to exist, it must obviously meet the definition of a x The date of commitment by
lease. The lease definition (per IFRS 16 Appendix B) is illustrated the parties to the principal
in the flowchart below. terms and conditions of the
lease. IFRS 16 App A

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 ‘right to control

See IFRS 16.9
‘identified asset’ the use’ of the asset See IFRS 16.9

782 Chapter 16
 Gripping GAAP Leases: lessee accounting

As can be seen from the flowchart, the lease definition requires that we have a contract. This contract
need not be in writing and the lease could even be just a part of the contract, but without a contract, there
is no possibility that a lease exists. If we decide that a contract exists, we must analyse it ± at contract
inception (see pop-up) ± for evidence that the lease definition is met. In other words, we assess if the
contract, or part thereof, has given the entity (the customer) µthe 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
thus that the entity is a lessee. IFRS 16 App A

IFRS 16 elaborates on this lease definition, explaining that although the definition refers simply to:
x µDQDVVHW¶WKLVDVVHWPXVWEHµidentified¶DQG
x the entity having the µULJKWWRXVH¶ this asset, this µULJKWWRXVH¶WKHDVVHWPXVWWUDQVODWHLQWR
WKHµULJht to control WKHXVH¶RIWKDWDVVHW See IFRS 16.9

3.2 Is the asset identified?

The asset must be identified:
3.2.1 Identification can be explicit or implicit x Can be explicitly/ implicitly identified.
x Can be a portion if it:
It does not matter if the asset is identified explicitly or  is physically distinct; or
implicitly. In other words, the contract might name a  reflects substantially all the
specific asset (explicit identification) or a specific asset asset’s capacity
x An asset is not identified if the
could simply be implied through it being made available supplier has a substantive right to
to the entity (implicit identification). See IFRS 16.B13 substitute it.

Example 1: Identified asset ± explicit or implicit

Aye Limited, a manufacturer of sports cars, enters into a contract with Bee Limited, in terms of which
Bee will manufacture and supply engine components to Aye over 5 years.

The engine components have a unique design and thus, for Bee to manufacture these components for
Aye, Bee needs to design, construct and install a specialised plant on Aye¶Vpremises. The contract does
not specify that Bee must use this specialised plant, but there are no practical alternatives for Bee other
than to use this plant.

Bee¶Vspecialised plant will be used exclusively in the manufacture of these unique components. Due to
the specialised nature of this plant, it 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 havH DQ µDVVHW¶ WKH SODQW +RZHYHU LW PXVW EH µLGHQWLILHG¶ 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 implicitly identified because Bee had no option but to construct it so as to fulfil
its contractual obligations (it was designed with the sole purpose of manufacturing the unique engine
components because there were no alternative plants that Bee could have used).

Before concluding that the plant is an identified asset, we need to consider if Bee has a substantive
right to substitute it. We conclude that it does not have this right since the plant is specifically designed
for the manufacture of the engine components and thus it is unlikely that Bee would have the practical
ability to substitute the plant for another plant and unlikely that it would benefit financially from doing so
(section 3.2.2 explains how to prove whether substitution rights exist).

Thus, since the specialised plant is implicitly identified and Bee does not have substantive rights to
substitute it, we conclude that it is an identified asset.

Note: Even though we proved the plant is an identified asset, it does not yet mean that this contract
should be accounted for as a lease. For the lease definition to be met (specifically, proving that there is
DµULJKWWRXVH¶WKHDVVHW we still need to prove that Aye has the µright to control the use¶ of the plant -
which was not the case in this example.

Chapter 16 783
 Gripping GAAP Leases: lessee accounting

3.2.2 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

substitute an asset is
not be identified if the supplier thereof has the substantive if the supplier:
µsubstantive right to substitute¶ assets throughout the
x has the practical ability to
period of use. See IFRS 16.B14 substitute throughout the lease; and
x would benefit economically if it did
$VXSSOLHU¶VULJKWWRVXEVWLWXWHDVVHWVLVsubstantive only: substitute the asset.
x if the supplier has the practical ability to substitute the If the substitution right is substantive,
asset throughout the lease (e.g. if the asset is not the asset is not identified and thus
particularly specialised in nature and thus the supplier there is no lease.
has a variety of suitable assets on hand that it could If it is difficult to determine if the right
to substitute is substantive, we assume
provide or use as an alternative asset), and See IFRS 16.B14 & .B19
it is not substantive.
x if the supplier would benefit economically by substituting
the asset (i.e. the benefit of substituting the asset exceeds the cost of substitution). See IFRS 16.B14
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 supplLHU¶VULJKWWRVXEVWLWXWHLVVXEVWantive or not, we must assume that the

µVXEVWLWXWLRQULJht is not sXEVWDQWLYH¶See IFRS 16.B19

Example 2: Identified asset ± substantive right of substitution

Adaptation of IFRS 16.IE2
Entity A is a small retailer of 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
throughout the lease. The right to change the VSDFH LV ZKDW LV UHIHUUHG WR DV WKH VXSSOLHU¶V right to
substitute the asset.
Since Entity B (supplier) has the right to substitute the asset, we need to assess whether this right 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).
x In this case, there are a variety of suitable places in the shopping centre that could be used to
KRXVH (QWLW\ $¶VNLRVN DQGWKXV (QWLW\ % KDVWKe practical ability to substitute the space currently
allocated on the second floor for another space elsewhere.
x 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 best use of
the shopping centre space, and thus maximise profitability. Thus, Entity B would benefit economically
from substituting the space if and when circumstances warranted it.

Conclusion:
The 16 square meters of space is not an 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.

784 Chapter 16
 Gripping GAAP Leases: lessee accounting

3.2.3 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 DVVHW¶Vcapacity, unless the portion of
WKHDVVHW¶VFDSacity is physically distinct or if the portion of the capacity is substantially all of the
DVVHW¶VFDSDFLW\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 VXSSO\RIRLOZLOOEHGHOLYHUHGWR(QWLW\$XVLQJ(QWLW\%¶VRLOSLSHOLQH

In terms of the contract, the quantity of oil, which is to be delivered on a daily basis, constitutes 20% of the
capacity of the oil pipeline.

Required:
Explain whether there is an identified asset.

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
deliYHU\YROXPHVUHTXLUHGE\(QWLW\$DUHVXFKWKDWRQO\RIWKHSLSHOLQH¶VFDSDFity will be used. Thus, the
asset to be used is actually a µcapacity 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.

3.3 'RZHKDYHWKHULJKWWRµFRQWUROWKHXVH¶RIWKHidentified asset?

3.3.1 Overview
We have the right to control
the use of an identified
The lease definition (see pop-up in section 3.1) includes the asset if, during the period of
requirement that the entity must hDYHDµright to use¶WKHDVVHW use, we have the right to:
x obtain substantially all the economic
The standard then clarifies that, for there tREHµDULJKWWRXVH¶ benefits from the use of the asset; &
it means that the entity needs WRKDYHWKHµright to control the x direct the use of the asset.
IFRS 16.B9 reworded
use RIWKHDVVHW¶ (see pop-up).

As explained above, thLVµULJKt to control WKHXVHRIWKHDVVHW¶LVHVWDEOLVKHGLIWZRFULWHULDDUHPHW

x the entity must hDYHWKHµright to obtain substantially all the economic benefits¶DQG
x WKHµright to direct the use¶

7KLV µULJKW WR GLUHFW WKH XVH¶RI WKH Dsset will need to be established LI WKH HQWLW\ KDV WKH µright to
direct how and what for purpose¶WKHDVVHWZLOO 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.

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‘Right to use’ the asset (section 3.1) IFRS 16.App A

The lease definition refers to a few items, one of which is that we must have a
x ‘right to use’ the asset

IFRS 16.9
‘Right to control the use’ of the asset (section 3.3)
IFRS 16.9 clarifies that:
A ‘right to use’ the asset = A ‘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 3.3.3)
economic benefits (section 3.3.2) IFRS 16.B9 (a) IFRS 16.B9 (

This right exists if the entity has the 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’

3.3.2 The right to obtain substantially all the economic benefits (IFRS 16.B21-23)

When trying to establish that an entity (customer) has the µright to control the use¶ of the asset, one of
the two criteria that needs to be met is that the entity (cuVWRPHU  PXVW KDYH WKH µright to obtain
substantially all the economic benefits¶IURP 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
µDOOWKHHFRQRPLF 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
substantially all the benefits:
µright to obtain substantially all the economic benefits¶
from the use of the asset, we limit our assessment to the x Include direct and indirect benefits
VFRSHRIWKHFXVWRPHU¶VULJKWVDVGHfined 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
the exclusive and unconditional use of an asset throughout a part of the benefits to the
particular period, this entity would have the right to all the lessor/third party 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 cusWRPHUKDVWKHµULght to obtain substantially all
WKHEHQHILWV¶ZHPXVWFRnsider 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
Tee Limited (customer) enters into a contract with Vee Limited (supplier).
Vee owns a wind farm that it uses to generate electricity (green energy).

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Vee, as owner of the farm, receives the tax benefits relating to the cost of constructing the farm (i.e. the tax
authorities allow Vee to deduct the cost of the farm against its taxable profits).
In terms of the contract, Tee buys Vee¶V HQWLUH supply of green energy, and since Tee is using green
energy, it also receives renewable energy credits.

Required:
Identify the primary products and by-products and conclude whether Tee 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).

Tee 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:
Tee has the right to obtain substantially all the benefits from the wind farm and thus, assuming all other
criteria are met, we conclude that it holds the wind farm as a right-of-use asset.

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 ZKHWKHU ZH KDYH WKH µULJKW WR
receive substantially all the benefitV¶ZHconsider 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 / month and that Jay (the customer) must pay 10% of
the revenue from the use of the asset to the lessor.
Required:
Explain whether Jay has the right to obtain substantially all the economic benefits.

Solution 5: Substantially all the economic benefits ± portion payable to lessor

The fact that Jay (the customer) only has the right to retain 90% of the benefits (100% - 10% payable to the
lessor) does not mean that it does not have the right to receive all the economic benefits.
Instead, we conclude that:
x Jay has the right to receive 100% of the revenue and that
x the lease consideration includes both:
 fixed lease payments of C1 000; and
 variable lease payments equal to 10% of the revenue.

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3.3.3 The right to direct the use

3.3.3.1 Overview

When trying to prove that an entity (cuVWRPHU KDVWKHµULJKWWRFRQWUROWKHXVH¶RIWKHDVVHWRQH

of the two criteria that needs to be met is that the entity (customer) must have the µright to direct
the use of the asset¶.

We would conclude that the entity (customer) has the µright

We have the right to direct
to direct the use of the asset¶ in any one of the following
the use of an asset:
three situations:
x if we have the right to direct how and
x If the entity (customer) µKDVWKHULJKWWRdirect how and for for what purpose the asset is used; or
what purpose WKHDVVHWLVXVHG¶. For example, the entity x if the ‘how and for what purpose’
using a factory may be able to decide what products will is already pre-determined, and:

be manufactured in the factory, when certain products will  we have the right to operate the
asset (or direct others in this regard)
be manufactured and who the entity will supply.
 we designed the asset and its
design predetermines the ‘how
x If the relevant decisions about µKRZ Dnd for what
and for what purpose’ See IFRS 16.B24
SXUSRVH WKH DVVHW LV XVHG¶ 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) KDVWKHµULJKWWRoperate the DVVHW¶ RU 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 µKRZDQGIRUZKDWSXUSRVHWKHDVVHWLVXVHG¶ is somehow already
pre-determined (i.e. neither the entity (customer) nor the supplier can make these decisions), but
the entity (customer) µdesigned WKH DVVHW¶ (or parts of the asset) and where this design
µpredetermines KRZDQGIRUZKDWSXUSRVHWKHDVVHWZLOOEHXVHG¶
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 XVHGLQWKHFXVWRPHU¶VPDQXIDFWXULQJSURFHVV See IFRS 16.B24 & B26

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’, OR
(customer) has the

use of the asset if:

right to direct the
The entity

The relevant decisions about ‘how and for what purpose’ the asset is used is predetermined, but:
x the customer has the right to operate the asset; OR

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: µKRZand IRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG

Adaptation of IFRS 16.IE6

Eff Limited enters into a contract with Gee Limited where Gee will transport Eff¶VFDUJRIURP
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 it will be
transported, the route the ship must take and that Gee will operate the ship and be responsible for all
maintenance and safety aspects. The ship is specified in the contract.

Required:
a) Explain whether Eff has the right to direct the use of the ship.
b) Assuming all other criteria are met, explain whether the contract contains a lease.

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Solution 6: Right to direct the use: µKRZ IRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG

a) Eff (customer) does not have the right to direct how and for what purpose the ship will be used: the
details regarding the dates and route thaWZLOOEHWDNHQ WKHµKRZ¶ DQGWKHGHWDils of the cargo to be
WUDQVSRUWHG WKHµSXUSRVH¶ DUHVSHFLILHGLQWKHFRQWUDFW

Since the decisions regarding µhow and for what purpose¶ is pre-determined in the contract, we must
analyse whether Eff either operates the ship or designed the ship. In this case, Eff neither operates
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 Eff neither operates the ship nor designed the ship, we
conclude that Eff does not have the right to direct the use of the ship.

b) Since Eff 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 Eff does not have the right to control the use of
the asset, the contract does not involve a lease.

For your interest:

Before we can say there is a lease, an identified asset must exist and Eff must have the right to
control its use.

In part (b), we looked at whether Eff had the right to direct the use of the ship, which is only one of the
criteria to prove if Eff has the right to control its use: the other criteria is that Eff must be able to obtain
substantially all the economic benefits from its use.

In part (b) we were told to simply assume that all other criteria were met. A full 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 Eff have the right to control the use of the ship? Two criteria must be met to prove this. The
first criteria is that Eff (customer) must have the right to substantially all the economic benefits from
the use of the ship throughout the contract. In this case, there is so much cargo that it will occupy
the entire ship such that no other parties can obtain any benefit from the use of the ship during this
period of use. Thus, Eff has the right to substantially all the benefits. The second criteria is that Eff
must have the right to direct its use. Eff does not have this right (see part b). Thus, Eff does not
control the use of the ship (Eff has the right to substantially all the economic benefits during the
period of use but does not have the right to direct its use)

x Conclusion: There is no lease because, although there is an identified asset (the ship), Eff does
not have the right to control its use .

Hypothetically, if we had concluded that Eff had the right to control the use of an identified asset and
thus that the contract included the lease of a ship, Eff would not necessarily account for the lease on
the balance sheet. This is because the use of the ship is for one trip only, and thus the lease is for less
than 1 year, which means Eff has the option to expense the lease instead (see section 6).

Example 7: Right to direct the use:

x µKRw and for wKDWSXUSRVH¶LVSUHGHWHUPLQHG
Em Limited (customer) enters into a contract with Aitch Limited. The terms and conditions
include the following:
x Em will acquire the nuclear power generated by Aitch.
x Aitch owns and is the exclusive operator of the nuclear power plant.
x This plant was specially designed by Em.

Required:
Explain whether Em has the right to direct the use of the asset and, assuming all other criteria are met,
whether the nuclear plant is leased by Em.

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Solution 7: Right to direct the use ± µKRZ IRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG

Aitch (supplier) operates the plant and thus Em (customer), 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 Em nor Aitch can
actually decide to change how the asset is used or for what purpose the asset is used. This is because
the specialised nature of the plant predetermines this. This is evidenced by the following:

x WKHµKRZ¶LVYHU\WHFKQLFDODQGWKXVWKHUHLVRQO\RQHZD\WRRSHUDWHWKLVplant; and

x WKHµIRUZKDWSXUSRVH¶LVFOHDUO\WKHSURGXFWLRQRISRZHU

7KHGHFLVLRQVUHJDUGLQJWKHµKRZDQGIRU what purpose¶ DUHWKXVµpredetermined’.

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, Em (the customer) does not operate the plant but it did design the plant for Aitch (supplier)
and this design actually predetermines how and for what purpose the asset is used. This fact is used as
evidence that Em has, in effect, the right to direct the use of the asset.

Conclusion: Em KDVWKHULJKWWRµGLUHFWWKHXVH¶RIWKHpower plant and thus, assuming all other criteria

are met, it should conclude that it holds the power plant under a lease.

3.3.3.2 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 µright to direct how and for what purpose¶ the asset
is used.

In fact, in most cases, the converse is true: the decisions regarding µhow 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 µhow and for what purpose¶ the asset is used are predetermined. See IFRS 16.B27

3.3.3.3 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 DUH PHUHO\ GHVLJQHG IRU H[DPSOH µWR SURWHFW WKH VXSSOLHU¶V
intereVW LQ WKH DVVHW RU RWKHU DVVHWV WR SURWHFW LWV SHUVRQQHO RU WR HQVXUH WKH VXSSOLHU¶V
FRPSOLDQFHZLWKODZVRUUHJXODWLRQV¶.

Protective rights come in many forms, such as limiting the usage of the asset for safety reasons, or
requiring the customer to follow FHUWDLQµRSHUDWLQJSUDFWLFHV¶LQRUGHUWRHQVXUHORQJHYLW\RIWKHDVVHWHWF

Protective rights are terms and conditions that generally simply µdefine the scope of the
FXVWRPHU¶s right of use, but do not, in isolation, prevent the customer from having the right to
GLUHFWWKHXVHRIWKHDVVHW¶See IFRS 16.B30

Example 8: Right to control the use with protective rights and maintenance
Adaptation of IFRS 16.IE6B

Jay Limited enters into a contract with Elle Limited for the right to the exclusive use of a
passenger train to be used along a specified train route.

Jay 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.

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However, the contract specifies that Jay may not carry more than 1 000 passengers at a time and may
not operate the train for more than 1 200 km per day.
The contract also specifies that Elle 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, Elle will substitute the train carriage with an alternative.

Required:
Indicate whether Jay 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 Jay (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.

Jay has exclusive use of the train along a specified route. As such, within the scope of this contract, Jay
has the right to substantially all the economic benefits from the use of the train.

The fact that Jay can operate the train is not relevant when assessing whether it has the right to direct the use
of the train. This is because being able to operate an asset does not mean one is able to make the decisions
UHJDUGLQJµhow and for what purpose¶WKHDVVHWZLOOEHXVHG(we only consider whether the entity can operate
the asset if the decisions regarding µhow and for what purpose¶ the asset is used are predetermined).

What is relevant is that Jay 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 Jay 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 Elle (supplier) puts restrictions on how many passengers may be carried in one trip and
how many kilometres may be travelled in one day are simply protective rights (i.e. they are protecting
Elle¶V investment in its train).

These protective rights simply define the scope of Jay¶V ULJKWWR XVe the train and do not detract from
Jay¶VULJKWWRGHFLGHKRZand for what purpose the train is used.

We thus ignore Elle¶VULJKWVbecause they are protective rights.

Similarly, the fact that Elle is responsible for scheduling and carrying out maintenance and repairs does not
mean that Jay does not have the right to direct the use of the train. In fact, the converse is true: the decisions
made by Jay 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 Jay has the right to direct the use of the train.

Since Jay 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 Jay is leasing the train from Elle.

For your interest:

One of the other criteria that must 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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3.4 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 3.2.1).
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 3.2.2).
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

There is no lease
it’s a capacity portion (that is not physically distinct), it must
reflect substantially all the capacity (see section 3.2.3).

Yes

Do we have the right to ‘control the use’ of the asset throughout the period
No
of use?
Core guideline – the 2 requirements: Further guidelines:
Do we have the right to obtain substantially We consider
all the economic benefits from the use of the x only the economic benefits within
identified asset throughout the period of the scope of the contract
use? x the direct and indirect benefits (e.g.
See IFRS 16.B9(a) (see section 3.3.2)
through using or sub-leasing the asset)
AND
Do we have the right to direct the use of We have this right if:
the identified asset throughout the period x we can decide ‘how and for what
of use? purpose’ the asset is used.
See IFRS 16.B9(b) (see section 3.3.3)
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

4. 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 should (ideally) be
accounted for separately from the lease component/s.
These non-lease components must be accounted for in
terms of the relevant standard.
However, a lessee may choose to apply what is
referred 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.
a right to use an underlying
asset where:
x the lessee can benefit from the
asset on its own (or with other
readily available resources ), and
x the asset is not highly dependent on/
interrelated with the other assets in
the contract. IFRS 16.B32 (reworded)

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 µare readily available to WKHOHVVHH¶ 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 µcontains a lease for each
potential separate OHDVHFRPSRQHQW¶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
separate lease components
lessor would charge the entity (lessee) if it supplied that and 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-
The portion of the consideration that is allocated to lease component
each lease component will be accounted for in terms of x unless the entity chooses the
practical expedient (not to
IFRS 16 and the portion that is allocated each of the separate non-lease components –
non-lease components will be accounted for in terms in which case the consideration is
of the relevant standard. See IFRS 16.16 simply allocated between separate
lease components)
See IFRS 16.13-16
If a contract contains more than one lease component,
there is no choice but to account for each lease component separately (separation is
compulsory). If the contract also contains non-lease components, it is recommended that the
non-lease components be accounted for separately from the lease components (this separation is
not compulsory). Where non-lease components exist, a practical expedient exists that allows the
lessee not to bother separating the non-lease components. In this case, a lease component and any
related non-lease component may 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

Enne Limited (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 contract 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 Enne with (a) the right to use a plant and (b) monthly maintenance services.
P.S. Although the contract states that part of the consideration also includes the provision of insurance,
this is not a good or service from which Enne benefits (the lessor benefits from the insurance): provision
of insurance is thus not a separate component of the contract and is disregarded when allocating the
consideration to the components of the lease.
x The right to use the plant is a lease component (since it is a right to use an asset).
x The right to maintenance services is a non-lease component (they do not represent the right to use
an asset).

The total consideration is allocated based on the relative stand-alone price per lease component and the
aggregate stand-alone prices of all non-lease components (in this case there is only one non-lease component):
Stand-alone prices
Allocation of annual contractual consideration:
C
Stand-alone price per lease component Given ± plant 10 000
Stand-alone prices for all non-lease components Given ± maintenance only 5 000
Total stand-alone prices 15 000

Annual contractual consideration allocated as follows: 12 000

x Lease component C12 000 x 10 000 / 15 000 8 000
x Non-lease component C12 000 x 5 000 / 15 000 4 000

The consideration allocated to the lease component (C8 000) is accounted for in terms of IFRS 16,
either using the simplified approach (see section 6 and 8) or using the general approach (see section 9).
The consideration allocated to the non-lease component (C4 000) is accounted for separately and
expensed as maintenance.

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 (SAP) 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 ± SAP of non-lease
component C5 000 = Estimated SAP of lease component: C7 000

5. Combining contracts (IFRS 16.B2)

If an entity (lessee) enters into more than one contract with the If we have
same counterparty (or related parties of the counterparty) (i.e. if the multiple
entity is effectively contracting with the same person in all the contracts with
contracts), these contracts must be accounted for as a single one person, we may
need to combine them.
contract if any one of the following criteria are met:
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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6. Recognition exemptions (optional simplified approach) (IFRS 16.5-8 & B3-B8)

6.1 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 DQ RSWLRQDO µUHFRJQLWLRQ H[HPSWLRQ¶ $Q HQtity that  Short-term leases; &
chooses this simplified approach does not recognise a right-of-use  Low-value asset leases.
asset and lease liability LH LW GRHV QRW UHFRJQLVH WKH OHDVH µRQ x offer a simpler
approach that involves:
EDODQFHVKHHW¶ , but simply expenses the lease instalments instead.
 expensing the lease
 using SL (normally)
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 iI LW LV µPRUH UHSUHVHQWDWLYH RI WKH SDWWern of the
OHVVHH¶VEHQHILW¶See IFRS 16.6

6.2 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
DSSO\WKHµVLPSOLILHGDSSURDFK¶ LHH[SHQVHGLQVWHDGRIµRQEDODQFH leases & the
VKHHW¶ RQDlease-by-lease basis. See IFRS 16.8 simple approach:
x The choice to opt for
the simpler approach
The assessment of whether or not an asset is considered to have a is available on a
low value is based on its value when it was new. It is not based on ‘lease-by-lease’ basis
WKHOHDVHGDVVHW¶Vcurrent age or value. See IFRS 16.B6 x Value of asset assessed
on its value when new.
)XUWKHUPRUHQRFRQVLGHUDWLRQLVJLYHQWRZKHWKHURUQRWWKHDVVHW¶V x Examples: phones, PC’s,
tablets etc (not cars).
value is material to the lessee ± in other words, this assessment is x Exemption not
not entity-specific. See IFRS 16.B4 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,
µWDEOHW DQG SHUVRQDO FRPSXWHUV VPDOO LWHPV RI RIILFH IXUQLWXUH DQG WHOHSKRQHV¶ EXW ZRXOG
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)

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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 enters 5 separate leases (as a lessee). The first lease is over a new machine with a
value of $2 000. The machine comes without an engine and three key components, all of
which must be acquired from other suppliers. The second lease involves the lease of the new
engine (valued at $5 000). The remaining three leases involve the three key components
needed for the machine to function (each component had a value, when new, of $3 000).
Required: For each lease referred to above, briefly explain whether the leased asset (underlying asset)
is a low-value asset and thus whether the lease could be accounted for in terms of the simplified
approach (i.e. if the low-value asset recognition exemption is available).

Solution 10: Exemptions and low-value assets

Lease A. This lease is below the threshold of $5 000 mentioned in IFRS 1¶V µbasis of conclusions¶.
+RZHYHU WKLV DPRXQW LV QRW D µKXUGOH UDWH¶, but simply a rough guideline. Thus, we simply
note that it is below the threshold, suggesting that it may be a low-value asset.
The retailer regards amounts above $2 000 to be material and thus WKH FRPSXWHU¶V YDOXH
($4 000) is material. However, µmaterialLW\¶ does not mean µKLJK-YDOXH¶. Instead, a material item
could be considered to be a low-value asset. This is because the assessment of whether a
leased asset has a low value must be based on an absolute amount - not on its value relative to
the entity¶V PDWHriality levels (i.e. the assessment is not entity-specific). Thus, WKH HQWLW\¶V
materiality levels is irrelevant.
Since ,)56OLVWVµSHrsonal computHUV¶DVan example of a low-value asset, and since there
is no evidence given to the contrary, we assume the leased computer is an average personal
computer and thus an example of a low value item, in which case the recognition exemption
is available when accounting for this lease. The entity can thus choose to expense this lease.
Lease B. Both the current value and value when new are given. However, we always look at the value when
new, even if the asset is second-hand. The value when new is $20 000, which is above the $5 000
threshold mentioned in ,)56¶V µEDVLV RIFRQFOXVLRQV¶. Although this threshold is not a definitive
µKXUGOHUDWH¶LWVXJJHVWVWKDWLWPD\QRWEHD low-value asset.
We then look at the nature of the asset as well. The underlying asset is a personal computer,
but although IFRS 16 lists these as being an example of a low-value asset, it can happen that
a personal computer is a high-end and unusually expensive computer. If WKLV FRPSXWHU¶V
value ($20 000) is higher than the average value of new personal computers, then it would
not qualify for the exemption.
Lease C. The exemption may not be used, even if the underlying asset is a low-value asset, because the entity
intends to sub-lease the asset. IFRS 16 specifically prohibits the use of the recognition exemption if
the underlying asset will/ may be sub-leased. See IFRS 16.B7
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.

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6.3 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
below)WKHFKRLFHRIDSSO\LQJWKHVLPSOLILHGDSSURDFKPXVWµEHPDGe & the simple
by class of underlying asset to which the right of usHUHODWHV¶In other approach:
words, the choice made in respect of short-term leases (i.e. to x The choice to opt for the
expense, or recognise µRQ EDODQFH VKHHW¶) 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).
x Lease term must be
For example, if we have a right to use a delivery vehicle that 12m/less from
qualifies as a short-term lease, we would have to decide what commencement date & the
lease may not include a
our accounting policy is with regard to accounting for short-term purchase option.
leases of delivery vehicles: either, we would account for all
short-term leases of delivery vehicles µRQEDODQFHVKHHW¶, or account for all short-term leases
of delivery vehicles in terms of the exemption (i.e. using the simplified approach). 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
x the date on which a lessor
has the right to use an underlying asset
x together with periods covered by an option to: x makes an underlying asset available for
IFRS 16 App A
use by a lessee.
 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
IXUWKHU GHILQHG WHUPV µOHDVH WHUP¶ DQG µFRPPHQFHPHQW GDWH¶ 7KH DSSOLFDWLRQ RI all three
defined terms is best explained by way of example.

Example 11: Exemptions and short-term leases

Consider .HZ/LPLWHG¶V non-related leases involving delivery vehicles:

Lease A. Kew enters a lease agreement where the contractual terms result in a lease term of 6
months, with no option to purchase.

Lease B. Kew 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-months. Given that the rentals in the
extra 6-month period would be significantly below market value, management concludes that it is
reasonably certain that it will exercise its option to extend the contract to the full 18-months.

Lease C. Kew enters into a lease where the contract terms include a non-cancellable lease term of 12
months, and a further 6 months during which Kew may, at any stage, choose to cancel the
contract. Management considers the cancellation penalty to be insignificant and thus that it
was not µreasonably certain that it would not exercise the termination option¶ (i.e. it is possible that
Kew could exercise its termination option).

Required: For each of the leases above, briefly explain if the lease meets the definition of a short-term
lease and thus if it would 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 may 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
when held under short-term leases.

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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 Kew has adopted the accounting policy of
accounting for short-term leases of delivery vehicles under the recognition exemption.
Lease B. The definition of a µlease 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, WKH GHILQLWLRQ RI µOHDVH
WHUP¶ 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). This means
the lease is not a short-term lease (the lease term is not 12 months or less) and this means it does
not qualify for the recognition exemption.
The lease must be recognised µon balance-sheet¶ instead.
Lease C. 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 Kew 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.
Thus, the lease meets the definition of a short-term lease. The lease costs will thus be expensed
(assuming .HZ¶s accounting policy is to account for short-term leases of vehicles under the
recognition exemption).

7. Recognition and measurement ± terminology (IFRS 16.9-16 and B9-B33)

7.1 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 (only if short-term lease
simplified approach, which involves expensing the lease or a low-value asset).
costs), or the lease is recognised on balance sheet (the (See section 6)

general approach). Before we explain how to recognise and measure leases under each of
these approaches, there are a few core terms we need to understand.

7.2 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
leased asset available for use by the lessee. IFRS 16.B36 and App. A use an underlying asset,
x together with periods covered by:
The lease term (measured in months or years etc) is the non-  an option to extend the lease if
cancellable period during which the entity may use the asset. the lessee is reasonably certain
to exercise that option; &
It includes any rent-free periods the lessor may give the lessee.
 an option to terminate the lease
if the lessee is reasonably certain
However, under certain circumstances, the lease term may
not to exercise that option.
also include optional renewal periods or possibly even IFRS 16 App A (slightly reworded)

cancellable periods (periods during which the lessee may

terminate the contract). This is explained below.
x If the entity (lessee) has an option to extend the lease (an optional renewal period), and the
entity is reasonably certain it will choose to extend the lease, then the lease term must include
these further extension periods (non-cancellable period + renewal periods). See IFRS 16.18(a)
x If the entity (lessee) has an option to terminate the lease (an optional cancellable period), but is
reasonably certain that it will not terminate it, then this µcancellable period¶ must be included in the
lease term. In other words, if there is a period during which the entity has the option to terminate
the lease, and it is likely that the entity will terminate it during this period, then this period (during
which termination is possible) is not included in the lease term. See IFRS 16.18(b)

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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 DOVRKDVWKHRSWLRQWRWHUPLQDWHWKHOHDVHGXULQJWKLVµFDQFHOODEOHSHULRG¶
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

Ag Limited (lessee) enters 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
Ag then has the option to extend the lease for a further 2 years. Ag is reasonably certain
that it will exercise the renewal option (e.g. Ag 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
Ag then has the option to extend the lease for a further 2 years. Ag is reasonably certain
that it will not exercise the renewal option (e.g. Ag 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, Ag has the option to terminate the lease. Ag is reasonably certain
that it will exercise the termination option (e.g. Ag believes there is an economic incentive to
terminate the lease).
Scenario 4. 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, Ag has the option to terminate the lease. Ag is reasonably certain
that it will not exercise the termination option (e.g. Ag believes there is no economic
incentive to terminate the lease).
Scenario 5. 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, both Ag and the lessor have the option to terminate the lease. Ag is
reasonably certain that it will not exercise the termination option (e.g. Ag 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 yrs
Explanation: The optional extension period is included because Ag (lessee) is reasonably certain it will
exercise the option to extend the lease.
Scenario 2: Lease term = 3 years
Calculation: Lease term = non-cancellable period: 3 yrs + Optional extension period: N/A = 3 years
Explanation: The optional extension period is excluded because Ag (lessee) is not reasonably certain
it will exercise the option to extend the lease.
Scenario 3: Lease term = 7 years
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 the lease would not be exercised. However, in this case,
Ag (lessee) is reasonably certain that it will exercise its option to cancel.

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Scenario 4: Lease term = 10 years

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, Ag
(lessee) is reasonably certain that it will not wish to cancel the lease.
Scenario 5: Lease term = 7 years
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, Ag (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 thHXQGHUO\LQJ DVVHW WRWKHHQWLW\LIDQXQGHUO\LQJDVVHWLVFULWLFDO WRWKHHQWLW\¶V
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
µUHFRJQLWLRQH[HPSWLRQ¶); 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

Ess Limited (lessee) leases a plant. The lease is non-cancellable for 3 years from
commencement date, after which Ess 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 The plant will be used to manufacture widgets (expected to 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 the lease term and provide a brief explanation to justifying your calculation.

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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 durinJWKHµRSWLRQDO-year extension pHULRG¶DUHH[SHFWHGWREHKLJKHUWKDQPDUNHW-

related rentals and thus do not provide the lessee with an economic incentive to extend the lease.
However, we must also consider all other facts and circumstances (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 provides no 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, it seems it is reasonably certain that the entity will renew the contract and thus that the optional
extension period should be included in the calculation of the lease term.

Please note: You could also have argued that the lease term is 3 years on the grounds that it is
reasonably certain the entity will not extend the lease because the lease rentals during the optional
extension period will exceed market-related lease rentals and where these extra costs are assumed to
outweigh the significant cost of having to install a different plant.

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

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7.3 Lease payments (IFRS 16.26-28 and Appendix A)

7.3.1 Overview

Lease payments is a defined term (see pop-up 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; a

(d) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an
to terminate the lease.
(e) 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
IFRS 16 App A (slightly reworded)
them as a single lease 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 7.3.2 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). Because 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 4 for a detailed explanation of how to allocate the consideration among separate lease
components.

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Gripping GAAP Leases: lessee accounting

7.3.2 Fixed payments Fixed payments are

defined as:
Fixed payments is a defined term (see pop-up alongside). This x Payments made by
a lessee to a lessor
definition essentially includes all payments that are made in x for the right to use
return for the right to use an asset, with the exception of all an underlying asset
variable lease payments (see section 7.3.3 below). x during the lease term,
x excluding variable lease
Although fixed payments are included in the calculation of pmts. IFRS 16 App A
lease payments, IFRS 16 requires that, when calculating the
lease payments, we deduct from the fixed payments any Lease incentives are
amounts that may have been received by (or be receivable defined as:
from) the lessor to incentivise the lessee to enter the lease. x pmts made by a lessor to
a lessee associated with
These receipts are called lease incentives, which is yet another a lease, or
defined term (see pop-up alongside). See IFRS 16.27(a) x the reimbursement or
assumption by a lessor of
Fixed payments also include payments referred to as in-substance costs of a lessee. IFRS 16 App A
fixed payments, which are simply payments that appear to contain
variability but are, in substance, unavoidable (e.g. where there is, in theory, a variety of payments that
the lessee could make, but wheUHµRQO\RQH of these sets of payments is realistic'). See IFRS 16.B42

7.3.3 Variable lease payments Variable lease pmts are

defined as:
Another category is variable lease payments, which is also a x the portion of payments
defined term (see pop-up alongside). Before we look at the made by a lessee to a lessor
definition of a variable lease payment, it is important to take note x for the right to use an
that not all variable lease payments will be included in the underlying asset during the
lease term
calculation of lease payments. This will be explained in a moment.
x that varies because of
changes in facts or
In terms of the definition, variable lease payments are circumstances after the
payments that are made in return for the use of the asset, but commencement date,
they differ from fixed payments: variable payments are those x other than the passage of
that are expected to vary, but must vary due to various facts or time. IFRS 16 App A
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).

Chapter 16 803
Gripping GAAP Leases: lessee accounting

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 9.6.

Worked example 1: 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.

7.3.4 Exercise price of purchase options

If the lessee 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.

7.3.5 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.

7.3.6 Residual value guarantees A residual value

guarantee is defined as:
7KHWHUPµUHVidual value guarantee is also a defined term (see x a guarantee made to a lessor
pop-up alongside). If the lessee guarantees to the lessor that x by a party unrelated to the lessor
the underlying asset will have a certain minimum value at the x that the value (or part thereof)
end of the lease, then any amount that is expected to be x of an underlying asset at the
end of a lease
payable as a result of this residual value guarantee would be x will be at least a specified
included as a lease payment. amount. IFRS 16 App A (slightly reworded)

Residual value guarantees (A great explanation by BDO)

Some leases require the lessee to guarantee the value of an asset when it is returned to the
lessor. These create an incentive for the lessee to maintain the asset properly and provide regular
maintenance and upkeep, and mean the lessor is not exposed to risks of obsolescence thereby giving it
greater assurance over the return it will earn over the period of the lease. The excess of the guaranteed
value over the expected fair value of the asset at the end of the lease would result in the lessee having to
make an additional payment to the lessor. Any amounts that a lessee expects to pay under residual value
guarantees are included in the initial measurement of the lease liability. BDO: IFRS in Practice: IFRS 16 Leases

Worked example 2: A lessee guarantees that the underlying asset will have a value of C100 at the end of
the lease. However, at commencement date, the lessee actually believes that, at the end of the lease, the
asset will have a value of only C20. This lessee will need to include in the calculation of its µlease paymentV¶
an amount of C80, because it has guaranteed a residual value of C100 but expects the physical asset to be
worth C80 less than this, which means it expects to have to pay a further C80 in order to honour its promise.

7.3.7 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 xxx
the entity will exercise this option)
x Amounts expected to be payable in terms of residual value guarantees xxx

804 Chapter 16
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7.4 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 7KHOHVVHH¶VLQFUHPHQWDOERUURZing 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 lHVVRU¶s
circumstances. For example, it assumes that the lessee has knowledge of the unguaranteed
residual value (which is essentially the DVVHW¶V fair value at the end of the lease if the residual
value is not being guaranteed¶). If the OHVVHH FDQQRW µUHDGLO\ GHWHUPLQH¶ WKH LPSOLFLW LQWHUHVW
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 is
defined as:
x The rate of interest that causes:
x the present value of (a) the lease payments and
(b) the unguaranteed residual value
to equal:
x the sum of (i) the fair value of
the underlying asset and (ii) any initial
direct costs of the lessor. IFRS 16 App A
A lessee’s incremental borrowing rate is
defined as:
x the rate of interest the lessee would have
to pay
x to borrow over a similar term, and with
similar security,
x the funds necessary to obtain an asset of a
similar value to the right-of-use asset
x in a similar economic environment. 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
x the realisation of which by a lessor is lease had not been obtained,
 not assured or x except for such costs incurred by a
 is guaranteed solely by a party related manufacturer/dealer lessor in connection
to the lessor. IFRS 16 App A with a finance lease. IFRS 16 App A

8. 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 6 for a
detailed explanation on when this recognition exemption may be used.

If the lease is to be accounted for under the optional recognition The simplified approach is:
exemption, it means the costs are recognised as an expense in Expense lease pmts over the
profit or loss, and measured on a straight-line basis over the lease lease term using straight-line
term (or using some other systematic basis). (See also section 6)

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.

Chapter 16 805
Gripping GAAP Leases: lessee accounting

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 EntLW\$¶VJHQHUDOMRXUQDO

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 measure 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

31 December 20X1 Debit Credit

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
Lease of computer under the optional simplified approach

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
Lease of computer under the optional simplified approach

9. Recognition and measurement ± the general approach (IFRS 16.22-46)

9.1 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 µRQ EDODQFH-VKHHW¶. This means that we must
recognise a right-of-use asset and a lease liability.

9.2 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 Initial measurement of
lease liability:
x a lease liability. See IFRS 16.22
x PV of lease payments
x that are still payable at
The lease liability is initially measured, at commencement commencement date,
date, at the present value of the unpaid lease payments x discounted using either the implicit
on this date (i.e. it would exclude any lease payments that interest rate or the lessee’s
are paid in advance or had been prepaid). 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, WKH OHVVHH¶V incremental borrowing rate (as explained in section 7.4, it will be
more likely that a lessee would use its incremental borrowing rate). See IFRS 16.26

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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 payments 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 future costs to dismantle and remove x Prepaid lease payments (i.e. pmts
the underlying asset, restore the site on which it was on/ before commencement date)
x PV of estimated future costs (to
situated or restore the asset to a predetermined condition, dismantle, remove or restore)
unless the obligation for these future costs arose because x Less lease incentives received.
the underlying asset was used to make inventories; See IFRS 16.24

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 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 that are xxx
Bank/ Payable etc (A/L) paid/payable 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
and remove the asset, or restore the asset or the site on which it was situated, then the lessee has a
contractual µobligation¶. The lessee must recognise the obligation for these future costs as a provision
(in terms of IAS 37) 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. This 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 (c)
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

Chapter 16 807
Gripping GAAP Leases: lessee accounting

Lease incentives: These are defiQHGDVµWKHpayments made by the lessor to the lessee associated
ZLWKWKHOHDVHRUWKHUHLPEXUVHPHQWRUDVVXPSWLRQE\DOHVVRURIWKHFRVWVRIWKHOHVVHH¶
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
FRXOGXQGHUWDNHWRSD\FHUWDLQRIWKHOHVVHH¶VFRVWVRQWKHOHVVHH¶VEHKDOI
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, Exe Limited (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 31 December 20X1.
x In addition, Exe is required to pay 10% of the revenue generated from the use of the
building per year, payable annually in arrears. Exe expects to generate revenue of
C80 000 per year from the use of the building.
x Exe incurred initial direct costs of C4 000 to obtain the lease (which it only paid in
20X2), of which C1 000 was received as a reimbursement from the lessor.
x Exe 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 Exe¶VJHQHUDl 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

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).

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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

1 January 20X1 Debit Credit

Right-of-use asset: cost (A) Balancing 41 699

Lease liability (L) W1.1 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

Bank (A) Given 1 000

Right-of-use asset: cost (A) 1 000
Reimbursements of initial direct costs received from lessor

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!

9.3 Subsequent measurement ± a summary overview

$ OHDVH WKDW LV DFFRXQWHG IRU XQGHU ,)56 ¶V JHQHUDO DSSURDFK LV DFFRXQWHG IRU µRQ-balance
VKHHW¶ZLWKWKHUHVult 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 9.2.
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 9.4 ± subsequent measurement of a lease liability
x Section 9.5 ± subsequent measurement of a right-of-use asset
x Section 9.6 ± subsequent measurement involving remeasurements
x Section 9.7 ± subsequent measurement involving lease modifications.

Chapter 16 809
Gripping GAAP Leases: lessee accounting

9.4 Subsequent measurement of the lease liability

9.4.1 Overview Subsequent measurement

of
The lease liability is initially measured at the present value lease liability:
of the unpaid lease payments at commencement date, x Amortised cost (increase by interest
and decrease by payments)
discounted at either the interest rate implicit in the lease
x May need to be remeasured if there
or, if this is not readily determinable, then at thH OHVVHH¶V is a subsequent change to the lease
incremental borrowing rate. Irrespective of which rate is payments. See IFRS 16.36 & .39

used, it is must be the rate applicable at commencement

date. See section 9.2 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.

9.4.2 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
Lease liability (L) Xxx
Interest on lease liability calculated using the EIR method
Lease liability (L) xxx
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, Exe Limited (the lessee) entered a lease over a building, for four years.
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 31 December 20X1.
x Exe is also required to pay, in arrears, 10% of the revenue generated from the use of the building
per year. At commencement date, Exe expected to generate revenue of C80 000 per year.
x Exe incurred initial direct costs of C4 000 to obtain the lease (which is only paid in 20X2), of which
C1 000 was subsequently received as a reimbursement by the lessor.
x The appropriate discount rate OHVVHH¶VLQFUHPHQWDOERUURZLQJUDWH ZDVDWFRPPHQFHPHQWGDWH
Additional information:
x Exe 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.
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%
31 December 20X2: 12%
Required: Journalise the subsequent measurement of the lease liability, and the variable lease payments,
using Exe¶V general journal for 20X1 and 20X2 assuming Exe has a 31 December financial year-end.

810 Chapter 16
Gripping GAAP Leases: lessee accounting

Solution 16: Lease liability ± subsequent measurement

Comments:
x Although the incremental borrowing rate changes over the lease period, we must continue using
the rate that applied at commencement date, 1 January 20X1: 10%.
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 example 15).
x Variable lease payments that do not vary based on an index or rate, and are thus not included in
the definition of lease payments, are expensed as they are incurred.

31 December 20X1 Debit Credit

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
Finance cost - lease (P/L: E) W1 2 487
Lease liability (L) 2 487
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) 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

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 31 699 (1) 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) (1)
*Slight rounding error
Notes:
(1) When measuring the lease liability we include lease payments, the definition of which includes fixed lease
payments. However, the lease liability measurement only includes fixed lease payments that are still
payable on commencement date (i.e. we exclude those that are paid on or before commencement date).
So, 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 (total nominal
cash outflow: C40 000 and present value thereof: 31 699 (see W1.1 in previous example); and thus
 only 4 lease payments (C10 000 each) appear in this effective interest rate table (see W1 above)

Chapter 16 811
Gripping GAAP Leases: lessee accounting

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) 6KRZWKHMRXUQDOVWRDFFRXQWIRUWKHOHDVHOLDELOLW\LQ(QWLW\$¶VJHQHUDOMRXUQDOIRU 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 made on or before commencement date).
This means the lease liability on commencement date is the present value of only 4 lease payments,
since it excludes the first lease payment 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 first lease payment paid on commencement date.

a) Journals:

1 January 20X1 Debit Credit

Right-of-use asset: cost (A) 75 964
Lease liability (L) W1 55 964
Bank (A) 20 000
Initial recognition and measurement of lease
31 December 20X1
Finance cost - lease (P/L: E) W2 8 954
Lease liability (L) 8 954
Interest on lease, based on the effective interest rate method
1 January 20X2
Lease liability (L) Given (paid in advance) 20 000
Bank (A) 20 000
Lease payment – fixed lease payment
31 December 20X2
Finance cost - lease (P/L: E) W2 7 187
Lease liability (L) 7 187
Interest on lease, based on the effective interest rate method
1 January 20X3
Lease liability (L) Given (paid in advance) 20 000
Bank (A) 20 000
Lease payment – fixed lease payment
31 December 20X3
Finance cost - lease (P/L: E) W2 5 137
Lease liability (L) 5 137
Interest on lease, based on the effective interest rate method
1 January 20X4
Lease liability (L) Given (paid in advance) 20 000
Bank (A) 20 000
Lease payment – fixed lease payment

812 Chapter 16
Gripping GAAP Leases: lessee accounting

31 December 20X4 Debit Credit

Finance cost - lease (P/L: E) W2 2 758
Lease liability (L) 2 758
Interest on lease, based on the effective interest rate method
1 January 20X5
Lease liability (L) Given (paid in advance) 20 000
Bank (A) 20 000
Lease payment – fixed lease payment

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 Interest at Lease Balance

(start) 16% payments (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)

9.5 Subsequent measurement of the right-of-use asset

9.5.1 Overview Subsequent measurement

of a RoU asset:

The right-of-use asset is normally accounted for in terms x model

Normally in terms of the cost
but may use the
of a cost model (per IFRS 16) in which case it is revaluation model or fair value
depreciated and tested for impairments (in terms of model depending on 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.

9.5.2 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
x Cost (per IFRS 16 Leases) See IFRS 16.30

x Less subsequent accumulated depreciation (simiODUWR,$6¶VGepreciation)

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

Chapter 16 813
Gripping GAAP Leases: lessee accounting

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 is slightly different in terms of the measurement of cost and the measurement of depreciation.

The initial cost of a right-of-use asset is stipulated in Depreciation of a RoU

asset:
IFRS 16 Leases (see section 9.2). This initial cost will be
x Starts: commencement date
subsequently remeasured (adjusted) if and when the
x Method: to reflect pattern in which
lease liability requires remeasurement during the course FEB from the RoU asset is expected
of the lease (see section 9.3). See IFRS 16.23-24 & .30 to be consumed (normally SL)
x Period: from commencement date to
With regard to depreciation, the principle in IFRS 16 Leases is  if ownership is not expected to transfer:
the same as that in IAS 16 Property, plant and equipment earlier of the end of useful life of the
RoU asset or end of lease term
in that the depreciation method must reflect the pattern in
 if ownership is expected to transfer:
which the future economic benefits (FEBs) of the right-of- end of useful life of the underlying
use asset will be consumed (thus the straight-line method asset See IFRS 16.31-32
is normally appropriate). However, differences arise in terms of when depreciation starts and the
depreciation period.
Commencement date is
The depreciation of a right-of-use asset starts from defined as
commencement date (see pop-up alongside). x The date the lessor makes
x the underlying asset
This differs from depreciation per IAS 16, where an item x available for use by a lessee.
See IFRS 16 App A
of property, plant and equipment is depreciated starting
from the 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 1¶V FRVW PRGHO UHTXLUHV WKDW DQ
item of property, plant and equipment be depreciated over its useful life, the depreciation period of
IFRS ¶VFRVWPRGHOLVGHSHQGent 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 DVVHW¶VXVHIXOOLIH
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 DVVHW¶VXVHIXOOLIH, 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, we have a right-of-use asset. Its cost is
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. Consider the following scenarios:
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 not renewable or cancellable, but the contract includes a purchase
option at the end of year 5 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.

814 Chapter 16
Gripping GAAP Leases: lessee accounting

Solution 18: Right-of-use asset ± subsequent measurement: depreciation

Scenario 1:
31 December 20X1 Debit Credit
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:
31 December 20X1 Debit Credit
Depreciation ± right-of-use asset (P/L: E) 10 000 ÷ 5 years 2 000
Right-of-use asset: acc. depreciation (-A) 2 000
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:
31 December 20X1 Debit Credit
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 : 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

1 January 20X1 Debit Credit

Right-of-use asset: cost (A) Given 10 000
Lease liability (L) 10 000
Initial recognition and measurement of lease and right-of-use asset (RoU)
31 December 20X1
Depreciation ± right-of-use asset (P/L: E) 10 000 ÷ 5 years 2 000
Right-of-use asset: acc. depreciation (-A) 2 000
Depreciation of right-of-use asset
31 December 20X2
Depreciation ± right-of-use asset (P/L: E) 10 000 ÷ 5 years 2 000
Right-of-use asset: acc. depreciation (-A) 2 000
Depreciation of right-of-use asset
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 – 1 000
Right-of-use asset: acc. depreciation (-A) 3 000) ÷ (5 – 2 ) remaining yrs 1 000
Depreciation of right-of-use asset

Chapter 16 815
 Gripping GAAP Leases: lessee accounting

9.5.3 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

9.5.4 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

9.6 Subsequent measurement: changing lease payments

If the lease payments change, then we must remeasure the Remeasurements:
lease liability to reflect this. For example the lease term might
increase, resulting in extra lease payments that now need to x if there is a subsequent change in
the lease payments that affects
be included in the lease liability, or a purchase option that was the measurement of the lease
previously considered reasonably certain of being exercised, liability (LL)
thus included in the lease payments when measuring the x A remeasurement adjustment to
lease liability, is now not reasonably certain of being exercised, the LL generally requires the
same adjustment to the RoU
and thus the lease liability needs to be decreased. asset. See IFRS 16.36 & .39

If there is an increase in the lease payments, the adjustment made to increase the lease liability is
also made to the right-of-use asset. E.g. a lease liability increase of C100 is journalised as:
Remeasurement adjustment ± increase in lease payments Debit Credit
Right-of-use asset (A) 100
Lease liability (L) 100
Remeasurement of lease liability and right-of-use asset due to
an increase in lease payments

However, if there is a decrease in the lease payments, the lease liability must be decreased.
However, the adjustment to the right-of-use asset (i.e. decreasing the asset) will be limited to the extent
RIWKHDVVHW¶VFDUU\ing amount, with any excess recognised as an expense in profit or loss.
In other words, if the adjustment made to the lease liability exceeds WKH DVVHW¶s carrying amount, we
VLPSO\UHGXFHWKHDVVHW¶VFDUU\LQJDPRXQWWR]HURDQGWKHH[FHVVDGjustment (that would otherwise drop
WKHDVVHW¶VFDUU\LQJDPRXQWEHORZ]HUR is recognised as an expense in profit or loss instead. See IFRS 16.39
x If the decrease in the lease liability would not decrease the carrying amount of the asset below
zero, the adjustment made to the lease liability is also made to the asset. E.g.: The right-of-use
asset has a carrying amount of C300 and the lease liability must decrease by C100 is:
Remeasurement adjustment ± decrease in lease payments Debit Credit
(CA of RoU asset does not drop below 0)
Lease liability (L) 100
Right-of-use asset (A) 100
Remeasurement of lease liability and right-of-use asset due to
a decrease in lease payments (decrease in L is = or < A’s CA)

x If the decrease in the lease liability would decrease the carrying amount of the asset below zero,
the adjustment to the lease liability is made partly to the asset and partly to profit or loss.
E.g.: A right-of-use asset has a carrying amount of C300 and the lease liability decreases by C400:
Remeasurement adjustment ± decrease in lease payments Debit Credit
(CA of RoU asset would drop below 0)
Lease liability (L) 400
Right-of-use asset (A) Carrying amount 300
Lease remeasurement income (P/L: I) Balancing 100
Remeasurement of lease liability and right-of-use asset due to a
decrease in lease payments (decrease in L > A’s CA)

816 Chapter 16
Gripping GAAP Leases: lessee accounting

When remeasuring the lease liability, we calculate the present value of the revised remaining lease
payments at the date of the reassessment and will have to either use a revised discount rate or the
original discount rate.
x We must use a revised discount rate if the lease payments change due to:
 a change in the estimated lease term, or
 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
x We must use the original discount rate if the remaining lease payments change due to:
 a change in the amount expected to be payable in terms of a residual value guarantee; or
 a change in the variable lease payments that vary based on an index or rate;
 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) oU WKH OHVVHH¶V
incremental borrowing rate at the date of the reassessment. See IFRS 16.41

Example 20: Remeasurement - change in lease term

Gee Ltd (lessee) signs a lease over a building on 1 January 20X1 (commencement date).

x 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.
x The lease payments, payable in arrears, will be C10 000 p.a. for the first 4 years and C8 000 p.a. during
the extra 3 years, should the lessee opt to extend the contract.
x At 1 January 20X1, Gee 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.
x The implicit interest rate is not known and thus the entity uses the incremental borrowing rate as the
discount rate. The incremental borrowing rates were as follows:
01 January 20X1: 10%
31 December 20X1: 11%
31 December 20X2: 12%
Required: Journalise the change in lease term on 31 December 20X2.

Solution 20: Remeasurement - change in lease term

Comment:
x The discount rate we use is 10%, being the incremental borrowing rate on commencement date, 1 January 20X1.
x The incremental borrowing rate at 31 December 20X1 was also given but was irrelevant because we did
not need to remeasure the lease liability on this date (P.S. even if the liability was being remeasured, we
would not necessarily revise the discount rate).
x However, we revise the discount rate to the incremental borrowing rate of 12% on 31 December 20X2. This
is because we had to remeasure the lease liability and the remeasurement was due to a change in lease
payments caused by a change in the lease term. See IFRS 16.40(a)

31 December 20X2 Debit Credit

Right-of-use asset (A) Revised PV C32 218 ± CA (current PV) C17 356 14 862
Lease liability (L) 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:
x 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).

Chapter 16 817
Gripping GAAP Leases: lessee accounting

x At 31 December 20X2, the total lease term (LT) 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 (original LT: 4 yrs ± 2 yrs), it
is now 5 years (revised LT: 7 yrs ± 2 yrs). At this dateWKHOHDVHOLDELOLW\¶VFDUU\LQJDPRXQW
- actual carrying amount is C17 356 (present value based on the original lease term and discount rate : W1).
- revised carrying amount is C32 218 (present value based on the revised lease term and discount rate: W2).
x Thus, the increase in the lease term causes an increase in the lease liability of C14 862 (C32 218 ± C17 356).
x This is processed after processing all other journals relating to the lease liability for the 20X2 year (i.e. interest
expense of C2 487 and lease payment of C10 000).

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!

9.7 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, or
(e.g. adding the right-to-use another asset) or the original
x the consideration for a lease,
consideration is changed (e.g. changing a fixed payment to a x that was not part of the
payment that varies with changes in the CPI index). original terms and conditions
of the lease
Modifications are either accounted for as: For example,
x separate leases, or as x adding or terminating the right to
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.

818 Chapter 16
Gripping GAAP Leases: lessee accounting

Worked example 3: Lease modification ± separate lease

Kay Limited (lessee) enters into a 4-year lease over a truck. During the first year of the lease, Kay¶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 rental that was slightly lower than a market-related lease rental, due
to the fact that Kay 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 consideration substantially reflects the stand-alone price of this second right-
to-use asset. Thus, this modification is accounted for as a separate lease:
x Kay recognises a second right-to-use asset and related lease liability.
x 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
 tKHOHVVHH¶Vincremental 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 LQ D µpartial or full termination of the
OHDVH¶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 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.
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: Show the journal entry 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)

Chapter 16 819
Gripping GAAP Leases: lessee accounting

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)
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 «your answer should be = 9,826344%
x The implicit interest rate in the modified contract is 8,687602%
PV = -280 000 N = 3 PMT = 110 000 Comp I « your answer should be = 8,687602%

Journal

1 January 20X2 Debit Credit

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

W1: Effective interest rate table: lease liability ± ORIGINAL CONTRACT

Date Interest (9,826344%) Instalment Liability balance
01 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
01 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)

10. Tax consequences

10.1 Overview Instalment credit

agreement (ICA) is
To understand the current and deferred tax consequences defined as:
of a lease, we need to first understand the consequences of x any agreement
the lease in terms of the tax legislation relevant to the x where goods (corporeal,
movable goods or
country in which the entity operates.
machinery/plant, whether
movable/immovable)
10.2 Tax treatment of leases x are supplied:
a) under sale where a stated sum
In South Africa, tax authorities look only at the legal form of will be paid in future, either in
the lease, and do not consider the substance thereof. total/ in instalments
(part (a) of ICA definition), or
The income tax treatment of leases per the South African b) under a lease of at least
12 months and lessee
Income Tax Act (IT Act) is interrelated with the two definitions
accepts full risk of
in the South African Value-Added Tax Act (VAT Act): destruction of the goods
x µLQVWDOPHQWFUHGLWDJUHHPHQW¶ ,&$ DQG (part (b) of ICA definition).
x µUHQWDODJUHHPHQW¶. See s1 of VAT Act (significantly summarised)

See definitions of each in the pop-ups on the right and on the next page.

820 Chapter 16
Gripping GAAP Leases: lessee accounting

If we have a lease (regardless of recognition approach), we will need to assess whether it meets:
x parW D  RI WKH 9$7 $FW¶V GHILQLWLRQ RI DQ µLQVWDOPHQW FUHGLW
DJUHHPHQW¶ Rental agreement is
x SDUW E RIWKH9$7$FW¶VGHILQLWLRQRIµLQVWDOPHQWFUHGLW defined as:
DJUHHPHQW¶RU x a lease agreement other than
that in part (b) of ICA definition.
x WKH9$7$FW¶VGHILQLWLRQRIDµUHQWDODgreHPHQW¶ See s1 of VAT Act (significantly summarised)

If the lease meets either the definition of a µUHQWDODJUHHPHQW¶or µSDUW E RIWKH ,&$GHILQLWLRQ¶
(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 the
deduction of allowances on the cost of the asset nor will it lease meets
allow the deduction of interest on the lease liability. Instead, x ‘part (a) of the ICA’ definition
the lessee will only be allowed to deduct the lease payments in 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 one
prepayments and the total prepayments are less than of the following
R100 000, then all prepayments will be allowed as a definitions per the VAT Act :
deduction. See South African Tax Act S11(e) and S23H x ‘rental agreement’ or
x ‘part (b) of the ICA’ definition
If the lease meets µSDUW D RIWKH,&$GHILQLWLRQ¶ (per the VAT then the lessee is assumed not
Act), then the tax authority views the asset as belonging to the to own the asset, and thus:
lessee. In other words, the tax authority views the asset as having x asset: nil tax base
been purchased by the lessee (the lease agreement is simply x liability: nil tax base (except
ILQDQFLQJWKHOHVVHH¶VSXUFKDVHRIWKHDVVHW  where there is VAT if it met
‘part (b) of the ICA’ definition )
As a result, the tax authority will allow the tax deductions (e.g.
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: EIR method).

10.3 Accounting for the tax consequences where the lease is accounted
for using the simplified approach
If the lease is reFRJQLVHGE\WKHOHVVHHµoff-balance sheet¶ LHWKHVLPSOLILHGDSSURDFK WKHHQWLW\
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 µstraight lining¶ the lease payments may lead to the recognition of a lease payable (liability) or a
lease prepayment (asset).
Simplified approach
10.3.1 From a tax-perspective, the lessee is renting the asset & 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:
,IWKHOHDVHLVUHFRJQLVHGE\WKHOHVVHHµRII-EDODQFHVKHHW¶ (i.e. using x add back:
the simplified approach), and the tax authority believes the lease lease payment expenses
x deduct:
meets the definiWLRQRIDµUHQWDODJUHHPHQW¶RUWKDWLWPHHWVµSDUW E RI
lease payments i.e. cash pmts
WKH,&$GHILQLWLRQ¶ LHLIWKHWD[DXWKRULW\YLHZVWKHOHVVHHDVVLPSO\
Deferred tax: arises on CA
borrowing/ leasing the asset), then the accounting treatment and tax
of Expense prepaid/
treatment will be similar. payable (TB = nil)

Chapter 16 821
Gripping GAAP Leases: lessee accounting

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 10.2). In other words, ERWK WKH DFFRXQWDQW DQG WD[ DXWKRULWLHV µDJUHH¶ WKDW WKH HQWLW\
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 µstraight lining¶ of the lease expense:
x If the µstraight 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 µstraight 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 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 this lease 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:
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 from the above.
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)

31/12/20X1 Debit Credit

Low-value lease expense (P/L: E) C2 500 (see calculations) x 9 m 22 500
Lease payable (L) Balancing (originating) 4 500
Bank (A) C2 000 x 9 months 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) C1 x 1 500 units 1 500
Bank (A) 1 500
Variable lease payments are expensed
31/12/20X2
Low-value lease expense (P/L: E) C2 500 (see calculations) x 12 m 30 000
Lease payable (L) Balancing (reversing) 3 000
Bank (A) C2 000 x 3m + C3 000 x 9m 33 000
Fixed lease payments on low-value asset expensed on the straight-line
method under the recognition exemption
Variable lease payment expense (P/L: E) C1 x 1 000 units 1 000
Bank (A) 1 000
Variable lease payments are expensed

822 Chapter 16
Gripping GAAP Leases: lessee accounting

31/12/20X3 Debit Credit

Low-value lease expense (P/L: E) C2 500 x 3 months 7 500
Lease payable (L) Balancing (reversing) 1 500
Bank (A) C3 000 x 3 months 9 000
Fixed lease payments on low-value asset expensed on the straight-
line method under the recognition exemption
Variable lease payment expense (P/L: E) C1 x 300 units 300
Bank (A) 300
Variable lease payments are expensed

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
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 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)
Profit before tax 76 000 69 000 92 200
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

Notice: The final µprofit 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 WUHDWLQJWKLVOHDVHDVDµUHQWDODJUHHPHQW¶RUDµOHDVHDJUHHPHQW¶ as defined
LQ WKH µSDUW E  RI WKH ,&$ GHILQLWLRQ¶ LQ WKH 9$7 $FW WKH\ VLPSO\ JUDQW WKH OHDVH LQVWDOPHnts 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.

Journals 20X1 20X2 20X3

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

Chapter 16 823
Gripping GAAP Leases: lessee accounting

W1: Deferred income tax

DT caused by: Carrying Tax Temporary Deferred
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

10.3.2 From a tax-perspective, the lessee owns the asset

(the lease meets ‘part (a) of the ICA definition’)

If the lease is recognised by the lessHH µRII-EDODQFH VKHHW¶ LH If using the
the simplified approach), and the tax authority believes the lease simplified approach
meets µSDUW D RIWKH,&$GHILQLWLRQ¶(i.e. the lessee is deemed to & the lessee ‘owns’
the asset from the tax
own the asset), then the accounting treatment and the tax
perspective:
treatment would differ.
Current tax: adjust profit
before tax as follows:
This is because the accountant is expensing the lease payments x add back:
on the straight-line method, thus potentially resulting in a lease lease payment expenses
prepaid/ payable, whereas the tax authority treats the lessee as x deduct:
being the owner of the asset and will thus allow the lessee to wear and tear allowance
finance costs (using EIRM)
deduct wear and tear and finance costs using the effective
Deferred tax: arises on CA of
interest rate method (EIRM).
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.

10.4 Accounting for the tax consequences where the lease is accounted
for using the general approach

If WKH OHDVH LV UHFRJQLVHG E\ WKH OHVVHH µRQ-balance shHHW¶ LH WKH JHQHUDO DSSURDFK  WKe
entity would recognise:
x an asset (subsequently depreciated and impaired), and
x a lease liability, on which interest is expensed.

10.4.1 From a tax-perspective, the lessee is renting the asset

(the lease meets the definition of ‘rental agreement’ or ‘part (b) of the ICA)

,I WKH OHDVH LV UHFRJQLVHG E\ WKH OHVVHH µon-balance sheet¶ LH If using the general
the general approach), and the tax authority believes the lease approach & it’s a
meets the definiWLRQRIDµUHQWDODJUHHPHQW¶, RUWKDWLWPHHWVµSDUW ‘lease’ from the tax
E RIWKH,&$GHILQLWLRQ¶ LHLW believes that the lessee is simply perspective:
borrowing/ leasing the asset), then the accounting treatment and
Current tax: adjust profit
the tax treatment will differ.
before tax as follows:
x add back: depreciation &
This is because, whereas the accountant recognises a right-of-
interest expense and
use asset and a lease liability, the tax authority will only allow the
x deduct: the lease payments
deduction of the lease payments, subject to section 23H (ITA)
limitations, in the event that there has been a prepayment (see Deferred tax: arises on

section 10.2). In other words, the tax authority does not x CA of RoU asset (TB = nil) &
µUHFRJQLVH¶WKDWWKHHQWLty has an asset and a lease liability. x CA of LL (TB = nil)

824 Chapter 16
Gripping GAAP Leases: lessee accounting

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 OHDVH¶VLPSOLFit 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 temporary or permanent differences other than those evident from the above.
x The local South AfrLFDQ WD[ DXWKRULW\ UHFRJQLVHV WKLV OHDVH DV D µUHQWDO DJUHHPHQW¶ LQ WHUPV RI
part E RIWKHGHILQLWLRQRIDQµLQVWDOPHQWFUHGLWDJUHHPHQW¶Ln 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 iQ'DYH/LPLWHG¶VERRNV
B. Repeat Part A assuming the lease was signed on 1 March 20X4 (not 1 January 20X4) and thus that
the first instalment was payable on 28 February 20X5 (not 31 December 20X4).

Solution 23: Lease under general approach ± tax consequences

Part A Part B
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)
Depreciation of right-of-use asset
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

Chapter 16 825
Gripping GAAP Leases: lessee accounting

Part A Part B
;FRQWLQXHG« 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 Presentation of financial statements (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 Part A Part B

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
becauVH WKH WD[ DXWKRULW\ EHOLHYHV WKH OHDVHPHHWV µSDUW E  RIWKH ,&$ GHILQLWLRQ¶ 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 allows 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.

826 Chapter 16
 Gripping GAAP Leases: lessee accounting

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, which is nil.
It is nil because the tax authority believes the lease meets µSDUW E RIWKH,&$GHILQLWLRQ¶ZLWKWKH
result that the tax authority will not allow any deductions relating to the cost of the asset (the tax
authority does not see the entity as owning 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

10.4.2 From a tax-perspective, the lessee owns the asset

(the lease meets ‘part (a) of the ICA definition’)

If the lHDVHLVUHFRJQLVHGE\WKHOHVVHHµon-balance sheet¶ Le. the general approach), and the

tax authority believes the lease meets µSDUW D RIWKH,&$GHILQLWLRQ¶(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 µDJUHHV¶WKDWWKHOHVVHe 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.

10.5 Accounting for the tax consequences involving transaction taxes

9$7 OHDVHPHHWVµSDUW E RIWKH,&$¶GHILQLWLRQ
10.5.1 Overview

In South Africa, if the lease meets certain requirements per the VAT Act¶V definition of an
µLQVWDOPHQW FUHGLW DJUHHPHQW¶, the lessor would need to charge the lessee VAT on the cash
selling price of the asset, and the lessor would be required to pay this VAT to the tax
authorities at the time of signing the lease contract. The existence of VAT has implications for
the measurement of the right-of-use asset, lease liability and both current and deferred tax.

Chapter 16 827
Gripping GAAP Leases: lessee accounting

10.5.2 VAT and the effect on the right-of-use asset

The VAT effect on DT for a
lease under the general
If the lessor is a VAT vendor, the lease will probably include approach (on-balance
VAT. This has implications for the measurement of the sheet):

OHVVHH¶Vright-of use asset: CA/TB with VAT: notice effect

of VAT being claimable/ not
x If the lessee can claim back the VAT included in the claimable:
lease (i.e. the lessee is a registered vendor for VAT x Asset:
purposes and uses the right-of-use asset to make - CA = excl VAT (if claimable),
taxable supplies), the right-of-use asset, which is initially - CA = incl VAT (if not claimable)
measured at cost, will exclude the VAT. - TB = nil
x Liability:
x However, if the lessee is unable to claim back the VAT - CA = incl VAT
in the lease (e.g. if the lessee is not a VAT vendor or the - TB = (total unpaid instalments/
asset is a motor car on which VAT is not claimable, or if total instalments) x total VAT
the asset is used in the production of exempt supplies), (if VAT claimable)
- TB = nil (if VAT not claimable)
then the initial measurement of the right-of-use asset is
its cost including VAT.

10.5.3 VAT and the effect on the lease liability

As already explained, if the lease meets certain requirements per the VAT Act, the lessor
would have to charge VAT on the lease, calculated based on the DVVHW¶V cash selling price.
The lessor has to then pay this VAT to the tax authorities on the lease at the time of signing
the lease contract (even before receiving a single payment from the lessee).

Requiring the vendor (lessor) to make this upfront payment of VAT to the tax authority can
cause the lessor severe cash flow problems if he recovers this VAT from the customer
(lessee) via lease payments. Thus, a lessor that is required to make an advance payment of
VAT, might choose to require the lessee to the pay the lessor the VAT in full on
commencement date. In other words, the lessor could recover VAT from the lessee in one of
two ways:
x the lessor may require the lessee to pay the VAT to the lessor at commencement date, or
x 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).

From the lessee perspective:

x If the lessee is required to pay the VAT to the lessor, upfront on commencement date,
then the lease payments and thus the lease liability will not include VAT (as the definition
of lease payments excludes payments made on or before commencement date).
x if the lessee is not required to pay the VAT to the lessor upfront, then the lease payments
will include VAT and so will the lease liability, (being the present value of the lease
payments).

10.5.4 VAT and the effect on taxable profits and current income tax

If the lease meeWVµSDUW E RIWKH,&$GHILQLWLRQ¶LWPHDQVthe tax authority sees the lease as a

µWUXH OHDVH¶ LQ ZKLFK FDVH WKH OHDVH SD\PHQWV DUH GHGXFWLEOH IRU LQFRPH WD[ SXUSRVHV see
section 10.4.1). However, how much of the lease payment may be deducted in the calculation
RIWKHOHVVHH¶VWD[DEOHSURILWVZLOOGHSHQGRQZKHWKHUWKHOHDVHLQFludes VAT and, if it does,
whether the lessee is charged this VAT upfront or as part of the lease payments and then also
on whether the lessee is able to claim from the tax authorities any VAT paid:
x If the lessor does not charge VAT, then the lease payments will not include VAT and thus
the lessee simply deducts the full lease payment.
x If the lessor does charge VAT but requires this VAT to be paid upfront on commencement
date, then the lease payments will not include VAT and thus the lessee deducts the full
lease payment.

828 Chapter 16
Gripping GAAP Leases: lessee accounting

x If the lessor does charge VAT and does not charge it as an upfront payment, then the
lease payments will include VAT. In this case:
 if the lessee can claim back the VAT paid as a VAT input, then the lease payments to be
deducted in the calculation of taxable profit each year, must exclude VAT (otherwise the
lessee would be claiming the VAT as a deduction for income tax purposes when the VAT
ZDVQ¶WDFRVWWRthe lessee at all because it had already been claimed back as a VAT input).
See below on how to calculate the portion of the VAT to be removed from each lease
payment.
 if the lessee cannot claim back the VAT, then the lease payments to be deducted in the
calculation of taxable profit each year, must include VAT.

If we need to remove the VAT from lease payments, we apply section 23C of the ITA. The essence
of this is that the portion of the total VAT to be removed from each lease payment (instalment) is
calculated based on the ratio of the lease payment relative to the total lease payments in the lease:

Instalment – Total VAT x Instalment paid = Instalment excluding VAT

Total instalments

10.5.5 VAT and the effect on deferred income tax

The discussion above explains the impact of VAT on the calculation of the taxable profit and
thus current income tax. However, there are also deferred tax consequences. There are
countless permutations but one must simply apply the usual principles: calculate the carrying
amount of the right-of-use asset and lease liability in terms of IFRS 16 and then compare it to
the tax base of each, where the tax base is calculated by considering the taxation legislation.

For example: Let us consider a lease that includes VAT in then lease payments, where the
lessee can claim VAT back and where the lease is recognised:
x by the accountant µRQ-EDODQFH VKHHW¶ LH WKH JHQHUDO DSSURDFK : the accountant will
recognise a right-of-use asset and a lease liability; and
x by the tax authority aV D WUXH OHDVH LH LW PHHWV µSDUW E  RI WKH ,&$ GHILQLWLRQ¶  WKH WD[
authorities do not believe the lessee has an asset or liability and thus allows the deduction of
the lease payments.

In this example, from thHOHVVHH¶VSHUVSHFWLYH:

x The right-of-use asset will have a carrying amount, but its tax base will be nil, thus
creating a temporary difference and deferred tax:
The tax base of an asset represents the future deductions that will be granted on that asset.
Since this lease is recognised as a µOHDVHDJUHHPHQW¶SHUWKH,7$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).
x The lease liability will have a carrying amount, but its tax base will represent only the VAT
included in the carrying amount, thus creating a temporary difference and deferred tax:
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:
 The carrying amount of the lease liability represents the full lease instalments owing
(including VAT).
 Since the lessee can claim the VAT back as a VAT input credit, the tax authority
allows the deduction of the lease instalments paid but does not allow the deduction of
the VAT included in the instalments. Thus, the tax base of the liability represents the
9$7WKDWLVLQFOXGHGLQWKHOLDELOLW\¶VFDUrying 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.

Chapter 16 829
Gripping GAAP Leases: lessee accounting

In summary, in the above example, the impact of the VAT is as follows:

x The impact of VAT on 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 paid = Instalment excluding VAT

Total instalments

x The impact of VAT on the deferred income tax calculation:

The tax base of the lease liability reflects the VAT included in the lease liability, calculated as:

Remaining unpaid instalments

Total VAT in the lease x = Tax base of the lease liability
Total instalments

Example 24: Lease under general approach - with VAT (basic)

Braithwaite Limited leases an asset, as a lessee ,for 4 years.
The contract requires payments of C39 907 (including VAT at 15%) annually in arrears. The present
value thereofGLVFRXQWHGDWWKHOHVVHH¶VLQFUHPHQWDOERUURZLQJUDWHRI, is C126 500.
Braithwaite is a VAT vendor and 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.
%&DOFXODWHWKHOHDVHOLDELOLW\¶VWD[EDVHIRUHDFK\HDURIWKHOHDVHWHUP

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

&DOFXODWLRQRIWKHOHDVHOLDELOLW\¶VWD[EDVH 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)
Tax base at end of year 2 [(39 907 x 2 years) ÷ (39 907 x 4 years)] x 16 500 8 250
Movement (4 125)
Tax base at end of year 3 [(39 907 x 1 years) ÷ (39 907 x 4 years)] x 16 500 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

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 that may be claimed back from the tax authority.

Example 25: Lease under general approach - with VAT

V Limited, with a 31 December year end, entered into a lease agreement over a machine on
1 January 20X1, as the lessee. Four annual instalments of C39 907 are due in arrears. The
effective interest rate table has been prepared for you (see next page)
x The profit before tax is C200 000 in each of the 4 years, after correctly accounting for the lease.
x V Limited depreciates the machine over the lease term.
x The tax rate is 30%.

830 Chapter 16
Gripping GAAP Leases: lessee accounting

x There are no other temporary or permanent differences.

x The effective interest rate table showing the lease payments at 10% is as follows:
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)
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 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

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:

W2.1: Tax base of the right-of-use asset (RoUA)

The tax auWKRULWLHVGRQRWUHFRJQLVHWKHDVVHW LHWKH\µVHH¶OHDVHSD\PHQWVRQO\ thus the
tax base of the right-of-use asset is nil

W2.2: Tax base of the lease liability (LL)

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

Chapter 16 831
Gripping GAAP Leases: lessee accounting

W3: Carrying amount working:

W3.1: Carrying amount of the right-of-use asset (RoUA)

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 of the lease liability (LL)

Given in the question (see effective interest rate table)

W4: Deferred tax CA TB TD DT

(W3) (W2)
Balance: 31/12/20X0 (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 DTA

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 DTA

x Right-of-use asset 55 000 0
x Lease liability (69 260) (8 250)

Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (408)

Balance: 31/12/20X3 (8 779) (4 125) 4 650 1 395 DTA

x Right-of-use asset 27 500 0
x Lease liability (36 279) (4 125)

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

10.6 Accounting for the tax consequences involving transaction taxes

9$7 OHDVHPHHWVWKHGHILQLWLRQRIDµUHQWDO DJUHHPHQW¶
If WKHOHDVHPHHWVWKHGHILQLWLRQRIDµUHQWDODJUHHPHQW¶ the lessor would be required to pay
VAT on the lease payments as they are received (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 may be able to
claim from the tax authorities the VAT that is included in each of the lease instalments paid (if
the lessee is a VAT vendor and uses the underlying right-of-use asset to make taxable supplies).
x If the lessee can claim the VAT, the lease payments claimed by the lessee as a deduction
for income tax purposes must exclude VAT. Assuming VAT is 15%, the lease payments
that will be allowed as a deduction for income tax purposes will be:
Instalment (consideration) x 100/115 = Instalment that will be allowed as a deduction
x If the lessee cannot claim VAT, the lease payments deducted for income tax purposes is simply
the instalment paid, including VAT.

832 Chapter 16
Gripping GAAP Leases: lessee accounting

When the lease payments include VAT, the measurement of the lease liability will include VAT.

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 µon-EDODQFHVKHHW¶ LHWKHJHQHUDODSSURDFh), and
x is treated by the tax authority DVDµUHQWDODJUHHPHQW¶
The VAT effect on DT for
In this example, the lessee has a right-of-use asset and a lease under the
general approach (on-
lease liability:
balance sheet):
x The right-of-use asset’s carrying amount will exclude the CA/TB with VAT: notice effect of
VAT. This is because the VAT was claimable and will be VAT being claimable/ not
claimable:
recognised as a separate VAT asset.
x Asset:
The tax base of this right-of-use asset will be nil. - CA = excl VAT (if claimable),
- CA = incl VAT (if not claimable)
 This is because the tax base of an asset represents the
- TB = nil
future deductions that will be granted on that asset. In x Liability:
this regard, since this leaVH LV UHFRJQLVHG DV D µUHQWDO - CA = incl VAT (PV!)
agreemHQW¶SHU WKH 9$7 $FWWKHWD[DXWKRULW\ will only - TB = PV of VAT (if claimable)
allow the deduction of the lease payments made. - TB = nil (if VAT not claimable)

 This means that no deductions will be granted against the asset as it does not believe the
lessee has an asset (thus TB of the asset = 0).
x The lease liability¶s carrying amount will be the present value of the lease payments, including VAT.
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.
 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 tKH SRUWLRQRI WKH OLDELOLW\¶V FDUU\Lng 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.

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.

11. Presentation and disclosure requirements (IFRS 16.47-60)

11.1 Presentation (IFRS 16.47-50)

11.1.1 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.

Chapter 16 833
Gripping GAAP Leases: lessee accounting

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 presented within the same asset classification that would have been appropriate
had it been owned (e.g. a 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
H[SHQVH SD\DEOH ZRXOG EH LQFOXGHG LQ WKH µWUDGH DQG RWKHU SD\DEOHV¶ OLQH-item whereas an
expense prepaid would be incOXGHGLQWKHµWUDGHDQGRWKHUUHFHLYDEOHV¶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 xxx xxx
included here)

EQUITY AND LIABILITIES

Non-current liabilities
Non-current portion of lease liability 16 xxx xxx
Current liabilities
Current portion of lease liability 16 xxx xxx

11.1.2 Presentation in the statement of comprehensive income

There are several 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 11.2), it is only
expenses 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
For the year ended 31 December 20X5 Note C C

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

834 Chapter 16
Gripping GAAP Leases: lessee accounting

11.1.3 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 was not 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)

11.2 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 KDYH D VRXQG EDVLV XSRQ ZKLFK µWR DVVHVV WKH HIIHFW WKDW OHDVHV KDYH RQ WKH
financial positioQILQDQFLDOSHUIRUPDQFHDQGFDVKIORZVRIWKHOHVVHH¶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)
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

Chapter 16 835
Gripping GAAP Leases: lessee accounting

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 PXVW DOVR LQFOXGH D µPDWXULW\ DQDO\VLV¶ IRU DQ\ OHDVH OLDELOLW\. This maturity
analysis must be presented separately from the µPDWXULW\DQDO\VHV¶RIRWKHUfinancial 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 leDVHQRWHPXVWDOVRLQFOXGHµDGGLWLRQDOTXDOLWDWLYHDQGTXDQWLWDWLYHLQIRUPDWLRQDERXWLWV
leaVLQJDFWLYLWLHV¶WKDWDUHQHFHVVDU\WRHQDEOHWKHXVHUVWRDVVHVVWKHLPSDFWRI the leases on
thH HQWLW\¶V ILQDQFLDO SRVLWLRQ SHUIRUPDQFH DQG FDVK IORws. For example, the following
information would typically be considered useful:
- the nature of the lessee¶VOHDVLQJDFWLYLWLHV
- 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
- 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 / 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.

An example of a typical lease note is presented overleaf:

836 Chapter 16
Gripping GAAP Leases: lessee accounting

Happy Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X5
1. 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.
The right-of-use assets relating to plant are measured under the revaluation model. In this regard:
- the effective daWHRIWKHODVWUHYDOXDWLRQLV«DQGZDVSerformed by valuer who LV«« LQGHSHQGHQWQRW
independent of the entity).
- Had the right-of-use asset over plant been measured under the cost model, its carrying amount would have
beHQ&««
- The revaluation surplus relating to the right-of-use asset over SODQW««(increased/ decreased) during the
\HDUE\DQDPRXQWRI&«« and now has a balance of C«.., over whLFKWKHUHDUH«. (no restrictions on
the distribution to shareholders/ the following restrictions over the GLVWULEXWLRQWRVKDUHKROGHUV« 

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 ZD\«

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 ± see note xx entitled µsignificant accounting policies¶).

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 includes« HJDQH[WHQVLRQRSWLRQ 
- 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 reasoQZK\WKHHQWLW\LVQRWUHDVRQDEO\FHUWDLQLWZLOOH[HUFLVHWKLVRSWLRQLVEHFDXVH« HJ
the future leases are expected to be well above the expected market-related leases).

Chapter 16 837
Gripping GAAP Leases: lessee accounting

12. 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-
x Depreciation/ impairment on right-of use asset term, generally using the SL method)
x Variable lease payments that do not vary x Variable lease payments that do not vary
with an index/rate with an index/rate

General approach

Right-of-use asset (RoU asset) Lease liability (LL)

Measurement model:
x Cost model (Cost – AD&AIL +/-
Remeasurement adjustments
x Fair value model (if investment property)
x Revaluation model (if PPE & RoU asset is a
class of PPE that is measured in terms of
RM and entity chooses to apply the RM to
this RoU asset)
Initial measurement (at cost):
x Initial measurement of lease liability
x Plus indirect costs
x Plus Prepaid lease payments
x Plus Estimated costs to dismantle/ remove/ restore
x Minus Lease incentives received
Depreciation:
x Starts commencement date
x Method reflects pattern in which FEB from
RoU asset expected to be consumed
x Useful life: If ownership
 transfers/ is expected to transfer (e.g.
purchase option & reasonably certain that
lessee will exercise it) then use UL of
underlying asset
 not expected to transfer, then use shorter
of lease term or UL of RoU asset
Impairments: per IAS 36 Impairment of assets
Remeasurements (up/down) due to a
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)
Measured under:
x Amortised cost model (i.e. effective
interest rate method)
x CA reflects PV of future ‘lease payments’
Initial measurement (at PV of future lease
payments) … Lease payments (LPs) include:
x Fixed payments (including in-substance
fixed pmts) less lease incentives receivable
x Variable LPs that vary with index/rate
x Residual value guarantees
x Exercise price of purchase options that are
reasonably certain will be exercised
x Termination penalties if termination is
reasonably certain this option will be
exercised
Discount rate:
x Implicit interest rate or
x Lessee’s incremental borrowing cost
Subsequent measurement:
x Add interest (effective interest rate
method)
x Less payments
x Remeasurement adjustments (up/down)
due to a change in lease payments (not a
lease modification – lease modifications
are accounted for as separate lease
contracts)

838 Chapter 16
Gripping GAAP Leases: lessor accounting

Chapter 17
Leases: Lessor Accounting
Reference: IFRS 16 (including any amendments to 1 December 2021)

Contents: Page:
1. Introduction 840
2. Lease classification 842
Example 1: Lease classification 843
3. Finance leases 844
3.1 Overview ± basic overview of recognition 844
3.2 Overview ± various defined terms and their measurements 844
3.2.1 Gross investment and net investment in a lease 844
Example 2: Finance lease ± gross investment in the lease 845
3.2.2 Interest rate implicit in the lease 845
Example 3: Finance lease ± implicit interest rate & net investment in the lease 846
3.2.3 Initial direct costs 849
Example 4: Finance lease ± includes initial direct costs 850
3.2.4 Fair value 852
Example 5: Finance lease ± initial recognition journal (basic) 852
3.3 µ0DQXIDFWXUHUGHDOHUOHVVRUV¶YHUVXVµQRQ-manufacturer/GHDOHUOHVVRUV¶ 853
3.3.1 Overview 853
3.3.2 Non-manufacturer/dealer lessor 854
3.3.3 Manufacturer/dealer lessor 854
Example 6: Finance lease ± manufacturer or dealer 855
3.4 Two methods to record a finance lease: gross method or net method 857
3.4.1 Overview 857
3.4.2 If the lessor is a manufacturer or dealer 858
Example 7: Finance lease: lessor is a manufacturer or dealer 858
3.4.3 If the lessor is neither a manufacturer nor a dealer 862
Example 8: Finance lease: lessor is not a manufacturer or dealer 863
3.5 Lease payments receivable in advance or in arrears 866
Example 9: Finance lease: lease payments receivable in advance 866
3.6 Lease payments receivable during the year 869
Example 10: Finance lease ± lease payments receivable during the period 869
3.7 Disclosure of a finance lease 872
3.8 Tax implications of a finance lease 873
Example 11: Finance lease deferred tax: no S23A limitation, VAT ignored 874
Example 12: Finance lease deferred tax: S23A limitation, VAT ignored 876
Example 13: Finance lease deferred tax: (manuf./ dealer): S23A limit, ignore VAT 878
4. Operating leases 881
4.1 Recognition of an operating lease 881
4.2 Measurement of an operating lease 881
Example 14: Operating lease ± recognition and measurement 881
4.3 Tax implications of an operating lease 882
Example 15: Operating lease ± tax implications 883
4.4 Disclosure of an operating lease 884
Example 16: Operating lease ± disclosure 886
5. Lease involving both land and buildings 887
5.1 Separate classification of the elements 887
Example 17: Lease of land and buildings 887
5.2 How to allocate the lease payments to the separate elements: land and buildings 888
Example 18: Lease of land and buildings 888
5.3 Land and buildings that are investment properties 890
6. Change in classification: modifications versus changes in estimates 890
7. Transaction taxes (e.g. VAT) 891
7.1 The effect of transaction taxes on a finance lease 891
Example 19: Finance lease with transaction taxes (VAT) 892
7.2 The effect of transaction taxes on an operating lease 894
7.2.1 Input VAT, s23C and Interpretation Note 47 894
Example 20: Operating lease with tax and VAT 894
8. Summary 896

Chapter 17 839
Gripping GAAP Leases: lessor accounting

1. Introduction

When a lessor accounts for leases, it uses the same standard that lessees use, IFRS 16
Leases. However, there are two sections within this standard: one that lessees use and one that
lessors use. Contrary to what we might have expected, these two sections provide methods of
accounting that are not mirror images of each other. When applying IFRS 16:
x lessees account for all leases, with a few exceptions, µon balance sheet¶, which means
they recognise the leased asset and lease liability, but yet
x lessors account for leases by first classifying them as either operating or finance leases,
where each of these is accounted for quite differently. Lessors classify leases
as either finance or
The method by which lessors account for operating and operating leases:
finance leases will be explained in this chapter. But, in the x if significant risks and
meantime, it is interesting to be aware that the two different rewards of ownership
methods of accounting by the lessee and lessor do not - transferred: finance lease
always result in a µV\PPHWULFDO¶ outcome. For instance, - not transferred: operating
x the lessor in an operating lease agreement continues to See IFRS 16.61

recognise the leased asset in his statement of financial position, but

x the lessee in this lease agreement will recognise this same asset in his statement of
financial position (as a right-of-use asset).
x This means both entities reflect the asset in their statement of financial position. This is a
contentious area in IFRS 16 and was subject to much debate leading up to its publication.

So how does IFRS 16 require a lessor to differentiate between an operating and finance lease? A
lessor does this by assessing the substance of the lease (not its legal form) to assess whether
substantially all the risks and rewards of ownership transfer from the lessor to the lessee:
x if they transfer, then the substance of the agreement is that it is more like 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 µtrue lease¶: this
is an operating lease. See IFRS 16.62

The definitions relevant to a lessee are the same definitions used by a lessor, except for the
µlease payment¶ definition, which differs slightly depending on whether we are a lessee or
lessor (please revise all definitions in µChapter 16: Lessees¶). However, there are a few extra
definitions that are relevant only to lessors, which are as follows:

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
h gross investment in the lease,
x discounted at the interest rate implicit in the lease.IFRS 16. App A

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

840 Chapter 17
Gripping GAAP Leases: lessor accounting

The following µOHDVHSD\PHQW¶definition GLIIHUVVOLJKWO\IURPWKHOHVVRU¶VSHUVSHFWLYH

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;
(e) 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).

Please notice WKDWWKHILIWKDVSHFWRIWKHµOHDVHSD\PHQW¶GHILQLWLRQ (see above), which deals with

residual value guarantees, differs depending on whether we are looking at the lease from the
lessee perspective or the lessor perspective.
x When looking at it from the lessee perspective, we would only include the amount the
lessee expects have to pay as a result of having provided a residual value guarantee (see
chapter 16, section 9.3.6).
x When looking at it from the lessor perspective, we include the entire residual value
guarantee, and we would also include all residual value guarantees, whether provided by
the lessee or another party.

Worked example 1: Residual value guarantees

A lessee guarantees that the underlying asset will have a value of C100 at the end of the lease.
However, at commencement date, the lessee actually believes that, at the end of the lease, the
asset will have a value of only C20.
This lessee ZLOOQHHGWRLQFOXGHLQWKHFDOFXODWLRQRILWVµOHDVHSD\PHQWV¶DQDPRXQWof C80, because it has
guaranteed a residual value of C100 but expects the physical asset to be worth C80 less than this, which
means it expects to have to pay a further C80 in order to honour its promise.
The lessor, on the other hand, will include the full residual value guarantee of C100.

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; or
 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:
(a) the fair value of the underlying asset plus (b) any initial direct costs of the lessor.
IFRS 16 App A (reworded slightly)

Chapter 17 841
Gripping GAAP Leases: lessor accounting

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

2. Lease Classification (IFRS 16.61-66)

)URPDOHVVRU¶VSHUVSHFWLYHWKHUHDUHWZRlease classifications:
The lease
x finance leases, and classification
x operating leases. depends on
whether the risks and
What differentiates the one type from the other is whether the lease rewards of ownership
transfers substantially all the risks and rewards of ownership of the have been transferred:
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.
If any one of
these examples
When assessing whether risks and rewards transfer, we must look to are met, it is:
WKHFRQWUDFW¶Vsubstance rather than its legal form.
x normally a finance lease.
Note:
In this regard, IFRS 16 provides guidance as to whether, in substance,
This list is not exhaustive.
the risks and rewards are transferred. This guidance is given by way of
the following list of µindicators¶ and µexample situations¶ that individually, or in combination, could lead
to a lease being classified as a finance lease:
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;
e) the leased assets are of such a specialised nature that only the lessee can use them without
major modifications;
f) LI WKH OHVVHH FDQ FDQFHO WKH OHDVH WKH OHVVRU¶V ORVVHV DVVRFLDWHG ZLWK WKH FDQFHOODWLRQ DUH
borne by the lessee;
g) 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); and
h) 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 16.63 (extract) and IFRS 16.64 (Extract)

842 Chapter 17
Gripping GAAP Leases: lessor accounting

Please note that the above list is not exhaustive. Thus, just because a lease agreement is
characterised by some of the elements above does not 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

The use of these guidance examples is best illustrated with an example.

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

Answer: 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

Chapter 17 843
Gripping GAAP Leases: lessor accounting

W1.2: Present value factors for interest rate of 10%

Present value factor = [1/(1+10%)]n «:here: 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:
x n = 4 i = 10% PMT = -10 000
x COMP PV ... and your answer should be: 31 698!

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 (DOVRFDOOHGµQet 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
Lease receivable (Net investment in the finance lease) 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

The net investment (NI) in
3.2.1 Gross investment and net investment in a lease the lease is defined as
x the gross investment in the lease,
The receivable (referred to above) is also referred to as the x discounted at the interest rate
IFRS 16. App A
µnet investment in the lease¶. ThLV µQHW LQYHVWPHQW¶ is a implicit in the lease.
defined term (see pop-up alongside) and is essentially the P.S. If we look at the definition
of ‘implicit interest rate’ (see
SUHVHQWYDOXHRIWKHµJURVVLQYHVWPHQW in the lease¶ 3.2.2), we can also say the ‘NI’ is:
x the FV of the underlying asset plus
x indirect costs of the lessor.

844 Chapter 17
Gripping GAAP Leases: lessor accounting

7KHWHUPµgross investment in the leasH¶is yet another defined term. If we look carefully at this
definition, we can see that the µJURVVLQYHVWPHQW¶LVWKHWRWDO undiscounted amount of:
x the future lease payments (remember the definition of lease The gross investment (GI)
payments includes guaranteed residual values, amongst in the lease is defined as
other items: see section 1 for the full definition), plus the sum of:
x any unguaranteed residual value ± the portion of the x the lease payments receivable
by a lessor under a finance
residual value of the asset the realisation of which is not lease; and
guaranteed to the lessor. x any unguaranteed residual
value accruing to the lessor.
IFRS 16.App A
In other words, this µgross investment¶ represents the total of the
expected gross inflows, including whatever value is left of the asset at the end of the lease term (i.e.
we include the entire residual value, whether guaranteed or not).

It is important to note that, from the lessee’s perspective, any unguaranteed residual value is
not included in the measurement of the µlease liability¶; but that, from a lessor’s perspective, it
is included in the measurement of the µlease liability¶ (because it is included in the calculation of
the gross investment in the lease ± see pop-up above.).

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 (NI) is the present x the rate of interest that causes
value of the gross investment (GI). the sum of:
(a) the PV of the lease pmts
When measuring this present value, we discount the gross plus
amounts using the interest rate implicit in the lease (see (b) the PV of the unguaranteed
residual value
pop-up alongside).
x to be equal to the sum of:
(a) the fair value of the
This implicit interest rate is (IRR) 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 WKHVXPRIWKHDVVHW¶VIDLUYDOXHSOXVDQ\LQLWLDOGLUHFWFRVWVLQFXUUHGE\WKHOHVVRU

Yet another way of putting it, is the implicit interest rate is the rate that makes:
x the net investment
x equal the sum of the asVHW¶Vfair value plus any initial direct costs incurred by the lessor.

Chapter 17 845
Gripping GAAP Leases: lessor accounting

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 prior
example, together with the following additional information:
x The SODQW¶Vcarrying amount and fair value 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).

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 prior example gave us the lease payments and unguaranteed residual values (C440 000) whereas
this example gave us the fair value (C220 000) and initial direct costs (C0).
x The DVVHW¶V carrying amount 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 GHILQLWLRQ RI µOHDVH SD\PHQWV¶ LQFOXGHV µJXDUDQWHHG UHVLGXDO YDOXHV¶ EXW ZH OHDve this out of the
amount that we µLQSXW¶LQWRWKHFDOFXODWLRQ DVWKHµ307¶
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). SLQFH WKH µJXDUDQWHHG UHVLGXDO YDOXH¶ ZLOl only be
received once, at WKHHQGRIWKHOHDVHWHUPWKLVµJXDUDQWHHGUHVLGXDOYDOXH¶ is input as part of
WKHIXWXUHYDOXHDPRXQWµ)9¶.

(2) From WKHOHVVRU¶VSHUVSHFWLYHµFV¶ 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
Explanation:
x The net investment (NI) is defined as being the present value (PV) of the gross investment (GI),
discounted at the implicit interest rate.
Net investment = Gross investment, discounted at the Implicit interest rate
7KHFDOFXODWLRQEDVHGRQGHILQLWLRQRIµQHWLQYHVWPHQW¶LVVKRZQLQ:

846 Chapter 17
Gripping GAAP Leases: lessor accounting

x However, the net investment could also simply be calculated as being the µfair value of the underlying asset¶
plus the µinitial direct costs¶:
This is based on the logic derived from the definition of the µimplicit interest rate¶, which is that the implicit interest
rate is the rate that will make the net investment (present value of the gross investment) equal the sum of the fair
value and any initial direct costs. In other words, the implicit interest rate is the rate that makes the following two
amounts equal:
 Net investment = Fair value of the leased asset + Initial direct costs
 Net investment = Gross investment, discounted at the Implicit interest rate
7KXVWKHFDOFXODWLRQRIQHWLQYHVWPHQWEDVHRQWKHGHILQLWLRQRIWKHµLPSOLFLWLQWHUHVWUDWH¶would be as follows:
Net investment = FV: 220 000 + initial direct costs: 0 = 220 000
W1: Net investment calculated as a present value calculation (using a financial calculator)
Net investment = Gross investment, discounted at the Implicit interest rate (i.e. PV of GI)
Implicit interest rate = 12.174776% (see solution 3A)
Gross investment = Lease payments (P.S this includes guaranteed RVs) + Unguaranteed RV
Thus, we need to calculate:
 PV of the lease payments (LP) =
The PV of the LPs receivable at the end of every year for 10 years (C33 000 for 10 years), and
The PV of the single LP receivable at the end of the 10th year, being the guaranteed residual value
(C66 000 after 10 years); plus
 PV of the unguaranteed residual value =
The PV of the unguaranteed residual value at the end of the 10th year (C44 000 after 10 years).

This information can be input into your financial calculator as follows:

PMTS = Lease payments (excluding guaranteed residual value) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = Guaranteed residual values + Unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = Solution 3A = 12,174776%
Compute PV = C220 000

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
DPRXQW DQGUHFRJQLVHVDUHFHLYDEOHPHDVXUHGDWWKHµQHWLQYHVWPHQWLQWKHOHDVH¶
x In this case, the asseW¶Vcarrying amount equals its fair value (and there were no initial direct costs). Thus,
the amount of the credit to derecognise the asset (carrying amount: 220 000) equals the amount of the
debit to recognise the receivable (measured at the net investment of the lease: 220 000).
x This means there is no profit to be recognised on the initial recognition of the finance lease.
1/1/20X0 Debit Credit
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 The lease receivable is subsequently measured at amortised cost, which means it is:
 increased by interest income, calculated using the effective interest rate method, and
 decreased by payments received.

Chapter 17 847
Gripping GAAP Leases: lessor accounting

x This example only asks us 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 (though the amount of interest in
the first journal would change each year).

31/12/20X0 (first year of lease) Debit Credit

Lease receivable (net investment) (A) W1 26 785
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)
Lease receivable (net investment) (A) W1 15 520
Lease interest income (P/L: I) 15 520
Interest income on the FL
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
at 12,174776% unguaranteed balance
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)
Notes relating to W1:
(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).

848 Chapter 17
Gripping GAAP Leases: lessor accounting

Solution 3E: Finance lease ± subsequent measurement journals

Comment:
x If a 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. In this case,
the lessee would need to contribute cash of C16 000 (C66 000 ± C50 000).
x Thus, the last lease payment from the lessee will be C49 000, being the fixed pmt (C33 000)
plus the extra pmt due to the residual value guarantee (C16 000).

31/12/20X9 (last year of lease) Debit Credit

Lease receivable (net investment) (A) W1 in Sol 3D 15 520
Lease interest income (P/L: I) 15 520
Interest income on the FL
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 EH FDOOHG µinitial
direct costs¶+RZHYHUWKHUHLVDQexception. 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 µinitial direct costs¶ EHFDXVH defined as:
initial coVWV LQFXUUHG E\ µPDQXIDFWXUHU GHDOHU OHVVRUV¶ DUH
H[SUHVVO\H[FOXGHGIURPWKHGHILQLWLRQRIµLQLWLDOGLUHFWFRVWV¶ x Incremental costs of obtaining
a lease
(see pop-up alongside).
x that would not have been
incurred if the lease had not
This distinction between a µmanufacturer/ dealer lessor¶ and been obtained,
a µnon-manufacturer/dealer lessor¶ is very important x except for such costs incurred
because it determines whether these initial costs meet the by
GHILQLWLRQRIµLQLWLDOGLUHFWFRVWV¶RUQRW  a manufacturer/dealer lessor
 in relation to a finance lease.
If the costs do meet the definitioQ RI µLQLWLDO GLUHFW FRVWV¶ IFRS 16 App A (reworded slightly)

then they are taken into account when calculating our implicit interest rate (see pop-up in
section 3.2.2) and thus they will also affect the measurement of our net investment (i.e. our
receivable).

If the costs do not meet the µGHILQLWLRQRIµLQLWLDOGLUHFWFRVWV¶ LHEHFDXVHWKH\ZHUHLQcurred by

DµPDQXIDFWXUHUGHDOHUOHVVRU¶ WKese costs would thus not be included in our implicit interest
rate and would not be included in our net investmenW ,QVWHDG WKHVH µVR-called initial direct
FRVWV¶ZRXOGVLPSO\EHH[SHQVHG

The differentiatiRQ EHWZHHQ µPDQXIDFWXUHU GHDOHU OHVVRUV¶ DQG µQRQ-manufacturer/dealer

OHVVRUV¶ 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 µmanufacturer 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 µneither 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.

Chapter 17 849
Gripping GAAP Leases: lessor accounting

When accounting for the initial direct costs incurred by a µmanufacturer/ dealer OHVVRU¶, the
justification for excluding WKH LQLWLDO FRVWV IURP WKH GHILQLWLRQ RI µLQLWLDO GLUHFW FRVWV¶ 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 (example 4 and 5) involve DµQRQ-manufacturer/deaOHUOHVVRU¶

Example 4: Finance lease ± includes initial direct costs

This example uses the same information given in the two prior examples (summarised below
for your convenience), except we now assume 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, commencing 1 January 20X0.
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. Co B
(lessee) has guaranteed the asset will have a residual value of C66 000. This means there
is a portion of the residual value that is unguaranteed (C44 000).
x The SODQW¶Vcarrying amount and fair value 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 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
 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 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
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual value + unguaranteed residual value = 66 000 + 44 000 = 110 000
Compute i = 11,267746%

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

850 Chapter 17
Gripping GAAP Leases: lessor accounting

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 (NI):
 Net investment = FV: 220 000 + initial direct costs: 10 000 = 230 000
 Net investment = Gross investment, discounted at the implicit interest rate (see W1 below)

W1: Net investment calculated as a present value calculation (using a financial calculator)
PMTS = lease payments (excluding guaranteed residual values) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual values + unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = see solution 4A = 11,267746%
Compute PV = C230 000

Solution 4C: Finance lease ± initial recognition journal (with initial direct costs)

Comment:
x When initially recognising a finance lease, the lessor derecognises the underlying asset (at its carrying
amount) and recognises a receivable, (measured at the net investment (NI) LQWKHOHDVH¶ 
x In this example, the lessor incurred initial direct costs, which must be included in the µnet investment
(NI) LQWKHOHDVH¶. The contra entry is bank (or a payable).
x Please note: if this was an example involving a manufacturer/ dealer lessor, the initial costs would be
expensed (see section 3.3)

1/1/20X0 Debit Credit

Lease receivable (net investment) (A) Sol 4B 230 000
Bank Given 10 000
Plant: carrying amount Given 220 000
Initial recognition at commencement date of sale of plant via a FL

Solution 4D: Finance lease ± subsequent measurement journals

Comment:
x On initial recognition, the lease receivable is initially measured at the DPRXQWRIWKHµnet investment
on commencement date¶ (i.e. present value of the gross investment, the latter being the sum of the
LPs and Unguaranteed RV).
x The lease receivable is then subsequently 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.
x The fact that there were initial direct costs incurred by the lessor is simply built into the implicit
interest rate (IRR) and does not affect any of the principles followed.

31/12/20X9 (last year of lease) Debit Credit

Lease receivable (net investment) (A) W1 14 481
Lease interest income (P/L: I) 14 481
Interest income on the FL
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

Chapter 17 851
Gripping GAAP Leases: lessor accounting

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
Residual value that is guaranteed (66 000) 44 000
Residual value that is unguaranteed (44 000) 0
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
lease and shows how this income is expected to be earned over the lease period.
(b) Lease payments + Unguaranteed RV: this column represents the gross investment (GI) in the
lease.
(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 (RV), 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
WKHWHUPµIDLUYDOXH¶

When using the term µIDLUYDOXH¶ in context of IFRS 16 Leases, we do not apply IFRS 13 Fair
value measurement. Instead, fair value foUWKHSXUSRVHVRI,)56LVVLPSO\µWKHDPRXQWIRU
which an asset could be exchanged, or a liability settled, between knowledgeable, willing
SDUWLHVLQDQDUP¶VOHQJWKWUDQVDFWLRQ¶. 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
SURILW GHSHQGV RQ ZKHWKHU WKH OHVVRU LV D µPDQXIDFWXUHUGHDOHU OHVVRU¶ RU D µQon-
PDQXIDFWXUHUGHDOHUOHVVRU¶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 journalV WR DFFRXQW IRU WKH ILQDQFH OHDVH LQ WKH OHVVRU¶V JHQHUDO MRXUQDO IRU WKH \HDU
ended 31 December 20X0.

Solution 5: Finance lease ± LQLWLDOUHFRJQLWLRQMRXUQDO&$)9ZLWKGLUHFWFRVWV

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 GI (the lease payments and unguaranteed residual value remain
unchanged). It does, however, affect the calculation of the IRR and NI.

852 Chapter 17
Gripping GAAP Leases: lessor accounting

x The implicit interest rate (IRR) in this example is now 9,301512% (W1)
This is because the implicit interest rate is the rate that makes the
 PV of the lease payments plus the PV of the unguaranteed residual value (UGRV)
 equal to the fair value of the asset plus any initial direct costs.
The previous examples (examples 2, 3 and 4) involved a different fair value.
x Net investment (NI) 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)

1/1/20X0 Debit Credit

Lease receivable (net investment) (A) W2 or: 244 200 + 10 000 254 200
Bank Given: initial direct costs 10 000
Plant: carrying amount Given 220 000
Profit on finance lease commencement (P/L: I) 24 200
Initial recognition at commencement date of sale of plant via a FL
Lease receivable (net investment) (A) 254 200 x 9,301512% 23 644
Lease interest income (P/L: I) 23 644
Interest income on the FL
Bank Given 33 000
Lease receivable (net investment) (A) 33 000
Lease payment received from the lessee

W1: Implicit interest rate, calculated using a financial calculator:

PV = fair value + initial direct costs = 244 200 + 10 000 = -254 200
PMTS = lease payments (excluding guaranteed residual values) = 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 = 66 000 + 44 000 = 110 000
Compute i = 9,301512%

W2: Net investment: alternative calculation using GI and IIR, and using a financial calculator:
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 values + unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = W1 = 9,301512%
Compute PV = C254 200

3.3 µ0anufacturer/ dealer OHVVRUV¶YHUVXVµQRQ-manufacturer dealer OHVVRUV¶

3.3.1 Overview

7KH HVVHQWLDO GLIIHUHQFH EHWZHHQ D µPDQXIDFWXUHUGHDOHU OHVVRU¶ DQG D µQRQ-manufacturer

GHDOHUOHVVRU¶can be summed up as follows:
x $OHVVRUWKDWLVDµPDQXIDFWXUHURUGHDOHU¶LVRQHZKRQRUPDOO\VHOOVWKHunderlying asset and thus,
the substance of the lease is that he is effectively selling inventory and providing finance.
x $ OHVVRU WKDWLV µQHLWKHUDPDQXIDFWXUHU QRUGHDOHU¶ LV someone who does not normally sell the
underlying asset and thus the substance of the lease is that he is simply providing finance (often
FDOOHGDµILQDQFLHUOHVVRU¶ .

AsVHVVLQJ ZKHWKHU D OHVVRU LV D µPDQXIDFWXUHU RU GHDOHU¶ RU D µQRQ-PDQXIDFWXUHUGHDOHU¶ LV
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 net investment in the lease (i.e. whether they are
capitalised to the receivable) and thus included in the calculation of the implicit interest rate.
The prior example 4 and example 5 related to a µnon-manufacturer/dealer lessor¶ We will now
FRQVLGHUH[DPSOHVLQYROYLQJDµmanufacturer/dealer lessor’.

Chapter 17 853
Gripping GAAP Leases: lessor accounting

3.3.2 Non-manufacturer/ dealer lessor

If the lessor is not DPDQXIDFWXUHUGHDOHUWKHQLWPHDQVWKDWWKHOHVVRU¶VQRUPDORSHUDWLQJDFWLYLWLHV

do not revolve around dealing in (selling) goods that he has manufactured or purchased. In this case,
it means that the aVVHWWKDWWKHOHVVRUµVROG¶XQGHUWKHILQDQFHOHDVHZLOOQRWEHLQYHQWRU\,QVWHDGWKH
asset might 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
SURILWRUORVVRQVDOHRIWKHDVVHW HJLIDUHFHLYDEOHH[FHHGVWKHDVVHW¶VFDUU\LQJDPRXQWthen we
would recognise a profit on sale):
Debit Credit
Lease receivable (Net investment in the finance lease) xxx
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 not a
manufacturer or dealer, any incremental costs incurred in obtaining the lease will meet the definition of
µLQLWLDO GLUHFWFRVWV¶ 6LQFH µLQLWLDO GLUHFWFRVWV¶DUHLQFOXGHGLQWKHGHILQLWLRQRIKRZ ZH FDOFXODWHG WKH
µLPSOLFLW LQWHUHVWUDWH¶ WKHVH costs will be included in the measurement of tKHµQHW LQYHVWPHQW LQ WKH
OHDVH¶ WKHUHFHLYDEOH 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
3.3.3 Manufacturer/ dealer lessor
depend on whether the lessor:

If the lessor is a manufacturer/ dealer, it means his x Is a manufacturer/dealer:

- sales and interest income; and
normal operating activities involve dealing in (selling)
- cost of sales and initial costs
goods that he has either manufactured/ purchased. Thus, expenses
the asseWµVROG¶XQGHUWKHILQDQFHOHDVHLVinventory. x Is not a manufacturer/dealer:
- interest income; and
When we derecognise the asset (inventory), it thus also - P/L on sale of the asset (if
means that we must recognise a cost of sales expense. applicable).

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 UHPHPEHULVLIWKHOHVVRULVDµPDQXIDFWXUHUGHDOHUOHVVRU¶WKHLQLWLDOLQFUHPHQtal

costs that it incurs at the time of obtaining the lease are explicitly excluded IURPWKHGHILQLWLRQRIµinitial
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.

854 Chapter 17
Gripping GAAP Leases: lessor accounting

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 The lease payments receivable by Co A are C33 000 per annum, payable in arrears.
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 OHDVHLQWKHOHVVRU¶Vrecords for the year ended 31 December 20X0.

Solution 6: Finance lease ± manufacturer/ dealer

Comment:
x The DVVHW¶Vfair value on commencement date is C244 200, which does not equal its carrying amount. This
has no impact on the gross investment (the lease payments and unguaranteed residual value remain
unchanged), but it affects 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 DVVHW¶V fair value (C244 200) exceeds its carrying amount (cost: 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 is shown using 2 journals. This present value cannot
remain expensed within the cost of sales account 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 WKH GHILQLWLRQ RI µLQLWLDO GLUHFW FRVWV¶ H[FOXGHV DQ\
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)

1/1/20X0 Debit Credit

Lease receivable (net investment) (A) 227 356
Revenue (P/L: I) Lower of FV of the inventory: 244 200 & the 227 356
PV of the LPs: 227 356
Cost of sales (P/L: E) Given, but see jnl adj. below 220 000
Inventory (-A) 220 000
Lease receivable (net investment) (A) PV of the URV (W3) 16 844
Cost of sales (P/L: E) 16 844
Initial legal fees expense (P/L: E) Given 10 000
Bank 10 000
Initial recognition of the finance lease at commencement date
(manufacturer/dealer)

Chapter 17 855
Gripping GAAP Leases: lessor accounting

31/12/20X0 Debit Credit

Lease receivable (net investment) (A) 244 200 x 10,078261% or W5 24 611
Lease interest income (P/L: I) 24 611
Interest income on the finance lease of 244 200 (227 356 + 16 844)
Bank (A) Given 33 000
Lease receivable (net investment) (A) 33 000
Lease payment received from the lessee

W1: Implicit interest rate, calculated using a financial calculator:

PV = fair value + initial direct costs (N/A) = 244 200 + 0 = -244 200
PMTS = lease payments (excluding guaranteed residual values) = 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 = 66 000 + 44 000 = 110 000
Compute i = 10,078261%

W2: Net investment: alternative calculation using GI and IIR, and using a financial calculator:
PMTS = lease payments (excluding guaranteed residual values) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual values + unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = W1 = 10,078261%
Compute PV = C244 200

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
i = implicit interest rate = W1 = 10,078261%
Compute PV = C16 844

W4: PV of lease payments, calculated using a financial calculator:

PMTS = lease payments (excluding guaranteed residual values) = fixed payment = 33 000
FV = guaranteed residual value = 66 000
N = number of times we receive the amount that we input as being the PMT = 10
i = implicit interest rate = W1 = 10,078261%
Compute PV = C227 356

W5: Effective interest rate table Finance income: Lease pmts plus Receivable
at 10,078261% unguaranteed RV balance
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
Residual value that is guaranteed (66 000) 44 000
Residual value that is unguaranteed (44 000) 0
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
lease and shows how this income is expected to be earned over the lease period.
(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.

856 Chapter 17
Gripping GAAP Leases: lessor accounting

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 7KHµgross investment in lease¶DFFRXQW *,DFFRXQW): 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 GI account is then decreased over the lease term by the account (UFI) (-A)
lease payments received (including the guaranteed residual
value) and then by any unguaranteed residual value.
x The µunearned finance income¶DFFount (UFI account):
This account has a credit balance and is set-off against tKHµJURVVLQYHVWPHQWDFFRXQW¶VRWKDWRXU
net lease receivable to be presented the statement of financial position is measured at an amount
HTXDOWRWKHµnet investment in the lease¶ *,± 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
EDODQFHLQWKHµJURVVLQYHVWPHQWLQOHDVH¶DFFRXQWWKHµQHWLQYHVWPHQWLQWKHOHDVH¶ LH39RIWKH
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 7KHµlease receivable¶ account (net investment in the lease¶) (NI): lease receivable
This account is measured at the present value (discounted at by using one account:
the 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 µgross investment in the lease¶ less µunearned 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.

:H ZLOO QRZ LOOXVWUDWH WKH GLIIHUHQFH EHWZHHQ WKHVH WZR PHWKRGV IRU D OHVVRU WKDW LV D µQRQ-
PDQXIDFWXUHUGHDOHU¶DQGWKHQIRUDOHVVRUWKDWLVDµPDQXIDFWXUHr dHDOHU¶

Chapter 17 857
Gripping GAAP Leases: lessor accounting

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 Lease receivable:
The lease receivable reflects the present value of the gross investment. However, the
implicit interest rate used to calculate the present value is affected by whether the lessor
is a manufacturer/ dealer or not. If you are a manufacture/ dealer, any incremental costs
in obtaining the lease will not meet the definiWLRQRIµLQLWLDOGLUHFWFRVWV¶DQGZLOOWKXVEH
expensed and not included in the implicit interest rate calculation.
x Sales revenue:
The 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:
The 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):
These 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. It
has a 31 December financial year-end.
x 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:
 commencement date: 1 January 20X1
 lease period: 5 years
 lease payments (LPs): C100 000, annually in arrears, payable on 31 December of each year.
x The implicit interest and market interest rate applicable is 16,9911%.

858 Chapter 17
Gripping GAAP Leases: lessor accounting

Required:
A. 3UHSDUH/HPRQ7UHH¶Vjournals for each of the years 20X2 to 20X5, using the gross method.
B. 3UHSDUH/HPRQ7UHH¶Vjournals for each of the years 20X2 to 20X5, using the net method.
C. Prepare Lemon Tree¶s disclosure for the year ended 31 December 20X1. (See Section 3.7 on
Disclosures)
Ignore comparatives and ignore tax.

Solution 7: Finance lease: lessor is a manufacturer or dealer

Comment: This is a basic example where the LPs are payable in arrears and the payment date coincides 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 table Finance Lease pmts plus Receivable
income: unguaranteed RV balance
16.9911%
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 gross amount receivable from the lessee (i.e. the lease pmts and
unguaranteed RV), and shows the periods in which we expect to receive each of these pmts.
(c) The balance reflected in this column represents the present value of the future lease payments plus
the present value of the unguaranteed RV, 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)

1/1/20X1 Debit Credit
Inventory (A) 250 000
Bank (A) 250 000
Purchase of inventory
Cost of sale (P/L: E) 250 000
Inventory (A) 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

Chapter 17 859
Gripping GAAP Leases: lessor accounting

31/12/20X1 Debit Credit

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
Finance lease receivable: gross investment (A) 100 000
Lease payment received under finance lease
Finance lease receivable: unearned finance income (-A) W2: EIRT 46 618
Lease finance income (P/L: I) 46 618
Interest income earned at 16.9911% ( effective int. rate table: FI column)
31/12/20X3
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 37 549
Lease finance income (P/L: I) 37 549
Interest income earned at 16.9911% (effective int. rate table: FI column)
31/12/20X4
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 26 938
Lease finance income (P/L: I) 26 938
Interest income earned at 16.9911% (effective int. rate table: FI column)
31/12/20X5
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 14 523
Lease finance income (P/L: I) 14 523
Interest income earned at 16.9911% (effective int. rate table: FI column)

Solution 7B: Journal entries (Net method)

1/1/20X1 Debit Credit
Inventory (A) 250 000
Bank (A) 250 000
Purchase of inventory
Cost of sale (P/L: E) 250 000
Inventory (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 receivable and the related sale (dealer), recognised on
commencement date, and measured at the net investment (i.e. gross
investment of C500 000 discounted at the implicit interest rate)

860 Chapter 17
Gripping GAAP Leases: lessor accounting

31/12/20X1 Debit Credit

Bank (A) 100 000

Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease

Finance lease receivable: net investment (A) W2: EIRT: FI column 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
Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease

Finance lease receivable: net investment (A) W2: EIRT: FI column 46 618
Lease finance income (P/L: I) 46 618
Interest income earned at 16.9911%, (effective int. rate table: FI column)
31/12/20X3
Bank (A) 100 000
Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease

Finance lease receivable: net investment (A) W2: EIRT: FI column 37 549
Lease finance income (P/L: I) 37 549
Interest income earned at 16.9911%, (effective int. rate table: FI column)
31/12/20X4
Bank (A) 100 000
Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease
Finance lease receivable: net investment (A) W2: EIRT: FI column 26 938
Lease finance income (P/L: I) 26 938
Interest income earned at 16.9911%, (effective int. rate table: FI column)
31/12/20X5
Bank (A) 100 000
Finance lease receivable: net investment (A) 100 000
Lease payment received under finance lease

Finance lease receivable: net investment (A) W2: EIRT: FI column 14 523
Lease finance income (P/L: I) 14 523
Interest income earned at 16.9911%, (effective int. rate table: FI column)

Solution 7C: Disclosure

Lemon Tree Limited

Statement of financial position 20X1
as at 31 December 20X1 C

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 income 30/1 53 382
included in this LP: 46 618

Chapter 17 861
Gripping GAAP Leases: lessor accounting

Lemon Tree Limited

Notes to the financial statements (extracts) 20X1
For the year ended 31 December 20X1 C

28. Profit before tax

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
 Income from variable lease payments that do not depend on an index or rate 0
 Other lease payments 0

30. Net investment in finance lease (finance lease receivable)

Carrying amount ± beginning of year 0
Net investment of new leases commenced during 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 column) 274 372

Gross Unearned Net

31. Maturity analysis: future lease payments 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 46 618 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 = c ± a) (c)
Notes:
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 x recognise only interest
is 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)

862 Chapter 17
Gripping GAAP Leases: lessor accounting

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)

Just as a reminder, when accounting for a finance lease in the books of a µQRQ-
PDQXIDFWXUHUGHDOHU¶WKHNH\LWHPVDUHPHDVXUHGDVIROORZV
x Lease receivable:
The lease receivable reflects the present value of the gross investment. However, the
implicit interest rate used to calculate the present value is affected by whether the lessor
is a manufacturer/ dealer or not.
If you are a non-manufacturer/ dealer, any incremental costs in obtaining the lease will
PHHWWKHGHILQLWLRQRIµLQLWLDOGLUHFWFRVWV¶DQGZLOOWKXVEH included in the implicit interest
rate calculation. This means they will effectively be capitalised into the lease receivable.
This will reduce the interest income recognised over the period of the lease.
x Interest income:
Interest income is measured by multiplying the interest rate implicit in the agreement by
the balance in the lease receivable account.

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 commencement date: 1 January 20X1
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: Show the journals for each of the years ended 31 December in Orange Tree /LPLWHG¶V
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. (See section 3.7 on Disclosures)
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.

W1: Analysis of total amount receivable C

Total future lease payments 90 000 x 3 years 270 000
Guaranteed residual value Given 10 000
Gross investment 280 000
Cost of asset Given 210 000
Finance income 280 000 ± 210 000 70 000

Chapter 17 863
Gripping GAAP Leases: lessor accounting

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).

Solution 8A: Journals: gross method

01/01/20X1 Debit Credit

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
Finance lease receivable: gross investment (A) 90 000
Lease payment received
Finance lease receivable: unearned finance income (-A) W2: EIRT 32 722
Lease finance income (I) 32 722
Interest income earned, (effective interest table: FI column)
31/12/20X2
Bank (A) 90 000
Finance lease receivable: gross investment (A) 90 000
Lease payment received
Finance lease receivable: unearned finance income (-A) W2: EIRT 23 797
Lease finance income (P/L: I) 23 797
Interest income earned, (effective interest table: FI column)
31/12/20X3
Bank (A) 90 000 + 10 000 100 000
Finance lease receivable: gross investment (A) 100 000
Lease payment received (cash pmt increased due to guaranteed residual
being 10 000 but the asset having a residual value of nil
Finance lease receivable: unearned finance income (-A) W2: EIRT 13 481
Lease finance income (P/L: I) 13 481
Interest income earned, (effective interest table: FI column)

Solution 8B: Journals: net method

01/01/20X1 Debit Credit

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

864 Chapter 17
Gripping GAAP Leases: lessor accounting

31/12/20X1 Debit Credit

Bank (A) 90 000
Finance lease receivable: net investment (A) 90 000
Lease payment received
Finance lease receivable: net investment (A) W2: EIRT 32 722
Lease finance income (P/L: I) 32 722
Interest income earned, (effective interest table: FI column)
31/12/20X2
Bank (A) 90 000
Finance lease receivable: net investment (A) 90 000
Lease payment received
Finance lease receivable: net investment (A) W2: EIRT 23 797
Lease finance income (P/L: I) 23 797
Interest income earned, (effective interest table: FI column)
31/12/20X3
Bank (A) 90 000 + 10 000 100 000
Finance lease receivable: net investment (A) 100 000
Lease payment received (cash pmt increased due to guaranteed residual
being 10 000 but the asset having a residual value of nil)
Finance lease receivable: net investment (A) W2: EIRT 13 481
Lease finance income (P/L: I) 13 481
Interest income earned, (effective interest table: FI column)

Solution 8C: Disclosure

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

Statement of financial position 20X1
as at 31 December 20X1 C

Non-current assets Notes

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

Notes to the financial statements (extracts) 20X1
For the year ended 31 December 20X1 C

28. Profit before tax

Profit before tax has been stated after taking into account the following separately
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 in new leases commenced during the current year Per jnl 210 000
Lease payments received Per jnl (90 000)
Finance income Per jnl 32 722
Carrying amount ± end of the year Per W2/ Note 31 (net investment column) 152 722

Chapter 17 865
Gripping GAAP Leases: lessor accounting

Orange Tree Limited

Notes to the financial statements (extracts) FRQWLQXHG«
For the year ended 31 December 20X1
Gross Unearned Net
31. Maturity analysis: future lease payments
investment finance investment
receivable
(undiscounted) charges (discounted)
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
Future lease payments (FLPs) 190 000 37 278 152 722
Unguaranteed residual value (URV) 0 0 0
Total (FLPs + URV) 190 000 37 278 152 722
(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 prior examples have dealt with lease payments that are Whether instalments 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
advance will reduce the principal balance owing (i.e. it will when:
only reduce the principal balance owing by the lessee and xcalculating interest income
will not include a repayment of interest). using the EIR Table; and
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 a
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 commencement date: 1 January 20X1
x lease period: 3 years
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.
(See Section 3.7 on Disclosures)
Ignore tax.

866 Chapter 17
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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.

Journals
Debit Credit
1/1/20X1
Machine: cost (A) Given; W2 210 000
Bank (A) 210 000
Purchase of machine

Finance lease receivable: gross investment (A) W1 250 000

Finance lease receivable: unearned finance income (-A) W1 40 000
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) Given; W2 80 000

Finance lease receivable: gross investment (A) 80 000
Finance lease lease payment received

31/12/20X1
Finance lease receivable: unearned finance income (-A) 24 431
Lease finance income (P/L: I) W2: EIRT 24 431
Interest income earned

1/1/20X2
Bank (A) Given; W2 80 000
Finance lease receivable: gross investment (A) 80 000
Finance lease payment received

31/12/20X2
Finance lease receivable: unearned finance income (-A) 13 988
Lease finance income (P/L: I) W2: EIRT 13 988
Interest income earned, (effective interest table, W2)

1/1/20X3

Bank (A) Given; W2 80 000

Finance lease receivable: gross investment (A) 80 000
Finance lease payment received

31/12/20X3
Finance lease receivable: unearned finance income (-A) W2: EIRT 1 581
Lease finance income (P/L: I) 1 581
Interest income earned, (effective interest table, W2)

Bank (A) Given; W2 10 000

Finance lease receivable: gross investment (A) 10 000
Finance lease instalment received

W1: Analysis of total amount receivable C

Total future lease payments 80 000 x 3 years 240 000

Guaranteed residual value Given 10 000
Gross investment 250 000
Cost of asset Given 210 000
Finance income 250 000 ± 210 000 40 000

Chapter 17 867
Gripping GAAP Leases: lessor accounting

W2: Effective interest rate table Finance income: Lease pmts plus Receivable
18.7927% unguaranteed RV balance
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)
(a) UFI (b) GI (c) NI
Comments: For explanation of (a) ; (b) and (c), please see example 7 (W2).

Solution 9B: Finance lease - disclosure

Pear Tree Limited

Statement of financial position (extracts)
As at 31 December 20X1
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 interest 30/1 55 569
income included in this LP: 24 431
Finance lease receivable: interest receivable W2 30/1 24 431

Pear Tree Limited

Notes to the financial statements
For the year ended 31 December 20X1
20X1
28. Profit before tax C
Profit before tax has been stated after taking into account the following separately
disclosable items:
x Finance income on net investment in lease 24 431

30. Net investment in finance lease

Carrying amount ± beginning of year 0
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
Notice: 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

receivable investment finance charges investment
(undiscounted) (discounted)
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)
Future lease payments (FLPs) 170 000 15 569 154 431
Unguaranteed residual value (URV) 0 0 0
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 = 74 431

868 Chapter 17
Gripping GAAP Leases: lessor accounting

3.6 Lease payments receivable during the year Lease payments during
the year:
Lease payments may be receivable during the year rather than
x this occurs when the year-end
on either the first or last day of the year. You can deal with this
does not coincide with the
by drawing up the effective interest rate table as follows: lease payment dates
x plot all the payments on the dates on which they fall due. x therefore plot the lease
x the portion of the interest earned for each reporting period payments on the EIR Table and
can then either be shown within this table (see W2 in apportion 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¶V books. Ignore tax.

Solution 10A: Finance lease - receipts during the period - journals

1/7/20X1 Debit Credit

Inventory (A) 100 000
Bank (A) 100 000
Purchase of inventory

Cost of sale (P/L: E) 100 000

Inventory (A) 100 000
Inventory sold under finance lease

Finance lease receivable: gross investment (A) W1 300 000

Finance lease receivable: unearned finance income (-A) W1 90 000
Sale (P/L: I) W1 210 000
Sale of machine under finance lease

Bank (A) 60 000

Finance lease receivable: gross investment (A) 60 000
Finance lease payment received

31/12/20X1
Finance lease receivable: unearned finance income (-A) 16 397
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
Finance lease receivable: gross investment (A) 60 000
Finance lease payment received

31/12/20X2
Finance lease receivable: unearned finance income (-A) 29 819
Lease finance income (P/L: I) W2: 16 396 + 13 423 29 819
Finance income earned, effective interest rate table:

Chapter 17 869
Gripping GAAP Leases: lessor accounting

1/7/20X3 Debit Credit

Bank (A) 60 000
Finance lease receivable: gross investment (A) 60 000
Finance lease payment received

31/12/20X3
Finance lease receivable: unearned finance income (-A) 23 221
Lease finance income (P/L: I) W2: 13 422 + 9 799 23 221
Finance income earned, effective interest rate table

1/7/20X4
Bank (A) 60 000
Finance lease receivable: gross investment (A) 60 000
Finance lease payment received

31/12/20X4
Finance lease receivable: unearned finance income (-A) 15 181
Lease finance income (P/L: I) W2: 9 799 + 5 382 15 181
Finance income earned, effective interest rate table

1/7/20X5
Bank (A) 60 000
Finance lease receivable: gross investment (A) 60 000
Finance lease payment received

31/12/20X5
Finance lease receivable: unearned finance income (-A) 5 382
Lease finance income (P/L: I) W2: 5 382 5 382
Finance income earned, effective interest rate table

W1: Analysis of total amount receivable C

Total future lease payments 60 000 x 5 years 300 000
Guaranteed residual value Not applicable in this example 0
Gross investment 300 000
Selling price (net investment) Given 210 000
Gross profit 210 000 ± 100 000 110 000
Cost of asset Given 100 000
Finance income 300 000 ± 210 000 90 000

W2: Effective interest rate table Finance income: Lease pmts plus Receivable
21.8623% unguaranteed RV balance
01 July 20X1 210 000
01 July 20X1 (60 000) 150 000
31 Dec 20X1 32 793 x 6/12 16 397 166 397
01 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
01 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
01 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
01 July 20X5 10 764 x 6/12 5 382 (60 000) 0
(*) Rounded to allow the table to equal zero 90 000 300 000
(a) UFI (b) GI (c) NI
Comments: For explanation of (a) ; (b) and (c), please see example 7 (W2).
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).

870 Chapter 17
Gripping GAAP Leases: lessor accounting

Solution 10B: Finance lease ± receipts during the period - disclosure

Avocado Tree Limited

Statement of financial position 20X1
As at 31 December 20X1 Notes C
Non-current assets
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

Notes to the financial statements (extracts) 20X1
For the year ended 31 December 20X1 C
28. Profit before tax

Profit before tax has been stated after taking into account the following separately
disclosable items:
x Finance income on net investment in lease 16 397

30. Net investment in finance lease

Carrying amount ± beginning of year 0

Net investment in new leases commenced during the year 210 000
Lease payments received (60 000)
Finance income 16 397
Carrying amount ± end of year 166 397

Notice: The 3 carrying amounts in the SOFP (122 793 + 27 207 + 16 397) add up to C166 397.

31. Maturity analysis: future lease payments Gross Unearned Net

receivable investment finance charges investment
(undiscounted) (discounted)
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
Unguaranteed residual value (URV) 0 0 0
Total (FLPs + URV) 240 000 (73 603) 166 397
Calculations:
(1) 60 000/1.2186320,5 = 54 352
(2) 60 000/1.2186321,5 = 44 601
(3) 60 000/1.2186322,5 = 36 599
(4) 60 000/1.2186323,5 = 30 033

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 Recognise 2 types of income: finance income & sales
x Recognise initial direct costs as expense up-front
(initial direct costs are excluded from the
definition of GI and thus affects the implicit
interest rate, causing interest income to increase)
x Derecognise the asset
x Recognise 1 type of income: finance income
x Recognise initial direct costs as part of cost
of lease receivable (included in the GI and
thus affects the implicit interest rate, which
will cause interest income to decrease)

Chapter 17 871
Gripping GAAP Leases: lessor accounting

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 EDVLVXSRQZKLFKµWRDVVHVVWKHHIIHFWthat leases have
on the financial position, financial performaQFHDQGFDVKIORZVRIWKHOHVVRU¶. 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:
- ZLWKLQ\HDUVDIWHUUHSRUWLQJGDWHRQDµSHUDQQXPEDVLV¶DQG
- after 5 years from reporting daWHDVDµWRWDO¶ DOWKRXJK\RXFDQREYLRusly also present
WKLVRQDµSHUDQQXP¶EDVLVLQVWHDGLI\RXSrefer).
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
HQDEOH XVHUV µWR DVVHVV WKH HIIHFW WKat leases have on the financial position, financial
performancHDQGFDVKIORZVRIWKHOHVVRU¶including, for example:
- µWKHQDWXUHRIWKHOHVVRU¶VOHDVLQJDFWLYLWLHV¶DQG
- µKRZ WKH OHVVRU PDQDJHV WKH ULVN DVVRFLDWHG Zith any rights it retains in underlying
DVVHWV¶ LQFOXGing 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
Notes to the financial statements (extracts) 20X1 20X0
For the year ended 31 December 20X1 C C

5. Profit before tax

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

8. Net investment in finance lease

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

872 Chapter 17
Gripping GAAP Leases: lessor accounting

Happy Limited
Notes to the financial statements (extracts) continued «
For the year ended 31 December 20X1
Gross Unearned Net
9. Maturity analysis: future lease payments investment finance investment
receivable (undiscounted) charges (discounted)
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
 in 20X4 xxx
a 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 oIWKHOHVVRU¶VOHDVLQJDFWLYLWLHV RSHUDWLQJDQGILQDQFHOHDVHV 
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 aVIROORZV«
The risk management sWUDWHJ\LVDVIROORZV« HJLQFRUSRUDWLRQRIUHVLGXDOYDOXHJXDUDQWHHVLQWKH
FRQWUDFWVHWF «

Examples involving disclosure of a finance lease from a lesVRU¶VSHUVSHFWLYH

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 oIWKHILQDQFHOHDVH LHWKHµVDOH¶ 
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¶VWD[DEOe profit will include
limitations:
the lease instalments it receives less an annual tax-deduction
x Tax allowances on machinery/plant
based on the OHDVHG DVVHW¶V FRVW HJ DQ DQQXDO FDSLWDO (s11 (e) & s12) are limited to taxable
allowance of 20% of the cost of the leased asset). This lease income.
creates a temporary difference because, for example: x This limitation does not apply to
x From an accounting perspective, the lessor immediately building allowances (s13)
derecognises tKH DVVHW¶V HQWLUH FRVW 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 IURP WKH OHVVRU¶V WD[DEOH
profits) (e.g. S12C manufacturing allowances); and

Chapter 17 873
Gripping GAAP Leases: lessor accounting

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 WKHOHVVRU¶V 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)
- interest income (remove from profit; not taxed)
x Leased asset (e.g. machine)
= Taxable profit - no CA, but has a TB

Example 11: Finance lease deferred tax: no S23A 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 20X1).
The lease is a finance lease, the terms of which are as follows:
x commencement date: 1 January 20X1
x lease period: 3 years
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%.
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 and deferred tax journals for each of the years affected. Ignore VAT.

Solution 11: Finance lease deferred tax: no S23A 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.

31/12/20X1 Debit Credit

Income tax expense (P/L: E) W5 3 000
Current tax payable (L) 3 000
Current tax charge

Income tax expense (P/L: E) W4 4 329

Deferred tax liability (L) 4 329
Deferred tax adjustment
31/12/20X2
Income tax expense (P/L: E) W5 3 000
Current tax payable (L) 3 000
Current tax charge

874 Chapter 17
Gripping GAAP Leases: lessor accounting

31/12/20X2 Debit Credit

Income tax expense (P/L: E) W4 1 197
Deferred tax liability (L) 1 197
Deferred tax adjustment
31/12/20X3
Income tax expense (P/L: E) W5 6 000
Current tax payable (L) 6 000
Current tax charge
Deferred tax liability (L) W4 5 526
Income tax expense (P/L: E) 5 526
Deferred tax adjustment

W1: Effective interest rate table Finance income: Lease pmts & Receivable
18.7927% unguaranteed RV balance
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)

W2: Deferred tax on the Carrying Tax Temporary Deferred

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 DTA
Capital allowance 0 (70 000)
Closing balance 20X2 0 70 000 70 000 21 000 DTA
Capital allowance 0 (70 000)
Closing balance 20X3 0 0 0 0

W3: Deferred tax on the Carrying Tax Temporary Deferred

finance lease receivable amount base difference taxation
Opening balance 20X1 0 0 0 0
New lease 210 000 0
Movement (W1) (55 569) 0
Closing balance (W1) 20X1 154 431 0 (154 431) (46 329) DTL
Movement (W1) (66 012) 0
Closing balance 20X2 88 419 0 (88 419) (26 526) DTL
Movement (W1) (88 419) 0
Closing balance (W1) 20X3 0 0 0 0

W4: Deferred tax summary Machine Finance lease Total

(W2) receivable (W3)
Opening balance 20X1 0 0 0
Adjustment 20X1 (4 329) cr DT; dr TE
Closing balance 20X1 42 000 (46 329) (4 329) DTL
Adjustment 20X2 (1 197) cr DT; dr TE
Closing balance 20X2 21 000 (26 526) (5 526) DTL
Adjustment 20X3 5 526 dr DT; cr TE
Closing balance 20X3 0 0 0

Chapter 17 875
Gripping GAAP Leases: lessor accounting

W5: Current tax 20X1 20X2 20X3 Total

C C C C
Profit before tax: finance income 24 431 13 988 1 581 40 000
Adjust for temporary differences
- less finance income (24 431) (13 988) (1 581) (40 000)
- add lease payment received 80 000 80 000 90 000 250 000
- less capital allowance (70 000) (70 000) (70 000) (210 000)
Taxable profit 10 000 10 000 20 000 40 000
Current income tax at 30% 3 000 3 000 6 000 12 000

Example 12: Finance lease deferred tax: S23A 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 a contract 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 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%.

Assume that the tax authorities:

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 (S23A);
x the income tax rate is 30%.

There are no other transactions during the years ended 31 December 20X1, 20X2 and 20X3.
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: Finance lease deferred tax: S23A limitation, VAT ignored
31/12/20X1 Debit Credit

There is no current tax charge and therefore no current tax journal (W5)
Income tax (P/L: E) W4 7 329
Deferred tax liability (L) 7 329
Deferred tax adjustment
31/12/20X2
There is no current tax charge and therefore no current tax journal (W5)
Income tax (P/L: E) W4 4 197
Deferred tax liability (L) 4 197
Deferred tax adjustment
31/12/20X3
Income tax (P/L: E) W5 12 000
Current tax payable (L) 12 000
Current tax charge
Deferred tax liability (L) W4 11 526
Income tax (P/L: E) 11 526
Deferred tax adjustment

876 Chapter 17
Gripping GAAP Leases: lessor accounting

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

Opening balance 20X1 0 0 0 0
Purchase 210 000 210 000
Finance lease disposal (210 000) 0
Capital allowance 0 (105 000)
S23A limitation (W2.1) 25 000
Closing balance 20X1 0 130 000 130 000 39 000 A
Capital allowance 0 (105 000)
S23A limitation (W2.1) 25 000
Closing balance 20X2 0 50 000 50 000 15 000 A
Capital allowance 0 0
S23A allowance (W2.1) (50 000)
Closing balance 20X3 0 0 0 0

W2.1: S23A: limitation of allowances that are deductible from

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
- S23A catch-up allowance b/f 0 25 000 50 000
Capital allowances disallowed (S23A) (25 000) (50 000) 0
- S23A limitation c/f 25 000 50 000 0

Comment: When doing a µOHVVRU± ILQDQFHOHDVH¶TXHVWLRQLWPD\EHEHVWWRILUVW do the s23A

check (W2.1) to see whether or not the limitation applies.

W3: DT on the fin lease receivable CA TB TD DT

Opening balance 20X1 0 0 0 0
New lease (W1) 20X1 210 000 0
Movement 20X1 (55 569) 0
Closing balance 20X1 154 431 0 (154 431) (46 329) Liability
Movement 20X2 (66 012) 0
Closing balance (W1) 20X2 88 419 0 (88 419) (26 526) Liability
Movement 20X3 (88 419) 0
Closing balance (W1) 20X3 0 0 0 0

W4: Deferred tax summary Machine Fin. lease receivable Total

(W2) (W3)
Opening balance 20X1 0 0 0
Adjustment 20X1 (7 329) cr DT; dr TE
Closing balance 20X1 39 000 (46 329) (7 329) Liability
Adjustment 20X2 (4 197) cr DT; dr TE
Closing balance 20X2 15 000 (26 526) (11 526) Liability
Adjustment 20X3 11 526 dr DT; cr TE
Closing balance 20X3 0 0 0

Chapter 17 877
Gripping GAAP Leases: lessor accounting

W5: Current tax 20X1 20X2 20X3 Total

Profit before tax: finance income 24 431 13 988 1 581 40 000
Adjust for temporary differences
- 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)
- S23A limitation 25 000 50 000 0
- S23A 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

Example 13: Finance lease deferred tax (manuf./ dealer):

S23A 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%.

Assume further that the tax authorities:

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: Finance lease deferred (manuf./ dealer): s23A 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

31/12/20X1 Debit Credit

There is no current tax charge and therefore no current tax journal (W4)
Income tax expense (P/L: E) W5 37 311
Deferred tax liability (L) 37 311
Deferred tax adjustment
Check: Tax expense in 20X1 will be C37 311 (CT: 0 + DT: 37 311) = 30% x accounting profit: 124 372
31/12/20X2
Income tax expense (P/L: E) W2 7 500
Current tax payable (L) 7 500
Current tax charge

878 Chapter 17
Gripping GAAP Leases: lessor accounting

31/12/20X2 continued « Debit Credit

Income tax expense (P/L: E) W5 6 486
Deferred tax liability (L) 6 486
Deferred tax adjustment
Check: Tax expense in 20X2 will be C13 986 (CT: 7 500 + DT: 6 486) = 30% x accounting profit: 46 618
31/12/20X3
Income tax expense (P/L: E) W2 22 500
Current tax payable (L) 22 500
Current tax charge
Deferred tax liability (L) W5 11 235
Income tax expense (P/L: E) 11 235
Deferred tax adjustment
Check: Tax expense in 20X3 will be C11 265 (CT: 22 500 – DT: 11 235) = 30% x accounting profit: 37 549
31/12/20X4
Income tax expense (P/L: E) W2 22 500
Current tax payable (L) 22 500
Current tax charge
Deferred tax liability (L) W5 14 419
Income tax expense (P/L: E) 14 419
Deferred tax adjustment
Check: Tax expense in 20X4 will be C8 081 (CT: 22 500 – DT: 14 419) = 30% x accounting profit: 26 938
31/12/20X5
Income tax expense (P/L: E) W2 22 500
Current tax payable (L) 22 500
Current tax charge
Deferred tax liability (L) W5 18 143
Income tax expense (P/L: E) 18 143
Deferred tax adjustment
Check: Tax expense in 20X4 will be C4 357 (CT: 22 500 – DT: 18 143) = 30% x accounting profit: 14 523

W1: Effective interest rate table Finance income: Lease pmts & Receivable balance
16.9911% unguaranteed RV
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)

W2: Current tax charge 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
Adjust for temporary differences
- 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

Chapter 17 879
Gripping GAAP Leases: lessor accounting

W3: DT on fin. lease receivable CA TB TD DT

Opening balance: 20X1 0 0 0 0
New lease 320 000 0
Capital repaid (45 628) 0
Closing balance: 20X1 W1 274 372 0 (274 372) (82 311) DTL
Capital repaid (53 382) 0
Closing balance: 20X2 W1 220 990 0 (220 990) (66 297) DTL
Capital repaid (62 451) 0
Closing balance: 20X3 W1 158 539 0 (158 539) (47 562) DTL
Capital repaid (73 062) 0
Closing balance: 20X4 W1 85 477 0 (85 477) (25 643) DTL
Capital repaid (85 477) 0
Closing balance: 20X5 W1 0 0 0 0

W4: DT on the machine CA TB TD DT

Opening balance: 20X1 0 0 0 0
Purchase 250 000 250 000
Finance lease sale (250 000) 0
50% tax allowance 0 (125 000)
0 125 000
20% tax allowance 0 (25 000)
s 23 limitation W2.1 0 50 000
Closing balance: 20X1 0 150 000 150 000 45 000 DTA
20% tax allowance 0 (25 000)
s 23A catch-up allowance W2.1 0 (50 000)
Closing balance: 20X2 0 75 000 75 000 22 500 DTA
20% tax allowance 0 (25 000)
s 23 adjustment 0 0
Closing balance: 20X3 0 50 000 50 000 15 000 DTA
20% tax allowance 0 (25 000)
s 23 adjustment 0 0
Closing balance: 20X4 0 25 000 25 000 7 500 DTA
20% tax allowance 0 (25 000)
s 23 adjustment 0 0
Closing balance: 20X5 0 0 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
Cap. allowances disallowed (s23A) (50 000) 0 0 0 0
- s 23A limitation c/f 50 000 0 0 0 0

W5: Deferred tax summary Machine (W4) Receivable (W3) Total

Opening balance 20X1 0 0 0
Adjustment 20X1 (37 311) cr DT; dr TE
Closing balance 20X1 45 000 (82 311) (37 311) DTL
Adjustment 20X2 (6 486) cr DT; dr TE
Closing balance 20X2 22 500 (66 297) (43 797) DTL
Adjustment 20X3 11 235 dr DT; cr TE
Closing balance 20X3 15 000 (47 562) (32 562) DTL
Adjustment 20X4 14 419 dr DT; cr TE
Closing balance 20X4 7 500 (25 643) (18 143) DTL
Adjustment 20X5 18 143 dr DT; cr TE
Closing balance 20X5 0 0 0

880 Chapter 17
Gripping GAAP Leases: lessor accounting

4. Operating Leases (IFRS 16.81-97)

4.1 Recognition of an operating lease

$QRSHUDWLQJOHDVHLVDµSXUHOHDVH¶VLQFH 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 instalments receivable under the lease will be
x Accounting for OLs by lessors is
recognised as income over the period of the lease, measured on
similar, in principle, to how leases
the straight-line basis over the period of the lease (i.e. evenly): are accounted for by lessees
total instalments over the lease ÷ number of periods in the lease. x Recognise: lease income
Only if there is another systematic basis that better reflects the x Measure:
pattern in which the asset is used, should a basis other than  Straight line over lease term
 unless another systematic
the straight-line basis be used. See IFRS 16.81
basis is more representative
of the usage of asset.
The costs involved in the lease (such as depreciation and
impairment losses on the leased asset) are measured in the normal way, in terms of the
relevant standard (e.g. IAS 16 Property, plant and equipment and IAS 36 Impairment of assets,
respectively). The depreciation policy used by the entity for its depreciable leased assets must
be the same policy used for similar assets. See IFRS 16.84-85

Costs that are considered to be µinitial direct costs¶ (definHGDVµincremental costs of obtaining a
lease that would not have been incurred if the lease had not been obtained¶) should be added
to the cost of the leased asset. These will then be expensed as the leased asset is expensed
(e.g. through depreciation). However, these costs are depreciated over the lease term, on the
same basis that the lease income is recognised (e.g. normally on the straight-line basis) ± not
over the useful life of the underlying asset.

Example 14: Operating lease ± recognition and measurement

Banana Limited (lessor) signed an operating lease with Frond Limited (lessee) on 1 January 20X1.
The lease was over a plant, which Banana had bought on 1 January 20X1 for C240 000.

The terms of the lease are as follows:

x commencement date: 1 January 20X1
x lease term: 2 years
x fixed lease instalments, payable as follows:
- 31 December 20X1: C120 000
- 31 December 20X2: C140 000
x Frond may purchase the leased asset at its market price on 31 December 20X2.
x Unguaranteed residual value: C30 000. Banana considers this to equal residual value for
depreciation purposes.

Other information:
x Banana incurred legal fees of C8 000 on 1 January 20X1 to obtain the lease (initial direct costs).
x Front paid both lease instalments on due date.
x Frond purchased the plant on 31 December 20X2 at its market price of C200 000.
x Banana depreciates its plant over ten years on the straight-line basis.
Required:
Prepare the journal entries for each of the years affected. Ignore tax.

Chapter 17 881
Gripping GAAP Leases: lessor accounting

Solution 14: Operating lease ± recognition and measurement

Comment: The operating OHDVH LQFRPH LQ WKH OHVVRU¶V UHFRUGV is measured as the average
instalments over the period of the lease. (P.S. This is the same principle used when measuring the
operating lease expense in a leVVHH¶VUHFRUGV± see chapter 16):
1/1/20X1 Debit Credit
Plant: cost (A) Given 240 000
Bank (A) 240 000
Purchase of plant
Plant: initial direct costs (A) Given 8 000
Bank (A) 8 000
Initial direct costs (legal fees) in obtaining the operating lease
31/12/20X1
Depreciation ± plant (P/L: E) See calculation below: 25 000
Plant: accumulated depreciation (-A) 25 000
Depreciation of plant (cost of plant and initial direct costs of obtaining lease)
Bank (A) Given 120 000
Operating lease receivable (A) Balancing 10 000
Operating lease income (P/L: I) (120 000 + 140 000) / 2 years 130 000
Lease income earned (lease payments straight-lined over two years)
31/12/20X2
Depreciation ± plant (P/L: E) See calculation below 25 000
Plant: accumulated depreciation (-A) 25 000
Depreciation of plant (cost of plant and initial direct costs of obtaining lease)
Bank (A) Given 140 000
Operating lease receivable (A) Balancing 10 000
Operating lease income (P/L: I) (120 000 + 140 000) / 2 years 130 000
Lease income earned (lease payments straight-lined over two years)
Plant: accumulated depreciation (-A) 25 000 x 2 years 50 000
Plant: cost (A) Given 240 000
Plant: initial direct costs (A) Given 8 000
Bank (A) Given 200 000
Profit on sale of plant Balancing 2 000
Sale of plant at market value
Calculation: Depreciation =
'HSUHFLDWLRQRISODQW¶VFRVW  000 ± 30 000) / 10 years + Depreciation of initial direct costs: 8 000 / 2 years = 25 000

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).

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.

882 Chapter 17
Gripping GAAP Leases: lessor accounting

Summary: Operating leases (lessor perspective)

Recognition Measurement Taxation

x still recognise asset
x lease instalments = income
x lease costs = expenses
x but recognise initial direct
costs as part of the cost of
the leased asset (recognised
as depreciation over the
period, if a depreciable asset)
x lease income = straight line
basis (or systematic basis…)
x depreciate asset (incl. initial
direct costs capitalised)
x accruals or prepayment
adjustments arise if
instalment amount differs
from amount recognised as
income
x current tax = lease income
taxed on cash basis (when
received)
x deferred tax =
- on asset: depreciation vs
tax allowance: DTA or DTL
- on received in advance:
DTA; or
- on receivable: DTL

Example 15: Operating lease ± tax implications

The facts from example 14 (Banana) apply. Assume there are no other transactions during
the years ended 31 December 20X1 or 20X2 and assume that the tax authorities:
x charge tax on the lease instalments that are received;
x allow the deduction of the legal fees in 20X1 and the cost of the leased asset at 20% per annum;
x levy income tax rate at 30% on taxable profits.
Required: Prepare %DQDQD¶V tax-related journals for each of the years 20X1 and 20X2. Ignore VAT.

Solution 15: Operating lease ± tax implications

Journals
31/12/20X1 Debit Credit
Income tax expense (P/L: E) W4 19 200
Current tax payable (L) 19 200
Current tax charge
Income tax expense (P/L: E) W3 12 300
Deferred tax liability (L) 12 300
Deferred tax adjustment
Check: tax expense in 20X1 will be C31 500 (CT: 19 200 + DT: 12 300), which = 30% x accounting profit: 105 000
31/12/20X2
Income tax expense (P/L: E) 44 400
Current tax payable (L) 44 400
Current tax charge
Deferred tax liability (L) 12 300
Income tax expense (P/L: E) 12 300
Deferred tax adjustment
Check: tax expense in 20X2 will be C25 200 (CT: 44 400 – DT: 12 300), which = 30% x accounting profit: 107 000

W1: DT ± plant CA TB TD DT
Opening balance 20X1 0 0 0 0
Purchase 240 000 240 000
Legal fees capitalised 8 000 8 000
Depreciation/ deduction [calc (a) & (b)] (25 000) (48 000)
Legal fee deduction [given] - (8 000)
Closing balance 20X1 223 000 192 000 (31 000) (9 300) DTL
Depreciation/ deduction [calc (a) & (b)] (25 000) (48 000)
Subtotal 198 000 144 000
Sale of asset (CA/ TB derecognised) (198 000) (144 000)
Closing balance 20X2 0 0 0 0
Calculations:
a) Depreciation of plant (20X1 and 20X2) = (240 000 ± 30 000) / 10 years + (8 000/2) = 25 000
b) Tax deduction of plant (20X1 and 20X2) = 240 000 x 20% = 48 000

Chapter 17 883
Gripping GAAP Leases: lessor accounting

W2: DT ± operating lease receivable CA TB TD DT

Opening balance 20X1 0 0 0 0
Movement 10 000 0 (10 000) (3 000)
Closing balance 20X1 10 000 0 (10 000) (3 000) DTL
Movement (10 000) 0 10 000 3 000
Closing balance 20X2 0 0 0 0 DTL

W3: Deferred tax summary Plant Receivable Total

(W1) (W2)
Opening balance 20X1 0 0 0
Adjustment 20X1 (12 300) Cr DT; Dr TE
Closing balance 20X1 (9 300) (3 000) (12 300) DTL
Adjustment 20X2 12 300 Dr DT; Cr TE
Closing balance 20X2 0 0 0 DTL

W4: Current tax 20X1 20X2 Total

Operating lease income 130 000 130 000 260 000
Less depreciation (25 000) (25 000) (50 000)
Add profit on sale of plant 0 2 000 2 000
- Proceeds on sale of plant 0 200 000 200 000
- Less carrying amount of plant sold 0 (198 000) (198 000)
Profit before tax 105 000 107 000 212 000
Adjust for temporary differences:
- less operating lease income (130 000) (130 000) (260 000)
- add depreciation 25 000 25 000 50 000
- less profit on sale 0 (2 000) (2 000)
- add lease instalment received 120 000 140 000 260 000
- less tax deduction on plant (48 000) (48 000) (96 000)
- less tax deduction of legal fees (8 000) 0 (8 000)
- add recoupment on sale 0 56 000 56 000
(proceeds: 200 000 ± tax base: 144 000)
Taxable profit 64 000 148 000 212 000

Current income tax at 30% 19 200 44 400 63 600

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. See IFRS 16.90 (b)
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. See IFRS 16.97
x additional qualitative and quantitative information about its leasing activities that would enable
userV µWR DVVHVs the effect that leases have on the financial position, financial performance
DQGFDVKIORZVRIWKHOHVVRU¶LQFOXGLQJIRr example:
- µWKHQDWXUHRIWKHOHVVRU¶VOHDVLQJDFWLYLWLHV¶DQG
- µKRZWKHOHVVRUPDQDJHVWKHULVNDVVRFLDWHGZLWKDQ\rights it retains LQXQGHUO\LQJDVVHWV¶
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). See IFRS 16.92

884 Chapter 17
Gripping GAAP Leases: lessor accounting

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. See IFRS 16.95-96
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. See IFRS 16.95
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 16.96

Happy Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X0
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)
«'HWDLORIPRYHPHQWVduring 20X0 VKRZQKHUH « (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)

28. Profit before tax C

Profit before tax has been stated after taking into account the following separately
disclosable items:
x Operating lease income from: xxx
 variable lease payment that do not depend on an index or rate xxx
 other lease payments xxx

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 per year for at least 5 years xxx
 in 20X4 xxx
 in 20X5 xxx
 after 20X5 Any lease payments expected after 5 years are shown in total xxx

41. Additional qualitative and quantitative information regarding operating and finance leases

Include a description of the natXUH RI WKH OHVVRU¶V OHDVLQJ DFWLYLWLHV RSHUDWLQJ DQG ILQDQFH OHDVHV 
(e.g. A group leased out a portion of its head office buildings. All risk and rewards with regards to the
head office building remains with the group, hence it is an operating lease as per IFRS 16).
The risks associated with the rights retained in the underlying assets (e.g. the risk and rewards with
regards to the underlying asset lies with the lessor Any damages to the property for example, would
be at the cost of the lessor).
The risk management strategy includes the incorporation of residual value guarantees in the contracts.

Chapter 17 885
Gripping GAAP Leases: lessor accounting

Example 16: Operating lease ± disclosure

The facts from example 14 and 15 apply. Assume 20X1 was the first year of operations
and that no payments were made to the tax authorities in either year.
Required: Prepare the disclosure for each of the years ended 31 December 20X1 and 20X2.
Ignore any additional qualitative disclosures

Solution 16: Operating lease ± disclosure

Comment:
x The tax workings are in example 15.
x All other workings are in example 14.

Banana Limited
Statement of financial position (extracts) 20X2 20X1
As at 31 December 20X2 C C
Notes
Non-current assets
Plant W1 14 0 223 000
Current assets
Operating lease receivable W2 0 10 000
Non-current liabilities
Deferred tax liability W3 15 0 12 300
Current liabilities
Current tax payable W4 63 600 19 200

Banana Limited
Statement of comprehensive income (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
Notes
Profit before tax W4 107 000 105 000
Taxation expense 17 (32 100) (31 500)
Profit for the year 74 900 73 500

Banana Limited
Notes to the financial statements (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C

14. Plant ± owned and leased under an operating lease

Net carrying amount ± 1 January 223 000 0
Gross carrying amount – 1 January 248 000 0
Less accumulated depreciation -1 January (25 000) 0
x Purchase 0 248 000
x Depreciation (25 000) (25 000)
x Sale (198 000) 0
Net carrying amount ± 31 December 0 223 000
Gross carrying amount – 31 December 0 248 000
Less accumulated depreciation – 31 December 0 (25 000)

15. Deferred tax asset/ (liability)

The deferred tax constitutes temporary differences from: 0 (12 300)
x Plant 0 (9 300)
x Operating lease receivable 0 (3 000)

17. Income tax expense 32 100 31 500

x Current income tax ± current year (Example 15 W4) 44 400 19 200
x Deferred income tax ± current year (Example 15 W3) (12 300) 12 300

886 Chapter 17
Gripping GAAP Leases: lessor accounting

Banana Limited
Notes to the financial statements (continued …) 20X2 20X1
For the year ended 31 December 20X2 C C
18. Profit before tax
Profit before tax has been stated after the following separately disclosable
(income)/ expenses:
x Depreciation 25 000 25 000
x Operating lease income from:
 variable lease payment that do not depend on an index or rate xxx xxx
 other lease payments (130 000) (130 000)

Notice: there was no maturity analysis because the lease receivable was nil at 31 December 20X2.

5. Lease involving both land and buildings (IFRS 16.B55-57)

5.1 Separate classification of the elements (IFRS 16.B55 and B56)

Leases of land and leases of buildings are classified as operating or Recognise lease
of land
finance leases in the same way as leases involving any other
separately from
assets. In fact, if a lease contract involves a property that combines lease of buildings:
land and buildings, IFRS 16 clarifies that classification of the lease of
x Except if the land
the 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 contract involving property as a single
land and buildings being recognised partly as an operating lease unit and use the UL of
the building as the UL
and partly as a finance lease.
of the property)

Now, an interesting feature of land is that its economic life is normally deemed to be indefinite.
This is an important consideration when determining whether the lease of the land element
should be classified as a finance lease or operating lease because it means we have no way of
concluding that the lessee will receive substantially all the risks and rewards of ownership
(unless legal title (legal ownership) is expected to pass to the lessee at the end of the lease
term). Thus, we normally classify leases over land as operating leases. In other words, this
would mean that the land would remain recognised in WKHOHVVRU¶VDFFRXQWLQJUHFRUGV.

However, it is not true to say that every lease of land where the legal title (ownership) does not
transfer from the lessor to the lessee should automatically be accounted for by the lessor as an
RSHUDWLQJ OHDVH7KH µbasis of conclXVLRQV¶ ZLWKLQ ,)56 H[SODLQV D
When
scenario that was debated where one could lease land over a 999- classifying the
year period. It explains that even if legal ownership does not pass to lease of land,
the lessee, the lessor will have effectively handed over the risks and an important point is
rewards of owneUVKLS6XEVWDQWLDWLQJWKLVIDFWLVWKDWIURPWKHOHVVRU¶V that it normally has
an indefinite
perspective, the present value of the residual value of its land (i.e. the
economic life
value of the land he expects to get back after the lease ends) will be
negligible even after leasing it out for just a few decades, let alone 999 years. Thus, it may be
necessary to classify a relatively long lease of land as a finance lease. In this case, it means the
lessor would have to derecognise the land (remove from its records as if it had been sold).

However, as always, it is important to examine the substance of the arrangement. The general
principle is, as always, if 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 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.

Chapter 17 887
Gripping GAAP Leases: lessor accounting

Required: Discuss the classification of the lease based purely on the information provided above.
Note: 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 should be classified as a finance lease because the lease period is even longer than µa
major part of its economic life¶ (which was only 80 years), and thus the risks and rewards of
ownership are, in substance, transferred.
x The land should 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
FODVVLI\ WKH SURSHUW\ DV µD VLQJOH XQLW¶ ,Q WKis 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

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 20 years.
x The lease instalments are C500 000 per annum, receivable in arrears.
x At lease inception, 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 was being depreciated over its total estimated useful
life of 30 years to a nil residual value. At inception, the building 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: 3UHSDUHWKHMRXUQDOHQWULHVIRU;DQGIRU;LQWKHOHVVRU¶VDFFRXQWLQJUHFRUGV

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.

888 Chapter 17
Gripping GAAP Leases: lessor accounting

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 portiRQ RI WKH EXLOGLQJ¶V UHPDLQLQJ XVHIXO OLIH WKXs
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
PDMRUSRUWLRQRIWKHDVVHW¶VOLIHWKXVVXJJHVWLQJWKDWWKHOHDVH was an operating lease.

Step 1: Splitting the lease instalments into operating and finance portions

Split instalments as follows: µFV of the land¶ (& then µFV of building¶)
x Lease instalment
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 income Finance lease Finance lease

3,293512 % instalment (receipt) receivable 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 receipts relating to the building will be C3 094 720 (154 736 x 20 years)
x Total interest income over 20 years will be C853 888 (3 094 720 ± original amt: 2 240 832)
Journals:
1/1/20X3 Debit Credit
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 ± 40 832
CA: (3 000 000 ± 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)
Bank (A) Given 500 000
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)

Chapter 17 889
Gripping GAAP Leases: lessor accounting

;FRQWLQXHG« Debit Credit

Bank (A) Given 500 000
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
asset HJ FKDQJH LQ WKH DVVHW¶V HVWLPDWHG HFRQRPLF OLIH RU lease, treat modified contract
residual value), the classification of the lease is not changed. as if it were a new lease; or
x a correction of error.
For example, if the useful life is re-estimated to be shorter Otherwise classifications should
than the previous estimate, such that the lease term is now never change (i.e. changes in
estimates do not lead to a lease
considered to be a substantial part of the economic life of the classification changing).
asset, where this was previously not the case and thus where
the lease had been classified as an operating lease, we would not subsequently reclassify the
lease as a finance lease.

Modifications only include, by definition (see pop-up), changes to WKHOHDVHFRQWUDFW¶V original terms
and conditions that affect the scope or consideration. See IFRS 16.App A

If there is a modification made to an operating lease, we treat Lease modifications are

the original lease as being cancelled and the modified lease as defined as:
being a brand-new lease from the date the modification x a change to the scope of the
becomes effective. Any adjustments are processed lease or the consideration for
prospectively. Any lease instalments receivable or received in a lease,
advance at effective date, will be treated as if they related to x that was not part of the
the brand-new lease. See IFRS 16.87 original terms and conditions.
IFRS 16 App A

A change made to a finance lease as a result of a modification will only be accounted for as a
separate lease if the following two criteria are met:
x µWKHPRGLILFDWLRQLQFUHDVHVWKHVFRSHE\DGGLQg 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

890 Chapter 17
Gripping GAAP Leases: lessor accounting

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 balancHLQWKHµQHWLQvHVWPHQWLQWKHILQDQFHOHDVH¶DFFRXQW FUHGLW 
and recognises it as the carrying amount of the underlying asset (debit). See IFRS 16.80

Worked example 2: Change in the contract terms and conditions

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.
In this case, 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 3: 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 means that, at commencement date, the
useful life should have been estimated to be 8 years instead of 20 years.
The re-estimation of the useful life means that the remaining lease term of 3yrs is now a
VXEVWDQWLDO SRUWLRQ RI WKH DVVHW¶V XVHIXO OLIH RI  \HDUV   $OWKRXJK this suggests that the
lease should have been classified as a finance lease at commencement date had we estimated
the useful life to be 8 years instead of 20 years (because, in that case, the µtotal lease term¶ = µtotal
useful life¶ = 8 years), or that it should be reclassified as a finance lease from the date the useful
life is re-estimated (µremaining lease term¶ = µremaining 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

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.

In South Africa, the VAT Act requires µVAT vendors¶ to calculate Output VAT is charged
and charge VAT (i.e. output VAT) on ³LQVWDOPHQW FUHGLW on initial lease
agreements´ A finance lease satisfies the criteria as an capitalisation:
³LQVWDOPHQW FUHGLW DJUHHPHQW´ and thus a lessor in a finance x being the earlier of date of
lease must charge VAT if he is a VAT vendor. The VAT charged delivery or date of payment.
becomes payable to the tax authorities at the commencement x It is recognised as a VAT
date, being the earlier of delivery, or payment (see chapter 16 for payable immediately.
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).

Chapter 17 891
Gripping GAAP Leases: lessor accounting

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 WKHOHVVRU¶V
taxable income and thus income tax is not payable on the VAT x 15/115 x cash selling price
incl. VAT (excl. fin charges)
included in the lease instalments received. As a result, lease
instalments included in taxable profit are adjusted to exclude the proportional VAT included
WKHUHLQ LHRXWSXW9$7 7KLVSURSRUWLRQDO9$7LVFDOOHG³QRWLRQDO´RXWSXW9$7

The tax base of the finance lease receivable initially reflects

the total VAT charged on the lease, but as and when the The effects of
lessee pays his instalments, a portion of the instalment is notional output VAT:
recognised as a repayment of part of this original total VAT x on current tax:
payable. As mentioned above, the portion of an instalment add instalment, less notional VAT
that is assumed to be a repayment of VAT is called a notional VAT = this instalment/
³QRWLRQDO´ 9$7 SD\PHQW  7KHVH QRWLRQDO 9$7 SD\PHQWV total instalments x output VAT
reduce the notional VAT balance still owed by the lessee (i.e. x on deferred tax:
the tax base of the receivable is gradually reduced by the the tax base of lease receivable
notional VAT payments until the tax base of the receivable is = total output VAT x
eventually nil). outstanding instalments/
total instalments ; or
If the lessor is not a VAT vendor, then the lessor will not = total output VAT less notional
charge VAT and thus the input and output VAT adjustments output VAT included in lease
instalments paid to date
referred to above do not apply. The result is that the entire
instalments are included in taxable profits and the 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.

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
- 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 tax
deductions (C570 000/5 = C114 000).

892 Chapter 17
Gripping GAAP Leases: lessor accounting

1/1/20X5 Debit Credit

Machine: cost (A) 500 000
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
Bank (A) Given 150 000
Finance lease receivable - gross investment (A) 150 000
Finance lease instalment received
Finance lease receivable - unearned finance income (-A) W2 56 459
Finance income 56 459
Recognition of finance income
Income tax (E) W3 10 800
Current tax payable (L) 10 800
Current tax charge
Income tax (E) W4.3 6 138
Deferred tax liability (L) 6 138
Deferred tax adjustment

W1: Analysis of total amount receivable C

Total future payments 750 000
Add guaranteed residual value (N/A) 0
Gross investment 750 000
Cost of asset 500 000
VAT output 70 000
Finance income 180 000

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 tax deductions 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
Taxable profit 36 000
Current income tax 36 000 x 30% 10 800

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) DTL

Chapter 17 893
Gripping GAAP Leases: lessor accounting

Calculations supporting 4.1

CA = Gross investment ± Unearned finance income TB = VAT x (outstanding instalments/ total instalments)
(a) = 750 000 ± 180 000 (W2/ jnls) (d) = 70 000 output VAT x (750 000/ 750 000)
(b) = 56 459 ± 150 000 (W2/ jnls) (e) = 70 000 output VAT x (150 000/ 750 000)
(c) = 750 000 ± 180 000 ± (150 000 ± 56 459) (jnls/ W2) (f) = 70 000 output VAT x (750 000 ± 150 000)/ 750 000
Note: The initial TB of the Lease receivable asset is calculated as: 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
Opening balance 0 0 0 0
Purchase (excluding VAT) 500 000 500 000
Lease disposal (500 000) 0
Tax deductions 0 (100 000)
Closing balance 0 400 000 400 000 120 000 DTA

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) DTL

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 include 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, s23C 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.
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 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%.
$¶VSURILWEHIRUHWD[IRU; & 000) has not been adjusted for the above lease transaction. There
are no temporary differences, no items of exempt income and no non-deductible expenses.
Assume that the tax authorities view this lease as a normal leasing agreement (i.e. not as a sale.
Required: Prepare the necessary journal entries for 20X5 LQ$/LPLWHG¶Vbooks.

Solution 20: Operating lease with tax and VAT

Comment: Notice how in W1 we average (smooth) the lease income net of VAT.

894 Chapter 17
Gripping GAAP Leases: lessor accounting

1/1/20X5 Debit Credit

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
Machine: accumulated depreciation (-A) 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
Income tax expense (E) W2 174 000
Current tax payable: income tax (L) 174 000
Current tax charge
Deferred tax asset (A) W3.1 63 000
Income tax expense (E) 63 000
Deferred tax charge

W1: Operating lease income

20X5 ± actual (net of VAT) Instalment: 433 200 x 100/114 380 000
20X6 ± actual (net of VAT) Instalment: 183 400 x 100/114 160 000
20X7 ± actual (net of VAT) Instalment: 136 800 x 100/114 120 000
660 000
Annual average lease income (net of VAT) Total instalments excl VAT: 660 000/3yrs 220 000
W2. Current tax charge 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)
Profit before tax 370 000
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 tax deductions [(Cost excl VAT: 1 140 000 x 100 / 114) ÷ 5yrs (200 000)
Taxable profit 580 000
Current income tax 580 000 x 30% 174 000

W3. Deferred income tax

W3.1 Machine CA TB TD DT
Opening balance 0 0 0 0
Purchase 1 000 000 1 000 000
Depreciation / tax deductions (250 000) (200 000)
Closing balance 750 000 800 000 50 000 15 000 DTA

W3.2 Rent received in advance CA TB TD DT

Opening balance 0 0 0 0
Movement (160 000) 0
Closing balance (160 000) 0 160 000 48 000 DTA

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 DTA

RRIA: = rent received in advance

Chapter 17 895
Gripping GAAP Leases: lessor accounting

8. Summary

Lessors

Lease classification and measurement

x Finance lease if substantially all the lessor’s risks and rewards of ownership over
the underlying asset are transferred to the lessee.
x Operating lease if substantially all the lessor’s risks and rewords of ownership over
the underlying asset do not transfer. See IFRS 16.61-63
IFRS 16 provides 8 example indicators that, individually or in combination, may
suggest it is a FL (e.g. we ask ourselves if ownership transfer to the lessee by the
end of the lease term, if the lease term equals a major part of the asset’s UL etc) –
for a full list see section 2 and IFRS 16.63-4
See IFRS 16.66
Assessed at inception and only reassessed if there is a modification.

Finance leases

Initial measurement of lease receivable (net investment)

Net investment in lease (NI) = PV of the Gross investment in lease (PV of GI)
GI = LPs receivable by lessor (see below) plus Unguaranteed residual value
Thus, NI = (Lease payments receivable + URV) x interest rate implicit in the lease *
*: The implicit interest rate
 includes initial costs if non-manufacturer/dealer lessor (i.e. the lease
receivable effectively includes these costs), but
 excludes initial costs if manufacturer/ dealer lessor (i.e. these costs are expensed)
LPs is the sum of 5 parts
1) Fixed pmts receivable – lease incentives payable
2) Variable pmts receivable
3) Termination penalties (if reasonably certain)
4) Purchase option price (if reasonably certain)
5) RV guarantees (from ANY 3rd party)

If a manufacturer/ dealer: If not a manufacturer/ dealer:

x Derecognise asset (Cr Inventory)
Recognise a cost of sales (Dr Cost of sales)
x Recognise the lease receivable (Dr Receivable)
Recognise sales income (Cr Sales)
x Recognise initial costs (e.g. legal fees) to
acquire a lease as an expense (when they are
incurred by a manuf/ dealer, they are excl
from the definition of ‘initial direct costs’)
(Dr Expense & Credit Bank)
x Derecognise asset (Cr Asset)
Recognise a receivable (Dr Receivable)
x The initial direct costs are automatically
included in the lease receivable due to how
the implicit interest rate is calculated, so
when you credit bank with these costs, you
do not debit lease receivable with an
additional separate amount – it will already
be included in the initial measurement of the
lease receivable (see jnl above)

Subsequent measurement
x Finance income recognised over lease term using effective interest rate
(Dr lease receivable and Credit Finance income)
x Payments received reduce receivable (Dr Bank and Credit Lease receivable)
x Lease receivable (NI) is subject to derecognition and impairment requirements
x Unguaranteed residual value should be reviewed regularly – any
reduction in this value impacts income allocation over the lease term.
x Notice that
 manufacturer/ dealers recognise two types of income: finance income & sales
 non-manufacturer/dealers recognise one type of income: finance income

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Gripping GAAP Leases: lessor accounting

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 (i.e. do
not derecognise the leased
asset)
x lease instalment = income
x lease costs = expenses
x but recognise initial direct
costs as part of the cost of
the leased asset
(recognised as expense over
the lease term)
x lease income = x current tax =
straight line basis (or lease income is taxed on
systematic basis…) cash basis (when
received)
x leased asset =
x taxable profit =
depreciate & test for
add operating lease
impairment as usual e.g.
rentals received (excl VAT)
depreciate it over its
useful life (although the less tax deductions on
capitalised initial direct the cost of the asset
costs expensed over lease (excl. VAT)
term) x deferred tax =
x ‘accruals’ could be - on asset:
recognised if: depreciation vs tax
amount received  deduction:
income recognised DT asset or DT liability
- on received in advance:
DT asset
- on receivable:
DT liability

Chapter 17 897
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 2021)

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 they are combined into one chapter is that they are very much
inter-related. However, since the chapter is long, it is split into these two separate parts as follows:
PARTS: Page
PART A: Provisions, Contingent Liabilities and Contingent Assets (IAS 37) 900
PART B: Events after the Reporting Period (IAS 10) 929

PART A:
Provisions, Contingent Liabilities and Contingent Assets
Contents: Page
A: 1 Introduction 900
A: 2 Scope 900
A: 3 Recognition: liabilities, provisions and contingent liabilities 901
A: 3.1 Overview 901
A: 3.2 Comparison: liabilities and provisions 901
A: 3.3 Comparison: liabilities and contingent liabilities 901
A: 3.4 Discussion of the liability definition 902
A: 3.4.1 Present obligations 902
A: 3.4.2 Past events 902
A: 3.4.3 Obligating events 902
Example 1: Obligating events 903
Example 2: Obligating events 904
A: 3.5 Discussion of the recognition criteria 904
A: 3.5.1 Overview 904
A: 3.5.2 Probable outflow of economic benefits 904
A: 3.5.3 Reliable estimate 904
Example 3: Reliable estimate 905
A: 4 Measurement: liabilities, provisions and contingent liabilities 906
A: 4.1 Overview 906
A: 4.2 Best estimates 907
Example 4: Best estimate using expected values 908
A: 4.3 Risks and uncertainties 908
A: 4.4 Future cash flows and discounting 908
Example 5: Discounting liabilities to present values and related journals 909
Example 6: Calculating present (discounted) values and related journals 910
A: 4.5 Future events 911
Example 7: Future events 911

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Gripping GAAP Provisions, contingencies & events after the reporting period

Contents: Page
A: 4.6 Gains on disposal of assets 912
Example 8: Gains on disposal of assets 912
A: 4.7 Provisions and reimbursement assets 912
Example 9: Guarantees 913
Example 10: Reimbursements 914
A: 4.8 Changes in provisions 914
A: 4.8.1 Change in provisions and the cost model 915
Example 11: Changes in decommissioning liability: cost model 916
A: 4.8.2 Change in provisions and the revaluation model 918
Example 12: Changes in dismantling liability: revaluation model 919
A: 4.9 Changes in provisions through usage or derecognition 921
Example 13: Reduction in provisions 922
A: 5 Recognition and measurement: four interesting cases 922
A: 5.1 Future operating losses 922
A: 5.2 Contracts 923
Example 14: Onerous contracts 923
A: 5.3 Restructuring provisions 923
Example 15: Restructuring costs 924
A: 5.4 Levies 925
Example 16: Levies 925
A: 6 Recognition and measurement: contingent assets 925
A: 6.1 Recognition of contingent assets 925
A: 6.2 Measurement of contingent assets 926
A: 7 Disclosure: provisions, contingent liabilities and contingent assets 926
A: 7.1 Disclosure of provisions 926
A: 7.2 Disclosure of contingent liabilities 927
Example 17: Disclosure: decommissioning provision (change in estimate) 927
A: 7.3 Disclosure of contingent assets 928
A: 7.4 Exemptions from disclosure requirements 928
A. Summary 934

PART B:
Events after the reporting period
Contents: Page
B: 1 Introduction 929
B: 2 Adjusting events after the reporting period 929
Example 18: Event after the reporting period 930
B: 3 Non-adjusting events after the reporting period 930
Example 19: Non-adjusting events after the reporting period 930
B: 4 Exceptions: no longer a going concern 931
Example 20: Events after the reporting period ± various 931
B: 5 Disclosure: events after the reporting period 933
B. Summary 935

Chapter 18 899
Gripping GAAP Provisions, contingencies & events after the reporting period

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 Provisions,
contingent liabilities and contingent assets, 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. Thus:
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 due to 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

900 Chapter 18
Gripping GAAP Provisions, contingencies & events after the reporting period

A: 3 Recognition: Liabilities, Provisions and Contingent Liabilities

(IAS 37.14 ± 30)

A: 3.1 Overview
7KHUH DUH VLJQLILFDQW GLIIHUHQFHV EHWZHHQ D µSXUH¶ OLDELOLW\ provision and 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. ,IDQLWHPGRHVQ¶WPHHWboth the definition
and the recognition criteria WKHQ LW ZRQ¶W EH recognised as a liability ± although it may still
need to be disclosed.

IAS 37 defines a liability in terms of the prior 2010 CF. It A liability is defined in
is a present obligation of the entity, having arisen from a IAS 37 (old 2010 CF) as:
past event, and which 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 definition is that there must be an result in an outflow from the entity of
obligation and this obligation must be present. Deciding if resources embodying economic benefits.
IAS 37.10
there actually is an obligation at a specific point in time can
be difficult and require professional judgement. IIZHFDQ¶WEHVXUH we have a present obligation, then
we know we do not have a µSXUH¶liability or µprovision¶ but we may have a µcontingent 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 WKHWHUPµSrovisioQ¶DQGWKHWHUPµOLDELOLWy¶DQGWKHQ
x WKHWHUPµFRQWLQJHQWOLDELOLW\¶DQGWKHWHUPµOLDELOLW\¶

A: 3.2 Comparison: liabilities and provisions

A provision is a type of liability (i.e. all provisions are A provision is defined as:
liabilities, but not all liabilities are provisions). A provision is
x a liability
a liability that involves uncertainty in terms of either (or both): x of uncertain timing or amount IAS 37.10
x the amount of the outflows; or
x the timing of the outflows (i.e. when they will occur). Provisions

If we do not know the amount or timing of the outflows, it x Recognised (journalised) as a L

means the measurement of the liability is uncertain. x Disclosed: separately to ‘pure’ Ls
Thus, a provision is simply a liability that involves a significant degree of measurement uncertainty.

Since a provision is a type of liability, like all liabilities, a provision may only be recognised if it
meets the liability definition and recognition criteria (per IAS 37). Thus, despite the
measurement uncertainty involved, a provision may be recognised on condition that we believe
that the estimate of the amount is reliably measurable (this is one of the recognition criteria).

Both provisions and liabilities are recognised in the statement of financial position but, because
provisions involve a higher level of uncertainty than usual, we disclose them 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 Recognised? No, thus no jnl is processed
x do not meet the recognition criteria (per IAS 37).
x Disclosed? If considered useful

Chapter 18 901
Gripping GAAP Provisions, contingencies & events after the reporting period

Thus, there are two types of contingent liabilities:

x one is a liability (i.e. meets the liability definition) that
may not be recognised because one or both recognition
criteria are not met OHW¶s call this type 1); and
x the other is not a liability because it fails the liability
definition on the basis that there was only a possible
obligation (instead of a present obligation  OHW¶V FDOO
this type 2). In this type, the existence of the
obligation will only be confirmed by the occurrence of
some future event/s that is not wholly within the
control of the entity.
Since, by definition, a contingent liability either fails to
meet the definition or recognition criteria, or both, they are
never recognised. Although they are not recognised,
they may need to be disclosed in the notes to the
financial statements (if it is considered useful information).
A: 3.4 Discussion of the liability definition
A: 3.4.1 Present obligations (IAS 37.15 – 16)
A contingent liability is
defined as either:
One where the recognition criteria are
not met (type 1):
x a present obligation
x from past events
x that is not recognised because the
recognition criteria are not met:
- it is not probable that an outflow
of economic benefits will be
needed to settle the obligation; or
- the amount of the obligation cannot
be measured sufficiently reliably.
One where the liability definition is
not met (type 2):
x a possible obligation
x from past events;
x whose existence will be confirmed
only by the:
- occurrence or non-occurrence
- of one/more uncertain future events
- not wholly within the control of the
entity (e.g. a negative court ruling.)
These two definitions have been reworded from IAS 37.10

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.
In these instances, the entity must decide if it is:
x more likely that a present obligation did exist at year-
end, in which case a provision is recognised (i.e.
greater than 50% chance); or
x more likely that a present obligation did not exist at
year-end (i.e. less than 50% chance), in which case
a contingent liability is disclosed (unless the possible
outflow of future economic benefits is remote, in
which case it is ignored).
How to decide if we actually
have an obligation?
A tip that may be helpful when
deciding if an obligation exists, is to
ask yourself the following question:
if the entity closed down tomorrow,
would the obligation still exist?
If the answer to that is yes, then
the entity has a present obligation
as a result of a past event.

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
x Occurred on/ before RD.
We need an event and it must have happened on or before
the reporting date (year-end) for it to be a past event. An obligating event is
defined as:
A: 3.4.3 Obligating events (IAS 37.17 – 22) x an event that
x creates an obligation
For the past event to lead to an obligation, the event must (constructive or legal)
x that the entity has no realistic
be an obligating event. An obligating event is a defined alternative to settling. IAS 37.10 reworded
term (see definition alongside) but is essentially an event
that leaves the entity with no realistic alternative but to settle the liability.

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Gripping GAAP Provisions, contingencies & events after the reporting period

There are two types of obligations possible: A legal obligation is

defined as:
x a legal obligation, and
x an obligation that derives from
x a constructive obligation. x a contract (through its explicit
or implicit terms);
A legal obligation (see definition in pop-up) refers to an x legislation; or
obligation the settlement or which µcan be HQIRUFHGE\ODZ¶. 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 (e.g. explicitly, by having published certain policies, or implicitly, by acting 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.
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 NQRZQDVWKHµZDON-DZD\WHVW¶: if the entity closed x by an established pattern of
past practice (implicitly),
down its business today, would the obligation still exist? published policies or a
See IAS 37.19
sufficiently specific current
x always involve another party (e.g.): statement (explicitly),
In other words, a decision must involve a third party, not x the entity has indicated to
just the entity. However, this other party does not need to other parties that it will accept
be known i.e. it could be the public at large. See IAS 37.20 certain responsibilities; AND
x as a result, the entity has
Thus, a decision made at a board meeting would not lead to a created a valid expectation on
present obligation because: the part of those other parties
that it will discharge those
x this event does not involve a third party; and responsibilities.
x it is not separate froPWKHHQWLW\¶VIXWXUHDFWLRQV LWVIXWXUH IAS 37.10

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 1: Obligating events

Consider the following issues 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 \HDUV¶ time.
C: Legislation recently passed means that one of the plants has to be dismantlHGLQD\HDU¶VWLPe.
D: Future losses are expected from a branch in Botswana.
Required: Explain whether any of the above result in present obligations at 31 December 20X3.

Solution 1: 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 shutdown before any losses are incurred). The
expected losses may, however, indicate that certain assets may need to be tested for impairment
(see chapter 11). Provisions shall not be recognised for future operating losses. IAS 37.63

Chapter 18 903
Gripping GAAP Provisions, contingencies & events after the reporting period

Example 2: Obligating events

Damij Limited owned a road tanker that overturned in December 20X3 during a bad
rainstorm. The tanker spilled its contents, thus contaminating a local river.
Damij has never before contaminated a river. It 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 2: 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 recogniseGDVDµSXUH¶OLDELOLW\

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 seSDUDWHO\IURPµSXUH¶ 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 LVQRWPHW LHFDQ¶W 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 3: 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 3 (a): Reliable estimate

To prove the liability definition is met, we first identify the event, then assess whether it occurred at or
before year-end and then decide if it leads to an obligation (legal or constructive): if it leads to an obligation
but it 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 ± maQDJHPHQW¶V
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 a liability but not a µpure¶ liability because there is more uncertainty than normal in predicting the
amount and timing of this outflow. Therefore, this liability is recognised and presented as a provision.
Please note: It is the sale of goods that is the obligating event.

Solution 3 (b): Reliable estimate

The answer to example 3(b) is identical to that of example 3(a) in terms of 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 criterion (reliable measurement) is not met and thus:
x no liability may be recognised in the financial statements, although
x a contingent liability would 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 WKH PHDVXUHPHQW RI µSXUH liabilitiHV¶ DOWKRXJK,
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 WKH µbest estimate of the expenditure required to settle the
present obligation at the end of the reporting period¶. See IAS 37.36
x The term µexpenditure¶refers to the payment the entity would have to make.
x IAS 37 clarifies that the best estimate could include either µsettling¶(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 RQDVSHFLILFGDWHEHLQJµthe end of the reporting period¶ i.e. WKHµUHSRUWLQJGDWH¶ 

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 µrationally 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.
x If we are to disclose it, we must try to estimate the amount thereof (remember that, by
definition, a reliable estimate of certain contingent liabilities may not actually be possible).
x 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 « XQOHVV WKHUH LV µVXIILFLHnt objective provision (or contingent
liability) involves:
evidence that they wLOORFFXU¶and
x deciding the best estimate of
x gains made on the expected disposal of assets. the amount needed to settle/
transfer the obligation
The measurement of the balance presented at year-end x after considering all related
risks & uncertainties
can also be affected by:
x calculating it at its present value,
x changes to estimated provisions; and if the effects of discounting are
x reductions in provisions. material.
The following are ignored in the
Some of these aspects involved in measurement will measurement:
now be explained in more detail. x Future events for which there
is insufficient evidence.
x Gains on disposals of assets.
A: 4.2 Best estimates (IAS 37.36 - 41)

The best estimate of the amount of an obligation is the amount 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, and management may have to base its estimate upon a combination of:
x PDQDJHPHQW¶VSURIHVVLRQDOMXGJHPHQW
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 µexpected value’. The application of the expected value
method when calculating the best estimate is explained in example 4.

However, if there is a continuous range of possible outcomes, where each and any point in the range is
equally likely to EHµWKHRXWFRPH¶, 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 WKHµmid-point¶LQthat range.

Another method of calculating the best estimate LVWKHµmost likely outcome¶PHthod. 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 4: 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 entit\¶V 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:
a) Measure the provision for warranty costs.
b) How would your answer change if we only had one warranty claim for C100 000 and there was a
70% probability we would have to honour it (30% probability that we would not have to honour it).

Solution 4: Best estimate using expected values

a) We measure provisions using the best estimate. In this case, it means using the expected value
(EV) of the future cost of settling the obligation: EV = (70% x C0) + (30% x C100 000) = C30 000
The journal would be: Debit Warranty cost expense and Credit Provision for warranty costs: C30 000
b) Since there is only a single obligation, with only a few distinct outcomes, the measurement of the
provision at the best estimate, involves using the µmost likely amount¶: C100 000.
The journal would be: Debit Warranty cost expense and Credit Provision for warranty costs: C100 000

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 vaOXHRIPRQH\LVRIWHQUHIHUUHGWRDVWKHµWLPHYDOXHRIPRQH\¶

Imagine being asked whether you would prefer to receive Discount rate
C100 today or C100 in 10 \HDUV¶WLPH. For many reasons, The rate to be used is:
(including the fact that you could utilise the C100
immediately), you would choose to receive it immediately. x a pre-tax discount rate
x based on the current market
This is because you can buy more with C100 today than assessment of:
you can with C100 in the future. In other words, WRGD\¶V - the time value of money and
value (the present value) of a future cash flow is less than - the risks specific to the liability.
See IAS 37.47
the actual (absolute/ future) amount of the cash flow. This
is essentially the present value effect or the effect of the time value of money.

If the difference between the actual amount of the future Using a WACC rate as the
cash outflow and its present value is material, then the discount rate is not
liability should be measured at its present value. appropriate!
The WACC (Weighted average cost of
The present value is calculated using a pre-tax discount capital) is not an appropriate discount
rate based on the current market assessment of the time rate as the WACC takes into account
the risk of the entity as a whole and not
value of money and the risks specific to the liability. The just the risk related to the provision.
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 liability is recognised and the date that the liability
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 liability (calculated as the present value) will
finally equal the actual value of the payment.
Unwinding the discount
This annual increase is debited to finance charges and The following journal is
credited to the liability so that at each reporting date, the processed each year to
liability is measured at its latest (increased) present value. unwind the discount:
DR Finance charges (E)
These finance charges are often called µQRWLRQDOILQDQFH CR Provision/Liability (L)
FKDUJHV¶ i.e. hypothetical, or µpretend¶ finance charges),
but they simply reflect WKHµXQZLQGLQJRf the discoXQW¶ process (i.e. they reverse the effects of
having originally recognised the liability at a discounted amount).

Example 5: 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 5: Discounting liabilities to present values and the related journals

01/01/20X1 Debit Credit
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
Finance charges (E) PV 31/12/X2: 90 000 – PV 31/12/X1: 70 000 20 000
Liability 20 000
Increase in liability as a result of time value of money
31/12/20X3
Finance charges (E) PV 31/12/X3: 100 000 – PV 31/12/X2: 90 000 10 000
Liability 10 000
Increase in liability as a result of time value of money
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 6: 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 6: Calculating present (discounted) values and related journals

Journals
Debit Credit
1 January 20X1
Plant: cost (A) Given 450 000
Bank (A) 450 000
Purchase of plant for cash
Plant (decomm.): cost (A) PV of future amount (W1) 300 000
Decommissioning liability 300 000
Initial recognition of the decommissioning obligation
31 December 20X1
Finance charges (P/L: E) PV 31/12/X1: 330 000 – PV 1/1/X1: 300 000; 30 000
Decommissioning liability 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
Depreciation of plant
31 December 20X2
Finance charges (P/L: E) PV 31/12/X2: 363 000 – PV 31/12/X1: 33 000
Decommissioning liability 330 000; OR 330 000 x 10% 33 000
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
Depreciation of plant
31 December 20X3
Finance charges (P/L: E) PV 31/12/X3: 399 300 – PV 31/12/X2 36 300
Decommissioning liability 363 000; OR 363 000 x 10% 36 300
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
Depreciation of plant
Decommissioning liability Given 399 300
Bank (A) 399 300
Payment in respect of decommissioning
Notice:
x The decommissioning cost (measured at PV) LVGHELWHGWRWKHSODQW¶VFRVW account. IAS 16.16
x The total asset-related expense over 3 years is C849 300:
Depreciation: 750 000 (250 000 p.a. for 3 years) + Finance charges: 99 300 = 849 300
x This total expense equals the total cost of both acquiring and decommissioning the plant:
Purchase cost: 450 000 + Decommissioning cost: 399 300 = 849 300

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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 3years: 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 to cash settlement Calculation of discount factor Discount factor (rounded): 10%
0 years (i.e. it¶VGXH) 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
Notice:
x As we get 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 time is often called the µXQZLQGLQg of GLVFRXQW¶
x The increase in the discount factor causes the liability to gradually increase from its original
present value of C300 000 (on 1 January 20X1) to C399 300 (on 31 December 20X3).
x This increase in the liability will be recognised as finance charges over the 3 years.
x The finance charges are sometimes referred to as µQRWLRQDO¶ILQDQFHFKDUJHV
x The discount rate used (10% in this case) must be a pre-tax discount rate.

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 WKHUHLVµVXIILFLHQW REMHFWLYHHYLGHQFH¶DYDLODEOH 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 7: Future events

Fairy Limited owns many nuclear plants.
x Fairy is presently obliged to dismantle one of these plants in 3 \HDUV¶WLPH.
x The last plant dismantled by Fairy cost C1 000 000 to dismantle, but Fairy expects that, if
it uses the same technology as before, it should be able to dismantle this nuclear plant 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 7: Future events

A provision should reflect expected future events only if sufficient objective evidence exists they will occur.
x Since Fairy has had experience in dismantling plants, it may be argued that the expected cost
savings due to this experience can be reasonably expected to occur.
x However, the cost savings expected due to the possible introduction of the new technology, being
outside of Fairy¶s control, should not be taken into account, unless Fairy 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. an entity has committed to restructure a
business, where this has resulted in an obligation to pay retrenchment packages, and the
funding of this will need them to sell certain assets), the expected asset disposals must be
seen as separate economic events. For this reason, gains on the expected disposal of
assets are not considered when 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 in terms of the IFRS relevant to the affected assets.

Example 8: Gains on disposal of assets

New legislation means that Undoo Limited must dismantOHLWVQXFOHDUSODQWLQD\HDU¶VWLPH
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 8: 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 enWLW\¶V
REOLJDWLRQUHSUHVHQWVDOLDELOLW\DQGWKHHQWLW\¶VH[SHFWHGUHLPEXUVHPHQWrepresents 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
A typical example involves guarantees (or warranties).
certain that the reimbursement
Let us look at a few examples. will be 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).

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x If, however, the manufacturer (the supplier) of a product provides the guarantee to the
entLW\¶V FXVWRPHU DQG WKH 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 9: Guarantees
A retailer 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 if:
A. The retailer 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 provides a guarantee irrespective of
whether the manufacturer honours his guarantee.
D. The manufacturer and retailer 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 provide a joint guarantee, whereby they share the costs of fulfilling the
guarantee: the retailer is not liable for amounts the manufacturer may fail to pay.

Solution 9: 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 retaLOHU¶VERRNV

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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 if the manufacturer fails to honour his obligations.

Example 10: 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 10(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

Entity name
Statement of financial position (extracts) 20X2
As at 31 December 20X2 C
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 10(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.

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We could also pay one of the costs that had been included in the provision. 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 we get 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 initial measurement of
the provision must be at its present value ± i.e. at the discounted amount. The subsequent
µunwinding of the discount¶ will reverse this original discounting (see example 6):
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 the initial recognition of the provision
to be capitalised to the cost of the related asset, instead of being recognised in profit or loss
(i.e. we must debit the asset and credit the provision « we must not debit an expense and
credit provision). Thus, if the measurement of this provision subsequently changes, we will
need to decide to what extent the change should be recognised in profit or loss or be
recognised as an adjustment to the 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.

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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
QHZ³LQIODWHG´FDUU\LQJDPRXQWLs 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 assHW¶Vcarrying amount)
Cr Profit/Loss (excess of the decrease in provision over the assHW¶Vcarrying amount)

Example 11: Changes in decommissioning liability: cost model

Susan Limited acquired a plant for C1 000 000 on 1 January 20X5. It will be measured under the
cost model, with depreciation on the straight-line method to a nil residual value.
Susan 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%).
Required: Show the journals for the years ended 31 December 20X5 and 20X6 assuming:
a) The dismantling costs increased to C60 000 on 1 January 20X6. (Ignore tax)
b) The dismantling cost decreased to C30 000 on 1 January 20X6. (Ignore tax)

Solution 11(a): Increase in decommissioning liability: cost model

1 January 20X5 Debit Credit
Plant: cost (A) 1 000 000 + 27 321 1 027 321
Bank Given 1 000 000
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
Plant: accumulated depreciation (-A) 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
Provision: decommissioning costs (L) 15 026
Increase in decommissioning liability
31 December 20X6
Depreciation: plant (P/L: E) (1 027 321 – 256 830 +15 026 - 0) 261 839
Plant: accumulated depreciation (-A) / 3 remaining years x 1 yr 261 839
Depreciation for 20X6 year: (CA – RV) / remaining useful life

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31 December 20X6 continued « Debit Credit

Finance charge (P/L: E) W1 4 508
Provision: decommissioning costs (L) 4 508
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.

W1: Effective interest rate table: estimate increases on 1 January 20X6

Date Liability Finance Calculations

account charges
01 Jan X5 O/balance 27 321 PV: 40 000 x 0.683013
31 Dec X5 Interest 2 732 2 732 O/balance 27 321 x 10% Or balancing: 30 053 – 27 321
31 Dec X5 C/balance 30 053 PV: 40 000 x 0.751315
01 Jan X6 Adjustment 15 026 PV of change: 20 000/ 1.13 Or balancing: 45 079 – 30 053
01 Jan X6 45 079 PV: 60 000 x 0.751315
31 Dec X6 Interest 4 508 4 508 O/balance 45 079 x 10% Or balancing: 49 587 – 45 079
31 Dec X6 C/balance 49 587 PV: 60 000 x 0.826446
31 Dec X7 Interest 4 958 4 958 O/balance 49 587 x 10% Or balancing: 54 545 – 49 587
31 Dec X7 C/balance 54 545 PV: 60 000 x 0.909091
31 Dec X8 Interest 5 455 5 455 O/balance 54 545 x 10% Or balancing: 60 000 – 54 545
31 Dec X8 C/balance 60 000 PV: 60 000 x 1
17 653

Solution 11(b): Decrease in decommissioning liability: cost model

1 January 20X5 Debit Credit

Plant: cost (A) 1 000 000 + 27 321 1 027 321
Bank Given 1 000 000
Provision: decommissioning costs (L) Given 27 321
Purchase of plant
31 December 20X5
Depreciation: plant (P/L: E) (1 027 321 – 0) / 4yrs x 1yr 256 830
Plant: accumulated depreciation (-A) 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
Provision: decommissioning costs (L) W1 7 514
Plant: cost (A) Note 1 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 (P/L: E) W1 2 254
Provision: decommissioning costs (L) 2 254
Finance charge for 20X6 based on the new estimate
Note 1: If our plant¶VFDUU\LQJ DPRXQW KDG 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, haGWKHSODQW¶VFDUUying 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 would have been able to be credited to the plant; and
x C514 would have had to be recognised in profit or loss.

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W1: Effective interest rate table: estimate decreases on 1 January 20X6

Date Liability Finance Calculations
account charges
01 Jan X5 O/balance 27 321 PV: 40 000 x 0.683013
31 Dec X5 Interest 2 732 2 732 O/balance 27 321 x 10% Or balancing: 30 053 – 27 321
31 Dec X5 C/balance 30 053 PV: 40 000 x 0.751315
01 Jan X6 Adjustment (7 514) PV of change: 10 000/ 1.13 Or balancing: 22 539 – 30 053
01 Jan X6 22 539 PV: 30 000 x 0.751315
31 Dec X6 Interest 2 254 2 254 O/balance 22 539 x 10% Or balancing: 24 793 – 22 539
31 Dec X6 C/balance 24 793 PV: 30 000 x 0.826446
31 Dec X7 Interest 2 480 2 480 O/balance 24 793 x 10% Or balancing: 27 273 – 24 793
31 Dec X7 C/balance 27 273 PV: 30 000 x 0.909091
31 Dec X8 Interest 2 727 2 727 O/balance 27 273 x 10% Or balancing: 30 000 – 27 273
31 Dec X8 C/balance 30 000 PV: 30 000 x 1
10 193

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 adjustment Important

due to unwinding of the discount (i.e. due to the passage of A change in the liability
time), the contra entry is the finance cost expense: (increase or decrease)
debit finance cost expense and credit provision. may be an indication that the asset
may have to be revalued in order to
ensure that its CA does not differ
This finance cost expense is recognised in profit or loss and materially from its fair value.
may never be subsequently capitalised to the asset. Any such revaluation shall be taken
into account in determining the
However, if the provision requires adjustment due to some amounts to be recognised in P/L or
other reason (e.g. a change in the estimated discount rate), OCI under IFRIC 1.IFRIC 1.6(c) slightly reworded
then we use the following logic instead. So before processing the adjustments
to the provision in terms of IFRIC 1,
If the revaluation model is used for the asset and an revalue the asset if necessary and
adjustment to its related provision is needed, and it has then use the updated balances in
nothing to do with the unwinding of discount, IFRIC 1 the revaluation surplus account to
do the relevant adjustments.
requires the adjustment to be processed as:
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).
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;
- Then credit any excess to the revaluation surplus account (i.e. other comprehensive income).
But, LI WKH µGHFUHDVH LQ WKe 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: depreciated cost), the excess shall be recognised immediately in profit or ORVV¶
For example: An asset with a historical carrying amount (HCA) of C200 000 (depreciated
cost), was previously revalued. The revaluation surplus balance is currently C300 000. The
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
DVVHW¶V+&$of C200 000. Thus, only C200 000 is credited to the revaluation surplus (OCI),
and the excess of C50 000 is credited to a revaluation income account in P/L.

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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 because, 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 take on 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 12: 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 µnet metKRG¶ Any resultant revaluation surplus is transferred to retained earnings on
disposal of the asset.
The plant was revalued on 31 December 20X5 when its µQHW¶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.

Solution 12(a): Increase in dismantling liability: revaluation model

1 January 20X5 Debit Credit

Plant: cost (A) 1 000 000 + 512 260 1 512 260
Bank Given 1 000 000
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
Plant: accumulated depreciation (-A) 378 065
Depreciation for 20X5 year
Finance charge (P/L: E) W1 or O/bal: 512 260 x 10% 51 226
Provision: dismantling costs (L) 51 226
Finance charge for 20X5

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Gripping GAAP Provisions, contingencies & events after the reporting period

31 December 20X5 continued « Debit Credit

Plant: accumulated depreciation (-A) 378 065
Plant: cost (A) 378 065
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
Depreciation for 20X6 year
Finance charge (P/L: E) W1; Or 56 349
Provision: dismantling costs (L) O/bal (512 260 + 51 226) x 10% 56 349
Finance charge for 20X6
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).

W1: Effective interest rate table: estimate increases on 31 December 20X6

Date Liability Finance Calculations

account charges
01 Jan X5 O/balance 512 260 PV: 750 000 x 0.683013
31 Dec X5 Interest 51 226 51 226 O/balance 512 260 x 10% Or balancing: 563 486 – 512 260
31 Dec X5 C/balance 563 486 PV: 750 000 x 0.751315
31 Dec X6 Interest 56 349 56 349 O/balance 563 486 x 10% Or balancing: 619 835 – 563 486
31 Dec X6 Subtotal 619 835 PV: 750 000 x 0.826 446
31 Dec X6 Adjustment 123 967 PV of change: 150 000/ 1.12 Or balancing: 743 802 – 619 835
31 Dec X6 C/balance 743 802 PV: 900 000 x 0.826 446
31 Dec X7 Interest 74 380 74 380 O/balance 743 802 x 10% Or balancing: 818 182 - 743 802
31 Dec X7 C/balance 818 182 PV: 900 000 x 0.909 091
31 Dec X8 Interest 81 818 81 818 O/balance 818 182 x 10% Or balancing: 900 000 – 818 182
31 Dec X8 C/balance 900 000 PV: 900 000 x 1
263 773

Solution 12(b): Decrease in dismantling liability: revaluation model

1 January 20X5 Debit Credit

Plant: cost (A) 1 512 260
Bank 1 000 000
Provision: dismantling costs (L) 512 260
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
Depreciation for 20X5 year
Finance charge (P/L: E) W1 or O/bal: 512 260 x 10% 51 226
Provision: dismantling costs (L) 51 226
Finance charge for 20X5

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31 December 20X5 continued « Debit Credit

Plant: accumulated depreciation (-A) 378 065
Plant: cost (A) 378 065
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 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) 587 829
Plant: Accum. depreciation (-A) / 3 years remaining x 1 year 587 829
Depreciation for 20X6 year
Finance charge (P/L: E) W1; Or 56 349
Provision: dismantling costs (L) O/bal (512 260 + 51 226) x 10% 56 349
Finance charge for 20X6
Provision: dismantling costs (L) Decr in prov: 371 901 (see W1) is credited 371 901
Revaluation surplus (Eq: OCI) to the RS to the extent that it does not
exceed the HCA of 756 130 (W2) Note 1 371 901
Decrease in dismantling liability
Note 1: If the amount of the decrease in the provision exceeded the assHW¶Vhistorical 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. It is thus recognised as a credit to the revaluation surplus, in other comprehensive income (OCI).
If the HCA had been C300 000, then the C371 901 decrease in the provision would be accounted for as follows:
 only C300 000 would be credited to revaluation surplus (OCI); and
 the remaining C71 901 would be credited to income (P/L).

W1: Effective interest rate table: estimate decreases on 31 December 20X6

Date Liability Finance Calculations
account charges
01 Jan X5 O/balance 512 260 PV: 750 000 x 0.683013
31 Dec X5 Interest 51 226 51 226 O/balance 512 260 x 10% Or balancing: 563 486 – 512 260
31 Dec X5 C/balance 563 486 PV: 750 000 x 0.751315
31 Dec X6 Interest 56 349 56 349 O/balance 563 486 x 10% Or balancing: 619 835 – 563 486
31 Dec X6 Subtotal 619 835 PV: 750 000 x 0.826 446
31 Dec X6 Adjustment (371 901) PV of change: 450 000/ 1.12 Or balancing: 247 934 – 619 835
31 Dec X6 C/balance 247 934 PV: 300 000 x 0.826 446
31 Dec X7 Interest 24 793 24 793 O/balance 247 934 x 10% Or balancing: 272 727 – 247 934
31 Dec X7 C/balance 272 727 PV: 300 000 x 0.909 091
31 Dec X8 Interest 27 273 27 273 O/balance 272 727 x 10% Or balancing: 300 000 – 272 727
31 Dec X8 C/balance 300 000 PV: 300 000 x 1
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

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 paid, the provision is
reduced. However, we may only reduce (debit) the provision with the payment of a cost if we are
sure this cost had originally been included in the provision: payments debited against a provision
that was recognised for a different purpose would conceal the impact of two different events. If a
provision is recognised for expenditures that are no longer expected to be paid, we must derecognise
the provision (the balance may not be used for any other payments), or the relevant portion thereof.

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Example 13: Reduction in provisions

An entity 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 entity attended several court hearings and on a few occasions received parking fines
whilst inside the courthouse.
The following are all the court-related payments 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 for the years ended 31 December 20X5 and 20X6.

Solution 13: Reduction in provisions

31 December 20X5 Debit Credit

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
Provision for legal expenses (L) 250 000
Legal expenses (P/L: E) 20 000
Bank (A) 270 000
Payment to Lawyer A: only C250 000 had been raised as a provision;
thus the C20 000 must be expensed (not debited to the provision)
31 August 20X6
Provision for legal expenses (L) 70 000
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

Notice:
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 liability definition A provision may never be
recognised for future operating
since there is no obligation to incur a future loss, and thus it
losses as it is avoidable. No present
may not be recognised as a provision (remember: a liability obligation exists to incur the loss.
exists independeQWO\RIWKHHQWLW\¶VIXWXUHDFWLRQVDQGthus, if
there is any future action that may avoid the obligation, there is no liability). However, expecting a
future loss may indicate that some of or all the entity¶V assets may be impaired (see chapter 11).

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An onerous contract is
A: 5.2 Contracts (IAS 37.3 & .66 - 69) defined as:
x a contract where:
There are two kinds of contracts referred to in IAS 37: - the unavoidable costs of
x Executory contracts, which are contracts where: meeting the obligations
 neither party has performed any of its (terms) of the contract
obligations; or - exceed the economic
 both parties have partially performed their benefits expected to be
obligations to an equal extent.¶ IAS 37.3 received from the contract
IAS 37.10 reworded
x Onerous contracts, which are contracts where:
 the unavoidable costs to fulfil the terms of the contract are greater than
 the benefits that will be derived from it (i.e. the contract will make a loss). IAS 37.10

Provisions are not recognised for executory contracts, unless onerous. However, a provision for the
expected loss is recognised in the case of an onerous contract. IAS 37.67 and IFRS µIn Brief: Onerous Contracts¶ 12/18

The unavoidable costs of an onerous contract are measured Measuring an onerous

contract provision
as thHµOHDVWQet cost of exitLQJ¶which is the lower of:
x the cost of fulfilling the contract; and The provision must be measured at
x the compensation or penalties that would be incurred the lower of the:
if the contract were to be cancelled. See IAS 37.68 x net cost of fulfilling the contract; &
x any compensation/ penalties
The cost of fulfilling the onerous contract includes all costs from failure to fulfil the contract
See IAS 37.68
that are directly related to the contract. In other words:
x it includes the incremental costs, e.g. the direct labour and direct materials that would not
have been incurred if we did not honour the contract; and
x it includes other direct costs that will be allocated to the contract (such as a portion of the
depreciation of the machinery that would be used on the contract).
x it does not include general and administrative overheads, since these are not direct costs,
unless the contract specifically states that they are chargeable to the customer.

Example 14: Onerous contract

Silliun Limited signed a contract to perform certain services. The contract price is C80 000.
x The accountant estimates that the cost to fulfil this contract is C160 000:
Incremental costs: C100 000 + Allocated direct costs: C40 000 + Allocated administrative costs: C20 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, if any.

Solution 14: Onerous contract

Debit Credit
Contract cost (P/L: E) 30 000
Provision for onerous contract (L) 30 000
Provision recognised at the minimum cost of the onerous contract
Comment: The onerous contract is measured at the µleast net cost to exit¶, which, in this case, is the µcost to
cancel¶ of C30 000. This is the least costly option since the µcost to complete¶ it would have been higher
at C60 000 [All direct costs (incremental + allocated): 140 000 ± Revenue: 80 000].

A: 5.3 Restructuring provisions (IAS 37.70 - 83)

Restructuring occurs when, for example, a line of business is sold (e.g. a company
manufacturing shoes and clothes might sell its shoe-manufacturing factory) or there is a change
in the management structure (see the definition of µUestruFWXULQJ¶Ln the pop-up on the next page).

An entity that is 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 must be met. In this regard, IAS 37 provides further criteria to
assist us in determining whether the basic definition and recognition criteria have been met.

Chapter 18 923
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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
Restructuring is defined as:
Where a restructuring is to be achieved by selling an x A programme that is planned and
operation, no obligation arises until there is a binding controlled by management, &
sale agreement. x materially changes either:
- the scope of a business
undertaken by an entity; or
The logic behind this is that the entity is able to - the manner in which that
reconsider the restructuring if a buyer on suitable terms business is conducted IAS 37.10
cannot be found (e.g. it may have to abandon the idea of
restructuring entirely ± and if it can do that, there is clearly no obligation yet).

However, if only part of the restructuring involves a sale of an operation, it is possible for a
constructive obligation to arise for the µnon-sale part¶ (i.e. 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

Example 15: 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 15: 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:
x The cost of retraining staff is a future operating cost and must thus not be provided for, as these costs
are avoidable.
x The loss on sale of assets simply indicates a possible need to impair the assets at year-end.See IAS 37.81(a)

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A: 5.4 Levies (IFRIC 21)

A levy is defined as µan 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 gives guidance on the accounting treatment IFRIC 21 on Levies does

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
standards (e.g. income taxes),
x The obligating event that gives rise to the recognition x Fines or penalties, and
of a liability to pay a levy is the activity that triggers x Liabilities arising from emissions
the payment of the levy, as identified by legislation. trading schemes. See IFRIC 21.4 & .6
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 16: 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.

Solution 16: 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 /LPLWHG¶V 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 x a possible asset
they are defined as possible assets (see pop-up), which x that arises from past events and
means we are not yet sure they exist. Recognising a x whose existence will be
confirmed only by the:
contingent asset could result in recognising income that
 occurrence or non-occurrence of
might never materialise. Whether or not these assets  one or more uncertain future events
exist will only be known in the future, and is dependent  not wholly within the control
on future events over which the entity has no control. of the entity IAS 37.10
E.g. a possible positive court ruling.

Chapter 18 925
Gripping GAAP Provisions, contingencies & events after the reporting period

If the inflow of economic benefitVIURPDµFRQWLQJHQWDVVHW¶:

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 D µFRQWLQJHQW¶ DVVHt 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 Contingent assets are
need to be disclosed (if the inflow of economic benefits is accounted for as follows:
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
x it must include any risks and uncertainties associated ‘pure’ asset (no longer a
contingent asset)
with the contingent asset;
x if the effect of discounting is material, then it must be measured at its present value (using
a pre-tax discount rate reflecting 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
µVXIficient objectLYHHYLGHQFH¶RIWKHLURFFurrence. 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 and IAS 8)

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;
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 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. See IAS 8.39

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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 17: Disclosure: decommissioning provision (change in estimate)

An item of plant was purchased on 1 January 20X1 for C450 000. On this date, it was
estimated that the future cash outflow relating to the future cost of decommissioning the plant,
expected to occur on 31 December 20X3, would be C399 300 (i.e. an undiscounted cashflow).
x Plant is depreciated over its useful life of 3 years, on the straight-line method, to nil residual values.
x On 1 January 20X2, it was established that, due to unforeseen price increases, the expected future
cost of decommissioning will be C665 500 (i.e. an undiscounted cash flow). The discount rate is 10%.
Required: Disclose the above in the financial statements for the year ended 31 December 20X2.

Solution 17: Disclosure: decommissioning provision (change in estimate)

Entity name
Statement of financial position (extracts) Note 20X2 20X1
As at 31 December 20X2 C C
Non-current assets
Property, plant and equipment 7 360 000 500 000
Non-current liabilities
Provision for decommissioning 6 605 000 330 000

Entity name
Notes to the financial statements (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
6. Provision for decommissioning
Opening carrying amount 330 000 0
Provision for decommissioning raised 0 300 000
Increase in provision ± increase in future cost 220 000
Increase in provision ± unwinding of discount: finance charges (note 8) 55 000 30 000
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.
7. Property, plant and equipment
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)
8. Profit before tax
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)

Chapter 18 927
Gripping GAAP Provisions, contingencies & events after the reporting period

W 1. Effective interest rate table: estimate increases on 1 January 20X2

Date Liability Finance Calculations
account charges
01 Jan X1 O/balance 300 000 PV: 399 300 x 0.751315
31 Dec X1 Interest 30 000 30 000 O/balance 300 000 x 10% Or balancing: 330 000 – 300 000
31 Dec X1 C/balance 330 000 PV: 399 300 x 0.826446

01 Jan X2 Adjustment 220 000 PV of change: 266 200/ 1.12 Or balancing: 550 000 – 330 000
01 Jan X2 Subtotal 550 000 PV: 665 500 x 0.826446
31 Dec X2 Interest 55 000 55 000 O/balance 550 000 x 10% Or balancing: 605 000 – 550 000
31 Dec X2 C/balance 605 000 PV: 665 500 x 0.909091

31 Dec X3 Interest 60 500 60 500 O/balance 605 000 x 10% Or balancing: 665 500 – 605 000
31 Dec X3 C/balance 665 500 PV: 665 500 x 1
Total 145 500

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: 1/1/20X2 (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)
Carrying amount: 31/12/20X1 500 000 500 000
Adjustment: 1/1/20X2 (see W1) 220 000 220 000 Extra asset
Carrying amount: 1/1/20X2 500 000 720 000
Remaining useful life (years) 2 years 2 years
Depreciation: 20X2 (250 000) (360 000) (110 000) Extra expense
Carrying amount: 31/12/20X2 250 000 360 000
Depreciation: future (250 000) (360 000) (110 000) Extra expense
Carrying amount: final 0 0 0 Total change

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.

928 Chapter 18
Gripping GAAP Provisions, contingencies & events after the reporting period

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 curUHQW\HDU¶Vfinancial 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. This period between
the end of the reporting period (the year-end) and the date on which the financial statements
are authorised for issue is often called the µpost-reporting date period¶.

During this period, certain things (events) may happen that we must consider carefully in
terms oI RXU XVHUV¶ information needs. Some of the events that happen during this period
could LQIOXHQFH RXU XVHUV¶GHFLVLRQV DQG WKXV ZH QHHG WR FRQVLGHU ZKHWher this information
should somehow be included in our financial statements. The events need not be
unfavourable to be included ± they could be favourable as well!
Events after the reporting
Each event after the reporting period will need to be period are defined as
analysed and categorised as being either: events that:
x an adjusting event; or x are favourable or unfavourable
x a non-adjusting event. x occur between the:
- end of the reporting period &
For example: An entity has a 31 December year-end and - date when the f/statements
its financial statements for 20X1 were completed and are authorised for issue. IAS 10.3
ready for authorisation on 25 March 20X2. In this case, the period 1 January 20X2 to
25 March 20X2, is the µSRVW-reporting date period¶, and events taking place during this period
need to be carefully analysed in terms of this standard.

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 aQµHvent after the reporting dDWH¶RUµpost- x provide evidence of
reporting periRG HYHQW¶  ZH VLPSO\ QHHG to ask ourselves x conditions that existed at the
IAS 10.3
if the event is one that gives more information about a end of the reporting period
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.

Chapter 18 929
Gripping GAAP Provisions, contingencies & events after the reporting period

Example 18: 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 deEWRU¶VODZ\Hrs 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 18: 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, which would be processed 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 to adjust for an event that occurred after the
reporting date but before the financial statements are authorised for issue, (i.e. referred to as
DQ µHYHQW DIWHU WKe repoUWLQJ GDWH¶ RU µpost-UHSRUWLQJ SHULRG HYHQW¶  ZH VLmply need to ask
ourselves if the event gives more information about a:
Non-adjusting events after
x condition that existed at reporting date; or about a the reporting period are
x condition that arose after reporting date. defined as events that:
x are indicative of
If the event gives us information about a condition that x conditions that arose after the
only developed after year-end, then this event obviously reporting period. IAS 10.3
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 19: 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. The fire occurred during January 20X3.
As a direct 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 in February 20X3.
The financial statements are not yet authorised for issue.
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 19: 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.

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.

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Gripping GAAP Provisions, contingencies & events after the reporting period

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 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
assumption is no longer
as a going concern. When assessing the going concern appropriate, the entire financial
of the entity, management needs to consider events that statements will need to be revised
have occurred right up until the date the financial even if these conditions were not in
statements have been authorised for issue! Thus, if it is existence at year end.
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 existed at year-end!

Example 20: 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
20XWKHGHEWRU¶Vlawyers 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 debtoU¶VIinancial 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¶V 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.
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.

Chapter 18 931
Gripping GAAP Provisions, contingencies & events after the reporting period

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 20: Events after the reporting period ± various

A. An adjusting event: the event that caused the debtor to go insolvent occurred before year-end: the
law\HU¶Vannouncement simply provided information regarding conditions in existence at year-end.
20X2 Debit Credit
Impairment loss (E) 36 000
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
Impairment loss (E) 60 000
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 happened before year-end.
Thus, the post-reporting period event gives more information about the net realisable value at year-end.
20X2 Debit Credit
Inventory write-down (E) 20 000
Inventory (A) 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
Income tax expense (E) 30 000
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 suggesting a constructive obligation existed at year-end and thus 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 thus 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)

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, and thus a
liability should be recognised.
The exact amount owed is not available, but an estimate is available, meaning the liability should be
classified as a provision.

932 Chapter 18
Gripping GAAP Provisions, contingencies & events after the reporting period

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 thus 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 reliable, then a contingent liability must 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
Inventory (A) 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).
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 FinitR¶VODZyers 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. Thus, the declaration is 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.

Chapter 18 933
Gripping GAAP Provisions, contingencies & events after the reporting period

Part A: Summary

Liabilities

Liabilities Provisions Contingent Contingent

x Present obligation
of the entity
x from past events
x the settlement of
which is expected
to result in an
outflow of
economic benefits
See IAS 37.10
This is not the same
liability definition as
the liability definition
in the 2018 CF
x Liability of uncertain
x Timing (not sure
when outflows will
occur), OR
x amount (unsure how
much)
Liability – type 1 Liability – type 2
x Present obligation x Possible obligation
x from past events x from past events
x the settlement of x the existence of
which is expected to which is to be
cause an outflow of confirmed
economic benefits x by the occurrence or
x but where the L may non-occurrence of
not be recognised since uncertain future
the recognition criteria event/s
are not met: x that are not wholly
- the amount is not within the control of
reliably measured, the entity
&/or
- the future outflow is
not probable

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’.

934 Chapter 18
Gripping GAAP Provisions, contingencies & events after the reporting period

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)

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)

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
information about conditions
that were already in
existence at year-end
Events that give more
information about
conditions that only arose
after year-end
Disclosure may be
necessary
Where the going concern
ability of the entity becomes
no longer feasible, the
financial statements need to
be completely revised,
whether or not this condition
was in existence at year-end

x Make adjustments x No adjustments x Make adjustments

x No extra disclosure x Disclosure may be needed x Disclosure is needed

Chapter 18 935
 Gripping GAAP Employee benefits

Chapter 19
Employee Benefits
Reference: IAS 19; IFRIC 14 (updated for any amendments to 1 December 2021)

Contents: Page

1. Introduction 937

2. Short-term employee benefits 938

2.1 Overview of short-term benefits 938

2.2 Short-term paid absences 939

2.2.1 Leave taken in the year it was earned 940

2.2.2 Unused leave 940

2.2.2.1 Non-accumulating leave 940

Example 1: Short-term paid leave: non-accumulating: single employee 940

Example 2: Short-term paid leave: non-accumulating: group of employees 941

2.2.2.2 Accumulating leave 941

Example 3: Short-term paid leave: accumulating: vesting vs non-vesting 942

Example 4: Short-term paid leave: accumulating, vesting and non-vesting 943

2.3 Profit sharing and bonus plans 945

Example 5: Bonuses ± recognising the bonus payable 945

Example 6: Bonuses ± paying the bonus 946

Example 7: Profit sharing as a bonus 946

3. Post-employment benefits 947

3.1 Overview of post-employment benefits 947

3.2 Defined contribution plans 948

Example 8: Defined contribution plans 949

3.3 Defined benefit plans 950

4. Other long-term benefits 952

5. Termination benefits 952

6. Disclosure 954

6.1 Short-term employee benefits 954

6.2 Post-employment benefits 954

6.2.1 Defined contribution plans 954

6.2.2 Defined benefit plans 954

6.3 Other long-term employee benefits 954

6.4 Termination benefits 954

7. Summary 955

936 Chapter 19
 Gripping GAAP Employee benefits

1 Introduction

Why do we work? Apart from philosophical reasons (that are unfortunately beyond the scope
of this book), we generally work for rewards.

,QWKHPLG¶VD5XVVLDQVFLHQWLVW, 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 calleGWKLVDµSV\FKLFVHFUHWLRQ¶ 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 DVµFRQGLWLRQDOUHIOH[HV¶ RUµ3DYORYLDQUHVSRQVH¶.

The answer WRµZK\GRZHZRUN¶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!

7KHWHUPµemployee¶LQFOXGHVDOOFDWHJRULHVIXOO-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 benefits Other long-term Post-employment Termination

benefits benefits benefits
EBs that are: All EBs other than: EBs that are: EBs that are payable as
x expected to be x short-term; x payable after the a result of either the:
settled wholly before x post-employment; or completion of x entity’s decision to
12m after the end of employment terminate employment
x termination benefits
the period x other than: before normal
See IAS 19.8
x in which the retirement date; or
 short-term
employees render employee benefits x the employee’s decision
the related service to accept an offer of
 termination
x other than: benefits in exchange
benefits
termination benefits for termination of
See IAS 19.8
See IAS 19.8 employment See IAS 19.8

Employee benefits include settlements made to both past and present employees. Benefits
JLYHQWRDQHPSOR\HH¶VVSRXVHFKLOGUHQ 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 19 937
 Gripping GAAP Employee benefits

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 ± 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 Paid leave Profit sharing Non-monetary

and social security (e.g. annual/sick and/or bonuses benefits Note 1
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-PRQHWDU\DVVHWVLWHPVVXFKDVµIUHHRUFKHDS¶KRXVLQJOXQFKHVZHHNHQGV

(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).

938 Chapter 19
 Gripping GAAP Employee benefits

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
Account payable (e.g. wages payable) (L) xxx
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
Employee benefit expense xxx
Account payable (e.g. wages payable) (L) xxx
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
Employee benefit expense 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 ± 18)

Short-term paid absences can
Short-term paid absences are also referred to as either be: See IAS 19.14
short-term paid leave. The term effectively refers to
x accumulating; or
a type of leave entitlement where an employer x non-accumulating
continues to pay his employee during certain This affects whether a liability is recognised.
periods in which the employee takes leave (i.e. is
Accumulating leave can either be:
absent) from work. For example, an employer may x vesting; or
offer its employees 10 days annual leave per year. x non-vesting. See IAS 19.15
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 19 939
 Gripping GAAP Employee benefits

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 HPSOR\HH¶VVKRUW-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 *X\WRRNGD\VOHDYHLQ;*X\¶VOHDYHLVQRQ-accumulating.
Required: Show all journals and calculate any leave pay liability at the 31 December 20X1 year-end.

940 Chapter 19
 Gripping GAAP Employee benefits

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).
7KHIROORZLQJMRXUQDOUHODWLQJWR*X\¶VVDODU\ZRXOGEHSURFHVVHGDVLQGLYLGXDOMRXUQDOVRYHUWKH\HDU
(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-GD\ ZRUNLQJ ZHHN $W /HH /LPLWHG¶V ILQDQFLDO \HDU HQGHG
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 IRU/HH/LPLWHG¶VILQDQFLDO\HDUHQGHG'HFHPEHU;
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 19 941
 Gripping GAAP Employee benefits

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 who is paid monthly. 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 6FRWWWRRNGD\VOHDYHLQ;6FRWW¶VOHDYHLVDFFXPXODWLQJ
0DUN/LPLWHG¶VILQDQFLDO\HDU-end is 31 December 20X1.
Required: Show all related 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

Part A Part B Part C
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)
The leave-pay liability is based on the expected cost per day of employing Scott.
The expected cost per day is calculated as follows:
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
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.

942 Chapter 19
 Gripping GAAP Employee benefits

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, entity of how many days the entity is expecting Scott
to be able to take ± this is because the entity 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 entity 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 /LPLWHG¶V ILQDQFLDO \HDU HQGHG
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 IRU/HH/LPLWHG¶VILQDQFLDO\HDUHQGHG'HFHPEHU;LI
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 19 943
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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: C115 068
= 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: C47 945
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).

944 Chapter 19
 Gripping GAAP Employee benefits

Compare this to part A where the liability was based on the fulOGD\VVLQFHWKHWHUPVRISDUW$¶V
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 = C47 945
[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 19.19-25)

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 terms of IAS 19.22, a reliable estimate can only be

Bonus schemes that are
made if the: either:
x the formal terms of the plan contain a formula for
x Settled in the entity’s own shares; or
determining the amount of the benefit;
x based on, or determined in relation to
x entity calculates these payments before authorising the entity’s share price
the financial statements for issue; or x are not within the scope of IAS 19,
but IFRS 2.
x past practice gives clear evidence of the amount of
WKHHQWLW\¶VFRQVWUXFWLYHREOLJDWLRQ

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 19 945
Gripping GAAP Employee benefits

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.

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) W1 (960 000) (900 000) (600 000)
Bonuses provided for

W1: Liability balance at year-end 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

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.

31 December 20X3 Debit Credit

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 ± ZKLFKLVVHWDWWKHHQGRIHDFK\HDUIRUWKHQH[W\HDU¶VSURILWVKDULQJFDOFulation.
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.

946 Chapter 19
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Solution 7: Profit sharing as a bonus

Part A Part B Part C
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%.
Notice: 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 19.26-152)

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
EHQHILWVZRXOGDFFUXHZKLOHKHZDVQRORQJHUHPSOR\HGWKH\ZRXOGEHUHIHUUHGWRDVµSRVW-
HPSOR\PHQW¶EHQHILWV 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) GXULQJWKHHPSOR\HH¶VZRUN-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
FRQWULEXWLRQSODQWKHHQWLW\¶VREOLJDWLRQµLVOLPLWHGWRWKHDPRXQWWKDWLWDJUHHVWRFRQWULEXWHWR
WKHIXQG¶,QWKHFDVHRIDGHILQHGEHQHILWSODQWKHREOLJDWLRQLVa 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
shortfall that the plan might experience.

Chapter 19 947
 Gripping GAAP Employee benefits

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 19.50-54)

7KHWHUPµGHILQHGFRQWULEXWLRQSODQ¶LV 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
separate entity (a fund), and
or retirement, the contributions together with any gains
 will have no legal or
(or less any losses) are paid to the employee. constructive obligation
to pay further contributions
What is important is that defined contribution plans limit
if the fund does not have
WKHHQWLW\¶VREOLJDWLRQ: the entity is only obliged to pay the sufficient assets to pay all
contributions in terms of the agreed plan (these are paid employee benefits relating to
to a separate entity that runs the plan). The entity is not employee service in the current
and prior periods. See IAS 19.8
responsible for any possible shortfall that may arise in
the plan and, conversely, has no claim to any gain that
may arise. Defined contribution
plans:
Thus, the economic substance of a defined contribution
x involve payments to a separate
plan is that: entity (a fund, usually
x the HQWLW\¶Vobligation is limited to the agreed upon independently administered);
contributions; and x limit the entity’s obligation to
contributions payable; and
x the employee carries the risk (e.g. the risk that the x burden the employee with the risks.
benefits will be less than expected).

The amounts recognised LQ WKH HQWLW\¶V accounting records are simply the contribution paid/
payable by the employer to the defined contribution fund. This contribution is expensed.

948 Chapter 19
 Gripping GAAP Employee benefits

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

0DWWKHZ/LPLWHG¶VDQQXDOVDODU\H[SHQVHIRU;LVDVIROORZV
x gross salary of C4 000 000, of which:
x C1 200 000 is HPSOR\HHV¶WD[ZKLFKZDVZLWKKHOG SD\DEOHWRWKHWD[DXWKRULWLHV 
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 0DWWKHZ¶VILQDQFLDO\HDUHQGHG December 20X4.
Show the journals on an annual basis (i.e. these are normally processed monthly).

Solution 8: Defined contribution plans

Journals Debit Credit

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
Notes to the financial statements (extracts)
For the year ended 31 December 20X4
20X4 20X3
3. Profit before tax C C

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 %RWK WKH HPSOR\HHV¶ DQG WKH HPSOR\HU¶V FRQWULEXWLRQV  000 + 400 000, respectively) are
included in the total employee benefit expense (this expense is disclosable in terms of IAS 1).
x 7KHHQWLW\¶VFRVWUHODWLQJWRWKH 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 Limited.

Chapter 19 949
 Gripping GAAP Employee benefits

3.3 Defined benefit plans (DBP) (IAS 19.26 & .55-152)

Where an entity guarantees (promises) that it will pay Defined benefit plans are
certain specific benefits to its employees after defined as:
employment, we have a µdefined benefit plan¶ (e.g. a
x Post-employment benefit plans
pension fund). This is quite different to an entity that
x Other than defined contribution plans.
simply commits to paying contributions to an external IAS 19.8

fund, where it is then the responsibility of the external

fund to pay the benefits to the employee after employment
LHDµdefined contribution SODQ¶ «Vee section 3.2). Defined benefit plans:

x the entity has the obligation to

Thus, when an entity offers a µdefined benefit plan¶, it opens pay 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. For example: entities offering defined benefits
often promise pension payments that will be a percentage of tKHHPSOR\HH¶VODVWVDODU\, where this
last salary may be far greater than originally expected.
The plan obligation balance
In the case of defined benefit plans, the entity is required is measured as the:
to set aside assets LHZKHUHLWFDQ¶WWRXFKWKHP so that x present value of the
it will be able to settle the obligation in the future. x future expected outflows based on
x actuarial assumptions at year-end.

Defined benefit plans expose the entity to risks: actuarial

risk WKHULVNWKDWWKHSURPLVHGµEHQHILWVZLOObe less than
H[SHFWHG¶ DQG investment risk (the risk that the assets
WKDW KDYH EHHQ VHW DVLGH µZLOO EH LQVXIILFLHQW WR PHHW
H[SHFWHGEHQHILWV¶ See IAS 19.26-30
Obviously, due to the greater risks involved in a µdefined
benefit plan¶, far more disclosure is required than when
disclosing a µdefined contribution plan¶.
Plan assets must: See IAS 19.8
x be held in a fund that is a separate
legal entity, or
x be a qualifying insurance policy
issued by an insurer that is not a
related party; and
x not be used for anything other than
paying/ funding employee benefits.

When recognising a µdefined benefit plan¶ we recognise both the:

x plan obligation (i.e. the benefits that it has promised The plan asset balance is
to its employees); and measured at its:
x plan assets (i.e. those assets that are set aside in x FV at year-end. See IAS 19.57

order to settle the obligation).

The plan obligation is measured at the present value of

Defined benefit costs:
the future expected outflows and the plan assets are See IAS 19.120
measured at their fair value (where this fair value reflects
the present value of the economic benefits expected x are the costs of offering a DBP
from the assets). Ideally these assets match or exceed x include service costs, interest costs
and remeasurement adjustments
the obligation.

The contra entries processed when accounting for the plan 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, e.g. they would be included in inventories if the employee worked on
manufacturing inventories).
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) and may never be reclassified to profit or loss. See IAS 19.120 & 122

950 Chapter 19
 Gripping GAAP Employee benefits

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 µnet defined benefit plan asset¶; or
x µnet defined benefit plan liability¶. Deficit or surplus

Plan asset xxx

With regard to the above-mentioned presentation, if at reporting Less plan obligation (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 ZHRZHPRUH WKDQ ZH RZQ DQG DUH WKXV µLQ WURXEOH¶ KDYLQJD QHW OLDELOLW\
position). A deficit would be presented DVDµQHWGHILQHGEHQHILWSODQliability¶LQWKHVWDWHPHQW
RI ILQDQFLDO SRVLWLRQ 7KH DPRXQW RI WKH GHILFLW ZLOO HTXDO WKH DPRXQW SUHVHQWHG DV WKH µQHW
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 &
PRUHWKDQZHRZHDQGDUHWKXVµLQDKHDOWK\SRVLWLRQ¶
surpluses
having a net asset position). Having a surplus means
tKDW ZH ZLOO SUHVHQW D µQHW GHILQHG EHQHILW asset¶ x A deficit is presented in the SOFP
as a ‘net DBP liability’
However, if we have a surplus, the amount of the surplus
x A surplus is presented in the
GRHVQRWDOZD\VHTXDOWKHDPRXQWSUHVHQWHGDVWKHµQHW SOFP as a ‘net DBP asset’, but
defined benefit plan asset¶ 7KLV LV EHFDXVHZKHQHYHU must first be limited to the asset
we have a surplus, we must first check that it does not ceiling (if the ceiling is lower).

H[FHHG WKHDPRXQW UHIHUUHG WRDV WKH µasset ceiling¶ ,Q RWKHU ZRUGVWKH µQHWGHILQHG EHQHILW
SODQDVVHW¶PXVWEHPHDVXUHGDWWKHlower 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, WKHDPRXQWSUHVHQWHGDVWKHµQHWGHILQHG EHQHILWDVVHW¶
must EHOLPLWHGWRWKHORZHUµDVVHWFHLOLQJ¶DPRXQW,QRWKHUZRUGVLIWKHVXUSOXVH[FHHGVWKH
DVVHWFHLOLQJWKHDPRXQWSUHVHQWHGDVWKHµQHWGHILQHGEHQHILWDVVHW¶ZLOOnot equal the surplus
but will equal the asset ceiling instead. 7KLVZLOOUHTXLUHWKHXVHRIDQµDVVHWFHLOLQJDGMXVWPHQW
DFFRXQW¶. 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.
Scenario A Scenario B
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 accountTo 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 19 951
 Gripping GAAP Employee benefits

4 Other Long-Term Benefits (IAS 19.153-158)

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 µother 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

µOther long-term employee benefits¶ are recognised and measured in the same way as we
UHFRJQLVH µGHILQHG EHQHILW SODQV¶ D 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 µother 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 µSRVW-employment benefits:
GHILQHG EHQHILW SODQV¶ DUH SURQH WR D KLJK GHJUHH RI XQFHUWDLQW\ this same high level of
uncertainty does not apply in the case of µRWKHUORQJ-WHUPHPSOR\HHEHQHILWV¶ See IAS 19.154-155

$OWKRXJK µRWKHU ORQJ-WHUP HPSOR\PHQW EHQHILWV¶ DUH An important observation!

Remeasurements:
UHFRJQLVHG DQG PHDVXUHG LQ WKH VDPH ZD\ DV µSRVW-
HPSOR\PHQW EHQHILWV GHILQHG EHQHILW SODQV¶ ,$6  x that relate to ‘post-employment
benefits’ are recognised in OCI;
stipulates many disclosure requirements for µSRVW-
x that relate to ‘other long-term
HPSOR\PHQW EHQHILWV GHILQHG EHQHILW SODQV¶ whereas benefits’ are recognised in P/L.
IAS 19 does not stipulate any disclosure requirements
IRUµRWKHUORQJ-WHUPHPSOR\PHQWEHQHILWV¶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 LQWKHFDVHRIµRWKHUORQJ-WHUPEHQHILWV¶, 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 µemployee benefit expense account¶ WKLVLVQRWWKH
FDVHZKHQZHDFFRXQWIRUµSRVW-HPSOR\PHQWEHQHILWVGHILQHGEHQHILWSODQV¶ .

Another important difference between µRWKHU ORQJ-WHUP HPSOR\PHQW EHQHILWV¶ DQG µSRVW-
HPSOR\PHQWEHQHILWV¶LVWKDWWKHIRUPHUUHIHUVWRDEHQHILWWKDWERWKaccrues 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 QHWDVVHWRUOLDELOLW\UHODWLQJWRµRWKHUORQJ-WHUPHPSOR\HHEHQHILWV¶WKDWZRXOGEHLQFOXGHG
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
REOLJDWLRQWRSURYLGHµRWKHUORQJ-WHUPEHQHILWV¶VXFKDVORQJ-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 µother long-term employee benefits¶ xxx

5 Termination Benefits (IAS 19.159-171)

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.

952 Chapter 19
 Gripping GAAP Employee benefits

Termination benefits are benefits payable as a result of either:

Termination benefits are the
x WKHHQWLW\¶VGHFLVLRQWRWHUPLQDWHWKHHPSOR\PHQWor
only employee benefits that:
x WKHHPSOR\HH¶VGHFLVLRQWRDFFHSWDQ HQWLW\¶V offer of
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 a 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 GDWHZKHQDUHVWULFWLRQ HJOHJDOUHJXODWRU\RUFRQWUDFWXDO RQWKHHQWLW\¶VDELOLW\WRZLWKGUDZWKH
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 WR WHUPLQDWHDQ HPSOR\HH¶V
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 µshort-term benefits¶DQGWKXVwould 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 µRWKHU long-term employee benefits¶ DQG WKXV would be
discounted to present values;
x if the benefits are enhancements of existing post-employment benefits, then they will be measured
like µpost-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 WKHQXPEHURIHPSOR\HHVZKRPD\DFFHSWWKHRIIHUZHZRQ¶WUHFRJQLVH
a liability (since we cannot measure it) but will disclose a contingent liability.

Chapter 19 953
 Gripping GAAP Employee benefits

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 19.53-54)

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 19.135-152)

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

954 Chapter 19
Gripping GAAP Employee benefits

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: All Defined in IAS 19 as:
All EB's* that are All EBs * that are 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 offered
x short-term employee in exchange for
*Other than: benefits 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
termination benefits
x recognises the restructuring costs in terms
of IAS 37 and where these costs include
termination benefits

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 19 955
 Gripping GAAP Employee benefits

Short-term benefits

Wages, salaries Short-term Profit sharing Use of non-

and social security compensated and/ or bonuses monetary benefits
contributions (e.g. absences (e.g. a company car)
medical aid) (paid sick/annual
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
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
all accumulated the accumulated because the employee simply loses his
unused leave unused leave that unused leave at year-end: there is no
will probably be obligation to either allow the employee
used in the future to take this leave in the future or to pay
the employee out for unused leave

Annual salary / Annual salary /

working days x working days x
number of number of
employees x days: employees x days:
(all days owed at (only the days c/f
year-end) 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.

956 Chapter 19
Gripping GAAP Employee benefits

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 x Obligation: provide certain benefits to the
contributions 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 x Plan obligation: PV of benefit promised (Credit)
need to discount if the x Plan assets: FV of separate plan assets Debit
contributions become payable after x Surplus/ (deficit) Dr/ (Cr)
12 months from the end of the x Asset ceiling adjustment (if there (Credit)
period in which the employee was a surplus)
provides the service)
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 19 957
Gripping GAAP Foreign currency transactions

Chapter 20
Foreign Currency Transactions
Reference: IAS 21 and IFRS 9 (all including any amendments to 1 December 2021)

Contents: Page
1. Introduction 959
2. Scope 959
3. Foreign currency transactions 959
3.1 Overview 959
3.2 Monetary and non-monetary items 960
3.3 How exchange rates are quoted 960
Example 1: Exchange rates 960
3.4 Dates 961
3.4.1 Determining the transaction date 961
3.4.2 Determining the settlement date 962
3.4.3 Determining the reporting date (if applicable) 962
Example 2: Dates: transaction, settlement and reporting dates 962
3.5 Initial recognition and measurement: monetary and non-monetary items 963
3.6 Subsequent measurement: monetary items 963
3.6.1 Overview 963
3.6.2 Translation at the end of the reporting period: monetary items 963
3.6.3 Translation at settlement date: monetary items 963
3.7 Exchange differences: monetary items 963
3.7.1 Overview 963
Example 3: Exchange differences ± monetary item: debtor 964
3.7.2 Import and export transactions 964
3.7.2.1 Transaction and settlement on same day (cash transaction) 964
Example 4: Import transaction: settled on same day (cash transaction) 965
Example 5: Export transaction: settled on same day (cash transaction) 965
3.7.2.2 Settlement deferred (credit transactions) 965
3.7.2.2.1 Settlement of a credit transaction before year-end 965
Example 6: Import: credit transaction settled before year-end 966
Example 7: Export: credit transaction settled before year-end 966
3.7.2.2.2 Settlement of a credit transaction after year-end 967
Example 8: Import: credit transaction settled after year-end 967
Example 9: Export: credit transaction settled after year-end 968
Example 10: Import: credit transaction: another example 968
3.7.3 Foreign loans 970
Example 11: Foreign loan received 971
Example 12: Foreign loan granted 972
3.8 Subsequent measurement: non-monetary items 973
Example 13: Non-monetary item: measurement of plant purchased from foreign supplier 974
Example 14: Non-monetary item: measurement of inventory owned by foreign branch 975
Example 15: Non-monetary item: measurement of plant owned by foreign branch 976
3.9 Exchange differences: non-monetary items 977
Example 16: Revaluation of PPE owned by a foreign branch 977
4. Presentation currencies and Functional currencies 978
4.1 General 978
4.2 Determining the functional currency 978
4.3 Accounting for a change in functional currency 979
4.4 Using a presentation currency other than the functional currency 979
4.4.1 Explanation of the foreign currency translation reserve 980
Example 17: Foreign currency translation reserve 980
5. Presentation and Disclosure 981
6. Summary 982

958 Chapter 20
Gripping GAAP Foreign currency transactions

1. Introduction

There are three areas involving foreign currency that are Foreign currency is
explained in IAS 21 The effects of changes in foreign defined as:
exchange rates: x a currency
x transactions that involve foreign currency, x other than the functional
currency of the entity. IAS 21.8
x foreign operations, and
x translating financial statements into a foreign presentation currency. See IAS 21.3

This section is not difficult: we simply need to 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.
Thus, for example, if we enter into a transaction that involves a foreign currency, the changing value of
the foreign currency will need to be accounted for.
Functional currency is
x Transactions entered into with foreign entities may or may defined as:
not be denominated in a foreign currency: an invoice x the currency
presented in dollars, is said to be µGHQRPLQDWHGLQGROODUV¶. x of the primary economic environment
x Since financial statements are prepared in one currency x in which the entity operates. IAS 21.8
only, any foreign currency denominated items must be
converted into the primary currency used by the entity (its functional currency).
x Converting foreign currency denominated items, which is done using the exchange rate ruling on the
date of the conversion (spot exchange rate), may result in exchange differences. For example:
 There is often a considerable time lag between the date that a foreign debtor or creditor is
created and the date upon which that debtor pays us, or the date upon which we pay the
creditor. As explained above, currencies are being traded daily and thus the spot exchange
rate used to measure a foreign debtor or creditor on initial recognition of the transaction will
no doubt be different to the spot rate on the date the debtor pays us or the date we pay the
creditor. This difference is an exchange difference.
An exchange difference is
 Similarly, an entity may wish to present their financial
defined as the:
statements in one or more currencies, other than its
functional currency (presentation currency). Converting x difference resulting from
x translating a given number of
the functional currency amounts into the presentation units of one currency
currency will also result in exchange differences. x into another currency
x at different exchange rates. IAS 21.8
The rest of this chapter is dedicated to:
x Foreign currency transactions
x Presentation and functional currencies
x Presentation and disclosure issues.

2. Scope

IAS 21 does not apply to:

x foreign currency derivatives or balances (e.g. from hedge accounting) that fall within the ambit
of IFRS 9 Financial instruments; &
x presentation of cash flows related to foreign currency transactions or the translation of cash
flows of a foreign operation. See IAS 21.4-5 & .7

3. Foreign Currency Transactions

3.1 Overview A foreign currency

transaction is defined as:
A transaction that is denominated in a foreign currency x a transaction that:
impacts both the initial recognition and measurement of that - is denominated; or
transaction and also its subsequent measurement. - requires settlement
x in a foreign currency. IAS 21.20 extract

Chapter 20 959
Gripping GAAP Foreign currency transactions

In this regard, a distinction must also be made between monetary items (e.g. cash) and non-
monetary items (e.g. plant), because whether an item is monetary or non-monetary affects
how we account for the LWHP¶V subsequent measurement and related exchange differences
(section 2.2).

To be able to account for foreign currency transactions, we must understand how exchange rates
are quoted (section 2.3) and must be aware of the various transactions that could be denominated in
a foreign currency and the dates on which we will need to convert our various foreign currency
denominated amounts (section 2.4). The important dates include transaction dates, settlement dates
and reporting dates.

3.2 Monetary and non-monetary items (IAS 21.8 & .16)

Monetary items are
The core feature of a monetary item is the right to
defined as:
receive (or obligation to deliver) a fixed or determinable
number of units of currency. Examples include: x units of currency held, and
x assets to be received, and
x cash; x liabilities to be paid
x accounts receivable; x in a fixed or determinable number of
x accounts payable; and units of currency. IAS 21.8 (slightly reworded)
x provisions to be settled in cash.

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:
Exchange rate is defined
x property, plant and equipment; as:
x intangible assets;
x the ratio of exchange
x inventories; and
x for two currencies. IAS 21.8
x prepaid expenses. See IAS 21.16

3.3 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. Spot exchange rate is
If you ask a bank or other currency dealer to buy or sell a defined as:
particular currency, you will be quoted an exchange rate x the exchange rate
that is valid for that particular day only (i.e. immediate x for immediate delivery. IAS 21.8
GHOLYHU\ 7KLVH[FKDQJHUDWHLVFDOOHGDµspot rate¶

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

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3.4 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).

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. Hedging is covered in chapter 21.
Transation date is
3.4.1 Determining the transaction date (IAS 21.22) described as:

The first important date in a foreign currency transaction is the the date on which the transaction
transaction date. This is the date on which the transaction will first qualifies for recognition in
accordance with IFRSs. IAS 21.22 (extract)
be recognised, and must be established with reference to 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 µwhen 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. To assist us 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 ³,QFRWHUPV´ .

The following are some common µIncoterms¶:

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 µGHOLYHUHGRYHUWKHVKLS¶VUDLO¶ (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.

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3.4.2 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.

3.4.3 Determining the reporting date (if applicable) Reporting date is:
x the financial year-end of the
It is possible for a foreign currency transaction to spread local entity; or
over more than one reporting period. In other words, at x any other date on which financial
least one reporting date (e.g. financial year-end) occurs information is to be reported.
between transaction date and settlement date. Every
time that a reporting date falls between the transaction date 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.
01 February 20X4: The bicycles were delivered to a harbour in Iceland and were loaded onto a ship.
04 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.
05 April 20X4: The bic\FOHVILQDOO\DUULYHGLQ+RPH/LPLWHG¶VZDUHKRXVH
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).
Part 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 LV)HEUXDU\;VLQFHWKLVLV+RPH/LPLWHG¶V\HDU-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.
Part 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.

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3.5 Initial recognition and measurement: monetary and non-monetary items

The foreign currency transaction is: Spot exchange rate is
defined as the:
x initially recognised on transaction date.
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.

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, on condition that it
approximates the spot exchange rate.

3.6 Subsequent measurement: monetary items (IAS 21.23)

3.6.1 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.

3.6.2 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.

3.6.3 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.

3.7 Exchange differences: monetary items (IAS 21.28)

Exchange differences on
3.7.1 Overview monetary items: are
generally recognised in P/L
The translation of monetary items will almost always (in certain cases, they are
result in exchange differences: gains or losses (unless recognised in OCI). See IAS 21.28
there has been no change in the exchange rate since transaction date).

Exchange differences on monetary items are generally µrecognised in profit or loss in the
period in which they arise¶. There is one exception though: 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 the exchange gains or losses on
monetary items in the following examples will be recognised in profit or loss.

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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
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 anG H[FKDQJH GLIIHUHQFHV ZRXOG EH MRXUQDOLVHG LQ WKH HQWLW\¶V ERRNV RQ
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 debtor (A) 6 000
Foreign exchange gain (I) 6 000
Translating foreign debtor
31 March
Foreign exchange loss (E) 2 000
Foreign debtor (A) 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.

3.7.2 Import and export transactions

3.7.2.1 Transaction and settlement on the same day (cash transaction)

If the date on which the transaction is journalised (µtransaction date¶) is the same date on
which cash changes hands in settlement of the transaction (µsettlement date¶), then there
would obviously be no exchange differences to account for.

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Example 4: Import transaction ± settled on same day (cash transaction)

On 5 March 20X1 (transaction date),
x a company in Botswana (in which the local / functional currency is the Pula: P)
x 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.

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
Purchase of inventory

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.
x The sale proceeds were received on the same day when the spot rate was P4: £1.
x The cost of the inventory to the UK company was £150.
x The local currency (functional currency) in Botswana is the Pula (P).
x 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

3.7.2.2 Settlement deferred (credit transactions)

Exchange differences arise when the µsettlement date¶ occurs after µtransaction 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.

3.7.2.2.1 Settlement of a credit transaction before year-end

When the µtransaction date¶ and µsettlement 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).

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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.

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
Foreign creditor (L) 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.
x The inventory cost the UK company £150.
x The inventory was paid for on 13 June 20X5.
x The year-end of the company in the United Kingdom is 30 September.
x 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!).

17 May 20X5 Debit Credit

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

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13 June 20X5 Debit Credit

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

3.7.2.2.2 Settlement of a credit transaction after year-end

When the µtransaction date¶ and the µsettlement 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.
x The purchase price was paid on 5 April 20X1.
x 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
Foreign creditor (L) 300
Purchase of inventory on credit
31 March 20X1
Foreign exchange loss (E) (£100 x 3.7) ± 300 = P70 70
Foreign creditor (L) 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
Foreign creditor (L) 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

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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.
x The cost of the inventory to the UK company was £150.
x The UK company has a 31 May financial year-end.
x The sale proceeds were received on 13 June 20X5.
x Relevant exchange rates are:
Date Spot rates (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.

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).
17 May 20X5 Debit Credit
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
Foreign exchange gain (I) 53
Translating the foreign debtor at year-end
13 June 20X5
Foreign debtor (A) P1200 / £3 = 400 ± (300 + 53) = £47 47
Foreign exchange gain (I) 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.
x The transaction date is 5 February 20X1.
x The year-end is 31 March 20X1.
x The relevant exchange rates are as follows:

Date Spot rates (Pound: dollar)

16 January 20X1 £1: $2.20
5 February 20X1 £1: $2.50
31 March 20X1 £1: $2.25
5 April 20X1 £1: $3.00
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).

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Solution 10A: Import ± credit transaction ± payment before year-end

Journals:

5 February 20X1 Debit Credit

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

Solution 10B: Import ± credit transaction ± payment at year-end

5 February 20X1 Debit Credit

Inventory (A) $900 / £2.5 360
Foreign creditor (L) 360
Purchase of inventory: exchange rate £1: $2.5
31 March 20X1
Foreign exchange loss (E) $900 / 2.25 ± 360 40
Foreign creditor (L) 40
Translation of foreign creditor at settlement date
Foreign creditor (L) $900 / 2.25 = 400 400
Bank (A) 400
Payment of foreign creditor

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

5 February 20X1 Debit Credit

Inventory (A) $900 / £2.5 360
Foreign creditor (L) 360
Purchase of inventory: exchange rate £1: $2.5
31 March 20X1
Foreign exchange loss (E) $900 / 2.25 ± 360 40
Foreign creditor (L) 40
Translation of foreign creditor at year-end
5 April 20X1
Foreign creditor (L) $900/ 3 ± (360 + 40) 100
Foreign exchange gain (I) 100
Translation of the foreign creditor at settlement date
Foreign creditor (L) $900/ 3 300
Bank (A) 300
Payment of foreign creditor

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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). Compare this to:
x part B where the foreign exchange loss recognised to payment date is 40; and
x 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.

3.7.3 Foreign loans

Accounting for foreign loans
The third possible type of transaction involves loans, where x Recognise loan capital at SR on TD
we are either granting a loan to a foreign entity or receiving a x Recognise pmts at SR on SD
loan from a foreign lender, but specifically where the loan x Recognise interest at average rates
amount is denominated in a foreign currency. over the period the interest accrued
x Remeasure the loan balance using
the SR on RD & recognise any difference
x As with all other foreign currency transactions, the as a foreign exchange gain or loss.
receipt (or payment) of the initial loan capital (the
µprincipal sum¶), if denominated in a foreign currency, would need to be initially measured by
translating it into the local currency using the spot rate 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 measured at LC120 000 (FC10 000 x LC12).
This would be journalised as: Debit: Bank and Credit Loan liability with LC120 000

x The next thing to consider is interest. Here we have two steps:

 First step: Interest incurred (or earned) on foreign currency loans raised (or given) must first
be calculated in terms of foreign currency, by applying the interest rate to the outstanding
foreign currency amount.
For example: If our loan of FC10 000 accrues interest at 10% pa, the interest incurred for a
year would be FC1 000 (FC10 000 x 10% x 1 year).
 Second step: 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. See IAS 21.22
For example: If during the year that the interest of FC1 000 was incurred on our loan, the
average spot rate over was LC14: FC1, then we would recognise interest expense measured
at LC14 000 (FC1 000 x average spot rate LC14). This interest expense would increase our
loan liability:
The interest of LC14 000 will be journalised as: Debit: Interest expense and Credit Loan liability.

x When making repayments on our loan (or receiving repayments from foreign borrowers), as with all
payments (or receipts) made in foreign currency, we translate the foreign currency amount into the
local currency using the spot rate on payment date.
For example: If we pay FC2 000 to our foreign lender a day before reporting date, when the spot
rate was LC15: FC1, we recognise the payment measured at LC30 000 (FC2 000 x LC15).
The payment of LC30 000 will be journalised as: Debit: Loan liability and Credit Bank.

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x If some or all of the loan remains unpaid at reporting date, we would have a monetary item
(loan liability or loan asset, depending on whether we borrowed or lent the money). As with all
other monetary items, a loan balance (whether it is a liability or asset) is first calculated in the
foreign currency and then translated into the local currency.
For example: Using our example so far, the loan liability balance, denominated in foreign currency,
would be FC9 000 (FC10 000 capital + FC1 000 interest accrued - FC2 000 paid).
This foreign currency denominated balance is then translated at the spot rate on reporting date
(i.e. at the closing rate).
For example: If the spot exchange rate on reporting date was LC16: FC1, our loan liability balance
should be measured at LC144 000 (Foreign currency balance: FC9 000 x Closing spot rate LC16).
 However, our loan liability balance currently reflects LC104 000 (LC120 000 capital +
LC14 000 interest payable ± LC30 000 paid).
 This means our loan liability balance is currently understated by LC40 000 (what the liability
balance should be: LC144 000 ± what the liability balance currently is: LC104 000).
 This difference of LC40 000 has arisen because we have been using various exchange rates
to account for different aspects of our loan:
 we used the spot rate on date of receipt of the loan,
 we used the average spot rate used to account for the interest incurred; and
 we used the spot rate on date of repayment of the loan capital).
 Thus, when increasing the loan liability, we recognise the adjustment as an exchange rate loss.
 This would be journalised as:
 Credit Loan liability, increasing its balance by LC40 000 (to reflect LC144 000); and
 Debit Foreign exchange loss, to show the overall unfavourable movement in exchange rates.

Summary: If we are, for example, the borrower in a loan transaction 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 gain or loss.

This is best explained by way of an example:

Example 11: Foreign loan received
2Q-DQXDU\; WUDQVDFWLRQGDWH %UL[¶Q6WRQHV/LPLWHGD6RXWK$IULFDQEULck 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 LQWR%UL[¶Q6WRQHV/LPLWHG¶VEDQNDFFRXQWRQ January 20X4.
x The interest rate on the loan was 7,931% p.a.
x %UL[µQ6WRQHVLVUHTXLUHGWRmake repayments on the loan of EUR25 000 annually in arrears, with
the first payment falling due on 31 December 20X4.
%UL[¶Q6WRQHV/LPLWHGKDVWKH=$5 6RXWK$IULFDQ5DQG DVLWVIXQFWLRQDOFXUUHQF\
The currency used in the Cayman Islands is the EUR (Euro).
%UL[µQ6WRQHV/LPLWHGKDV a 31 December financial year-end.
Relevant exchange rates are: Date Spot rates Average rates
01 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 %UL[ ¶Q 6WRQHV
/LPLWHG¶VDFFRXQWLQJUHFRUGVIRUWKH\HDUVHQGHG'HFHPEHU;DQG'HFHPEHU;

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Solution 11: Foreign loan received

Comment: Notice how:
x the loan capital received (loan principal) is translated at the spot rate on transaction date (TD);
x the interest expense 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
Long-term loan (L) 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 so 52 380
Long-term loan (L) 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
Long-term loan (L) 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 so 84 247
Foreign exchange gain (I) 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

W1: 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

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Required: Show the journals to record the above loan in IncrediEOH/LPLWHG¶VDFFRXQWLQJUHFRUGVfor 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.

1 January 20X5 Debit Credit

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 (I) 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 (I) 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 = 44 301

W1: 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)

3.8 Subsequent measurement: non-monetary items (IAS 21.23 - 26)

Foreign currency can affect non-monetary items (e.g. expenses prepaid and plant) in two
basic ways:
Non-monetary items are
x Local currency denominated non-monetary items: described as items:
A non-monetary item, the purchase of which had x that do not have a right to
been denominated in a foreign currency, would have receive/ an obligation to deliver
been initially measured by converting it into the x a fixed or determinable number of
units of currency. IAS 21.16 (slightly reworded)
local currency at the spot rate on transaction date. At
this point we say it is now denominated in the local currency (called the functional
currency). Since this item is now already measured for in the local currency, there is no
need to translate it into the local currency at a later date. See IAS 21.21

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x Foreign currency denominated non-monetary items:

A 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 HQWLW\¶VORFDl currency (i.e.
into the local HQWLW\¶VIXQFWLRQDOFXUUHQF\ . 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 on the date when this other value was determined. See IAS 21.23(b) and (c)
What spot rate to use
The subsequent measurement of non-monetary items when translating a foreign
that 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:
by subsequent changes in exchange rates. x CA based on historic cost,
x use the spot rate on original
For example, where the purchase of an item of plant is transaction date.
See IAS 21.23 (b) & .25 (a)
denominated in a foreign currency, this is converted into the
If you’re translating:
local currency on transaction date and the plant is then x CA that represents FV, a NRV or a RA
measured in terms of IAS 16 Property, plant and equipment x use the spot rate on the date
this value was determined (e.g.
without any subsequent foreign currency adjustments.
closing 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 if the measurement of the item depends
on the comparison of two or more amounts. This happens when, for example:
x its cost or carrying amount is translated at the spot rate on transaction date; whereas
x its net realisable value or recoverable amount, for example, is translated at the spot rate on,
for example, reporting date.

Examples: of foreign currency denominated non-monetary items that could be affected by

changing exchange rates include:
x investment properties measured under the fair value model: for example, its previous carrying
amount, at fair value translated at the spot rate when that fair value was determined, is remeasured
to its latest fair value at reporting date (translated at the spot rate at reporting date);
x property, plant and equipment measured using the revaluation model, where its previous carrying
amount is remeasured to fair value at reporting date (translated at the spot rate at reporting date);
x property, plant and equipment measured using the cost model or revaluation model,
where its previous carrying amount may need to be impaired to its recoverable amount at
reporting date (translated at the spot rate at reporting date); and
x inventory, where its previous carrying amount may need to be written down to its net
realisable value at reporting date (translated at the spot rate at 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

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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 HQWLW\¶Vjournals 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.
1 January 20X1 Debit Credit
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
Foreign creditor (L) 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
Payment of foreign creditor
31 December 20X1
Depreciation: plant (E) (R600 000 ± 0) / 5 years 120 000
Plant: accumulated depreciation (-A) 120 000
Depreciation of plant
31 December 20X2
Depreciation: plant (E) (R600 000 ± 0) / 5 years 120 000
Plant: accumulated depreciation (-A) 120 000
Depreciation of plant
Impairment loss (E) CA: 600 000 ±120 000 ±120 000 40 000
Plant: accumulated impairment 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; functional currency is Pounds); and
B. in the books of the South African entity (the local entity; functional currency: Rands).

Solution 14: Non-monetary item:

Measurement of inventory owned by a foreign branch
Comment on Part A: Notice how, in the foreign EUDQFK¶VERRks, the inventory is written down because
the net realisable value in Pounds is less than the carrying amount in Pounds.

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Comment on Part B: The British branch recognises a write-down whereas the South African branch does not.
x There is no write-down of invHQWRU\LQWKH6$HQWLW\¶VERRNVEHFDXVHWKHQHWrealisable 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!
Part A Part B
Pounds (£) Rands (R)
1 January 20X1 Debit/(Credit) Debit/ (Credit)
Inventory (A) A: Given: £100 000 100 000 1 000 000
Bank (A) B: £100 000 x R10 (100 000) (1 000 000)
A: Purchased inventory from a local supplier (British); or
B: Purchased inventory from a foreign supplier (translated at spot rate)
31 December 20X1
Inventory write-down (E) A: £100 000 ± £90 000: See W1 10 000 N/A
Inventory (A) B: No write-down applicable: See W1 (10 000) N/A
A 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) NRV is less than CA, therefore a write-down is needed (1) (2)
(2) NRV is greater than CA, therefore no write-down is processed

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. The plant is depreciated, straight-line, to a nil residual
value over 5 years. The recoverable amount was calculated on 31 December 20X2: $70 000.
Date Spot rates: (Rand: Dollar)
1 January 20X1 R12.0: $1
31 December 20X1 R10.7: $1
31 December 20X2 R10.0: $1
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 Part A: Notice how:
x In the foreign EUDQFK¶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 ($100 000 ± 20 000 ± 20 000).
x There are obviously no exchange differences in this example since the purchase in Dollars is
recorded in Dollars in the books of the United States branch.
Comment on Part B: Notice how:
x The South African entity reflects an impairment loss on the plant despite the fact that, in Dollar terms,
the plant is not impaired! This is because of the change in the exchange rate.
- WKH UHFRYHUDEOH DPRXQW LQ WKH 6$ HQWLW\¶V ERRNV LVPHDVXred 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!

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Part A Part B
Dollars ($) Rands (R)
1 January 20X1 Debit/ (Credit) Debit/ (Credit)
Plant: cost (A) A: Given: $100 000 100 000 1 200 000
Bank (A) B: $100 000 x R12 (100 000) (1 200 000)
Purchased plant
31 December 20X1
Depreciation: plant (E) A: ($100 000 ± 0) / 5 yrs 20 000 240 000
Plant: acc depr (-A) B: (1 200 000 ± 0) / 5 yrs (20 000) (240 000)
Depreciation of plant
31 December 20X2
Depreciation: plant (E) A: ($100 000 ± 0) / 5 yrs 20 000 240 000
Plant: acc depr (-A) B: (1 200 000 ± 0) / 5 yrs (20 000) (240 000)
Depreciation of plant
Impairment loss (E) A: N/A: see W1 N/A 20 000
Plant: acc imp loss (-A) B: 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: Check for possible impairment Dollars Rands

Carrying amount: 31/12/20X2 A: $100 000 x 3 / 5 yrs 60 000 720 000

B: $100 000 x 3 / 5 yrs xR12
Recoverable amount: 31/12/20X2 A: Given: $70 000 70 000 700 000
B: $70 000 x R10
Impairment: 31/12/20X2 N/A 20 000

3.9 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 unGHU ,$6 ¶V UHYDOXDWLRQ PRGHO RU investment property
measured at fDLUYDOXHXQGHU,$6¶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.
The plant is depreciated to a nil residual value over 5 years using the straight-line method.
The plant was revalued on 31 December 20X2 to $110 000 using the net method.
Date Spot rates
1 January 20X1 R12.00: $1
31 December 20X1 R10.70: $1
31 December 20X2 R10.00: $1

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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 on Part 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.
Comment on Part 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).

Part A Part B
$ R
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
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)
Depreciation of plant
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)
Depreciation of plant

31 December 20X1
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)
NRVM: set-off of accumulated depreciation before revaluation
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

4. Presentation Currencies and Functional Currencies (IAS 21.8 ± 14)

4.1 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. HowevHU,$6UHTXLUHVWKDWDQHQWLW\¶VWUDQVDFWLRQVDQG
balances be measured LQWKDWHQWLW\¶VIXQFWLRQDOFXUUHQF\7KXV, it is important that entities know how to
correctly establish their functional currencies. AQHQWLW\¶VIXQFWLRQal and presentation currency is often
the same currency, but where it is not the same, a translation reserve will arise.

4.2 Determining the functional currency (IAS 21.9 ± 12)

An entity determines its functional currency (a defined term, Functional currency is
see pop-up) based on a number of factors, outlined below. defined as:
We are not able to choose our functional currency. It must be x the currency of the
based on the µprimary economic environment in which the x primary economic environment
entity operates¶, which is usually the environment in which it x in which the entity operates. IAS 21.8

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primarily generates and expends cash.

In determining its functional currency, an entity must consider the following factors:
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 entit\¶VFLUFXmstances have changed so significantly that the above factors
would result in a different functional currency being more appropriate. See IAS 21.13

4.3 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¶V 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

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.

4.4 Using a presentation currency other than functional currency (IAS 21.38 - 41)

An entity may choose to present its financial statements

Presentation currency is
in any currency of its choice (presentation currency).
defined as:

However, if an entity chooses to present its financial x the currency in which the
x financial statements are presented.
statements in a currency other than its functional IAS 21.8
currency, it will have to translate all its items from the
functional to the presentation currency at year end.

The following procedure (often referred to as the closing rate method) is used to translate an
HQWLW\¶VWULDOEDODQFHLQWRDSUHVHQWDWLRQFXUUHQF\ 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 
presentation currency,
spot rate available at the dates of the various translate:
transactions (for practical purposes, it is often
x assets & liabilities @ spot rate at
acceptable to use the average rate for the
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 (in an account that is referred to as the µforeign currency
translation reserve¶, being an equity account). See IAS 21.39

Chapter 20 979
Gripping GAAP Foreign currency transactions

4.4.1 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 do not affect future cash flows (i.e. they are just book entries), they
are not recognised in µprofit or loss¶, but rather in µother comprehensive income¶ (accumulated in equity).

Example 17: Foreign currency translation reserve

StickyFingers Limited, a sweet manufacturer in NeverNever Land, has a functional currency of
&KRFFD¶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
Cost of sales 733 200
Operating expenses 407 000
Taxation 439 300
3 698 800 3 698 800
Required: Translate this trial balance into the presentation currency.

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).

980 Chapter 20
Gripping GAAP Foreign currency transactions

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

5. 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
- GLVFORVH WKH HQWLW\¶V IXQFWLRQDO FXUUHQF\ DQG WKH Pethod of translation used to
determine the supplementary information.

Chapter 20 981
Gripping GAAP Foreign currency transactions

6 Summary

Foreign currency transactions

Functional currency Foreign currency Presentation currency

This is the currency
x used in the primary
economic environment; &
x that we must use in our
own records (i.e. all
transactions/ balances
must be measured in the
functional currency)
This is a currency
x other than
x the functional currency
x This is the currency we
present our financial
statements in
x The presentation currency
may be any currency
x Functional currency is
translated into
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:
x 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

982 Chapter 20
 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 2021)
Contents: Page
1. Introduction 986
2. Scope of IFRS 9 986
3. Financial instruments 987
4. Financial assets 987
4.1 Financial assets: identification 987
Example 1: Financial assets 988
Example 2: Financial assets versus financial instruments 988
4.2 Financial assets: recognition 989
4.3 Financial assets: classification 989
4.3.1 Overview of the different classifications 989
4.3.2 Overview of the classification process 989
4.3.3 Classification: financial assets at amortised cost 990
4.3.4 Classification: financial assets at fair value through OCI ± debt instruments 990
4.3.5 Classification: financial assets at fair value through profit or loss 991
4.3.6 Classification: financial assets at fair value through OCI ± equity investments 991
4.3.7 Classification process ± a diagrammatic summary 992
4.3.8 The contractual cash flows criteria 993
Example 3: Classifying financial assets ± considering the cash flows 993
4.3.9 The business model criteria 994
Example 4: Classifying financial assets ± considering the business model 995
4.4 Financial assets: measurement overview 996
4.5 Financial assets: initial measurement 996
4.5.1 Initial measurement: fair value and transaction costs 996
4.5.2 Initial measurement: fair value and day-one gains or losses 997
4.6 Financial assets: subsequent measurement 998
4.6.1 Overview 998
4.6.2 Subsequent measurement: Financial assets at amortised cost 999
4.6.2.1 If the financial asset is not credit impaired 999
Example 5: Calculating the effective interest rate using a calculator 1001
Example 6: Financial assets at amortised cost 1001
4.6.2.2 If the financial asset is credit-impaired 1002
4.6.2.2.1 If the financial asset becomes credit impaired after
initial recognition 1002
4.6.2.2.2 If the financial asset was already credit impaired on
initial recognition 1003
4.6.2.3 If the financial asset is renegotiated or modified 1003
Example 7: Financial assets at amortised cost ± with modification 1003
4.6.3 Subsequent measurement: Financial assets at FVOCI ± debt instruments 1004
Example 8: Debentures at fair value through other comprehensive income 1005
Example 9: Financial assets at FVOCI-debt (foreign currency treatment) 1006
4.6.4 Subsequent measurement: Financial assets at FVOCI ± equity instruments 1008
Example 10: Financial assets at fair value through OCI ± equity 1009
4.6.5 Subsequent measurement: Financial assets at fair value through profit or loss 1010
Example 11: Financial assets at fair value through profit or loss 1010

Chapter 21 983
Gripping GAAP Financial instruments ± general principles

5. Financial assets: Impairments 1011

5.1 Overview 1011
5.2 Explanation of the principles behind the loss allowance 1013
5.3 Expected credit loss model ± the general approach 1014
5.3.1 Assessment of credit risk on initial recognition date 1014
5.3.1.1 Financial assets that are not credit-impaired on initial recognition 1014
5.3.1.2 Financial assets that are already credit-impaired on initial recognition 1014
5.3.2 Re-assessing the credit risk at reporting date 1015
5.3.2.1 Overview 1015
5.3.2.2 Assessing the credit risk 1015
5.3.2.3 The effect of the credit risk assessment at subsequent reporting dates 1016
5.3.2.4 Lifetime expected credit losses 1016
5.3.2.5 12-month expected credit losses 1017
5.4 Measurement of expected credit losses 1017
Example 12: Loss allowances ± comparison of the three stages 1018
Example 13: Loss allowances ± effect of an increase in credit risk 1019
Example 14: Loss allowances ± significant increase in credit risk 1021
5.5 Expected credit loss model ± the simplified approach 1023
Example 15: Expected credit losses ± simplified approach ± trade receivable 1023
Example 16: Expected credit loss measurement ± simplified approach ± measurement
of the expected credit losses using a provision matrix 1024
6. Financial assets: Derecognition 1025
6.1 Overview 1025
6.2 A transfer of a financial asset that qualifies for derecognition 1027
Example 17: Derecognition of financial assets (equity) ± FVOCI & FVPL 1027
Example 18: Derecognition of financial assets (debt) ± amortised cost 1028
6.3 A transfer of a financial asset that does not qualify for derecognition 1029
Example 19: Financial asset that does not qualify for derecognition 1030
6.4 A transfer of a financial asset involving continuing involvement 1030
7. Financial liabilities 1031
7.1 Financial liabilities: Identification 1031
Example 20: Financial liabilities 1031
7.2 Financial liabilities: Recognition 1032
7.3 Financial liabilities: Classification 1032
7.3.1 General classification 1032
7.3.1.1 Overview 1032
7.3.1.2 Held for trading 1033
7.3.1.3 Designated as FVPL 1033
7.3.2 Exceptions to the general classifications 1033
7.4 Financial liabilities: Measurement overview 1034
7.5 Financial liabilities: Initial measurement 1034
7.6 Financial liabilities: Subsequent measurement 1035
7.6.1 Overview 1035
7.6.2 Financial liabilities at amortised cost ± subsequent measurement 1035
Example 21: Financial liabilities at amortised cost 1035
7.6.3 Financial liabilities at fair value through profit or loss ± subsequent measurement 1036
Example 22: Financial liability at FVPL ± no change in credit risk 1037
Example 23: Financial liability at FVPL ± with a change in credit risk 1038
7.6.4 Financial liabilities general classification exceptions: subsequent measurement 1038
7.6.4.1 Financial liabilities due to a derecognition prohibition 1039
7.6.4.2 Financial liabilities due to continuing involvement 1039
7.6.4.3 Financial liabilities that are financial guarantee contracts 1039
7.6.4.4 Financial liabilities: loan commitments at below-market interest rates 1039
7.7 Financial liabilities: Derecognition 1039
7.7.1 Overview 1039
7.7.2 Extinguishment results in the derecognition of the liability 1040
Example 24: Financial liability extinguishment 1040

984 Chapter 21
Gripping GAAP Financial instruments ± general principles

7.7.3 Extinguishment results in derecognition of the liability and recognition of another liability 1040
Example 25: Financial liability: modification lead to extinguishment 1040
7.7.4 Extinguishments using equity instruments after renegotiating terms 1041
Worked example: Debt for equity swaps 1042
8. Reclassifications of financial instruments 1042
8.1 Reclassifications overview 1042
Example 26: Reclassification date 1042
8.2 Reclassifying from amortised cost to fair value through P/L 1043
Example 27: Reclassification of a financial asset from AC to FVPL 1043
8.3 Reclassifying from fair value through P/L to amortised cost 1045
Example 28: Reclassification of a financial asset: FVPL to AC 1045
8.4 Reclassifying from amortised cost to fair value through OCI 1046
Example 29: Reclassification of a financial asset from AC to FVOCI 1047
8.5 Reclassifying from fair value through OCI to amortised cost 1048
Example 30: Reclassification of a financial asset from FVOCI to AC 1049
8.6 Reclassifying from fair value through OCI to fair value through P/L 1051
8.7 Reclassifying from fair value through profit or loss to fair value through OCI 1051
9. Compound financial instruments 1051
9.1 Overview 1051
Example 31: Compound financial instruments: initial recognition & measurement 1053
9.2 Compound financial instruments consisting of convertible instruments 1054
Example 32: Convertible debentures ± theory 1054
Example 33: Convertible debentures ± calculations 1055
Example 34: Compulsorily convertible debentures 1056
9.3 Compound financial instruments consisting of non-convertible preference shares 1057
9.3.1 Overview 1057
9.3.2 Preference shares: dividends 1058
9.3.3 Preference shares: redemptions 1058
Example 35: Non-redeemable preference shares ± discretionary dividends 1061
Example 36: Non-redeemable preference shares ± mandatory dividends 1061
Example 37: Non-redeemable preference shares ± mandatory & discretionary dividends 1062
Example 38: Redeemable preference shares ± discretionary dividends 1063
10. 6HWWOHPHQWLQHQWLW\¶VRZQHTXLW\LQVWUXPHQWV 1064
([DPSOH6HWWOHPHQWLQHQWLW\¶VRZQHTXLW\LQVWUXPHQWV 1064
11. Interest, dividends, gains and losses 1065
12. Derivatives 1066
12.1 Overview 1066
12.2 Options 1066
12.3 Swaps 1067
Example 40: Swaps 1067
12.4 Futures and forwards 1067
12.5 Embedded derivatives 1067
Example 41: Hybrid instruments 1068
13. Offsetting of financial assets and liabilities 1069
14. Deferred tax consequences of financial instruments 1069
14.1 Overview 1069
14.2 Financial assets and liabilities subsequently measured at amortised cost 1070
14.3 Financial assets subsequently measured at fair value 1070
Example 42: Deferred tax consequences of financial assets 1070
15. Financial risks 1071
15.1 Overview 1071
15.2 Market risk 1071
15.2.1 Interest rate risk 1072
15.2.2 Currency risk 1072
15.2.3 Price risk 1072
15.3 Credit risk 1072
15.4 Liquidity risk 1072
16. Disclosure 1072
17. Summary 1075

Chapter 21 985
 Gripping GAAP Financial instruments ± general principles

1. Introduction

IFRS 9 Financial instruments essentially deals with:

x the classification and measurement of financial instruments,
x impairment of financial assets and Financial instruments is
x hedge accounting. affected by 3 standards:
x IFRS 9
Hedge accounting is explained in chapter 22. x IAS 32
x IFRS 7
Apart from IFRS 9, there are two other standards that also deal with financial instruments:
x IAS 32 Financial instruments: presentation; and
x IFRS 7 Financial instruments: disclosures.

IAS 32 provides some essential definitions and clarification that IFRS 9 deals with:
assist in: x Classification and
x identifying whether an item is a financial instrument, measurement of
financial instruments
x whether it should be presented as a financial asset, financial
x Impairment of
liability or equity instrument and financial assets
x whether a financial asset and financial liability may be offset x Hedge accounting (this
against each other. aspect is covered in ch 22)

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 both this chapter and in chapter 23 on 'share
capital'.

IFRS 7 explains the disclosures requirements. These help us ensure our users will be able to assess our:
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.

2. Scope of IFRS 9 (IFRS 9.2.1)

IFRS 9 applies to most financial instruments, although the following are some of the µscope exclusions¶:
x Rights and obligations to which IFRS 15 Revenue from contracts with customers applies, except to the
extent that IFRS 15 specifically states that IFRS 9 must apply.
x Rights and obligations to which IFRS 16 Leases applies, however, in terms of:
Lessors: Lease receivables are subject to the impairments and derecognition requirements of IFRS 9.
Lessees: Lease liabilities are subject to the derecognition requirements of IFRS 9.
x EmployerV¶ULJKWVDQGREOLJDWLRQs XQGHUµHPSOR\HHEHQHILWSODQV¶per IAS 19 Employee benefits.
x Equity instruments, as defined by IAS 32, that are issued by the entity.
x Rights to receive reimbursements for expenditure that will be required to settle an obligation that has
been recognised as a provision in terms of IAS 37 Provisions, contingent liabilities and contingent assets
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 Certain loan FRPPLWPHQWVWKRXJKDOOORDQFRPPLWPHQWVDUHVXEMHFWWR,)56¶VGHUHFRJQLWLRQ
SULQFLSOHVDQGDOOORDQFRPPLWPHQWVLVVXHVDUHVXEMHFWWR,)56¶VLPSDLUPHQWWHVWLQJ
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

986 Chapter 21
 Gripping GAAP Financial instruments ± general principles

3. Financial Instruments (IAS 32.11)

A financial instrument is defined as:

any contract that gives rise to a:

Financial asset AND Financial liability or equity instrument

of one entity of another entity. IAS 32.11
(Section 4) (Section 7 and 9)

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 DIRUPRIµmatching¶, where one entity
has a financial asset (for example, the right to receive cash) and another entity has a financial
liability or equity instrument (for example, an 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
(see section 4), 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.

4. Financial Assets (IFRS 9.4.1.1 ± 4.1.5)

4.1 Financial assets: identification (IAS 32.11)

A financial asset is defined as
For an item to be identified as a financial asset, it must x cash,
meet the definition of a financial asset (see pop-up x an equity instrument of another entity
alongside). The definition states that WKHWHUPµfinancial x a contractual right to:
asset¶ZRXOG include any asset that is: - receive cash or another financial
asset from another entity; or
a) Cash ± this is because cash is at the root of all our - exchange financial assets or financial
transactions ± it is 'the medium of exchange' and liabilities with another entity under
the 'basis on which all transactions are measured conditions that are potentially
and recognised'. See IAS 32.AG3 favourable to the entity; or
x certain contracts to be settled in
Interestingly, cash invested in a bank account would the entity's own equity instruments.
also meet part (c) of the financial asset definition, since IAS 32.11 (summarised)

a cash deposit in the bank gives the entity a contractual

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 (however, the issuer of
these shares would recognise the shares as equity instruments).
c) Contractual rights that give the entity the right:
- µto receive cash or any other financial asset from another entity¶.
For example, accounts receivable is normally a financial asset because it gives the entity
the contractual right to receive payment in cash. However, it is possible that this right to
receive payment may involve a payment in something other than cash. In this regard, 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 have a contractual right to receive cash or any other financial
asset. Similarly, for this same reason, a prepaid expense would not be a financial asset.

Chapter 21 987
 Gripping GAAP Financial instruments ± general principles

- µTo exchange financial assets or financial liabilities under conditions that are 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) DFRQWUDFWWKDWZLOORUPD\EHVHWWOHGLQWKHHQWLW\¶VRZQHTXLW\LQVWUXPHQWVDQGLV
- µa non-derivative for which the entity is or may be obliged to receive a variable number of the
HQWLW\¶VRZQHTXLW\LQVWUXPHQWV¶ (see section 9.2); or
- µa 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 QXPEHURIWKHHQWLW\¶VRZQHTXLW\LQVWUXPHQWV'.
*: A derivative is simply a financial instrument whose value depends on the value of another
item. For example: an µoption¶ to buy oil at a certain price in the future is a derivative, because
it is a financial instrument that becomes more or less valuable depending on what price the
oil price is currently trading at (see section 12). Extracts from IAS 32.11: Financial asset & IFRS 9 App A: Derivatives
The situations described in (d) above may sound confusing because it refers to the entity
expecting to receive its own equity instruments in settlement of a receivable (either a variable
number or a fixed number of its own shares). In essence, the substance of the transaction is that
the entity is expecting to receive its own equity instruments back as 'currency'. Transactions that
involve an entity expecting to receive its own shares in settlement of a receivable is fairly rare
and it is more likely that the entity might expect to settle an obligation by paying with its own
shares (see section 7.1 and section 10).

Example 1: Financial assets

Discuss whether any of the following meet the definition of a µfinancial asset¶:
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. $ULJKWWRUHFHLYHDVPDQ\RIWKHHQWLW\¶VRZQHTXLW\LQVWUXPHQWVDVHTXDOV&
g. $ULJKWWRUHFHLYHDVPDQ\RIWKHHQWLW\¶VRZQHTXLW\LQVWUXPHQWVDVHTXDOVWKHmarket
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).
b. Gold is not 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 reflect a contractual 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 (electricity).
f. $ULJKWWRUHFHLYHDVPDQ\RIWKHHQWLW\¶VRZQHTXLW\LQVWUXPHQWVDVHTXDOV&is a financial asset. This
is because the right is a non-derivative that will be settled by the exchange of a variable number of the
HQWLW\¶VRZQHTXLW\LQVWUXPHQWV (part (d) (i) of the definition).
g. $ULJKWWRUHFHLYHDVPDQ\RIWKHHQWLW\¶VRZQHTXLW\LQVWUXPHQWVDVHTXDOVWKHmarket value of 100 barrels
of crude oil is a financial asset. This is because the contract is a derivative (the value of the contractual
right is dependent on the market value of crude oil) and it will be settled by the exchange of a variable
number 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.

988 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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 (IAS 32.11(a)) 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

4.2 Financial assets: recognition (IFRS 9.3.1.1) Financial assets are

recognised when the
Financial assets are initially recognised when, and only when, the entity becomes party to
the contractual provisions of
entity becomes party to the contractual provisions of the instrument. the financial instrument.
Interestingly however, this may not result in an amount being
recognised! This happens if the financial asset is a derivative: derivatives often have a nil value on initial
recognition, with their subsequent value being derived over time by reference to another item (e.g. the
gold price) (see section 12 for more about derivatives).

4.3 Financial assets: classification (IFRS 9.4.1.1 ± 4.1.5)

There are four
4.3.1 Overview of the different classifications classification models of
FAs:
Financial assets are essentially classified into two basic measurement amortised cost and three
models of amortised cost and fair value. However, there are actually variations based on fair value.
four formal classifications due to the three possible accounting treatments 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 measure amortised cost and fair value is explained in section 4.4.

4.3.2 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) will generally pass the test. The
assessment of cash flow characteristics is explained in detail in section 4.3.8.

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 4.3.9.

Chapter 21 989
 Gripping GAAP Financial instruments ± general principles

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 4.3.5), the asset
may be designated at FVPL instead (although this designation can only happen on initial
recognition and is irrevocable). Please see section 4.3.7 for the summary diagram.

4.3.3 Classification: Financial assets at amortised cost (IFRS 9.4.1.2)

A financial asset shall be classified as amortised cost (AC) if Financial assets

both the following conditions are met: classified at AC:
x The contractual cash flows: the contractual terms of the asset This classification only applies to
must give rise to cash flows on specified dates and these cash investments in debt instruments:
x CCF = specified dates & SPPI; &
flows must be solely payments of principal and interest on the
x BM = held to collect CCF.
principal amount outstanding (i.e. SPPI); & See IFRS 9.4.1.2

Note: if classifying at AC leads to

x The business model: the objective of the business model an accounting mismatch, it may
relevant to this asset must be to collect contractual cash flows be classified at FVPL instead.
(i.e. no intention to trade in the instruments). See IFRS 9.4.1.2 See IFRS 9.4.1.5

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 4.3.5).

4.3.4 Classification: Financial assets at fair value through other comprehensive income
– debt instruments (IFRS 9.4.1.2A)
Financial assets
classified at FVOCI –
A financial asset shall be classified as fair value through other debt:
comprehensive income (FVOCI) if both the following conditions are
met (which means, by implication, that the asset will be an This classification only applies to
investments in debt instruments:
investment in some kind of debt instrument e.g. a loan asset): x CCF = specified dates & SPPI; &
x The contractual cash flows (CCF): the contractual terms of x BM = held to collect CCF and sell.
See IFRS 9.4.1.2A

the financial asset must give rise on specified dates to cash Note: if classifying at FVOCI leads
flows that are solely payments of principal and interest on to an accounting mismatch, it
may be classified at FVPL instead.
the principal amount outstanding (i.e. SPPI); and See IFRS 9.4.1.5

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 4.3.5). 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 instruments 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 4.3.6).

990 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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 4.6.3.

4.3.5 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. 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 may be recognised in different
periods and would be measured on different bases. To avoid this, one is able to choose to designate
the asset to be measured at FVPL instead of amortised cost. 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 (AC) Financial assets
and does not meet the criteria for classification as fair value through classified at FVPL:
other comprehensive income (FVOCI-debt), i.e.: x This classification applies to any
- the contractual terms do not lead to cash flows on specified FA that does not meet the
requirements to be classified as
dates that are solely payments of principal and interest on AC or FVOCI See IFRS 9.4.1.4
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 'hold to mismatch. See IFRS 9.4.1.5
collect and sell' (i.e. the objective of the business model is to Note: some equity investments
'hold to sell') (i.e. the BM test fails); or that meet these requirements may
be designated as FVOCI-equity
x the entity chooses to designate the asset as FVPL because instead.
another classification would have caused an accounting See IFRS 9

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 depending on the circumstances.
See section 4.3.6.

The measurement of this classification is explained in section 4.6.5.

4.3.6 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 through at FVOCI – equity:
other comprehensive income (FVOCI-equity) is regarded as a fourth
This classification is one that may
classification because the measurement thereof differs from the be elected if the FA is an:
measurement of the classification of fair value through other x investment in equity instruments that is
comprehensive income (FVOCI-debt) described in section 4.3.4. x not held for trading &
x not contingent consideration in an
IFRS 3 business combination
The FVOCI-debt classification only involves investments in debt This election is
instruments and is a mandatory classification (i.e. if the requirements x only possible on initial recognition
are met, the debt instrument must be classified at FVOCI). In contrast, x irrevocable. See IFRS 9.4.1.4 and IFRS 9.5.7.5
the FVOCI-equity classification described in this section involves only Reclassification to P/L: prohibited.
See IFRS 9.5.7.5 & B5.7.1
investments in equity instruments and is purely an elective
classification.

Chapter 21 991
 Gripping GAAP Financial instruments ± general principles

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 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.

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
ORVV¶ 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.

The measurement of this classification (FVOCI-equity) is explained in section 4.6.4.

4.3.7 Classification process – a diagrammatic summary

Step 1: CCF Test (contractual cash flows)

No Yes
Do the contractual terms of the FA give rise, Is it a derivative?
x on specified dates, No
x to cash flows that are SPPI i.e. solely payments of:
Is it an investment in No
x principal and
an 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 collect Yes
FV through P/ L

collect'? and sell'?

i.e. is the objective to
collect only the:
x contractual cash flows
(i.e. the entity does
not intend dealing in
the instruments)
FV through OCI
i.e. is the objective to (equity instrument)
collect both the:
x contractual cash flows; &
x cash flows from selling
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)

992 Chapter 21
 Gripping GAAP Financial instruments ± general principles

Let us now look in more detail at the issues surrounding the contractual cash flows and then the
business model and its characteristics.

4.3.8 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 µprincipal sum¶ and µinterest 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) &LVDQLQYHVWPHQWLQDERQGFRQYHUWLEOH DWWKHRSWLRQRIWKHKROGHU LQWRDIL[HGQXPEHURIWKHLVVXHU¶V
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.

Chapter 21 993
 Gripping GAAP Financial instruments ± general principles

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) 7KH&&)633,7KHSD\PHQWVUHFHLYHGZLOOQRWEHVROHO\SULQFLSDODQGLQWHUHVWRQWKHSULQFLSDO
EHFDXVHWKHSULQFLSDOLVQRWJXDUDQWHHGWREHUHSDLGLQFDVK«LWFRXOGFRPHEDFNDVVKDUHVLQVWHDG
in which case the holder would be exposed to the value of the ordinary shares.
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) 7KH&&)633,$OWKRXJKWKHERQGLQYROYHVUHSD\PHQWRISULQFLSDODQGLQWHUHVWDVDUHVXOWRI 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).

4.3.9 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 WKHEXVLQHVVPRGHO¶VREMHFWLYHPD\EHWRKROGILQDQFLDODVVHWVLQRUGHUWRFROOHFW

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 8 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

994 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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

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
GRFXPHQWHGLQWKHHQWLW\¶VLQYHVWPHQWSROLF\

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
HQWLW\¶VDELOLW\WRFROOHFWFRQWUDFtual 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
GHULYDWLYHVWRSURWHFWLWVLQWHUHVWFDVKIORZVGRHVQRWGHWUDFWIURPWKHIDFWWKDWWKHHQWLW\¶VEXVLQHVVPRGHO
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) (QWLW\$ V%0 KROGWRVHOO(QWLW\$¶VEXVLQHVVPRGHOLQYROYHVWUDGLQJWKHDVVHWVUDWKHUWKDQFROOHFWLQJ

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.

Chapter 21 995
 Gripping GAAP Financial instruments ± general principles

Entity B's BM = hold to collect. EQWLW\%¶VEXVLQHVVPRGHOLQYROYHVFROOHFWLQJWKHFRQWUDFWXDOFDVKIORZV,

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.

4.4 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 µfair value¶, although, depending on their
classification, some are adjusted for transaction costs. See section 4.5.1.
However, a trade receivable (i.e. a receivable arising from revenue in terms of IFRS 15; see
chapter 4) may have to be measured at its µtransaction price¶ . See section 4.5.1.
 A day-one gain or loss arises if the fair value does not equal the transaction price.
This LV HLWKHU UHFRJQLVHG LQ SURILW RU ORVV RU DV SDUW RI WKH DVVHW¶V FDUU\LQJ DPRXQW
depending on the reliability of the fair value measurement. See section 4.5.2.
x Subsequent measurement:
 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 4.6.
 Impairment losses must also be recognised on financial assets subsequently measured at
AC and FVOCI-debt. IFRS 9 uses WKHµH[SHFWHGFUHGLWORVV¶ 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
DµFUHGLWHYHQW¶RFFXUV A loss allowance is recognised and measured at each reporting date
to reflect the latest estimate of the expected credit losses, based on updated information
UHJDUGLQJWKHDVVHW¶VFUHGLWULVN The application of this model (i.e. how to journalise the loss
allowance) is described in section 4.6. However, a more detailed explanation, including how
to measure the loss allowance, is given in section 5.

Fair value is defined as: Amortised cost of a financial asset/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
- paid to transfer a liability initial recognition minus the principal repayments
x in an orderly transaction x Less/add: cumulative amortisation using the
between market participants effective interest rate method to account for the
x at measurement date. IFRS 13.9 difference 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)

4.5 Financial assets: initial measurement (IFRS 9.5.1)

4.5.1 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).

996 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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 do have 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 In the unusual event that the transaction price does not equal fair value, we have what is called a
day-one gain or loss. In certain situations, this gain or loss must be deferred, which will mean we
effectively measure the asset at transaction price. See section 4.5.2

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

Transaction costs relating to a financial asset are, by definition (see pop-up), the incremental costs that
are directly attributable to its acquisition or disposal. Incremental costs are, by definition (see pop-up),
costs µWKDWZRXOGQRWKDYHEHHQLQFXUUHG¶LIWKHILQDQFLDOasset KDGQRWEHHQµDFTXLUHGRUGLVSRVHGRI¶.
Transaction costs are defined
Transaction costs: as:
x include payments made, for example, to: x incremental costs that are
x directly attributable to the acquisition,
- agents or brokers in respect of their commissions/ fees; issue or disposal of a FA/FL.
- regulatory agencies and securities exchanges for levies; or An incremental cost is defined as a cost that:
- government bodies in respect of transfer taxes and duties. x would not have been incurred
x if the entity had not acquired, issued or
x exclude costs such as: disposed of the fin instrument. IFRS 9 App A
- internal administration or holding costs, e.g. the monthly fee
charged for servicing loans;
- debt premiums; or
- financing costs. See IFRS 9.B5.4.8

4.5.2 Initial measurement: fair value and day-one gains or losses (IFRS 9.5.1.1A and B5.1.2A)

The fair value at which all financial assets (except trade receivables with no 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 determined either:
- as a quoted price in an active market, referred to as a level 1 input; or
- 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 (fair value)
debit day-one loss expense (P/L): C20 (balancing amount)

Chapter 21 997
 Gripping GAAP Financial instruments ± general principles

x If the fair value measurement was 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
between fair value and the transaction price (i.e. day-one gain or loss) is deferred. We defer it by
recognising the difference as an adjustment directly 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 subsequently reversed out of the asset's carrying amount and recognised
in profit or loss, but only to the extent µit arises from a change in a factor (including time) that market
participants would take into account 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:
DebitµILQDQFLDODVVHW¶ (A): C100 (fair value)
DebitµILQDQFLDODVVHWGHIHUUHGGD\-RQHORVV¶ (A): C20 (balancing amount)
Credit bank: C120,
The net effect is that the µfinancial asset¶ is measured at its transaction price of C120 (FV 100 + deferred
loss C20). This deferred loss may be subsequently reversed out of the asset and expensed in profit or
loss (by crediting the µfinancial asset deferred loss¶DQGdebiting the µday-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)

4.6 Financial assets: subsequent measurement (IFRS 9.5.2 - 3)

4.6.1 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 µgross carrying amount¶, (measured using the effective interest rate method) and its µloss allowance¶
(measured at expected credit losses). These two accounts are set-off against each other:
Gross carrying amount (measured using the effective interest rate method): This account has a debit
Initial fair value, including transaction costs, balance
Plus interest income (at the effective interest rate)
Less repayments
Less: Loss allowance for expected credit losses This account has a credit
x Measured at expected credit losses balance
Net carrying amount (Amortised cost)
x Assets that are equity instruments classified at fair value through other comprehensive income
(FVOCI ± equity) will be measured and presented at fair value.
All fair value adjustments are recognised as gains or losses in other comprehensive income.
These gains or losses may never be reclassified to profit or loss.
There is no loss allowance.
x Assets that are debt instruments classified at fair value through other comprehensive income (FVOCI
± debt) will be measured and presented at fair value. However, the asset is first measured as if it were
classified as an amortised cost asset, using the effective interest rate method, and then LW¶VFDUU\LQJDPRXQW
(gross carrying amount) is revalued to fair value.
The fair value adjustments are recognised as gains or losses in other comprehensive income.
These gains or losses will be reclassified to profit or loss, but only when the asset is eventually derecognised.
This classification involves a loss allowance.
x Assets that are classified at fair value through profit or loss (FVPL) will be measured and presented at
fair value. The fair value adjustments will be recognised as gains or losses in profit or loss.
There is no loss allowance.

998 Chapter 21
 Gripping GAAP Financial instruments ± general principles

Thus, the classification of the financial asset affects its measurement in a number of ways:
x whether the asset is measured at fair value or amortised cost, and whether transaction costs should
be included or expensed.
x whether the asset will require the recognition of a loss allowance.
x whether any fair value gains or losses should be recognised in other comprehensive income.
x whether any fair value 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 (because it is a monetary item);
x in OCI under the FVOCI classification for equity instruments (because it is a non-monetary item).
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

How to journalise a loss allowance is shown within the section on subsequent measurement at
amortised cost (see section 4.6.2) and the section on subsequent measurement of debt
instruments at fair value through other comprehensive income (see section 4.6.3). 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 loss allowance (expected credit losses)
is included in section 5.

4.6.2 Subsequent measurement: Financial assets at amortised cost (IFRS 9.4.1.2; 9.5.4)

4.6.2.1 If the financial asset is not credit-impaired 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 DWµDPRUWLVHGFRVW¶ LHusing 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
method is defined as:
The effective interest rate is the rate that exactly discounts the
future cash flows throughout the life of the financial asset, to x the method that is used in the
the gross carrying amount of the asset (i.e. its present value). - calculation of the amortised
cost of a FA (or FL) and the
- allocation & recognition of the
Please note: when calculating this effective interest rate, we interest revenue (expense) in P/L
must take into account all the cash flows that are expected over the period. See IFRS 9 App A (Reworded)
to arise from the terms of the contract (i.e. the contractual
cash flows) and must ignore WKHIDFWWKDWZHPD\H[SHFWDVDUHVXOWRIWKHDVVHW¶VFUHGLWULVNWKDW
some of these contractual cash flows may not be received (i.e. we ignore expected credit losses).
Section 5 explains how to measure the expected credit losses.

Chapter 21 999
 Gripping GAAP Financial instruments ± general principles

Thus, the effective interest rate method recognises the The effective interest rate is
difference between the future contractual cash flows and the defined as
present value thereof as interest income over the life of the
x the rate that exactly discounts
asset. TKHµSUHVHQWYDOXH¶DWDQ\RQHSRLQWLQWLPHLVreferred x estimated future cash flows
to as WKHµJURVVFDUU\LQJDPRXQW¶DWWKDWSRLQWLQWLPH . through the expected life of the
financial asset
x to the asset’s gross carrying amount.
We measure this interest income by multiplying the
These cash flows are the contractual
opening gross carrying amount (GCA) by the effective cash flows, not adjusted for expected
See IFRS 9 App A (Reworded)
interest rate (EIR): credit losses.

Interest income = GCA x EIR

The asset's closing gross carrying amount is then calculated The gross carrying amount
is defined as:
by adding this effective interest income to the opening gross
carrying amount and subtracting any receipts x the amortised cost of a FA, but
x before adjusting for any loss
Asset¶s closing GCA = allowance.
See IFRS 9 App A (reworded)
Opening GCA + Interest income ± Receipts

The journals to account for the above interest income and cash flows would be as follows:
Debit Financial asset (gross carrying amount)
Credit Interest income (P/L: I)
Income earned on financial asset (interest income at the effective interest rate)

Debit Bank
Credit Financial asset (gross carrying amount)
Receipt of cashflow from financial asset (e.g. interest received at the coupon rate on a corporate bond)

7KHµDPRUWLVHGFRVW¶FODVVLILFDWLRQ also requires the application of IFRS 9¶s impairment requirements:

the expected credit loss model. This µexpected credit loss model¶ involves recognising a loss allowance
and a related µimpairment loss¶ (or reversal). This is journalised as follows:
Debit Impairment loss (E: P/L)
Credit Financial asset: Loss allowance (-A).
Recognising the loss allowance (this is an ‘asset measurement account’ i.e. a ‘negative asset’)

The loss allowance must be measured at each reporting date to reflect the µexpected credit losses¶. We
QRUPDOO\ EDVH WKLV PHDVXUHPHQW RQ WKH HVWLPDWHG µ-PRQWK H[SHFWHG FUHGLW ORVVHV¶ DOWKRXJK
GHSHQGLQJRQWKHVLWXDWLRQWKH\PD\QHHGWRUHIOHFWµOLIHWLPHH[SHFWHGFUHGLWORVVHV¶
How to measure this loss allowance is explained in more detail in section 5.

Assets classified at amortised cost (AC) must obviously be presented at amortised cost7KHµDPRUWLVHG
FRVW¶is the µgross carrying amount¶ (i.e. the balance per your effective interest rate table), less the µloss
allowance¶: See IFRS 9.5.2.2
$VVHW¶VFORVLQJFDUU\LQJDPRXQWat µDmortised 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 4.6.2.2.

Sometimes the terms relating to an asset are renegotiated or modified. Modifications are
explained in section 4.6.2.3.

1000 Chapter 21
Gripping GAAP Financial instruments ± general principles

How to calculate the effective interest rate using a financial calculator:

The EIR is sometimes provided, but in some circumstances, may need to 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.
x The debentures are redeemable at C250 000 on 31 December 20X7.
x Eternity intends to hold them to collect contractual cash flows, thus classifies them at amortised cost.
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. Thus, the loss allowance is to be
measured based on 12-month expected credit losses (12m ECL), estimated 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

1 January 20X5 Dr/ (Cr)

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 12-month ECL (given)
31 December 20X5
Bank Face value: 200 000 x Coupon rate: 10% 20 000
Interest income (I: P/L) W1 (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 12m 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)
FA: Debentures at AC (A) Balancing 15 874
Interest earned on debentures and cash received (EIR method)

Chapter 21 1001
 Gripping GAAP Financial instruments ± general principles

31 December 20X6 FRQWLQXHG« Dr/ (Cr)

Impairment loss (E: P/L) ECL at reporting date: 12 000 – 2 000
FA: Debentures: Loss allowance (-A) Bal in this account: 10 000 (2 000)
Remeasuring the loss allowance to reflect the latest 12m ECLs at reporting date
Notice:
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 7KHDVVHW¶Vnet 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
x If the full interest and redemption is received in 20X7 (Debit Bank and Credit FA), the loss allowance
will simply be reversed (Debit FA: Loss allowance and Credit Impairment loss reversed (I: P/L))

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
(GCA) @16,6386% (GCA)
A B C D
20X5 0
202 000 Note 1
202 000 33 610 Note 2 (20 000) Note 3 215 610
20X6 215 610 35 874 (20 000) 231 484
20X7 231 484 38 516 (20 000) 250 000
(250 000) Note 4 0
108 000 Note 5 (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
receipts (C310 000) is recognised in profit or loss over 3 years as interest income of C108 000.

4.6.2.2 If the financial asset is credit-impaired (IFRS 9.5.4.1-2)

If the asset is credit impaired, the measurement of the financial asset and its related interest income
will differ slightly from the calculation described above. There are two scenarios, explained below:

4.6.2.2.1 If the financial asset becomes credit-impaired after initial recognition

If the financial asset becomes credit-impaired after initial recognition, the effective interest rate
method would involve calculating the effective interest rate LHWKHµQRUPDO¶HIIHFWLYHLQWHUHVW
rate described in section 4.6.2.1), 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 (if asset becomes credit-impaired) = 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-LPSDLUHG HJLIWKHUHLVDQLPSURYHPHQWLQWKHERUURZHU¶V
FUHGLWUDWLQJ WKHQZHZRXOGUHYHUWWRPHDVXULQJWKHDVVHW¶VFDUU\LQJDPRXQWDQGUHODWHGLQWHUHVW
income in the usual way, by applying the effective interest rate to the gross carrying amount:
Interest income (if asset ceases being credit-impaired) = Gross carrying amount x EIR

1002 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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
4.6.2 for more detail. See IFRS 9.5.4.1-2

4.6.2.2.2 If the financial asset was already credit-impaired on initial recognition

If the financial asset was already credit-impaired on initial The credit-adjusted

recognition, the effective interest rate method will involve effective interest rate of a
calculating Dµcredit-adjusted HIIHFWLYHLQWHUHVWUDWH¶ (instead of FA is defined as
WKHµQRUPDO¶HIIHFWLYHLQWHUHVWUDWHGHVFULEHGLQVHFWLRQ4.6.2.1). x the rate that exactly discounts
x estimated future cash flows through
Furthermore, when calculating the effective interest income the expected life of the financial asset
x to the asset’s amortised cost.
on this asset, the credit-adjusted effective interest rate will be
These cash flows are the contractual
applied to the DVVHW¶V amortised cost (gross carrying amount cash flows adjusted for the expected
± loss allowance), (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 (see pop-up for definition) 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 IFRS 9 Appendix $GHILQHGWHUPµFUHGLW-adjusted EIR

Please note, WKLVGLIIHUVIURPWKHFDOFXODWLRQRIWKHµQRUPDO¶effective interest rate which:

x involved GLVFRXQWLQJWKHIXWXUHFDVKIORZVWRWKHILQDQFLDODVVHW¶Vgross 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 4.6.2.1)

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.

When buying a financial asset that is already credit-impaired, the assumption is that the fair value
on initial acquisition would already reflect the expected losses inherent in the asset (i.e. the fair
value and transaction price will have already taken the expected losses into account, and thus the
price will already have been reduced). Thus, there is no loss allowance to recognise on initial
acquisition. Furthermore, the lifetime expected credit losses that existed on initial recognition date,
are already built into the credit-adjusted effective interest rate. For these reasons, the subsequent
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). See IFRS 9.5.5.13

4.6.2.3 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 6. 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%.

Chapter 21 1003
 Gripping GAAP Financial instruments ± general principles

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

1 January 20X6 Debit Credit

FA: Debentures at AC (A) W1 (EIRT) 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) W1 (EIRT) 38 853
FA: Debentures at AC (A) Balancing 18 853
Interest earned on debentures

W1: Effective interest rate table:

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
17 900 Note 2

233 510 Note 1 38 853 Note 3 (20 000) 252 363

20X7 252 363 41 990 (20 000) 274 352
20X8 274 352 45 647 (20 000) 299 999
(300 000) (1) Rounding error

160 100 Note 4 (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 for 20X6, (using the original EIR!) calculated on the revised GCA:
Revised GCA x original EIR = 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.

4.6.3 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 FVOCI – debt instruments
value through other comprehensive income (FVOCI- are measured as follows:
debt), the asset is presented in the statement of financial x Initially at FV plus transaction costs.
position at an amount reflecting its fair value. All fair value x Subsequently measured:
adjustments are recognised in other comprehensive - 1st step: using the EIR method; &
income (OCI). - 2nd step: at FV.
x Tested for impairment
However, the objective of this classification is to provide x Gains or losses due to:
- Changes in FV: recognised in OCI
users with information on both a fair value basis and on
(reclassify to P/L on derecognition),
an amortised cost basis. Thus, before we measure the - Anything else: recognised in P/L.
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

1004 Chapter 21
 Gripping GAAP Financial instruments ± general principles

Debt instruments that are classified as fair value through other comprehensive income (FVOCI-
debt) are also subject to the impairment requirements of IFRS 9. These requirements involve
recognising a loss allowance to reflect the expected credit losses relevant to the asset,
remeasured at each reporting date.

The recognition and measurement of the loss allowance follow the same basic impairment
principles in IFRS 9 that are applied to assets classified at amortised cost (see sections 4.6.2.1-2).
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 µother comprehensive
income¶ DQG QRW DV DQ µDVVHW 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
µloss allowance¶ is recognised in other comprehensive income, the related µloss allowance
adjustments¶ (impairment losses/ reversals) are recognised in profit or loss. See IFRS 9.5.2.2

Thus, the steps to follow for debt instruments classified at FVOCI (FVOCI-debt) are as follows:
Step 1: Measure the asset as if it were classified at amortised cost, and in so doing, recognise
interest income, (as well as foreign exchange gains or losses, refer to section 4.6.1),
presenting them all in profit or loss.
Step 2: Recognise a loss allowance for the expected credit losses. Remember that this loss allowance
is recognised in other comprehensive income (i.e. it is not an asset measurement account ± in
other words, it will not be set-off against the carrying amount of the financial asset). 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

The measurement of the loss allowance is explained in more detail in section 5.

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. Thus, the loss allowance is
measured based on the relevant µ-month expected credit losses¶, estimated 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 31 December 20X6

Solution 8: Debentures at fair value through other comprehensive income

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)

Chapter 21 1005
 Gripping GAAP Financial instruments ± general principles

20X5 20X6
1 January continued « Dr/ (Cr) Dr/ (Cr)
Impairment loss (E: P/L) Given 7 000 N/A
FA: Debentures: Loss allowance (OCI) See note 1 (7 000) N/A
Recognising a loss allowance, measured at the appropriate ECL (given)
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) See note 1 (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)
Note 1: Since the FA was measured at FVOCI-debt, this loss allowance is recognised in OCI and is NOT a
µQHJDWLYHDVVHW¶PHDVXUHPHQWDFFRXQW
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

W1: Effective interest rate table:

x The EIR and EIR table is the same as those shown in the solution to example 6 (Eternity).

Notice: The journals are very similar to those in example 6, however, the loss allowance is now
recognised in OCI and there is an additional journal for the fair value adjustment.

As mentioned previously (section 4.6.1), if our financial asset involves foreign currency (e.g. we
have invested in bonds denominated in a foreign currency), then we must bear in mind the
requirements of IAS 21 The effect of changes in foreign exchange rates. In this regard, IAS 21
requires that the foreign exchange gains or losses on monetary items (e.g. debt instruments)
always be recognised in profit or loss, but that foreign exchange gains or losses on non-
monetary items (e.g. equity instruments) must be recognised in the same component (P/L or
OCI) that any fair value gains or losses are recognised. Thus, since debt instruments are
monetary items, all foreign currency exchange differences will be recognised in profit or loss,
even if the debt instrument is classified at FVOCI, and thus its fair value gains or losses are
recognised in OCI. When dealing with foreign currency denominated transactions, it is
important to do all the calculations (e.g. calculate the effective interest rate and the interest
earned etc) in foreign currency, and only after all amounts have been calculated, translate the
amounts using the relevant exchange rates (e.g. spot rates or average rates etc.). Please see
chapter 20.

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).

1006 Chapter 21
Gripping GAAP Financial instruments ± general principles

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)

20X5 20X6
1 January Dr/(Cr) Dr/(Cr)
FA: Debentures at FVOCI (A) W1 (EIRT) 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) W1 (EIRT) 206 000 266 000
Interest income (I: P/L) W1 (EIRT) (434 459) (545 169)
Interest earned & interest received on debentures
FA: Debentures at FVOCI (A) W1 (EIRT) 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

W1: Effective interest rate table:

Effective interest rate calculation using a financial calculator (calculated in $):
PV: -200 000 FV: +250 000 PMT: 20 000 N: 2 Comp i: ? Answer: i = 21,29703%
Date Amortisation in Exchange rate Amortisation in
foreign currency ($) (Rx: $1) functional currency (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)
Forex gain/(loss) (balancing) - 64 259
GCA: 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)
Forex gain/(loss) (balancing) - 753 113
GCA: 31 December 20X6 250 000 13.3 Note 1 3 325 000
Notes:
1) Foreign currency monetary items are translated using the closing spot exchange rate on
transaction date and at each reporting date (e.g. financial year-end). 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 transaction date.

Chapter 21 1007
 Gripping GAAP Financial instruments ± general principles

Notice: 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:
Step 1. Calculate the effective interest rate (EIR) in the foreign currency.
Step 2. Prepare the effective interest table in the foreign currency.
Step 3. Translation difference: Translate the effective interest table into the HQWLW\¶V functional
currency, using the relevant exchange rates (spot or average, as the case may be). Restate
the GCA at the spot rate at year-end. The adjustment must be recognised in P/L as foreign
exchange gain or loss. See IAS 21.28
Step 4. Fair value adjustment: Translate the fair value into the functional currency at the spot rate
at year-end. The FV less the GCA (both in the functional currency) reflects a cumulative
gain or loss which must be recognised in OCI. In subsequent periods, the gain or loss to be
recognised is determined by deducting the cumulative gain/loss in the prior period from the
cumulative gain/loss in the current period.

4.6.4 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 µfair 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
IDLUYDOXHWKURXJKSURILWRUORVV )93/ RUDWµIDLUYDOXH
x Gains or losses: all recognised in OCI
WKURXJKRWKHUFRPSUHKHQVLYHLQFRPH¶LQVWHDG )92&,- (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 4.3.6).

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
These gains or losses recognised in OCI may never be recognised when:
reclassified to profit or loss (P/L). See IFRS 9.B.5.7.1 x the entity's right to receive
payment has been established;
x it is probable that the economic
If the equity instrument declares a dividend, we will only benefits associated with the dividend
recognise the dividend income as having been earned once will flow to the entity; and
three criteria are met (see pop-up alongside). x the amount of the dividend can be
measured reliably. IFRS 9.5.7.1A
Dividends that are earned are recognised in µprofit or loss¶ (P/L), unless it is a µpart 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 a 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 GHELW D VHSDUDWH µUHFHLYDEOH¶ HJGHELW
dividend receivable, credit dividend income). However, IFRS 9 is silent on this issue and thus
one could debit the carrying amount of the investment, if preferred (e.g. debit investment in equity;
credit dividend income). When the cash flow occurs, we will reduce the carrying amount of the
financial asset (whether a µreceivable¶RUthe µinvestment in equity¶ and recognise the receipt of
cash. In other words, we account for it as follows:
x Earn the dividend: Debit Dividend receivable (or investment in equity); Credit Dividend income
x Receive the dividend: Debit Bank, Credit Dividend receivable (or investment in equity).

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. This
is not the case for assets at FVOCI-equity.

1008 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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).
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 fair value gains or
losses recognised in OCI, any related foreign 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 reflect a partial recovery of the DVVHW¶V cost), but dividends earned on debt
instruments at FVOCI (FVOCI-debt) (e.g. an investment in redeemable preference shares) 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
LQYHVWPHQW TXDOLILHG DV D µVWUDWHJLF HTXLW\ LQYHVWPHQW¶ DQG HOHFWHGWR SUHVHQW WKHIDLU YDOXH
changes in other comprehensive income (i.e. it classified the financial asset at FVOCI-equity).
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 µH[GLY¶IDLUYDOXH .
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

1 January 20X8 Debit Credit

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: Dividend receivable (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 this a/c: 12 000
Fair value gain (I: OCI) (100 000 + 8 000) 12 000
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: Dividend receivable (A) 1 000
Dividend received

Chapter 21 1009
 Gripping GAAP Financial instruments ± general principles

4.6.5 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 in profit or loss) and are then
x Initially at FV (transaction costs
subsequently remeasured at each reporting date to their are expensed).
latest fair values. The resultant fair value adjustment (fair x Subsequently measured at FV
value gain 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 x Dividend income (if any):
investment in debentures would generate interest and an recognised in P/L
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 receivable (interest receivable or
If the FV of a fin asset classified
dividend receivable) and credit income (interest income or at FVPL drops below zero, the
dividend income). financial asset switches to being:
x identified as a financial liability and
x measured as a financial liability!
Then, if and when the cash is received, we would debit See IFRS 9.B5.2.1

bank and credit the financial asset. This is the approach

used in this text. Other alternative approaches are 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 4.6.4 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. However, the dividend had not been received by 31 December 20X5.
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.

1010 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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.

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
Dividend receivable (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 – 30 000
Fair value gain (I: P/L) Bal in this account: (25 000) 30 000
Re-measurement of shares (FVPL) to FV at year-end (recog in P/L)

5. Financial Assets: Impairments (IFRS 9.5.2.2 and IFRS 9.5.5)

5.1 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
WKH µH[SHFWHG FUHGLW ORVV PRGHO¶ WKH (&/ PRGHO . This on financial assets measured at
model requires that, in the case of certain financial assets, amortised cost, lease receivables &
contract assets;
we recognise a loss allowance. This loss allowance reflects
 accumulated impairment amount
the credit losses that are expected on an asset due to credit for financial assets measured at FV
risk LHWKHORVVDOORZDQFHUHIOHFWVµH[SHFWHGFUHGLWORVVHV¶ . through OCI; and the
The model is thus a forward-looking model that requires us  provision for expected credit losses on
to recognise a credit loss before DµFUHGLWHYHQW¶RFFXUV loan commitments and guarantee
IFRS 9 Appendix A (slightly reworded)
contracts.
This ECL model has been designed specifically for financial assets that LQYROYHµFRQWUDFWXDOFDVKIORZV¶
and that are managed in a business model that regards the 'collection¶ thereof as being an µintegral activity¶.
The idea behind this model is that, since the collection of the contractual cash flows is considered to be an
integral activity, information about the effects of an DVVHW¶Vcredit 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
FRQWUDFWXDOFDVKIORZV LVLQWHJUDOWRWKHHQWLW\¶VEXVLQHVVPRGHO
x 7KHµamortised cost¶ classification (AC); and
x 7KH µIDLU YDOXH WKURXJK RWKHU FRPSUHKHQVLYH LQFRPH - GHEW¶ FODVVLILFDWLRQ )92&,-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 µIDLUYDOXHWKURXJKRWKHUFRPSUHKHQVLYHLQFRPH± 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 µIDLUYDOXHWKURXJKSURILWRUORVV¶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). Since fair value adjustments are already recognised in profit or loss, it means that the effects
RIDQ\FKDQJHVWRWKHDVVHW¶V credit risk are already reflected there. Thus, if we also recognised a loss
allowance, with the related loss allowance adjustments in profit or loss, the effects of the credit risk
would be double-counted (i.e. once as a fair value adjustment and once as an impairment adjustment).

Chapter 21 1011
 Gripping GAAP Financial instruments ± general principles

As mentioned earlier, tKHµ)92&,¶-debt¶FODVVLILFDWLRQdoes 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 that, when we use this classification, the
related fair value adjustments are recognised in other comprehensive income (OCI).
x The µproblem¶ with this is that IFRS 9 states that the effects of any change to WKHDVVHW¶V
credit risk must be recognised in profit or loss (P/L).
x So, to fix this problem, we need to process a journal that:
- ZLOOUHIOHFWWKHDVVHW¶VFKDQJLQJFUHGLWULVNZLWKLQprofit or loss (i.e. debit impairment loss
or credit impairment reversal), and then,
- in order to avoid double-counting WKH QHJDWLYH HIIHFWV RI FUHGLW ULVN RQ WKH DVVHW¶V
carrying amount (because it is already measured at fair value), this journal must
recognise the related µloss 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 recognised as an µasset measurement account¶ WKDWUHGXFHVWKHILQDQFLDODVVHW¶V
carrying amount. Instead, it will be recognised in OCI (part of equity). Also, because the
impact on µprofit or loss¶ of a financial asset classified at FVOCI-debt must be the same as
if it was classified at AC instead, when we recognise the loss allowance (or subsequently
adjust the loss allowance balance), the contra entry must be recognised in profit or loss
(e.g. Debit Impairment expense (P/L) and Credit Loss allowance (OCI)).

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 LVDQµDVVHWPHDVXUHPHQWDFFRXQW¶ ZLWKDFUHGLWEDODQFH 
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 UHFRJQLVHG DV DQ µDVVHW
PHDVXUHPHQWDFFRXQW¶ LHLWGRHVQRWUHGXFHWKHFDUU\LQJDPRXQWRIWKHILQDQFLDODVVHW 
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 regarding this journal:

1) 5HPHPEHU WKH IDFW WKDW WKH ORVV DOORZDQFH LV UHFRJQLVHG LQ 2&, LQVWHDG RI DV DQ µDVVHW
PHDVXUHPHQWDFFRXQW¶WKDWUHGXFHVWKHDVVHW¶VFDUU\LQJDPRXQW GRHV not result in the asset
being overstated. This is because assets in this classification are measured at fair value, where
IDLUYDOXHDXWRPDWLFDOO\UHIOHFWVWKHPDUNHW¶VUHDFWLRQWRWKHDVVHW¶VFUHGLWULVN
2) 5HPHPEHUWKDW,)56UHTXLUHVWKDWWKHHIIHFWVRIFUHGLWULVNRIDQDVVHWDWµ)92&,-GHEW¶PXVWEH
PHDVXUHGDQGUHIOHFWHGLQSURILWRUORVV 3/ DVLILWZHUHDQDVVHWDWµDPRUWLVHGFRVW¶ $& LQVWHDG
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: this is 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).

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 Gripping GAAP Financial instruments ± general principles

This can all be summarised as follows:

Classification of financial asset
FVPL (all sorts)
FVOCI (equity investments )
FVOCI (debt instruments)
Amortised cost (debt instruments)
Loss allowance
Not applicable
Not applicable
Applicable: The FA is presented separately from the LA:
x Financial asset (A): Fair value
x Loss allowance (OCI ± part of equity) See IFRS 9.5.5.2
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:
The general approach is always used for financial assets classified at AC and FVOCI-debt
x The simplified approach
The simplified approach may only be used in certain specific circumstances involving trade
receivables, contract assets and lease receivables (sometimes it is mandatory and sometimes it
is an accounting policy choice ± see section 5.5).

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.

Let us now consider the new ECL model in more depth:

Section 5.2 explains the basic principle behind the loss allowance under the ECL model.
Section 5.3 explains how to measure the loss allowance in terms of the general approach.
Section 5.4 goes into a bit more depth as to how to measure the expected credit losses.
Section 5.5 explains how and when to measure the loss allowance in terms of the simplified approach.

5.2 Explanation of the principles behind the loss allowance

The recognition and measurement of the loss allowance
Credit risk is defined as –
is based on what is referred to as the ECL model. This
model kicks in as soon as the financial asset is recognised  The risk that one party to a
in the financial statements. In other words, it is not financial instrument
necessary for an impairment event (also known as a  will cause a financial loss for
µFUHGLW HYHQW¶ RU µWULJJHU¶  WR EH HYLGHQW EHIRUH WKH ORVV the other party
 by failing to discharge an
allowance is accounted for ± we account for credit losses obligation IFRS 7 Appendix A
based on expectations ± we do not wait for them to occur.

Financial assets are initially measured at fair value, where this Expected credit losses are
fair value will reflect the DVVHW¶V credit risk on this initial calculated as –
recognition date. If the general approach is followed (and  a probability-weighted estimate of
assuming the asset is not already credit-impaired on initial credit losses (i.e. the present
recognition), the loss allowance on initial recognition would be value of all cash shortfalls)
measured at 12-month expected credit losses. The loss  over the expected life of the
allowance is then remeasured at each reporting date based financial instrument. IFRS 9.B5.5.28
on an assessment of the changes in credit risk since this initial recognition date. Depending on
the level of change in credit risk on reporting date, we will categorise the asset as being stage 1,
stage 2 or stage 3. Depending on this assessment, the loss allowance will be measured either at
an DPRXQWHTXDOWRµ12-month expected credit losses¶ or µlifetime expected credit losses¶.

Chapter 21 1013
 Gripping GAAP Financial instruments ± general principles

However, an exception to the above general approach is in the case of assets that were µalready
credit-impaired¶ RQ LQLWLDO UHFRJQLWLRQ. In this case no loss allowance is recognised on initial
recognition of the asset (this is explained in section 5.3.1.2), but a loss allowance would be
recognised at each subsequent reporting date, measured at the µchange in lifetime expected credit
losses since initial recognition¶. Financial assets that are already credit-impaired on initial recognition
were explained in section 4.6.2.2 and are also referred to again in section 5.3.2. See IFRS 9.5.5.13-14

The simplified approach requires that the loss allowance always be measured at lifetime expected
credit losses. See section 5.5 for when to use and how to use this approach.

5.3 Expected credit loss model ± the general approach (IFRS 9.5.5.1±14 & B5.5.33)
5.3.1 Assessment of credit risk on initial recognition date

5.3.1.1 Financial assets that are not credit-impaired on initial recognition:

Expected credit losses are
If the assessment of the credit risk on initial recognition date
defined as –
indicates that the financial asset is not µalready 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).

The journal entries to recognise the purchase of the financial asset (that is not credit-impaired) and the
related loss allowance assessed on initial recognition date would be as follows:
On initial recognition date Debit Credit
Financial asset (A) xxx
Bank (A) xxx
Purchase of financial asset that is not credit impaired on initial recognition
Impairment loss (P/L: E) xxx
Financial asset: loss allowance (-A or OCI) Note 1 xxx
Recognising loss allowance of financial asset that is not credit impaired on
initial recognition

Note 1: Remember the loss allowance of a financial asset recognised at amortised cost is recognised as an
µDVVHWmeasurement DFFRXQW¶ i.e. it has a credit balance WKDWUHGXFHVWKHDVVHW¶VFDUU\LQJDPRXQW), whereas
the loss allowance of a financial asset recognised at FVOCI-debt will be recognised in OCI. (See section 5.1).

5.3.1.2 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 µalready
credit-impaired’ on initial recognition date, then we do not recognize a separate loss allowance on
this date. This is because, since the asset was already in a credit-impaired state on initial
recognition, its fair value would already reflect this fact and recognizing a loss allowance on top
of this would simply be double-FRXQWLQJ)XUWKHUPRUHVLQFHWKHDVVHW¶VFUHGLWULVNLVVRVHULRXV
on LQLWLDOUHFRJQLWLRQZHZLOOEHPHDVXULQJWKHDVVHW¶VLQWHUHVWLQFRPHDQGVXEVHTXHQWFDUU\LQJ
amount using a credit-adjusted effective interest rate. This 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 4.6.2.2)

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

1014 Chapter 21
 Gripping GAAP Financial instruments ± general principles

The journal entry to account for the purchase of a financial asset that is already credit-impaired
would be as follows:
On initial recognition date Debit Credit
Financial asset (A) Note 1 xxx
Bank (A) xxx
Purchase of financial asset that is credit impaired on initial recognition

Note 1: Notice that there is no separate journal to record a loss allowance on initial recognition. This is
EHFDXVHWKHDVVHW¶VFUHGLWULVNLVVRVHULRXVWKDWDFUHGLW-adjusted effective interest rate will be determined
for the financial asset. Thus, any initial expected credit losses will be taken into account indirectly through
lower interest income recognised. A loss allowance will be recognised at subsequent reporting dates to reflect
the cumulative change in lifetime expected credit losses since initial acquisition. See IFRS 9.5.5.13

5.3.2 Re-assessing the credit risk at reporting date

5.3.2.1 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

Financial assets that were already credit-impaired on initial recognition:

The measurement of the loss allowance relating to an asset that was µalready credit-impaired
on initial recognition¶ must always equal the latest estimate of µthe cumulative changes in
lifetime expected credit losses since initial recognition'. 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

5.3.2.2 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 µsignificant 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
µpast due¶ 30 days or more overdue), that there has been a µsignificant 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

Chapter 21 1015
 Gripping GAAP Financial instruments ± general principles

5.3.2.3 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)

As mentioned above (section 5.3.2.2), where the financial asset is not credit impaired on date
of initial recognition, the remeasurement of the loss allowance to reflect 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.

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 12A and example 13A.
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.
If our asset 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 12B, example 13B and example 14A.
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).

If our asset falls into stage 3:

- 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 12C and example 14B.

5.3.2.4 Lifetime expected credit losses

The 'lifetime expected credit loss' is essentially the difference between:

x the present value of the total remaining cash flows due to an entity in terms of the contract, and
x the present value of the total remaining 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

1016 Chapter 21
 Gripping GAAP Financial instruments ± general principles

If the financial assets are not credit-impaired at initial recognition but subsequently become
credit-impaired (that means the asset would be categorised as stage 3), 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

5.3.2.5 12-month expected credit losses

The µ12-PRQWK H[SHFWHG FUHGLW ORVV¶ LV WKH SRUWLRQ RI WKH µlifetime expected credit loss¶ (see
section 5.3.2.4) reflecting the present value of the lifetime cash shortfalls that would result if a
default had to occur within the next 12 months after reporting date, weighted by the probability
that the default will occur within this period. See IFRS 9.B5.5.43

This means that the entity must consider what percentage of the asset it stands to forfeit if the
financial asset had to default within the next financial year, as well as the probability that this
will occur within this 12-month period.

12-month ECLs versus Lifetime ECLs

The interrelationship between 12m ECLs & Lifetime ECLs can be described as follows:
The cumulative probability that a long-term loan or receivable will default at any time within 12
months usually will be substantially lower than the cumulative probability it will default at any
time over its remaining expected life. As a result, 12-month ECLs usually will be lower, often
PWC: IFRS 9 financial instruments—Understanding the basics
substantially so, than Lifetime ECLs.

5.4 Measurement of expected credit losses (IFRS 9.5.5.17±20)

$µFUHGLWORVV¶UHIHUVWRWKHSUHVHQWYDOXHRIWKH total remaining cash shortfalls over the life of

WKH DVVHW¶ µcontractual cash flows that should be received¶ less µcash flows expected to be
received¶, discounted at either the original effective interest rate, or the credit-adjusted effective
interest rate if the asset was already credit-impaired on initial recognition).

7KHµH[SHFWHGFUHGLWORVV¶LVWKHFUHGLWORVVDGMXVWHGIRUWKHSUREDELOLWLHVRIGHIDXOW

When an entity measures µexpected 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 identified and taken into
account in the calculation. +RZHYHUFUHGLWORVVHVPXVWEHEXLOWLQWRWKHFDOFXODWLRQRIµH[SHFWHG
FUHGLW ORVV¶ HYHQ LI WKH SRVVLELOLW\ RI WKH ORVV RFFXUULQJ LV YHU\ ORZ LH WKH ORZ SUREDELOLW\ LV
simply built into the measurement thereof). 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 another financial reorganisation,
 the disappearance of an active market for that financial asset because of financial difficulties, or
 the purchase or origination of a financial asset at a deep discount (below market prices for
instruments of a similar profile) that reflects incurred credit losses. IFRS 9 Appendix A (Reworded).

Chapter 21 1017
Gripping GAAP Financial instruments ± general principles

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
increase significantly; or increased significantly but FA is '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 µloss 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 A: Because there was no sLJQLILFDQWLQFUHDVHLQWKHDVVHW¶VFUHGLWULVNZHFDOFXODWHWKHORVV
allowance based on 12 month expected credit losses.
x 3DUW%%HFDXVHWKHDVVHW¶VFUHGLWULVNKDGincreased significantly, we calculate the loss
allowance based on lifetime expected credit losses.
x 3DUW&%HFDXVHWKHDVVHW¶VFUHGLWULVNKDGLQFUHDVHGVRVLJQLILFDQWO\WKDWLWDOVRbecame credit-impaired, we
not only calculate the loss allowance based on lifetime expected credit losses but we now also calculate the
LQWHUHVWLQFRPHEDVHGRQWKHDVVHW¶VDPRUWLVHGFRVW LQVWHDGRIRQWKHJURVVFDUU\LQJDPRXQW 

1018 Chapter 21
Gripping GAAP Financial instruments ± general principles

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: o/b C450 000 x 10% GCA: o/b C450 000 x 10% GCA: o/b C450 000 x 10%

Interest income in 20X3 C46 500 C46 500 C44 826

GCA: o/b (C450 000 + GCA: o/b (C450 000 + AC: o/b (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. The principal plus all interest accrued 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 a probability of default of 0.8% for the lifetime of the loan. Joyous 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 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 the asset does not qualify for the simplified approach and that:
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, a loss allowance must be recognised, and since it does not
qualify for the simplified approach, the allowance must be measured using the general approach. This
means we recognise the loan asset¶V gross carrying amount and related loss allowance. When presenting
this asset, these two accounts are set off against each other and presented at the net amount, called the
amortised cost. As the investment is not credit-impaired on initial recognition, a loss allowance is
recognised on this date, measured at 12-month expected credit losses (12m ECLs). The remeasurement
of this loss allowance at reporting date will be baVHGRQWKHODWHVWHVWLPDWHRIWKHP(&/V DQGZRQ¶W
be remeasured to lifetime ECLs) since there was no significant increase in credit risk at reporting date.

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.
+RZHYHUWKHWRWDOH[SHFWHGORVVVKRXOGDGHIDXOWRFFXULV,QRWKHUZRUGVWKHµORVVJLYHQGHIDXOW¶
(LGD) is equal to 20%. However, our loss allowance must only equal the expected credit losses over the
next 12-month period.

Chapter 21 1019
Gripping GAAP Financial instruments ± general principles

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] =
$PRXQWUHFHLYDEOH[ORVVLIWKHFXVWRPHUGHIDXOWVGXULQJDVVHW¶VOLIHWLPH[SUREDELOLW\RIWKLV
default occurring within 12 months
= C100 000 x 20% x 0.5% = C100
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:
Exposure x LGD x Probability of default over 12 months [PD] =
$PRXQWUHFHLYDEOH[ORVVLIWKHFXVWRPHUGHIDXOWVGXULQJDVVHW¶VOLIHWLPH[SUREDELOLW\RIWKLV
default occurring within 12 months
= (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) ECL at reporting date:336 – Balance 236
FA: Loan: loss allowance (-A) 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.
Exposure x LGD x Probability of default over 12 months [PD] =
$PRXQWUHFHLYDEOH[ORVVLIWKHFXVWRPHUGHIDXOWVGXULQJDVVHW¶VOLIHWLPH[SUREDELOLW\RIWKLV
default occurring within 12 months
= (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'

1020 Chapter 21
Gripping GAAP Financial instruments ± general principles

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.
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 picture)
Comment:
x This example compares the situation of an asset, which is not credit-impaired on initial recognition
that 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 Notice that this example gave us the 12m ECLs and Lifetime ECLs and thus we did not have to
calculate these, as was the case in the prior example (example 13).
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 XVLQJDµQRUPDO¶HIIHFWLYHLQWHUHVWUDWH QRWDµcredit-adjusted effective
LQWHUHVWUDWH¶ .
x At 31 December 20X4, the reporting date, WKHGHEHQWXUH¶V 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, (it is at stage 2), 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, (it is at stage 3), the interest income
recognised in future periods will now be calculated as: Amortised cost x EIR.
,QWKLVUHJDUGQRWLFHWKDWVLQFHµamortised cost¶PHDQVµgross carrying amount ± loss allowance¶
when we apply the EIR to the amortised cost, it means that both WKHµJURVVFDUU\LQJDPRXQW¶and the
µORVVDOORZDQFH¶DUHQRZbeing unwound at the effective interest rate.

Chapter 21 1021
Gripping GAAP Financial instruments ± general principles

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 the lifetime expected credit losses have increased since the previous reporting date).
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)

Part A Part B
Journals Not credit- Credit-
impaired impaired
2 January 20X4 Dr/ (Cr) Dr/ (Cr)
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) W1; Or 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 – Balance 14 375 14 375

Debentures: loss allowance (-A) 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)

31 December 20X5
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

1022 Chapter 21
 Gripping GAAP Financial instruments ± general principles

W1: Effective interest rate table:

Date Opening balance Effective interest Receipts Closing balance

@ 9,4678%
20X4 0
492 500 Note 1

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 µamortised cost¶, thus transaction costs are capitalised: FV 490 000 +
Transaction costs 2 500 = 492 500

5.5 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. See IFRS 9.5.15(a)

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
could also choose to apply the simplified approach to the µtrade receivable¶ but not to µcontract
assets¶, or vice versa, but we must simply apply the accounting policy consistently);
x a lease receivable accounted for in terms of IFRS 16 Leases (we can also choose to apply the
simplified approach to µlease receivables from finance leases¶ and not to µlease 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 µUHYHQXH¶ and debiting µWUDGHUHFHLYDEOH¶ 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 FXVWRPHU¶Vcredit 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.

Chapter 21 1023
 Gripping GAAP Financial instruments ± general principles

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).
x In this example, we were not given the expected credit losses and thus had to calculate them.
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 during lifetime: 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
Remeasurement 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.

1024 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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)

W1. Loss allowance at 31 December 20X5:

Lifetime expected
GCA Default rate
credit loss 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

6. Financial assets: derecognition (IFRS 9.3.2)

6.1 Overview
Derecognition is
defined as:
A financial asset may only be derecognised if either of the
following criteria are met: x the removal of
x a previously recognised FA/ FL
x The contractual rights to the financial asset's cash flows
x from an entity’s SOFP. IFRS 9 App A
have expired; or
x The entity has transferred a financial asset, and this transfer qualifies for derecognition. See IFRS 9.3.2.3

An example of an expiry is when we receive all cash flows A FA must be

from a trade debtor. The derecognition journal would be: derecognised if the:
Debit Bank x rights to the cash flows have
Credit Financial asset (Receivable). expired; or
x the FA has been transferred &
An example of a transfer that qualifies for derecognition is this transfer qualifies for
derecognition. See IFRS 9.3.2.3
the sale of an investment in shares. Assuming we sold them
at fair value, the derecognition journal would be:
Debit Bank
Credit Financial asset (Investment in shares, at fair value)

We may need to assess whether to derecognise a single financial asset or a group of similar
financial assets. Furthermore, we may need to consider the derecognition of the entire financial
asset (or the entire group of similar financial assets), or a part thereof. These are important issues
to establish because the criteria that need to be met before derecognition occurs will need to be
applied to the single asset, group of assets, and to the whole or part thereof. See IFRS 9.3.2.2

Let us now look at the criteria for derecognition (referred to above). ,IWKHILQDQFLDODVVHW¶VFDVKIORZV
have expired, then we must process the derecognition. However, a financial asset that is transferred
may not necessarily qualify for derecognition. In fact, there are three possible outcomes:
x The transfer does qualify for derecognition;
x The transfer does not qualify for derecognition; or
x The transfer entails continuing involvement.

The reason we have to be very careful before derecognising a financial asset that has been
transferred is because, in the past, entities were found to be hiding the existence of financing
liabilities E\ GHUHFRJQLVLQJ ILQDQFLDO DVVHWV WKDW WKH\ KDG DUJXHG KDG EHHQ µWUDQVIHUUHG¶. For
example, an entity might need C100 000 in cash and manage to raise the cash, but instead of
recognising it as a liability (debit bank and credit liability), the entity creates a clever transaction
in which it derecognises an asset instead (debit bank and credit asset), but where this asset is,
LQVXEVWDQFHVWLOOWKHHQWLW\¶VDVVHW. Although the impact on net assets is the same, entities often
prefer to reduce their assets than to increase their liabilities.

Chapter 21 1025
 Gripping GAAP Financial instruments ± general principles

In essence, the whole issue here is really whether to:

x Treat the transfer of the financial asset as a derecognition (debit bank and credit financial asset)
x Treat the transfer of the financial asset as a borrowing (debit bank and credit financial liability).

A financial asset is considered to have been transferred if the following criteria are met:
x The entity has transferred its contractual right to receive the financial asset's cash flows
(e.g. the entity has sold the asset); or
x The entity has retained its contractual right to receive the financial asset's cash flows, but
has assumed a contractual obligation requiring it to pay these cash flows '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 recipients 'unless it collects equivalent amounts from
the original asset' (i.e. if we do not receive the cash flows from the asset, then we have
no obligation to pay the recipient).
If this criterion is not met (i.e. if we will have to pay the recipient even if we do not
receive the cash flows from the asset), then it would seem that we have an obligation
and thus we should credit a liability instead of derecognising the 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 asset was only
pledged as security to the recipients in terms of the arrangement).
If this criterion is not met (i.e. we still have something to sell or use as a pledge), then it
would seem that we still have a resource (i.e. it seems we still have an asset and thus we
should not derecognise it).
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.
If this criteria is not met (i.e. if we are expecting to receive cash from the asset and
expect to be able to invest this cash and earn interest on it before transferring the cash
from the asset to the recipients), then it would seem we still have a resource (i.e. it
seems we still have an asset and thus should not derecognise it).See IFRS 9.3.2.4-5

The essence of the above is that we must recognise the substance of the transaction and thus we
derecognise the asset only if, in substance, we no longer have the risks and rewards associated
with the asset.

Thus, if the criteria are met with the result that the asset is considered to have been transferred,
the next step is to consider the extent to which the related risks and rewards of ownership have
transferred.
x If substantially all the risks and rewards have been transferred, the asset is derecognised
and any rights and obligations created in the transfer transaction must be recognised as
separate assets and liabilities;
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 then
need to consider who controls the asset.
 If the entity retains control of the asset (through some level of continuing involvement),
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 and any rights
and obligations created in the transfer transaction must be recognised as separate
assets and liabilities. See IFRS 9.3.2.6

1026 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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 (extract from IFRS 9.B3.2.1)

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 all Yes
Derecognise the FA
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

6.2 A transfer of a financial asset that qualifies for derecognition

Where a transfer of an entire 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.
B. See next page«

Chapter 21 1027
Gripping GAAP Financial instruments ± general principles

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 and thus 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

20 April 20X6 Debit Credit
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

20 April 20X6 Debit Credit
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
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
FV gains (OCI) FV: 60 000 – Original purchase price: 35 000
Retained earnings (Equity) 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 P/L 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.

1028 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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

20 April 20X6 Debit Credit

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
Recognition of proceeds and derecognition of the investment in shares
and recognition of a gain on sale in P/L
Transaction costs (E: P/L) Transaction costs: given 1 000
Bank 1 000
Recognition of transaction costs paid as an expense in P/L

Notice:
x There was a gain on derecognition (recognised in profit or loss). It is normal to have a gain or loss on
derecognition when the asset is measured at amortised cost because it is unlikely 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.

6.3 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 1029
 Gripping GAAP Financial instruments ± general principles

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.

1 January 20X1 Debit Credit

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 (I) 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

6.4 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

1030 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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.

7. Financial Liabilities

7.1 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. According to the financial liability definition, 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
unfavourable conditions; or
b) DFRQWUDFWWKDWZLOORUPD\EHVHWWOHGLQWKHHQWLW\¶V b) a contract to be settled in the
own equity instruments and is: entity's own equity instruments,
that is either a:
- a non-derivative for which the entity is or may
- non-derivative involving a
be obliged to deliver a variable number of the variable # of shares, or a
HQWLW\¶VRZQHTXLW\LQVWUXPHQWVRU - derivative involving a fixed # of shares
See IAS 32.11 (Summarised)
- 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
QXPEHURIWKHHQWLW\¶VRZQHTXLW\LQVWUXPHQWV. 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.

Chapter 21 1031
 Gripping GAAP Financial instruments ± general principles

Worked example: Settling a contractual obligation ZLWKWKHHQWLW\¶VRZQHTXLW\LQVWUXPHQWV

Steffen Limited owes C100 000, a debt that will be settled by issuing its own equity instruments
(ordinary shares).

Scenario one:
Steffen is required to issue a variable number of its ordinary shares to settle the debt (C100 000).
In this case, the contractual obligation is a financial liability. This is because it fails WKHµIL[HGIRUIL[HGWHVW¶,Q
other words, there is a fixed currency amount owing (C100 000) but a variable number of shares to be issued
in settlement thereof. The outcome of this scenario is that, no matter what our shares are trading at, we will
only be exposed to an outflow of C100 000 (i.e. when we need to settle our debt, we could buy C100 000 of
our own shares and hand them over to the creditor ± if the shares are trading at C1 each, then we buy 100 000
shares to give to the creditor ± if the shares are trading at C20 each, then we buy 5 000 shares to give to the
creditor. It is the creditor who is exposed to the risk of the share price fluctuations on the settlement date.

Scenario two:
Steffen is required to issue a fixed number of its ordinary shares (5 000 shares) to settle the debt (C100 000).
In this case, the contractual obligation is an equity instrument. This is because it meets WKHµIL[HGIRUIL[HGWHVW¶
In other words, there is a fixed currency amount owing (C100 000) and a fixed number of shares to be issued
in settlement thereof (5 000 shares). The outcome of this scenario is that it is Steffen that is exposed to the
fluctuations in its share price. For example, if Steffen decides to buy the shares from the market in order to
give to the creditor in settlement of the debt (i.e. instead of just issuing more shares), then if the share price is
trading at C1 on settlement date, then Steffen will need to pay C5 000 to settle the debt (5 000 shares x C1).
However, if the share price is trading at C20 each, then Steffen will need to pay C100 000 to settle the debt
(5 000 shares x C20). In other words, it is Steffen who is exposed to the risks of share price fluctuations. Or,
put another way, the instrument is affected by 6WHIIHQ¶V performance (Steffen¶VSHUIRUPDQFHLQIOXences the
share price). Thus, this instrument is more suited to being recognised as an equity instrument.

7.2 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.

7.3 Financial liabilities: Classification (IFRS 9.4.2)

7.3.1 General classification Financial liabilities are

classified as follows -
7.3.1.1 Overview x at fair value through profit or loss
x at amortised cost
Essentially, a financial liability is:
Financial liabilities may
x classified as at amortised cost (AC) never be reclassified!
x unless it meets the criteria to be classified as at fair value See IFRS 9.4

through profit or loss (FVPL). See IFRS 9.4.2.1

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)

Diagram: 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)

IFRS 9.4.4.2
Once the financial liability is classified, it may never be reclassified.

1032 Chapter 21
 Gripping GAAP Financial instruments ± general principles

7.3.1.2 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 recently x is acquired or incurred principally
for the purpose of selling/
evidenced short-term profits. See IFRS 9 App A repurchasing it in the near term; or
x is a derivative (except for a
7.3.1.3 Designated at FVPL derivative that is a financial
guarantee contract or is a designated
and effective hedging instrument); or
Financial liabilities that do not meet the definition of 'held for
x on initial recognition, is part of a
trading' may be designated as FVPL. Most designations at portfolio of identified financial
FVPL may only take place on initial recognition and are instruments that are managed
irrevocable. The following summarises the conditions under together and for which there is
evidence of a recent actual pattern
which a designation as at FVPL may occur. of short-term profit-taking.
IFRS 9 App A
x Designations that are only possible on initial
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

7.3.2 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)

Chapter 21 1033
 Gripping GAAP Financial instruments ± general principles

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)

7.4 Financial liabilities: measurement overview

The measurement of financial liabilities can be split into:

x initial measurement; and
x subsequent measurement.

Both the initial measurement and subsequent measurement are affected by whether the liability
has been classified as amortised cost or fair value through profit or loss. Initial measurement
is explained in section 7.5 and subsequent measurement is explained in section 7.6.

7.5 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 4.5.1. This is
summarised below. See IFRS 9.5.1.1

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 4.5.2.

1034 Chapter 21
 Gripping GAAP Financial instruments ± general principles

7.6 )LQDQFLDOOLDELOLWLHVVXEVHTXHQWPHDVXUHPHQW ,)56DQG,)56

Financial liabilities at
7.6.1 Overview
amortised cost are
measured as follows -
The subsequent measurement of a financial liability
x Initially measured at FV
depends on whether it was classified as: less transaction costs
x Amortised cost or x Subsequently measured at
amortised cost using the
x Fair value through profit or loss. 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 7.3.2). 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).

7.6.2 Financial liabilities at amortised cost: subsequent measurement

Financial liabilities that are classified at amortised cost
are obviously measured at amortised cost.
To be measured at amortised cost means that the
subsequent measurement of a financial liability will
The effective interest rate, of
a FL, is defined as
x the rate that exactly discounts
x estimated future cash flows through the
expected life of the financial liability

involve using the effective interest rate method. This x to the liability’s amortised cost.

method means that interest on the liability will be These cash flows are the contractual
See IFRS 9 App A (Reworded extract)
cash flows.
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

1 January 20X4 Debit Credit

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) W1 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) W1 150 000
Bank 150 000
Payment of annual debenture interest based upon the coupon rate

Chapter 21 1035
 Gripping GAAP Financial instruments ± general principles

W1. Effective interest rate table:

Date Opening balance Effective interest Payments Closing balance

A B C D
20X4 1 400 000 Note 1 228 576 Note 2 (150 000) Note4 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
20X7 1 676 311 273 689 (150 000) 1 800 000 Note 5

(1 800 000) 0
1 000 000 Note 6 (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) 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
4) Payment of interest based on coupon interest = 150 000 debentures x C10 x 10% = C150 000
5) Payment of redemption amount = 150 000 debentures x C12 = C1 800 000
6) Notice: The total of the interest expense is C1 000 000, which is the difference between the
net amount originally received (C1 400 000) and the total of the payments (C2 400 000).

7.6.3 Financial liabilities at fair value through profit or loss: subsequent measurement

Financial liabilities that are classified at µfair value through profit or loss¶, are initially measured at fair
value, with transaction costs expensed (see section 7.5) 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). x Initially measured at fair value.
x Transaction costs are expensed
IFRS 9 does not stipulate how to account for the cash flows, x Subsequently measured at fair value
but the approach generally followed in practice is to:
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.

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

1036 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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 µother comprehensive income¶ would create
or enlarge an accounting mismatch in µprofit 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 specific 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.

For example, at the end of 20X1, an entity had issued debentures with a fair value of C100 000.
In 20X2, due to the increase in credit risk during the year, the debentures now had a fair value
of C50 000, as traders were willing to sell the debentures for a lower price, to avoid the
increased risk. If we had to recognise this transaction through profit or loss, we would have to
debit the liability with C50,000 and credit fair value gain with C50,000. However, this does not
PDNHVHQVHDVWKHµJDLQ¶LVRQO\GXHWRDQLQFUHDVHLQFUHGLWULVN

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. 0RXVVHGHVLJQDWHGWKHVHGHEHQWXUHVDVDWµIDLUYDOXHWKURXJKSURILWRUORVV¶
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.
Required:
Prepare all journals relating to the information above.

Solution 22: Financial liability at FVPL ± no change in credit risk

1 January 20X5 Debit Credit

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)

Chapter 21 1037
 Gripping GAAP Financial instruments ± general principles

Journals 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 – 100 000
FL: Debentures: at FVPL (L) Balance in this a/c: (200 000 + 100 000
20 000 – 20 000)
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)
Note: The interest accrual and interest payment are shown as separate journals, but could have been
shown as one journal, as follows: debit interest expense C20 000 and credit bank C20 000.

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:
3DUWRIWKHFKDQJHLQWKHOLDELOLW\¶VIDLUYDOXHUHVXOWHGIURPDQLQFUHDVHLQWKHHQWLW\¶VFUHGLW
ULVN7KHIDLUYDOXHJDLQFDXVHGE\WKHLQFUHDVHLQWKHHQWLW\¶VFUHGLWULVNLV&30 000. Recognising this
portion of the fair value adjustment in OCI does not create or enlarge an accounting mismatch.
Required: Prepare all journals relating to the information above.

Solution 23: Financial liability at FVPL ± with a change in credit risk

1 January 20X5 Debit Credit
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
FL: Debentures at FVPL (L) 20 000
Interest expense on debentures (incurred on 31 December 20X)
FL: Debentures at FVPL (L) 20 000
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)

7.6.4 Financial liabilities general classification exceptions: subsequent measurement

As mentioned in section 7.3, 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)

1038 Chapter 21
 Gripping GAAP Financial instruments ± general principles

7.6.4.1 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 (section 6.3).

7.6.4.2 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)

7.6.4.3 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:
x classified at fair value through profit or loss (see section 7.6.3) or
x if it was involved in the transfer of a financial asset that either did not qualify for derecognition
(see section 7.6.4.1) or
x qualified for only a partial derecognition due to continuing involvement in the asset (see section 7.6.4.2).

7.6.4.4 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 will not apply if the financial liability is classified at fair value through profit or loss
(see section 7.6.3).

7.7 Financial liabilities: derecognition (IFRS 9.3.3.1-3; IFRIC 19)

7.7.1 Overview Derecognition of a FL

Financial liabilities may only be derecognised when: x Occurs when extinguished

x all obligations relating to that financial liability have been x Extinguishment = discharge,
cancellation or expiry
extinguished (discharged, cancelled, or expired); x Gain or loss = Pmt made – CA of L

Chapter 21 1039
 Gripping GAAP Financial instruments ± general principles

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

7.7.2 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

7.7.3 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.

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 Gripping GAAP Financial instruments ± general principles

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

7.7.4 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
µFRQVLGHUDWLRQSDLG¶ 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.

Chapter 21 1041
 Gripping GAAP Financial instruments ± general principles

Worked example8VHRIHTXLW\WRH[WLQJXLVKILQDQFLDOOLDELOLW\ µGHEWIRUHTXLW\VZDSV¶

Papaya borrowed C500 000 (a financial liability to Papaya) from Guava 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.
7KHIDLUYDOXHVRI3DSD\D¶VHTXLW\VKDUHVDUH&RQ'HFHPEHU;DQG&RQ'HFHPEHU;
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

8. Reclassification of Financial Instruments (IFRS 9.4.4 ; 9.5.6 and B4.4.1 ± B4.4.3)

8.1 Reclassifications overview

Reclassifications
Financial liabilities may never be reclassified whereas
financial assets may be reclassified. However, the x Only possible for financial assets
x Both the following must have
reclassification of financial assets is only allowed when: occurred:
x the entity changes its business model for managing - BM objective must have changed &
- New BM already in effect
those specific assets; and
x Reclassification accounted for:
x this change in the business model has already been put - from 1st day of the financial
into effect. See IFRS 9 B4.4.1-2 year after the change;
- prospectively with no
restatement
The following changes are not considered to be changes in
a business model:
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
b) the 'disappearance of a particular market for financial reporting 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
Adaptation of example in IFRS 9.B4.4.2
Example 26: Reclassification date
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.

1042 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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).

8.2 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 4.6.5.

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%.

Chapter 21 1043
Gripping GAAP Financial instruments ± general principles

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

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.

31 December 20X3 Debit Credit

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 1 200
FA: Bond: Loss allowance (-A) losses: 9 200 – 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 income (I) 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

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

1044 Chapter 21
 Gripping GAAP Financial instruments ± general principles

8.3 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
H[DFWO\\HDUVDZD\&KDQJH¶VERDUGRIGLUHFWRUVSDVVHGDUHVROXWLRQWKDWWKHbonds 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)

31 December 20X2 Debit Credit

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

Chapter 21 1045
 Gripping GAAP Financial instruments ± general principles

31 December 20X3 Debit Credit

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 o
the 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
initial recognition, thus still measured at 12-month expected credit
losses, recognised as a credit to the asset

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
30 June 20X8 (a) 26 132 (25 000) 600 000
285 000 (275 000)
(a) 598 868 x 8.7271% x 6/12

8.4 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 «KRZHYHUit should be remembered that, although both these
classifications recognise the µimpairment adjustments¶ in µprofit or ORVV¶:
x the AC classification recognises the µloss allowance account¶ DVDQµDVVHWPHDVXUHPHQW
DFFRXQW¶ LHDQDFFRXQWWKDWacts to reduce the carrying amount of the asset), whereas
x the FVOCI-debt classification recognises the loss allowance as a loss reserve in OCI.

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.

1046 Chapter 21
Gripping GAAP Financial instruments ± general principles

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:
x 31 December 20X1 and 1 January 20X2 C145 350
x 31 December 20X2 and 1 January 20X3 C148 850
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
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.
Required: Provide the journals for the year ended 31 December 20X1 and 31 December 20X2.

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 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

1 January 20X1 Debit Credit

FA: Debentures at amortised cost (A) Fair value (given) 147 408
Bank 147 408
Purchase of debentures

Impairment loss (E: P/L) 12m ECL: 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

Impairment loss (E: P/L) Latest estimate of 12m expected credit 2 000
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

Chapter 21 1047
 Gripping GAAP Financial instruments ± general principles

1 January 20X2 Debit Credit

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
Bank 100 000 x Coupon rate 20% (or W1) 20 000
Interest income (I: P/L) (142 149 x EIR: 10%) or (W1) 14 215
FA: Debentures at amortised cost (A) Balancing 5 785
Debentures measured at amortised cost and related interest recognised
based on the effective interest rate method (interest income in P/L)
Impairment loss (E: P/L) Latest estimate of 12m expected credit 1 000
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

W1: Effective interest rate:

PV=-147 408 PMT=20 000 n=3 FV=130 000 COMP i= 10%

W2: Effective interest rate table

Effective interest Receipts Balance
@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

8.5 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).

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 Gripping GAAP Financial instruments ± general principles

x Transfer the balance in the µcumulative 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 DVVHW¶Vcarrying 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 µexpected credit loss reserve account¶ in other
comprehensive income to the 'asset's loss allowance account'. *
* Notice that, when transferring the EDODQFHLQWKHµexpected credit loss reserve DFFRXQW¶ (OCI) to the
asset's µloss allowance account¶ and ZKHQWUDQVIHUULQJWKHµFXPXODWLYHfair value gains or losses¶
(OCI) to the asset¶V µcost 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
only difference being that, instead of the debentures being initially classified at amortised
cost and requiring reclassification to FVOCI-debt:
x 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).
x 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.
x This portfolio is managed with the objective of simply collecting the contractual cash flows.
Required: Show the journals for the year ended 31 December 20X1 and 31 December 20X2.

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

1 January 20X1 Debit Credit

FA: Debentures at FVOCI (A) Fair value (given) 147 408

Bank 147 408
Purchase of debentures

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

Chapter 21 1049
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-RXUQDOVFRQWLQXHG« Debit Credit

31 December 20X1
Bank 100 000 x Coupon rate 20% (or W1) 20 000
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

Impairment loss (E: P/L) Latest estimate of 12m expected credit 2 000
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
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
Bank 100 000 x Coupon rate 20% (or W1) 20 000
Interest income (I: P/L) (GCA: 142 149* x EIR: 10%) or (W1) 14 215
FA: Debentures at amortised cost (A) Balancing 5 785
Debentures measured at amortised cost and related interest recognised
based on the effective interest rate in P/L
*GCA = 145 350 – 3 201 = 142 149 (or see W1: EIRT)
Impairment loss (E: P/L) Latest estimate of 12m expected credit 1 000
FA: Debentures: Loss allowance (-A) losses: 8 000 – previous balance: 7 000 1 000
Loss allowance remeasured: no significant increase in credit risk since
initial recognition, thus still measured at 12-month expected credit losses,
but now recognised as a credit to the asset

W1: Effective interest rate:

PV=-147 408 PMT=20 000 n=3 FV=130 000 COMP i= 10%

W2: Effective interest rate table

Effective interest Receipts Balance
@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

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8.6 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 µother comprehensive income¶ to µprofit or loss¶.
x Similarly, we must also reclassify the cumulative gains or losses due to loss allowance
adjustments that were previously recognised in µother comprehensive income¶ to µprofit 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.

8.7 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.

9. Compound Financial Instruments (IAS 32.28 - 32)

9.1 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

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 the issuer of x Non-derivative FIs
x That, from the issuer's
the financial liability does not have an unconditional right perspective, contain both:
to avoid settling the obligation, whereas - A financial liability; and
x equity instruments involve no such obligations (the - An equity instrument. See IAS 32.28

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 (CFI).

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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 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 4.5.2 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
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

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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.

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'.

Chapter 21 1053
 Gripping GAAP Financial instruments ± general principles

9.2 Compound financial instruments consisting of convertible instruments

Non-derivative financial instruments would, from the issuer's A financial liability

perspective, be accounted for as compound financial represents:
instruments (CFIs) if the instrument is a convertible
x A contractual obligation requiring us:
instrument that has the effect of creating for the issuing entity: - to deliver cash or another FA or
x a financial liability, for example through the compound - exchange financial assets /
liabilities under potentially
instrument creating a contractual obligation to deliver unfavourable conditions; or
cash or another financial asset to the holder of the x A contract that we may have to
instrument (e.g. the obligation to pay interest to a settle using our equity instruments
and where the contract is:
debenture holder); and also
- A non-derivative the settlement of
x an equity instrument, through the compound instrument which may involve a variable
number of our eq. instruments; or
giving the holder the option to convert it (or being
- A derivative the settlement of
compulsorily convertible) into a fixed number of equity which may involve a fixed number
instruments (e.g. a debenture holder who is given the of our own eq. instruments.
See IAS 32.11
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
An equity instrument is
possible conversion of the instrument involves conversion
defined as:
into a fixed number of equity instruments. If the non-
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 liability x after deducting all of its Ls.
IAS 32.11 (slightly reworded)
(please re-read this definition).

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

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.

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At first glance, these further 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.
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

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W1: Calculate the financial liability portion

W1.1 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
W1.2 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
W1.3 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.

$QDSSURSULDWHDGMXVWHGPDUNHWGLYLGHQGUDWHIRUµSXUH¶UHGHHPDEOHdebentures: 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.

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.

2 January 20X4 Debit Credit

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

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-RXUQDOVFRQWLQXHG« Debit Credit

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
Payment of interest on debentures
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
Payment of interest on debentures
Debenture: equity instrument W2 4 572 000
Ordinary stated capital 4 572 000
Conversion of debentures into ordinary shares

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)

9.3 Compound financial instruments consisting of non-convertible preference shares

(IAS 32.18(a); IAS 32.AG25-26 & IAS 32.AG37)

9.3.1 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 (CFI).

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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.

9.3.2 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.
x 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 and this is because the entity is not obliged to declare an ordinary dividend.
x 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.

x This liability is measured at the present value of the future dividends, discounted at an
appropriate market rate.
x 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.
x These dividends are recognised as distributions of equity to equity participants (and
presented in the statement of changes in equity)
x They will only be recognised if and when they are declared.

9.3.3 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).

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.

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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.
x Thus, this means 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).
x 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.
x Thus, this means that the financial liability definition is not met and thus that the definition
of an equity instrument would be met instead.
x 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 µother 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:
x PV of the redemption amt +
x PV of the dividends
The preference dividends and the
effect of the redemption will be
recognised as
x an interest expense in P/L (in
the SOCI)
x due to the process of
unwinding of the L using the
EIR method
See IAS 32.AG25
Liability initially measured at FV:
x PV of the redemption amt
Equity measured as residual:
x FV of CFI – FV of L
The preference dividends will be
recognised as
x a distribution of equity (in the
SOCIE)
The effect of the redemption will
result in the recognition of
x interest expense in P/L (in the
SOCI)
x due to the process of
unwinding the L using the EIR
method
See IAS 32.AG37

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Summary: continuation…
Redeemable/
Non-redeemable
Redeemable:
x at the issuer's option (Eq)
Non-redeemable (Eq)
Pref dividends: Pref dividends:
Non-discretionary (i.e. mandatory) (L) Discretionary (Eq)
Compound financial instrument Pure equity
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
(in the SOCI) due to the process of equity (in the SOCIE)
unwinding of the L using the EIR method
See IAS 32.AG25 See IAS 32.AG25-.26
Note 1
Pure liability or a Pure equity
Compound financial instrument Note 1, 2 & 3

Liability initially measured at FV: Equity measured at the entire proceeds

x PV of the dividends
Equity measured as residual:
x FV of CFI – FV of L Note 1, 2 & 3
The mandatory preference
dividends will be recognised as
x an interest expense in P/L (in
the SOCI)
x due to the process of unwinding
of the L using the EIR method
Note 2 & Note 3
P.S. There is no need to determine
FVs because equity is the residual
interest in the A (the proceeds)
after deducting the L (nil).
The preference dividends will be
recognised as:
x a distribution of equity (in
the SOCIE)

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).

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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).

4 January 20X3 Debit Credit

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.

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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 Part B
1 January 20X1 Dr/ (Cr) Dr/ (Cr)
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 and 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 (CFIs).
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.

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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.

1 January 20X1 Debit Credit

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 portion at amortised cost,
measured at the PV of the dividend stream, discounted at the market rate and
the balance of the compound financial instrument (CFI) recognised as equity
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 ³C1 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 (CFIs).
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

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1 January 20X1 Debit Credit

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 portion at amortised cost, measured
at the PV of the capital amount to be repaid in two years, discounted at the market
rate and the balance of the compound financial instrument recognised as equity
31 December 20X1
Interest expense (E: P/L) L bal: C123 967 x 10% 12 397
FL: Preference shares (L) 12 397
Interest on pref share liability: unwinding of the discount (use mkt rate)
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) 13 636
Interest on pref share liability: unwinding of the discount (use mkt rate)
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

10. Settlement in (QWLW\¶V2ZQ(TXLW\,QVWUXPHQWV(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 QXPEHU RI WKH HQWLW\¶V RZQ HTXLW\ LQVWUXPHQWV
(shares) whose value equals a fixed amount, or an amount based on changes in an underlying
variable (e.g. a commodity price) is a financial liability.

Example 39: SHWWOHPHQWLQHQWLW\¶VRZQHTXLW\LQVWUXPHQWV

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: SHWWOHPHQWLQHQWLW\¶VRZQHTXLW\LQVWUXPHQWV (fixed number)

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
31 December 20X5
Stated capital ± deferred shares (Eq) 600 000
Stated capital (Eq) 600 000
Issue of 120 000 shares (at C6 per share)

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6ROXWLRQ%6HWWOHPHQWLQHQWLW\¶VRZQHTXLW\LQVWUXPHQWV IL[HGDPRXQW
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
Stated capital (Eq) 600 000
Issue of 100 000 shares (at C6 per share)

11. 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 (let
XVFDOOWKHVHµitems¶). See IAS 32.35

Basically, the intention behind this is that if an instrument is recognised in the statement of
financial position, then any RIWKHµitems¶ 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 µitems¶ 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

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

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12. Derivatives (IAS 32.AG15 - .AG19; IFRS 9.4.3 & IFRS 9.BA.1 ± .BA.5)

12.1 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:

x stand-alone derivatives and
x 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 12.5).

12.2 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).

1066 Chapter 21
 Gripping GAAP Financial instruments ± general principles

12.3 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 DJUHHPHQWLVDQµLQWHUHVWUDWHVZDS¶ 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: -RXUQDOLVHWKHUHFHLSWVSD\PHQWVRIFDVKLQ&RPSDQ\$¶VERRNVIRU\HDUDQG\HDU

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
Finance income 2 000
Difference between variable & fixed rate loan received from Co. B

12.4 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 µfuture¶ commits (i.e. obligates)
the entity whereas an µoption¶ 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.

12.5 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.

Chapter 21 1067
 Gripping GAAP Financial instruments ± general principles

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 interest based on a coupon rate.
The principal will be settled (on redemption date) by the conversion of the debentures into a fixed
number RI;<=¶VRZQVKDUHV

Required: Discuss how to account for WKHVHGHEHQWXUHVLQERWK$%&¶VDQG;<=¶VILQDQFLDOVWDWHPHQWV

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 4.1).
The mandatorily convertible debentures exhibit the characteristics of a hybrid instrument:
x it consists of a non-derivative host (the contractual right to receive cash in the future ± see IAS 32.11), and
x an embedded derivative (a forward contract obliging ABC to buy a fixed number of shares on
redemption date ± ABC is effectively obliged to use the principal amount on redemption date to
purchase a fixed number 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 $%&¶VILQDQFLDOVWDWHPHQWV
XYZ’s financial statements
XYZ has issued these debentures and, for the same reason as above, the contract is a hybrid
LQVWUXPHQW+RZHYHUIURP;<=¶VSHUVSHFWLYHWKHQRQ-derivative host is not a financial asset (XYZ has
the contractual obligation to make cash payments ± a financial liability, see IAS 32.11).
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 cash 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 thus will be accounted for at amortised cost.

1068 Chapter 21
 Gripping GAAP Financial instruments ± general principles

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 9.1). In other words, after measuring the financial liability
portion (i.e. the non-derivative host), the equity portion (i.e. the embedded derivative) is measured as
the balancing amount (cash received on issue ± liability portion)

13. 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.

If the requirements for offsetting are met, the financial asset and financial liability must be offset.

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-RIIDVVRFLDWHGZLWKWKHHQWLW\¶VILQDQFLDODVVHWV
and financial liabilities subject to enforceable master netting arrangements

14. Deferred tax consequences of financial instruments

14.1 Overview

The measurement of deferred tax in respect of financial instruments is, as usual, dependent on
PDQDJHPHQW¶VLQWHQWLRQ 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 assumes that the income tax legislation applicable in South Africa applies
and DGGUHVVHVWKHWD[FRQVHTXHQFHVRIµSODLQYDQLOOD¶ILQDQFLDOLQVWUXPHQWV

Chapter 21 1069
 Gripping GAAP Financial instruments ± general principles

14.2 )LQDQFLDODVVHWVDQGOLDELOLWLHVVXEVHTXHQWO\PHDVXUHG DWDPRUWLVHGFRVW

The amortised cost method requires the calculation of the DT effect of FAs that are
held at amortised cost (AC):
effective interest rate, which takes into account premiums,
discounts, as well as the amount and timing of future cash x Carrying amount = AC;
flows. These calculations are the same as those used to x Tax base = AC
GHWHUPLQH WKH ³\LHOG WR PDWXULW\´ in terms of the South x Therefore TD = 0; DT = 0
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.

14.3 Financial assets subsequently measured at fair value

Financial assets held for trading: DT effect of FAs that are
held for trading (fail BM
If PDQDJHPHQW¶VLQWHQWLRQLVWRKROGILQDQFLDODVVHWVIRUWUDGLQJ test):
purposes (i.e. speculative), the financial asset is accounted for x FA is classified at FVPL
at FVPL (because it fails the business model test). This means x Thus, carrying amount = FV;
the carrying amount will reflect fair value. However, if x Tax base = Cost
management intends trading with the financial assets, the x Tax rate = income tax rate
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. DT effect of FAs that are
neither held for trading nor
Financial assets held to collect dividends:
at amortised cost:
If management intends to hold the financial asset for the x FA is classified at
purposes of collecting dividend income, but the financial FVPL or FVOCI-equity
instrument is classified at FVOCI or FVPL (i.e. because it x Thus, carrying amount = FV;
failed the SPPI test), the tax base of the financial asset will be x Tax base = Cost
its cost. Assuming the dividend income is exempt from tax x Tax rate = 0% (dividend
(e.g. the shareholder is a South African company receiving a income is exempt)
local dividend), deferred tax on local instruments would be calculated at 0% of the temporary difference.
The movement in deferred tax is 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.
DT effect of FAs that are held
Other financial assets: for sale:

In all other cases, the future economic benefits of the x Carrying amount = FV
financial asset will be consumed through the eventual x Tax base = Base cost (cost)
sale of the financial asset. Thus, the tax base of the x Tax rate = income tax rate x
financial asset will equal its base cost and deferred tax will CGT inclusion rate
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 ordinary shares. 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
A Shares held for trading FVPL C5 000 C6 000 C8 000
B Shares held to collect dividends FVPL C4 000 C5 000 C5 500
C Shares held for long-term capital growth FVOCI 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.

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 Gripping GAAP Financial instruments ± general principles

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)
31 December 20X5 Dr (Cr) Dr (Cr) Dr (Cr)
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 liability (L) (600) (0) (300)
Deferred tax on shares

Carrying Tax Temporary Deferred

W1. Portfolio A Note 1 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
Note 1: The deferred tax is measured at 30% of the TD because profits from trading in assets are taxed at 30%

W2. Portfolio B Note 2

Opening Balance: 20X5 5 000 4 000 (1 000) 0 L
Movement 500 0 (500) 0
Closing Balance: 20X5 5 500 4 000 (1 500) 0 L
Note 2: A tax rate of 0% is used as the TD reflects dividend income, which, in this example is exempt from tax.

W3. Portfolio C Note 3

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 3: The effective tax rate of 24% has been used, due to CGT effects of the intended sale of the asset.

15. Financial Risks (IFRS 7)

15.1 Overview
There are three categories of financial risks and they are:
x market risk;
x credit risk; and
x liquidity risk.

15.2 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.

Chapter 21 1071
 Gripping GAAP Financial instruments ± general principles

15.2.1 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.

15.2.2 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).

15.2.3 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).

15.3 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).

15.4 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).

16. Disclosure (IFRS 7)

The following narrative disclosure is required (by IFRS 7):

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).
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

1072 Chapter 21
 Gripping GAAP Financial instruments ± general principles

x For liquidity risk:

- Maturity analysis for derivative and non-derivative financial liabilities
- Description of how liquidity risk is managed.

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.

Entity name
Statement of comprehensive income (extracts) 20X5 20X4
For the year ended 31 December 20X5 C C
Note
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)
Profit before tax 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 designated 24 xxx xxx
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

Chapter 21 1073
 Gripping GAAP Financial instruments ± general principles

Entity name
Statement of changes in equity
For the year ended 31 December 20X5 (extracts)
Ordinary Retained Gains/ losses on Gains/ losses Total
shares earnings financial assets on cash flow
at FVOCI hedge
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

Entity name
Statement of financial position (extracts) 20X5 20X4
As at 31 December 20X5 Note C C

EQUITY AND LIABILITIES or ASSETS*

Loans/ debentures xxx xxx
Financial instruments 39 xxx xxx
Preference shares xxx xxx
*Assets and liabilities must be classified as current and non-current

Entity name
Notes to the financial statements (extracts) 20X5 20X4
For the year ended 31 December 20X5 C C
1. Statement of compliance
«
2. Accounting policies
2.1 Financial instruments
The following UHFRJQLWLRQFULWHULDDUHXVHGIRUILQDQFLDOLQVWUXPHQWV«
The fair values of the financial instruments are GHWHUPLQHGZLWKUHIHUHQFHWR«
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

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 XVHV«WRPDQDJHfinancial risks.
Such risks and methods are:
x We are exposed to Currency risk in «DQG)RUHLJQ&XUUHQF\ULVNLVPDQDJHGE\«
x :HDUHH[SRVHGWR,QWHUHVWUDWHULVNLQ«DQG,QWHUHVWUDWHULVNLVPDQDJHGE\«
x :HDUHH[SRVHGWR0DUNHWULVNLQ«DQG0DUNHWULVNLVPDQDJHGE\«
x :HDUHH[SRVHGWR&UHGLWULVNLQ«DQG&UHGLWULVNLVPDQDJHGE\ «
x :HDUHH[SRVHGWR/LTXLGLW\5LVNLQ«DQG/LTXLGLW\5LVNLVPDQDJHGE\«

1074 Chapter 21
Gripping GAAP Financial instruments ± general principles

17. Summary
Financial Assets: Classification Process

Step 1: CCF Test (contractual cash flows)

No Yes
Do the contractual terms of the FA give rise, Is it a derivative?
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

collect'?
i.e. is the objective to
collect only the:
x contractual cash
flows (i.e. the entity
does not intend
dealing in the
instruments)
FV through P/ L
collect and sell'?
i.e. is the objective FV through OCI
to collect both the: (equity instrument)
x contractual cash
flows; and
x cash flows from
selling the asset
No (Neither BM applies)

Yes Yes

Would classification at amortised cost / FV Yes

through 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 FV + trans costs FV + trans costs FV + trans costs FV
measurement:
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
& then to FV Dividend/ interest Dividend/ interest
FV adj in OCI income in P/L income in P/L
All 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 at 12-month ECLs (apply the EIR to the GCA)
- significant increase in credit risk: LA measured at lifetime ECLs (apply the EIR to the GCA)
- become credit-impaired: LA measured at lifetime ECLs (apply the EIR to the Amortised cost)
(i.e. no longer: 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 1075
Gripping GAAP Financial instruments ± general principles

Financial Assets: Subsequent measurement in more detail

Classification
Amortised cost
(debt instruments)
FV through profit or loss
(debt instruments, all derivatives and
investments in equity instruments)
Subsequent measurement:
Measure the asset using the EIR method with interest
income, impairment gains/losses recognised in P/L
Loss allowance: recognised as an asset measurement account
Present the asset at AC (AC = GCA – Loss allowance)
See IFRS 9.5.7.2
Any related foreign exchange gains/losses in P/L *.
Measure the asset to FV on subsequent reporting dates with
FV gains or losses accounted for in P/L.
See IFRS 9.5.7.1
Loss allowance: N/A

FV through other comprehensive income Measure the asset as if it was at amortised cost (i.e. using
(debt instruments) the EIR method with interest income, impairment gains or
losses and foreign exchange gains or losses recognised in
P/L*); then also
Measure the asset to FV on 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)
Present the asset at FV (i.e. not at amortised cost)
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
(investments in equity instruments) dates with 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 method) Fair value
measurement: 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
x at the option of the holder (L) redemption 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
x Eq measured as the residual
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
x Eq measured as the residual
Discretionary Pure equity
(Eq) x Eq measured as the entire proceeds

1076 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 2021)

Contents: Page
1. The basics of hedge accounting 1079
1.1 Overview 1079
1.2 What do we mean by hedges and hedging? 1079
1.3 What is a hedged item? 1080
1.3.1 Overview 1080
Worked example 1: Hedged items 1080
1.3.2 Recognised transactions 1081
1.3.3 Forecast transactions (an uncommitted future transaction) 1081
1.3.4 Firm commitments (committed future transaction) 1081
1.3.5 Hedged items can be single items, groups of items or hedged components 1082
1.3.6 Summary of the periods during which items may be hedged 1082
1.4 What is a hedging instrument? 1082
1.5 How hedging is achieved using a forward exchange contract 1083
Worked example 2: Settlement of a FEC 1084
:RUNHGH[DPSOH)(&¶VFDQ result in gains or losses 1084
Worked example 4: Accounting for speculative FECs 1085
1.6 How to measure a forward exchange contract at its present value 1086
Example 1: Present value of a FEC 1086
2. Hedge accounting 1087
2.1 What is the objective of hedge accounting? 1087
2.2 Hedge accounting qualifying criteria 1088
2.3 Hedge effectiveness as a qualifying criterion 1088
2.4 Types of hedges 1089
3. Fair value hedges 1090
3.1 What is a fair value hedge? 1090
Worked example 5: Fair value hedge of a foreign debtor 1090
3.2 Accounting for a fair value hedge 1090
4. Cash flow hedges 1091
4.1 What is a cash flow hedge? 1091
Worked example 6: Cash flow hedge of a foreign creditor 1091
4.2 Accounting for a cash flow hedge 1091
4.2.1 General approach 1091
4.2.2 Accounting for a cash flow hedge that contains an ineffective portion 1092
4.2.3 Calculating the effective and ineffective portions of a cash flow hedge 1093
Example 2: Cash flow hedges and the concept of ineffective portions 1093
5. Designation of hedging instruments 1094
Example 3: Splitting the interest element and the spot price of a FEC 1095
6. Discontinuance of hedge accounting 1095
6.1 Discontinuing hedge accounting 1095
6.2 How to stop using cash flow hedge accounting 1096
6.3 Rebalancing 1096
Worked example 7: A rebalancing exercise 1096

Chapter 22 1077
 Gripping GAAP Financial instruments - hedge accounting






Contents FRQWLQXHG« Page
7. Hedging across the timeline: application of the theory 1097
7.1 Overview 1097
7.2 Accounting for hedges involving forward exchange contracts 1100
7.3 Hedges in the post-transaction period (phase 3) 1100
Example 4: FEC taken out in the post-transaction period: fair value hedge 1100
7.4 Hedges in the pre-transaction period (phases 1 and 2) 1102
7.4.1 Overview 1102
7.4.2 Hedges in the pre-transaction period where no firm commitment was made 1102
Example 5: Cash flow hedge with a non-financial asset (basis adjustment) 1103
Example 6: Cash flow hedge with a financial asset (reclassification adjustment) 1105
7.4.3 Hedges in the pre-transaction period where a firm commitment was made 1106
Example 7: FEC taken out pre-transaction: Firm commitment as a cash flow hedge 1107
Example 8: FEC taken out pre-transaction: Firm commitment as a fair value hedge 1108
Example 9: FEC taken out pre-transaction: Firm commitment before year-end
and transaction date after year-end 1110
8. Tax consequences 1112
9. Disclosure 1113
Example 10: Disclosure: cash flow hedge: basis versus reclassification adjustments 1113
10. Summary 1114

1078 Chapter 22
 Gripping GAAP Financial instruments - hedge accounting

1. The Basics of Hedge Accounting

1.1 Overview
You may think a hedge is a row of bushes planted along the boundary of a property, a hedged
item is the house in the middle of this property, a hedging instrument is the pair of garden shears
used to trim the hedge and that hedging is the act of trimming the hedge. However, in our world of
accounting, which is a bit like a parallel universe, concepts such as hedges, hedged items, hedging
instruments and hedging take on strangely similar, yet very different meanings.

This chapter first explains some terminology and the theory of hedge accounting and then shows how
to apply this theory using a series of examples. To keep things simple and comparable, the examples
will all focus on hedging items (e.g. a foreign loan) that are exposed to µforeign currency risks¶, and will
all involve the use of a relatively common hedging instrument: µthe forward exchange contract (FEC)¶.

Hedging involves protecting against risks and thus most Hedging  Hedge accounting
entities will be involved in hedging transactions to some
degree or another. However, accounting for hedging transactions using IFRS ¶V µhedge
accounting¶ principles is optional. The purpose of hedge accounting is to ensure that the financial
VWDWHPHQWVUHIOHFWWKHHQWLW\¶VULVNPDQDJHPHQWDFWLYLWLHV, to the extent these activities involve using
financial instruments to manage risks that could affect profit or loss (or, in some cases, other
comprehensive income). Although the application of hedge accounting is optional, once we start
hedge accounting, we may not stop hedge accounting unless certain criteria are met.

1.2 What do we mean by hedges and hedging?

7KHWHUPVµKHGJH¶RUµKHGJLQJ¶DUHQRWGHILQHGLQ,)56+RZHYHULf we take out a hedge, it simply
means we are trying to protect ourselves against a risk. Thus, a hedge is our protection against a
risk (e.g. that our asset might lose value) and hedging is the act of protecting against risk.
Hedging, from the
Hedging involves any activity designed to protect
perspective of IFRS 9, is a
ourselves against the risk of incurring losses. For
risk mgmt. activity that
instance, when taking out insurance, we are trying to uses a financial instrument as the
hedge against possible losses from certain risks (e.g. we hedging instrument to protect
might insure our car against loss due to theft). against the risk that a hedged
item could negatively affect P/L
However, hedging from the perspective of IFRS 9 refers (or in certain cases, OCI)
See IFRS 9.6.1.1
specifically to the use of a financial instrument (normally a
derivative) to protect against risks that could otherwise negatively affect profit or loss (or, in certain
cases, other comprehensive income). Interestingly, although insurance contracts could be
considered as financial instruments, they are excluded from the scope of IFRS 9 Financial
instruments (see IFRS 9.2.1). This means that, although insurance contracts are used to hedge
risks, they cannot be accounted for as a hedging instrument (i.e. using ,)56¶VKHGJHDFFRXQWLQJ
principles), because a µhedging instrument¶ must be a financial instrument in terms of IFRS 9.

The idea behind hedging is that changes in our hedging instrument’s fair value or cash flows will
offset the changes in our hedged item’s fair value or cash flows and thus reduce the impact on
profit or loss (or in certain cases, other comprehensive income). For example: if our hedged item is
an asset and its fair value decreases (debit loss; credit hedged item), our KHGJLQJLQVWUXPHQW¶VYDOXH
should increase (debit hedging instrument; credit gain) so that the loss on the hedged item and the
gain on the hedging instrument offset each other and negate or reduce the impact on profit or loss.

Since this chapter explains hedging mainly using hedges of foreign currency transactions, it would
be useful to define the hedge of a foreign currency transaction. In this regard, we could define it as:
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.

Chapter 22 1079
 Gripping GAAP Financial instruments - hedge accounting

1.3 What is a hedged item? (IFRS 9.6.3) Eligible hedged items

include:
1.3.1 Overview
x recognised assets or liabilities, or
The reality is that an entity can hedge any item that is x unrecognised firm commitments, or
x highly probable forecast transactions, or
exposed to a risk (or risks) that could lead to an unfavourable
x net investments in foreign operations,
change in its related cash flows or fair value. However, the
x that:
KHGJH FDQ RQO\ EH DFFRXQWHG IRU XQGHU ,)56 ¶V µKHGJH - are reliably measured, and
DFFRXQWLQJ¶SULQFLSOHVLIWKHLWHPLVDQeligible µKHGJHGLWHP¶ - involve a party external to the
reporting entity See IFRS 9.6.3.1/2/3/5
In this regard, an eligible µhedged item¶ can be any:
x recognised asset or liability (this could be a financial or non-financial item),
x unrecognised firm commitment (FC), Note 1 & 2
x unrecognised highly probable forecast transaction (HPFT); Note 2 or
x a net investment in a foreign operation. See IFRS 9.6.3.1 & 6.3.3
(1): See section 1.3.3.
(2): :HFDOOWKHVHµunrecognised¶ since they would not meet the definition and recognition criteria of an asset or liability.

The eligible hedged item must also be reliably measurable and must involve parties external to the entity
(i.e. third parties). For example, we could not designate a firm commitment as a hedged item unless it
involved a commitment to a third party (i.e. a decision simply made in a management meeting to purchase
an asset is not a firm commitment). Interestingly, the requirement for third party involvement means that
if hedging has been achieved using transactions between entities within a group, hedge accounting can
be applied in the separate financial statements but not in the consolidated financial statements.
See IFRS 9.6.3.2 and 6.3.5

Entities hedge items that are exposed to a risk of some kind. For example, an item that is a recognised
liability denominated in a foreign currency (i.e. a foreign payable) would be exposed to the risk that the
resultant cash outflows might increase due to unfavourable changes in the foreign currency exchange rate.
This particular risk is referred to as a foreign currency risk. Thus, the entity might consider hedging this risk.

Worked example 1: Hedged items

Hedged items are the items that had exposed the entity to a risk/s, and the hedging instruments
were entered into to protect against those risks. Consider an import transaction:
We are in South Africa (where the 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.
Until we pay this creditor, the 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 (SR) Scenario A Scenario B

01 January 20X3 (Transaction date ± TD) R10: $1 R10: $1
31 March 20X3 (Settlement date ± SD) R 8: $1 R14: $1

In scenario A, the dollar becomes cheaper to South Africans ($1 used to cost R10, but now it only costs
R8). Thus, we say that the Rand has strengthened against the dollar. The effect of this is that, in Rand
terms, the amount we expect to have to pay our creditor decreases from R100 000 to R80 000 (good).
Conversely, in scenario B the Rand weakened ($1 used to cost R10, but now costs R14). The result is that
the amount we expect to have to pay our creditor increases from R100 000 to R140 000 (bad). This is
journalised as follows:
Scenario A Scenario B
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 to spot rate (SR) on settlement date

1080 Chapter 22
 Gripping GAAP Financial instruments - hedge accounting

Scenario A Scenario B
31 March 20X3 FRQWLQXHG« Dr/ (Cr) Dr/ (Cr)
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 at spot rate (SR) on settlement date

:KHQHQWHULQJ DIRUHLJQFXUUHQF\GHQRPLQDWHGWUDQVDFWLRQOLNH WKLVRQHZHFDQHLWKHUGHFLGHWRWDNHDFKDQFH

WKDWWKHH[FKDQJHUDWHZLOOPRYHLQRXUIDYRXU OLNHVFHQDULR$ RUZHFRXOGGHFLGHWRKHGJHDJDLQVWWKHSRVVLELOLW\
WKDWWKH H[FKDQJHUDWHZLOOPRYHLQDZD\WKDWLV XQIDYRXUDEOHWRXV OLNHVFHQDULR% 
If we decide to hedge the item (the creditor), we must choose an instrument to hedge it with (see section 1.4).
Please note: If a foreign debtor owed us $10 000 (instead of us owing a foreign creditor), then scenario A would
be an exchange rate movement that was unfavourable to 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).

$QLWHPWKDWLVHOLJLEOHWREHGHVLJQDWHGDVDµKHGJHGLWHP¶FRXOGbe a single such item in its entirety, or a

group thereof, or even just a component (part) of one of these items or groups of items. See section 1.3.5.

1.3.2 Recognised transactions

The hedged item could be a recognised asset or liability (see section 1.3). A recognised asset or
liability is simply an asset or liability that has been recorded (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. Hedges
of recognised assets or liabilities (i.e. recognised transactions) are accounted for either as cash flow
hedges or fair value hedges, depending on the situation (see section 7.3 for details).

1.3.3 Forecast transactions (an uncommitted future transaction)

In terms of its definition (see pop-up), a forecast transaction is A forecast transaction is

a transaction that has: defined as:

x not yet happened (i.e. it is a future transaction); and x an uncommitted but anticipated
x not yet been committed to (no firm order exists); but x future transaction. IFRS 9 Appendix A

x is expected to happen.

An entity can hedge a forecast transaction but can only account Highly probable
for it as a hedged item if it is highly probable that the transaction is not defined in IFRS 9 but
will occur (just ‘expecting it’ is not good enough!). In other words, it is defined in IFRS 5 as:
ZH FDQ RQO\ DFFRXQW IRU KHGJHV RI µhighly probable forecast x significantly more likely
x than probable IFRS 5 App A
WUDQVDFWLRQV¶ (HPFT). +3)7¶VDUHDOZD\VDFFRXQWHGIRUDVFDVK
Thus, it means roughly 'likely to occur'.
flow hedges (see section 7.4.2 for details).

1.3.4 Firm commitments (committed future transaction)

In terms of its definition (see pop-up), a firm commitment is a future A firm commitment is
transaction (i.e. one that has not yet happened) but one that we defined as: IFRS 9Appendix A
have already committed to. In other words, it is a transaction we x a binding agreement
cannot avoid. IFRS 9 Appendix A x for the exchange of a specified
quantity of resources
A commitment is binding (unavoidable) if it is enforceable, legally x at a specified price
x on a specified future date/ dates.
or otherwise. Something would be enforceable if non-performance
would result in penalties, whether these were stipulated in the agreement or would apply for other
reasons (e.g. through a court of law).

An example of a firm commitment is an entity signing a contract, ordering goods to be delivered from
a foreign supplier. In this case, the future transaction is a future purchase and 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'.

Chapter 22 1081
 Gripping GAAP Financial instruments - hedge accounting

A firm commitment exists from the date we make the commitment until the transaction is eventually
recognised in our books (i.e. when the µfirm commitment¶ becomes a µtransaction¶ instead). In our
example, this recognition date would be the day we obtain control over the imported goods.

Thus, the µlife-span of a firm commitment¶ begins on the date we make a commitment and ends on the
date the transaction is recognised (transaction date). Hedges of firm commitments are accounted for
either as cash flow hedges or fair value hedges, depending on the situation (see section 7.4.3 for details).

1.3.5 Hedged items can be single items, groups of items or hedged components
Items that are eligible to be designated as a µKHGJHGLWHP¶ HJDUHFRJQLVHGDVVHW FRXOGEH
x a single item in its entirety, in which case we would be hedging all the cash flow changes or all
the fair value changes (e.g. hedging against the change in fair value of an investment in shares).
x a group of items, in which case certain extra criteria must be met before it can be designated as
a hedged item (e.g. all items in the group must, individually, be eligible hedged items, and must
be managed together for risk purposes). See IFRS 9.6.6.1 for the extra criteria
x a part of the change in the cash flows or fair value of an item (this part is called a hedged component).

Risk components can only be designated as hedged items if they are separately identifiable and
reliably measurable (this is a requirement that applies to all hedged items). In this regard, if our
hedged item is going to be a risk component, this risk component could be explicitly referred to in a
contract (contractually specified) or simply be implied (non-contractually specified). If it is non-
contractually specified, it does not mean it cannot be designated as a hedged item, it just makes it
slightly more difficult to prove it is separately identifiable and that its effect on the fair value or cash
flows can be reliably measurable. See IFRS 9.B6.3.10

Components of a nominal amount can be designated on a layer or proportional basis. For example:
x $µOD\HUFRPSRQHQW¶RQO\purchases after the first C200 000 sales are designated as a hedged item.
x A µproportional component¶: only 50% of the contractual cash flows of a loan are designated as a hedged
item. See IFRS 9.B6.3.17 & .18

1.3.6 Summary of the periods during which items may be hedged

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
becomes highly probable commitment is made is recognised transaction 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 even 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 is a financial instrument that is expected A hedging instrument

to gain in value when the hedged item loses value, or vice versa. could be a designated:
There are many financial instruments that can be utilised as x derivative measured at FV through
P/L (except for some written
hedging instruments, including: options), or
x Derivatives at fair value through profit or loss (e.g. options, x non-derivative financial A/L
swaps, futures and forward contracts). See IFRS 9.6.2.1 measured at FV through P/L.
Only contracts with external parties
But please note the following derivatives may not be used may be designated as hedging
IFRS 9.6.2.1-3(reworded)
as hedging instruments: instruments.

 certain written options (please see IFRS 9.B6.2.4 for details)

1082 Chapter 22
 Gripping GAAP Financial instruments - hedge accounting

x Non-derivative financial asset or liabilities measured at fair value through profit or loss,
including natural hedges that minimises foreign currency risk (e.g. internal matching of foreign
debtors & foreign creditors in the same currency). See IFRS 9.6.2.2
But please note the following non-derivatives may not be used as hedging instruments:
 equity instruments issued by an entity (because these are not financial assets or liabilities)
 financial liabilities designated at fair value through profit or loss where fair value changes
resulting from changes in credit risk are recognised in OCI.
If we are hedging a foreign currency risk, then there is a further non-derivative that may not
be used as a hedging instrument:
 the foreign currency risk component of a non-derivative financial asset/ liability that has
been designated at fair value through other comprehensive income. See IFRS 9.6.2.2

Financial instruments that qualify to be used as hedging instruments are generally required to be
designated in their entirety but there are three exceptions to this:
x separating the intrinsic value (i.e. the value obtained from the instrument itself) from the time value
of the instrument;
x separating the forward element and spot element of a forward contract and designate only the
change in value of the spot element as our hedging instrument.
x A proportion of the entire instrument may be designated as the hedging instrument. See IFRS 9.6.2.4

Obviously, these financial instruments could be held to collect contractual cash flows or for speculative
reasons, but if they are to be accounted for as hedging instruments, there must be a clear intention by
management to use them as hedging instruments.

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. )(&¶VDUHentered into between an entity and a bank or other financing house.

1.5 How hedging is achieved using a forward exchange contract

A forward exchange contract
To explain how to account for hedges, this chapter
(FEC) is defined as:
focuses on hedging foreign currency denominated items
x an agreement between two parties
(i.e. the hedged item) against foreign currency risks, with x to exchange a given amount of
WKH XVH RI IRUZDUG H[FKDQJH FRQWUDFWV )(&¶V  LH the currency
hedging instrument). x for another currency
x at a predetermined exchange rate &
By hedging against currency risks, an entity hopes that x at a predetermined future date.
http://www.nasdaq.com/investing/glossary
any gain (or loss) on a foreign currency denominated
item, such as a foreign creditor (hedged item) will be offset by an opposite loss (or gain) on the
FEC (hedging instrument).

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 increase when
we remeasure it to the spot rate on settlement date). We could hedge against this possible loss
by using a FEC to µORFNLQ¶DVSHFLILFfuture 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
foreign exchange rate (forex rate). However, the contract may work against us instead, resulting
in us making a loss or reducing possible gains.

The forward rate agreed upon in the FEC contract (the FEC rate) will differ from the spot rate available
on that date. This is because the FEC's forward rate reflects the financing house's prediction of what
WKHVSRWUDWHZLOOEHRQWKHGDWHWKH)(&LVVHWWRH[SLUH7KXVGHSHQGLQJRQWKHILQDQFLQJKRXVH¶V
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.

Chapter 22 1083
 Gripping GAAP Financial instruments - hedge accounting

When the FEC expires, the difference between the forward rate agreed to in the contract and
the spot rate ruling on expiry date will get settled. Settling the difference means either:
x we pay the difference to the financing house, in which case we would have already
recognised a FEC liability and a foreign exchange loss
debit forex loss and credit FEC liability, and then
debit FEC liability and credit bank; or
x we receive the difference from the financing house, in which case we would have already
recognised a FEC asset and a foreign exchange gain
debit FEC asset and credit forex gain, and then
debit bank and credit FEC asset.

Worked example 2: Settlement of a FEC

We made a gain on a FEC to purchase $1 000, because:
x the forward rate we locked in is $1 = R10, while
x the spot rate on settlement is $1 = R15.
By locking into a forward rate of R10 in an FEC that involves us purchasing the foreign currency, it
means we will have to pay R10 000 on settlement date ($1 000 x R10).
When we discover the spot rate is R15 on settlement date, it means the foreign currency is worth
R15 000 ($1 000 x R15).
Thus, we have made a gain of R5 000 (R15 000 ± R10 000).
The journal entries processed would be to:
x recognise the gain: debit FEC asset and credit forex gain, with R5 000 [$1 000 x (R15 ± R10)] and
x recognise the settlement: debit bank and credit FEC asset, with R5 000.
The reason we debit bank with R5 000 is because it is the net impact of us
x buying $1 000 at the forward rate (i.e. CR bank R10 000) and then
x immediately selling $1 000 at the spot rate (i.e. DR bank R15 000).

Important comparison!
Thus, whether our forward exchange contract (FEC)
will result in a gain or loss to us will obviously only be x The spot rate is a current
known on expiry date, when we know the final spot exchange rate being offered at
exchange rate. any one given point in time.
x The forward rate is a
When our FEC expires, our accounting records will be predetermined exchange
updated to reflect either the µFEC asset and gain¶, or rate we agree to pay or
the µFEC liability and loss¶, measured by comparing: receive in the future.
x the forward rate agreed to in our forward
exchange contract (FEC); and
x the spot rate ruling on expiry of the FEC.

However, between the date the FEC is entered into and the date the FEC expires, we
REYLRXVO\ ZRQ¶W know what the final spot rate will be, and thus, if there is a reporting date
between these two dates, we will need to recognise an estimated µFEC asset and gain¶ or
estimated µFEC 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 being offered (i.e. on the date we are estimating our FEC asset
or liability) in similar forward exchange contracts that expire on the same date as our FEC.

Worked example 3)(&¶V can result in gains or losses

Hedging instruments are useful because they help us to effectively lock-in to a known
amount or reduce our risks. Let's assume our hedging instrument is an 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 foreign
exchange rate (forex rate).

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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 (FR) of R11: $1 in an FEC to cover a future payment of $10 000.
This means we know our future cash outflow will be R110 000 ($10 000 x R11). However, if the spot
rate is R9: $1 when this FEC expires, we will regret having signed the FEC. This is because, had we
not signed the FEC, and thus simply been left exposed to the spot rate (SR), our cash outflow when
paying our creditor would only have been R90 000 ($10 000 x R9). However, the FEC has resulted in a
loss to us of C20 000 and thus we will pay the bank R20 000 ($10 000 x FR: R11 - $10 000 x SR: R9)
when the FEC expires. Thus, in this case, the FEC was 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 we know our future cash inflow will be R110 000 ($10 000 x R11) and thus, a spot rate
of R9: $1 on the date the FEC expires would have been a 'good thing'. This is because, had we not
signed the FEC, and thus been left exposed to the spot rate, our only cash inflow would have been from
our debtor at R90 000 ($10 000 x R9). However, this FEC resulted in a gain to us of C20 000 and thus
the bank will pay us R20 000 when the FEC expires. Thus, in this case, 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 signed the FEC (i.e. the FEC was an asset and
thus made us a gain) or we may regret it (i.e. the FEC was a liability and thus made us a loss).

However, please note that, irrespective of whether a speculative FEC improved or worsened the cash
flow, when it is used as a hedge, it has achieved its objective, which was simply to lock into a price
and thus reduce risk attached to the hedged item

Worked example 4: Accounting for speculative FECs

To illustrate the accounting treatment of a speculative FEC (not used as a hedging
instrument), consider the following example: Our functional currency is Rands and we owe
$10 000, payable on 31 March. To cover this payment, we sign an FEC expiring on 31 March, locking
into a forward rate of R11: $1. By doing this, we now have comfort in knowing that when we pay our
creditor on 31 March, it will cost us R110 000 ($10 000 x R11). We might do this for speculative reasons
because we think the spot exchange rate on 31 March will be, say R12: $1, thus we think the FEC will
save us R10 000.

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 (i.e. we compare our forward rate with forward
UDWHVFXUUHQWO\EHLQJRIIHUHGLQVLPLODU)(&¶VZLWKWKHVDPHH[SLU\GDWH , 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). The fact that the FEC seems to be working against us, is
recognised as a FEC liability and foreign exchange loss (credit: FEC liability and debit: forex loss with
an amount of R20 000).

Because it is too time-consuming to keep checking daily to compare the latest forward rates on offer
with the forward rate we obtained, 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.

Then, when the FEC expires on 31 March, we will compare the forward rate we obtained with the final
spot rate on 31 March. We will now know for sure whether the FEC worked for or against us.

The table below summarises the information involving the FEC.

Scenario A Scenario B
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

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In scenario A, the strengthening Rand reduces the amount we owe our creditor (good) but our FEC
locked us into a higher forward rate (R11: $1) 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 increases the amount we owe our creditor (bad) but our FEC locked
us into a lower forward rate (R11: $1) than if we had been left exposed to the spot rate (good) ± thus the
FEC was an asset to us.
Scenario A Scenario B
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'.

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.

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 various dates:
Forward Rate to 30 November 20X5
28 February 20X5 ¼ ¥1
30 June 20X5 ¼–
31 August 20X5 ¼.006820 : ¥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 (¼) on;
x 30 June 20X5;
x 31 August 20X5.
%6KRZDOOMRXUQDOVQHHGHGWRUHFRJQLVHWKH)(&LQWKH*HUPDQHQWLW\¶VERRNV

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): ¼$VVHW W1
x 31 August 20X5 (i.e. 3 months to expiry): ¼/LDELOLW\ 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 ¼0.007131 and will have to pay ¼7 131.
x Had it waited and entered into the FEC on 30 June 20X5, it would have obtained a rate of ¼0.007404
and had to pay ¼7 404.
x By entering the FEC on 28 February rather than on 30 June 20X5, it saved ¼273 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: ¼263 (i.e. FEC asset/ gain measured LQµUHDOPRQH\¶ 

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W1. Value of the FEC on 30 June 20X5:

30 June 20X5 Rate Amount (¥) Amount payable (¼ : FV Present values (5 months to 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)]
¼273 Asset/ gain ¼263 Asset/ gain

The present value can be calculated using a financial calculator:

(1) FV = 7 131 N = 5/12 I = 10 Comp PV « your answer should be: 6 853
(2) FV = 7 404 N = 5/12 I = 10 Comp PV « your answer should be: 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 ¼0.007131 and will have to pay ¼7 131.
x Had it waited and taken out the FEC on 31 August 20X5, it would have obtained a rate of ¼0.00682
and had to pay ¼6 820.
x By taking out the FEC on 28 February rather than on 31 August 20X5, it has to pay an extra ¼311
thus losing ¼311 (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: ¼304 (i.e. the latest estimate is that the
FEC represents a liability / loss, measured at ¼LQµUHDOPRQH\¶ 

W2. Value of the FEC on 31 August 20X5:

31 August 20X5 Rate Amount (¥) Amount payable (¼ )9 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)]
¼  Liability/ loss ¼  Liability/ loss

The present value can be calculated using a financial calculator:

(1) FV = 7 131 N = 3/12 I = 10 Comp PV « your answer should be: 6 963
(2) FV = 6 820 N = 3/12 I = 10 Comp PV « your answer should be: 6 659

Solution 1B: Journals

Not Present Valued Present Valued
30 June 20X5 Debit Credit Debit Credit
FEC asset W1 (above) 273 263
Forex gain (I: P/L) 273 263
Recognising FEC asset.
31 August 20X5
Forex loss (E: P/L) W3 (below) 584 567
FEC liability 584 567
Re-measuring the FEC on 31 August 20X5

W3: Remeasurement adjustment at 31 August 20X5 Not Present Valued Present Valued
FEC asset at 30 June 20X5 reversed W1 (273) (263)
FEC liability at 31 August 20X5 recognised W2 (311) (304)
(584) (567)

2. Hedge Accounting

2.1 What is the objective of hedge accounting?

The idea of hedge accounting arose because, when we apply the usual IFRS requirements
to the hedged item and to the hedging instrument, we would not necessarily recognise the loss
(or gain) on the µhedged item¶ and the gain (or loss) on the µhedging instrument¶ in the same
period and/or in the same place (e.g. a loss on the hedged item might be recognised in P/L
whereas the gain on the hedging instrument is recognised in OCI). These are referred to as
accounting mismatches.

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The objective of hedge accounting (see pop-up) is to ensure

The objective of hedge
WKDWWKHILQDQFLDOVWDWHPHQWVUHIOHFWµWKHHIIHFWRIDQHQWLW\¶VULVN
accounting:
PDQDJHPHQW DFWLYLWLHV¶. Thus, when hedge accounting is
applied, the gain or loss on the µhedged item¶ and µhedged x to represent in the fin. statements;
instrument¶ are recognised in the same period and in the x the effect of an entity’s risk
management activities that use
same place (both in µprofit or loss’ or both in ‘other
x financial instruments to manage
comprehensive income’). Hedge accounting thus attempts to exposures from particular risks
avoid accounting mismatches (e.g. recognising a loss in µprofit x that could affect P/L (or, in certain
or loss¶ and a related gain in µother comprehensive income¶ . cases, OCI). See IFRS 9.6.1.1 (slightly reworded)

Hedge accounting is entirely voluntary but there are certain criteria that must be met before we
are allowed to apply hedge accounting (see section 2.2).

2.2 Hedge accounting qualifying criteria (IFRS 9.6.4)

If we have an item that we believe is at risk, we may decide to hedge these risks, by using an
instrument that we believe will offset these risks.

If our item meets the definition of a hedged item (see section 1.3) and if our instrument meets the
definition of a hedging instrument (see section 1.4) then we have two ingredients necessary for
hedge accounting. However, we may only account for the relationship between the hedged item
and the hedging instrument as a hedge if all 3 criteria are met. These are listed in the pop-up 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) (slightly reworded)
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 must identify:
 the hedging instrument,
 the hedged item,
 the nature of the risk being hedged (e.g. in this chapter we focus on foreign exchange risk), &
 how the entity will assess the hedging effectiveness of the hedging relationship’.
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’, &
 the hedge ratio of the hedging relationship for accounting purposes must mirror the
ratio for risk management purposes (i.e. ‘the quantity of the hedged item’ that is
actually hedged relative to ‘the quantity of the hedging instrument that the entity
IFRS 9.6.4.1 (c)(reworded)
actually uses to hedge’ it).

2.3 Hedge effectiveness as a qualifying criterion

One of the criteria to be met before being able to apply
Hedge effectiveness:
hedge accounting is that the entity needs to document
how it will assess the effectiveness of the hedging x Economic relationship must exist
instrument. However, there is no absolute ratio of hedge x Credit risk must not dominate value
effectiveness required for purposes of assessing changes
whether the criterion of hedge effectiveness is met (e.g. x Designated hedge ratio must be
it does not have to be 100% or 80% effective etc). consistent with risk management
See IFRS 9.6.4.1(c)
strategy
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.

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x The value changes within the economic relationship

are not driven primarily by the impact of credit risk. Credit risk is defined as:

This requires an entity to monitor changes in the fair x The risk that one party to a
value of the instruments within the economic financial instrument
relationship and assess the extent to which such x Will cause financial loss to the
changes are driven by changes in credit risk. other party
x By failing to discharge an
x The hedge ratio for accounting purposes mirrors the obligation IFRS 7 Appendix A
hedge ratio for risk management purposes, provided
the ratio does not reflect a deliberate imbalance designed to achieve an accounting
outcome that is not consistent with the purposes of either hedge accounting or risk
management. See IFRS 9.6.4.1(c)
Hedge ratio is defined as
the relationship between
Despite the fact that there is no pre-determined level of
hedge effectiveness required for this particular qualifying x the quantity of the hedging
criterion to be met, it is important to understand what is instrument and
x the quantity of the hedged item
meant when people refer to the µlevel of hedge x in terms of their relative weighting.
effectiveness¶. IFRS 9 Appendix A

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 a hedge becomes ineffective, by failing to adequately meet one of the three criteria (see the
characteristic features listed above), we do not discontinue hedge accounting. Instead, we may
need to rebalance the quantities of either the hedging instrument or the hedged item, and also
immediately recognise the ineffective portion in profit or loss. Refer to section 6.3 for further
explanation on rebalancing.

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). Hedge
ineffectiveness does not pose a problem for fair value hedges, because all gains or losses are
already reflected in profit or loss. The effects of hedge ineffectiveness are discussed in
section 4.2.2 and section 4.2.3.

2.4 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
discussed in detail. in a 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 related gains or losses (which are
recognised when creating and adjusting the FEC asset or liability balance) are recognised:
x in 'profit or loss' (P/L) if it is a fair value hedge,
x in 'other comprehensive income' (OCI) if it is a cash flow hedge.

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3. Fair value hedges (IFRS 9.6.5.2-4)

3.1 What is a fair value hedge? (IFRS 9.6.5.2-3)

A fair value hedge is
A fair value hedge, by definition (see pop-up), is one that defined as:
is trying to protect our profit or loss from being affected by x a hedge of the exposure to
changes in the fair value of a specific item, where these x changes in fair value of:
fair value changes 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,
HQWLW\¶V profit or loss, there is one exception where the liability or firm commitment;
hedge is trying to protect other comprehensive income: x that is attributable to a particular
this is where the hedged item is an investment in equity risk (e.g. a foreign currency risk); &
instruments that is classified at fair value through other x could affect P/L. IFRS 9.6.5.2(a)

comprehensive income (FVOCI-equity). See IFRS 9.6.5.3

Thus, a fair value hedge that is hedging (protecting) against the effects of changes in fair value on our
profit or loss (or other comprehensive income ± see exception above) 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 5: 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 honoured 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.

Note that the requirement of recognising hedge ineffectiveness in profit or loss is automatically
achieved with a fair value hedge, because all movements relating to a fair value hedge are
always recognised in profit or loss.

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
x changes in cash flows of:
specific risks that could cause variability in the cash flows  a recognised asset or liability; or
relating to a specific item (the item to be hedged), where  of a highly probable forecast
changes in the cash flows could end up affecting profit transaction; or
 a firm commitment*
or loss and where these cash flows relate to: x attributable to a particular risk; &
x a recognised asset or liability (or part thereof); or x that could affect P/L.
x a highly probable forecast transaction (or part thereof); IFRS 9.6.5.2(b) reworded

*A hedge of a FC can only be accounted

or for as a CFH if the hedge is protecting
x a firm commitment (but only if it is being hedged the FC against foreign currency risks.
See IFRS 9.6.5.4
against foreign currency risk!). See IFRS 9.6.5.2 & .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 6: 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 attempts 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 µcash 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 (µfair value hedges¶ recognise these gains or losses in profit or loss).
Gains or losses that accumulate in other comprehensive income are eventually reversed out of
other comprehensive income and into profit or loss, either by using a reclassification adjustment
(affecting profit or loss directly) or a basis adjustment (affecting profit or loss indirectly).

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Gains or losses RQDµFDVKIORZKHGJH¶ 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)

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 does not affect the amount of
other comprehensive income in the statement of comprehensive income. 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 µusual way¶ (i.e. through other
comprehensive income) (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)

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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)

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: Show 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.

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 Gripping GAAP Financial instruments - hedge accounting

x Part (b) FRQWLQXHG«

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

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 in 200 000
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
HQWLW\¶VREMHFWLYHV
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

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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 (functional currency is Rands: R) entered into
a FEC for $100 000 to hedge the import of a plant, expiring on 31 December 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.

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:

30 June 20X1 Debit Credit

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 WKHHQWLW\¶VGRFXPHQWHGKHGJLQJ
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.

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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).

6.3 Rebalancing (IFRS 9.6.5.5 & .B6.5.7-21)

One of the qualifying criteria for hedge accounting is that the hedging relationship must be
considered to be effective. However, if our hedging relationship was effective originally, but is
now no longer effective because there is an imbalance in the hedge ratio, we are not allowed to
simply stop hedge accounting. Instead, 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 called a
‘rebalancing’ exercise.

Rebalancing requires the quantities of the hedged item or hedging instrument to be adjusted in
a way that leads to the hedge ratio once again complying with the hedge effectiveness
requirements of IFRS 9.

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.

Changes to the quantities of the designated items for any other purpose are not classified as
µUHEDODQFLQJ¶DGMXVWPHQWV

Worked example 7: A rebalancing exercise

An airline needs to buy 100 000 litres of jet fuel in 2 years. As the price of jet fuel is
constantly fluctuating, the airline wants to hedge its exposure to this risk.

,GHDOO\WKHDLUOLQHZRXOGHQWHULQWRDGHULYDWLYHUHODWHGWRMHWIXHO+RZHYHUDVWKLVGHULYDWLYHGRHVQ¶W
exist, the airline will to hedge its exposure by purchasing a common derivative that has an economic
relationship to jet fuel, for instance, a futures contract for crude oil (refer to chapter 21 for an
explanation of futures contracts).

However, the airline cannot buy 1 litre crude oil futures to hedge against the price fluctuation of 1 litre
of jet fuel. This is because crude oil is only one component affecting the price of jet fuel ( there are a
number of other components that will also impact the price of jet fuel, such as costs to refine the fuel).

7KHDLUOLQH¶VKHGJLQJH[SHUWVGHWHUPLQHWKDWFUXGHRLOWUDGHVDW, approximately, a 20% discount

compared to jet fuel prices. Therefore, the hedging ratio is determined to be 0.8:1. This means that, in
order to hedge its exposure to the price fluctuation of 100 000 litres of jet fuel, the airline must enter
into a futures contract to purchase 125 000 litres of crude oil. Note that these futures would be settled
net (refer to the comment below).
At the time of the hedge inception, the price of jet fuel is C15 per litre, while the futures for crude oil is
trading at C12.50 per litre.

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After 6 months, the price of jet fuel is C16.50 per litre, while the futures for crude oil is now trading at
C13.25 per litre.
x The change in the fair value of the hedged item (the jet fuel) is C150 000 ((C16.50 ± C15) x 100 000)
x The change in the fair value of the hedging instrument (the futures contract) is C93 750 ((C13.25
± C12.50) x 125 000)

Given that the change in the fair value of the futures contract is C93 750, while the change in the fair
value of the jet fuel is C150 000, this hedge would be regarded as ineffective, given that only
approximately 62.5% (93 750 / 150 000) of the change in the fair value of the jet fuel is being covered
by the change in fair value of the futures contracts. The airline would need to rebalance this hedge.

To do this, the airline would purchase more crude oil futures contracts. The hedging experts have
DVVHVVHGWKDWWKHDLUOLQHVKRXOGSXUFKDVHDQDGGLWLRQDOµOLWUHFUXGHRLO¶IXWXUHVFRQWUDFWV7KH
new hedging ratio is now 0.79:1 (100 000/126 500). The airline has now rebalanced the hedging
relationship, to ensure hedge effectiveness.

Comment:
A net settled forward contract is one where actual products are not exchanged on settlement date.
Instead, on this date, parties to the contract settle the difference between the exercise price (in this
case, C12.50) and the prevailing selling price (SP) of the µunderlying¶ (oil) on settlement date. A gross
settled forward contract is one that will be settled by actually transferring the µunderlying¶ (i.e. in this
case, we would actually have to receive 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).

Consider the following:

x If we enter into a hedging instrument on the date 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).

Chapter 22 1097
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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 either before a forecast transaction has become highly probable, or after the
transaction has been settled.
x 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 on the date that our forecast transaction becomes highly probable.
x The circumstances of our particular transaction may not necessarily involve all three phases
(e.g. we could enter into a transaction without it first going through phases where we consider it
WREHDµhighly probable forecast transaction¶DQGor µfirm 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 µrecognised assets or liabilities¶ and µfirm commitments¶. On
the other hand, the definition of a cash flow hedge (see section 4.1) refers to hedges of
µrecognised assets or liabilities¶, µfirm commitments¶ (but only if we are hedging against foreign
currency risk) and µhighly probable forecast transactions¶. Thus, hedges of µhighly 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 forecast transaction Date a firm commitment Date the transaction Date the transaction is
becomes highly probable is made is recognised 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
Pre-transaction period Post-transaction period

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 enter into a hedging instrument only on or after the transaction is recognised (i.e. on or
after transaction date), we will 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).
x If we enter 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. However, 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)

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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 trigger 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).
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

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7.2 Accounting for hedges involving forward exchange contracts (IFRS 9.6.5)
Section 7 involves a series of examples showing how to apply hedge accounting theory. These
examples will involve:
x the hedged item: the examples will involve a variety of hedged items
- foreign currency denominated highly probable forecast transaction (HPFT),
- firm commitment (FC) and/ or
- recognised asset or liability (recognised transaction); and
x the hedging instrument: all examples will involve the use of 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

Hedges of a recognised A/L

If a hedging instrument (e.g. FEC) is entered into (or already
are accounted for:
exists) on or after the date on which the transaction is x as CFHs or FVHs
recognised (i.e. on or after transaction date) it means the
instrument is hedging a recognised asset or liability (i.e. a recognised transaction).

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
x settlement date
The hedged item, being the foreign currency denominated x reporting date (normally a
transaction is recognised and measured using the spot rate financial year-end)
on transaction date.

If the hedged item is a monetary item (e.g. a payable), it must be 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.
x Payment is due to take place on 7 July 20X1 (payment is made on due date).
x 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 7 July20X1.
x At -XQH;WKHUDWHDYDLODEOHRQVLPLODU)(&¶VH[SLULQJRQthe same date is R9,50: $1.
x The entity designates the hedge as a fair value hedge. The year-end is 30 June 20X1.

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.

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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 thus saved us R100 000 (R1 000 000 ± R900 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 trans 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 $100 000 x R9.55 previous spot rate 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 creditor a/c balance: 1 000 000
Bank 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 1101
 Gripping GAAP Financial instruments - hedge accounting

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 WKDWLVQRW\HWµKLJKO\SUREDEOH¶(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
‘highly probable forecast
transaction date), the asset or liability that was the transaction’ (HPFT):
ultimate purpose of the forecast transaction will then be
x Must be accounted for as a CFH
recognised (e.g. purchased inventory is recognised). x Recognise an FEC asset/ liability
(measured at FEC rates) and
At this point we no longer have a highly probable forecast x Gains or losses recognised in OCI
transaction, since it has been replaced by the actual
transaction. Thus, the hedge of the highly 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)

1102 Chapter 22
 Gripping GAAP Financial instruments - hedge accounting

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 )(&UDWHVDYDLODEOHRQWKHUHOHYDQWGDWHVRQVLPLODU)(&¶VWKDWZRXOGH[SLUHRQWKLVVDPHSD\PHQW
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 µhighly 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 R900 000 ($100 000 x 9) 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
Foreign creditor (L) 900 000
Inventory purchased & related creditor, at spot rate on trans. date

Chapter 22 1103
 Gripping GAAP Financial instruments - hedge accounting

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
Inventory (A) 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
7 July 20X1: payment date
FEC asset $100 000 x R10 spot rate on payment date ± 40 000
Forex gain (I: P/L) $100 000 x R9.60 previous FR 40 000
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; Or the creditor 1 000 000
Bank balance: (900 000 + 60 000 + 40 000) 1 000 000
Payment of creditor: based on the spot rate on payment date
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 + R50 000 100 000
+ R40 000)
Receipt from the financing house on expiry of the FEC: FR versus SR
15 July 20X1: on sale of inventory
Cost of sales (E: P/L) (900 000 ± 10 000) x 40% 356 000
Inventory (A) 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
Inventory (A) 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 the 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.

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Example 6: Cash flow hedge with a financial asset (reclassification adjustment)

Required: Repeat example 5, assuming we 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
Foreign creditor 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
30 June 20X1: year-end
FEC asset $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 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 $100 000 x R9.00 previous spot rate 60 000
Foreign creditor remeasured to the spot rate at year-end
7 July 20X1: payment date
FEC asset $100 000 x R10 spot rate on payment date 40 000
Forex gain (I: P/L) ± $100 000 x R9.60 previous FR 40 000
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 on payment date ± 40 000
Foreign creditor $100 000 x R9.60 previous spot rate 40 000
Foreign creditor remeasured to the spot rate on payment date
Foreign creditor $100 000 x R10 SR on pmt date; Or the 1 000 000
Bank creditor balance: (900 000 + 60 000 + 40 000) 1 000 000
Payment of creditor: based on the spot rate on payment date
Bank $100 000 x (R9: the FR we obtained ± R10: 100 000
the SR on expiry date)
FEC asset Or: Balance in the FEC asset: (10 000 + 100 000
50 000 + 40 000)
Receipt from the financing house on expiry of the FEC: FR versus SR
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 1105
 Gripping GAAP Financial instruments - hedge accounting

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
Debtor Given 600 000
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 a
The principles we used when accounting for a hedge of a firm commitment as a CFH:
highly probable forecast transaction (HPFT) (phase 1) as x Recognise an FEC asset/ liability
a cash flow hedge (see section 7.4.2) are exactly the (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.

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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 (repeated below) except that a firm commitment is
entered into before transaction date.
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 recognised asset or liability was designated as a fair value hedge.
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 )(&UDWHVDYDLODEOHRQVLPLODU)(&¶VWKDWwill 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 ineffective.

Solution 7: Firm commitment 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
(measured at FEC rates) and
instrument as an asset or liability (FEC A/L) with the
x recognise a FC asset/ liability
related gains and losses first recognised in other
(measured at spot rates).
comprehensive income.
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 1107
 Gripping GAAP Financial instruments - hedge accounting

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 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 stop recognising
gains or losses on the FEC asset/liability in OCI and recognise them in P/L instead.
x When 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 that had
accumulated in OCI while it was a CFH will be released using a basis adjustment. This adjustment will only be
processed on transaction date (i.e. on the day we recognise the purchase of inventory).
x As with the previous examples, the FEC has saved us R100 000 (R1 000 000 ± R900 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

No entries relating to the FEC are processed

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 Gripping GAAP Financial instruments - hedge accounting

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 transaction date 900 000
Foreign creditor 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
Forex gain (I: P/L) $100 000 x R9.06 previous FR 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 ± $100 4 000
Firm commitment liability 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)
30 June 20X1: year-end
FEC asset $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: 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 ± $100 000 60 000
Foreign creditor x R9.00 previous spot rate 60 000
Foreign creditor remeasured to spot rate at year-end

7 July 20X1: payment date

FEC asset $100 000 x R10 spot rate on payment date ± 40 000
Forex gain (I: P/L) $100 000 x R9.60 previous FR 40 000
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 $100 000 x R9.60 previous spot rate 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
Payment of creditor: based on the spot rate on payment date

Bank $100 000 x (R9: the FR we obtained ± R10: the SR 100 000
on expiry date)
FEC asset Or: Balance in the FEC asset: 100 000
(6 000 + 4 000 + 50 000 + 40 000)
Receipt from the financing house on expiry of the FEC: FR versus SR

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
Debtor Given 400 000
Sales (I: P/L) 400 000
Sale of 40% of inventory: sales and cost of goods sold

 

Chapter 22 1109
Gripping GAAP Financial instruments - hedge accounting

20 August 20X1: date of sale of inventory Debit Credit

Cost of sales (E: P/L) (900 000 ± 6 000 ± 4 000) x 60% 534 000
Inventory 534 000
Debtor Given 600 000
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: firm commitment

before year-end and transaction date after year-end
Apple Limited's functional currency is the Rand (R). It purchases an asset for $100 000. A
FEC is taken out before transaction date and before a firm commitment is made and is
scheduled to expire on 31 August (payment date).
x The hedge of the recognised asset or liability is designated as a fair value hedge.
x The hedge of the firm commitment is designated as a fair value hedge.
x )(&UDWHVDYDLODEOHRQ)(&¶VH[SLULQJRQ$XJXVW;DUHVKRZQEHORZ
x 40% of this asset is 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 commitmen 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: firm commitment before
year-end and transaction date after year-end
Part A Part B
1 March 20X1: date FEC entered into Dr/ (Cr) Dr/ (Cr)
No entries relating to the FEC are processed
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
30 June 20X1: year-end
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

1110 Chapter 22
Gripping GAAP Financial instruments - hedge accounting

Journals FRQWLQXHG« Part A Part B

20 July 20X1: transaction date Dr/ (Cr) Dr/ (Cr)

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
Forex gain (P/L) $100 000 x R9.1 previous FR (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 ± $100 40 000 40 000
Forex gain (P/L) 000 x R9.60 previous FR (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)
Payment of creditor: based on the spot rate on payment date

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)
Receipt from the financing house on expiry of the FEC: FR versus SR
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 1111
 Gripping GAAP Financial instruments - hedge accounting

Part A Part B
1RYHPEHU;FRQWLQXHG« Dr/ (Cr) Dr/ (Cr)
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 inclusion of the related gain or
loss in the calculation of taxable profit 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
DQ)(&LVDQµDIIHFWHG)(&¶

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
WKHµDIIHFWHG)(&¶ WKHKHGJLQJLQVWUXPHQW ZDVWDNHQXQWLOWUDQVDFWLRQGDWH 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.

1112 Chapter 22
 Gripping GAAP Financial instruments - hedge accounting

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:
x Revenue in 20X2: C1 000 000, constituted entirely by 2 sales involving the imported asset.
x Revenue in 20X1: C600 000, constituted entirely by services rendered.

Required: Show 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
Statement of comprehensive income 20X2 20X1
For the year ended 30 June 20X2 Notes 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
Profit for the year 111 000 589 000
Other comprehensive income for the year 11 0 6 000

x Items that may never be reclassified to profit or loss:

- Gain on cash flow hedge, 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 1113
Gripping GAAP Financial instruments - hedge accounting

Apple Limited
Statement of changes in equity (extracts)
For the year ended 30 June 20X2
Retained Cash flow Total
earnings hedges
C C C
Balance 1/7/20X0 xxx 0 xxx
Total comprehensive income 589 000 6 000 595 000
Balance 30/6/20X1 xxx 6 000 xxx
Total comprehensive income 111 000 0 105 000
Basis adjustment 0 (6 000)
Balance 30/6/20X2 xxx 0 xxx

Apple Limited
Notes to the financial statements (extracts)
For the year ended 30 June 20X2
20X2 20X1
C C
10. Profit before tax

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

x Items that may never be reclassified to profit or loss:

- Gain on cash flow hedge, net of tax * 6 000

x Items that may be reclassified to profit or loss 0 0

* The tax effect should be presented, but this example has ignored tax.

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
Statement of comprehensive income
For the year ended 30 June 20X2
Notes 20X2 20X1
C C
Revenue 1 000 000 600 000
Expense of the hedged item 20X2: 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
Profit for the year 111 000 589 000
Other comprehensive income for the year 11 (6 000) 6 000
x Items that may never be reclassified to profit or loss 0 0
x Items that may be reclassified to profit or loss:
- Gain on cash flow hedge, (net of tax and reclassification adjustment) (6 000) 6 000

Total comprehensive income for the year 105 000 695 000

1114 Chapter 22
Gripping GAAP Financial instruments - hedge accounting

Apple Limited
Statement of changes in equity (extracts)
For the year ended 30 June 20X2
Retained Cash flow Total
earnings hedges
C C C
Balance 1/7/20X0 xxx 0 xxx
Total comprehensive income 589 000 6 000 595 000
Balance 30/6/20X1 xxx 6 000 xxx
Total comprehensive income 111 000 (6 000) 105 000
Balance 30/6/20X2 xxx 0 xxx

Apple Limited
Notes to the financial statements (extracts)
For the year ended 30 June 20X2
Notes 20X2 20X1
C C
10. Profit before tax

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) 0

11. Other comprehensive income

x Items that may be reclassified to profit or loss:

- Gain on cash flow hedge* 0 6 000
- Reclassification of gain to profit or loss (2 400 + 3 600) * *(6 000) 0

x Items that may not be reclassified to profit or loss 0 0

* The tax effect should be presented (either on the face or in the notes), but this example ignored tax.

10. Summary

Various important facts about hedge accounting

x Objective of hedge accounting
- To represent, in the financial statements
- The effects of risk management activities
- That use financial instruments to manage exposure to particular risks
- That could affect P/L (or, in certain cases, OCI)
x Eligible hedged items include:
- Recognised assets or liabilities, or
- Unrecognised firm commitments, or
- Highly probable forecast transactions, or
- Net investments in foreign operations.
These items must be reliably measured and involve a third party. See IFRS 9.6.3.1/2/3/5
x Hedging instruments are:
- Financial instruments
- Expected to gain value when hedged item loses value, or vice versa
Mainly derivatives (e.g. options, swaps, futures and forward contracts) See IFRS 9.6.2.1
x Criteria required to apply hedge accounting:
- Hedging relationship must consist of eligible hedged items and hedging instruments
- There must be formal designation and documentation of the hedging relationship and the
risk management objectives and strategy for undertaking the hedge
- Hedging relationship must meet all the hedging effectiveness criteria
x Economic relationship must exist between hedged item and hedged instrument
x Effect of credit risk must not dominate value changes resulting from economic
relationship
x Hedge ratio of relationship must mirror ratio for risk management purposes See IFRS 9.6.4.1

Chapter 22 1115
Gripping GAAP Financial instruments - hedge accounting

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:
x changes in fair value of:
 a recognised asset or liability; or
 an unrecognised firm commitment; or
 a component of such asset, liability or firm
commitment;
x that is attributable to a particular risk (e.g.
a foreign currency risk); and
x could affect profit or loss. IFRS 9.6.5.2(a)
A hedge of the exposure to:
x changes in cash flows of:
 a recognised asset or liability; or
 of a highly probable forecast transaction; or
 a firm commitment*
x attributable to a particular risk; and
x that could affect P/L. IFRS 9.6.5.2(b) reworded
*A hedge of a FC can only be accounted for as
a CFH 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:
x recognised directly in P/L
If FEC (hedging instrument) is hedging a firm
commitment (hedged item), then we also:
x Recognise a FC A/L with related gains or losses
x recognised in P/L (measured using SR)
Recognise a FEC A/L with related gains or losses:
x recognised first in OCI and
x then go to P/L
- directly via a reclassification adjustment; or
- indirectly via a basis adjustment.
When estimating the FEC A/L (i.e. before expiry)
we 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/
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 This transfer is done on trans. date i.e. when
the hedged item affects profit or loss (e.g. the non-fin. asset (e.g. PPE) is recognised. It
when a forecast sale is made or interest thus affects P/L when this asset affects P/L
expense is incurred) (e.g. depr on the PPE)

Hedges and Important Dates / Periods

Date trans became Date firm commitment Date transaction Date transaction
highly probable 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
Pre-transaction period Post-transaction period

1116 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 2021)

Contents: Page
1. Introduction 1118
2. Ordinary shares and preference shares 1118
2.1 Ordinary share and preference shares on liquidation 1118
2.2 Ordinary dividends and preference dividends 1119
Worked example 1: Ordinary dividend obligations ± proposal vs declaration dates 1119
Example 1: Preference dividend 1119
2.3 Redeemable and non-redeemable preference shares 1120
2.3.1 Overview 1120
2.3.2 Redeemable preference shares 1120
2.3.3 Non-redeemable preference shares 1120
Example 2: Issue of non-redeemable preference shares 1121
Example 3: Issue of non-redeemable preference shares 1123
2.4 Participating and non-participating preference shares 1125
Example 4: Participating dividend 1125
3. Changes to share capital 1127
3.1 Par value and no par value shares 1127
Example 5: Issue at par value and above par value 1127
Example 6: Issue of ordinary shares 1128
3.2 Share issue costs and preliminary costs 1128
Example 7: Share issue costs and preliminary costs 1128
3.3 Conversion of shares 1129
Example 8: Converting ordinary shares into preference shares 1129
3.4 Rights issue 1129
Example 9: Rights issue 1130
3.5 Share splits 1130
Example 10: Share split 1130
3.6 Share consolidations (Reverse share split) 1130
Example 11: Share consolidation 1131
3.7 Capitalisation issue 1131
Example 12: Capitalisation issue 1131
3.8 Share buy-backs (treasury shares) and other distributions made by the company 1132
Example 13: Share buy-back 1133
3.9 Redemption of preference shares 1134
3.9.1 Overview 1134
3.9.2 Financing of the redemption 1135
Example 14: Redemption at issue price ± share issue is financing of last resort 1135
3.9.3 Redemption at a premium 1136
Example 15: Redemption at premium ±shares were recognised as equity 1136
Example 16: Redemption at a premium ± shares were recognised as a liability 1137
3.10 Companies Act requirements relating to distributions 1140
3.10.1 Overview 1140
3.10.2 Requirements relating to distributions to shareholders 1140
3.10.3 Solvency and liquidity test 1140
3.10.4 Requirements relating to share buy-backs 1140
4. Summary 1141

Chapter 23 1117
Gripping GAAP Share capital: equity instruments and financial liabilities

1. Introduction

An entity needs money to start its business and to continue Entities raise
funding in many
running it. This money can be raised in several ways:
ways:
x by making profits; x Profits
x by borrowing (e.g. raising a loan or issuing debentures); and x Lenders
x by raising funds from its owners (e.g. through issuing shares). x Owners

Profits are an internal source of funding whereas obtaining funds from lenders and owners
are external sources. Funds from lenders differ from funds from owners: we are obliged to
repay funds from lenders, (thus these are liabilities), whereas there is generally no obligation
to repay funds from owners, in which case they are classified as equity. I say there is
µgenerally no obligation to repay funds from owners¶ because some funds from owners have
terms and conditions that result in the funds actually being repayable, in which case they will
be wholly or partly classified as liabilities.

Who are the owners?

x In the case of a partnership the owners would be referred to as partners.
x In the case of a close corporation, the owners would be referred to as members (in
South Africa, close corporations still exist but these are gradually being phased out, in
terms of the Companies Act 2008).
x In the case of companies, the owners would be referred to as shareholders.

This chapter concentrates on a company raising funds through the issue of shares to its
shareholders. Please note that the company and shareholder will classify the share differently:
x The company issuing the share will recognise the share as an equity
An equity
instrument (or, in some cases, as a financial liability); and instrument is
x The shareholder will recognise the share as a financial asset. defined as:
x any contract
This chapter looks at shares from the perspective of the company issuing
x that evidences a
the shares, and thus focuses on the classification as an equity instrument, residual interest in
or in some cases, as a financial liability. Shares from the perspective of the assets of an entity
the investor (shareholder), being financial assets, are explained in the x after deducting all
financial instruments chapter (chapter 21). its liabilities. IAS32.11

An equity instrument is a contract in which the holder has a residual interest in the assets of the
entity after deducting its liabilities (i.e. the accounting equation: Equity = A ± L).
For example: Let¶s apply this logic to an issue of shares for cash of C100, where there are no
terms and conditions obligating the company to repay the funds.
x When issuing the shares for cash, our assets increase by C100 (i.e. cash increases) and,
since there is no obligation to repay the funds, there is no increase in liabilities.
x This means our equity increases by C100, and thus we would classify these shares as equity
instruments (Assets: 100 ± Liabilities: 0 = Equity: 100).
Shares must
There are two classes of shares that a company can issue: be authorised
x ordinary shares (also called common stock); and before they
x preference shares (also called preferred stock). may be issued. See Co’s Act s38

A FRPSDQ\¶VMemorandum of Incorporation must specify each class of shares, the description

of each class and the maximum number of shares within each class that the company is
authorised to issue. Only authorised shares may be issued to shareholders. See Co¶V Act s36 & 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.

1118 Chapter 23
Gripping GAAP Share capital: equity instruments and financial liabilities

2.2 Ordinary dividends and preference dividends

Ordinary shareholders are not guaranteed to receive dividends because ordinary dividends
depend on both the profitability of the company and its cash flow. Since ordinary shares are
equity instruments, dividends on ordinary shares are recognised as distributions to the equity
participant (shareholder) ± 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

It is important to note that an ordinary dividend to a shareholder should only be recognised

when the company has a present obligation to pay it. In other words, when this obligation
occurs, we will recognise the liability and the related dividend (credit liability and debit equity).

Companies sometimes declare ordinary dividends twice a year: an interim dividend may be
declared during the year with a final dividend at year-end, or shortly thereafter. Importantly,
however, a dividend only becomes a present obligation once it has been appropriately authorised
and is no longer at the discretion of the company. This obligation generally arises when the
dividends are declared. In this regard, dividends are first proposed in a meeting and if the proposal
is accepted, the company will then declare the dividend. Declaring a dividend means publicly
announcing that the dividend will be paid on a specific future date. However, in some
jurisdictions, a declaration may need further approval before the company becomes obligated
(e.g. although it may be declared by the board of directors, there may be a requirement for the
directors¶ declaration to be approved by the shareholders). See IFRIC 17.10 & IAS 10.13 & Co¶V Act s46

Worked example 1: Ordinary 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.

For ordinary shareholders, there is no certainty that they will receive their ordinary dividend. In
contrast, preference shareholders are often offered fixed preference dividends, calculated
using a µcoupon rate¶. If these preference dividends are not declared in a particular year, perhaps
because the company does not meet the regulatory requirements to pay out the dividend, the
company would still have an obligation to pay these preference dividends in future.
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

Preference dividend = 1 000 x C2 x 12% (coupon rate) = C240
Note: Whether this dividend is recognised depends on if the dividend discretionary or non-discretionary.
This also affects the timing of its recognition (when it gets recognised): this is explained below.

It is important to note that, in the case of preference shares, the terms of the preference share
could indicate that the preference dividend is discretionary (i.e. the company can choose to pay
the dividend or not), or non-discretionary (i.e. payment is mandatory ± it cannot be avoided).
x Discretionary preference dividends will only be recognised once they have been declared
(i.e. they are recognised in the same way as an ordinary dividend).
x Non-discretionary preference dividends (i.e. mandatory dividends) result in the company
having an obligation to pay all future preference dividends from date of issue. Thus, the
company must recognise a liability for all future preference dividends on the day the preference
share is issued. This liability 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.

Chapter 23 1119
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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.
x 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.
x 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 company is not allowed to declare a dividend to its ordinary shareholders
until all cumulative dividends promised to the preference shareholders have been declared.

However, it is important to note that, even though a dividend may be cumulative, it does not
mean that the company has an obligation to pay that dividend. Instead, the company has an
obligation to pay the dividend (and thus should recognise a liability for the dividend) if the
dividend is either non-discretionary (i.e. mandatory) or µdiscretionary and also declared¶.
To redeem
2.3 Redeemable and non-redeemable preference shares means:
x to return capital
2.3.1 Overview

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 company or not.
x If the redemption is at the issuing company¶s discretion, it means that the issuing company
has the right to choose whether or not to redeem the shares. In other words, the company can
avoid the redemption. If it can avoid the redemption, it does not have a present obligation and
so this aspect of the shares (the possible redemption of capital) represents equity. See IAS 32.AG25
x If the redemption is non-discretionary, it means that the issuing company does not have the
right to choose whether or not to redeem the shares. Since the company cannot avoid the
redemption of the share capital, it has an obligation from the date that it issues the shares, and
must thus recognise a liability on this date. A redemption is considered to be non-
discretionary (i.e. mandatory) if the terms of the preference share stipulate either that the:
 shareholder has the option to choose whether or not the shares should be redeemed; or
 redemption must take place on a specific future date.

2.3.3 Non-redeemable preference shares (IAS 32.AG26 and AG6)

If the shares are non-redeemable, the classification as equity or liability depends on the other
rights attached to the shares.
x If the preference share comes with the right to receive dividends but the payment of these
dividends is at the discretion of the issuing company, then the share is classified as an
equity instrument. See IAS 32.AG26
x If the payment of dividends is not at the company¶s discretion (i.e. the payment of dividends
is mandatory), then the share issue is classified as a financial liability. See IAS 32.AG6
 Non-redeemable preference shares that offer mandatory dividends effectively provide
the shareholder with a µcontractual right to receive payments on account of interest at
fixed dates extending into the indefinite future¶. This is referred to as a µperpetual
annuity¶ and the shares would be referred to as a µperpetual instrument¶. See IAS 32.AG6

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 With mandatory dividends, the shareholder has a financial asset (contractual right to receive
cash) and the issuer has a financial liability (contractual obligation to deliver cash). See IAS 32.AG6
 Assuming, for example, that this financial liability (preference share liability) is
classified at amortised cost (see chapter 21):
- The issuing company¶s liability would be measured at the present value of the
future mandatory dividend payments (a perpetual annuity: calculated at the coupon
rate applied to the face value of the shares), discounted at the market interest rate.
- The issuing company¶s mandatory dividends would be recognised as an interest
expense in its profit or loss, calculated on the effective interest rate method.

Example 2: Issue of non-redeemable preference shares

On 1 January 20X1 (date of incorporation) 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 except for
20X3, when the preference dividend was declared but not yet paid at 31 December 20X3.
Required:
A. Provide all journal entries from the date of issue of the preference shares to 31 December 20X3.
B. Disclose the ordinary and preference shares in the financial statements for all years affected
including 20X3. Show the statement of changes in equity for 20X3 only (with no comparatives).
C. Explain how the journals in 20X1 would change if the dividends on the non-redeemable preference
shares were mandatory (not discretionary). The market interest rate is 8%.

Solution 2A: Journals

Comment: Since the preference shares are non-redeemable, we consider the share¶s other rights when
classifying them: the dividend payment is at Glow¶s discretion, and thus the shares are classified as equity.

1 January 20X1 Debit Credit

Bank(A) 50 000 x C2 100 000
Preference share capital (Eq) 100 000
Preference shares issued: 50 000 at C2 each, 10% discretionary dividends,
non-redeemable (pure equity)
31 December 20X1 ± 31 December 20X3 *
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 declared *
31 December 20X1 ± 31 December 20X2 **
Preference shareholders for dividends (L) 10 000
Bank 50 000 x C2 x 10% 10 000
Preference dividends paid **
* This journal is processed on 31 December 20X1, 20X2 and 20X3 since the dividends were declared each year.
** This journal will be processed on 31 December 20X1 and 20X2 but not in 20X3, since the dividends were
not paid in 20X3 (the µpreference shareholders for dividends will be presented as a current liability).

Solution 2B: Disclosure

Glow Limited
Statement of financial position (extracts)
At 31 December 20X3
Note 20X3 20X2 20X1
Equity and Liabilities C C C
Issued share capital and reserves
Ordinary share capital Journals / SOCIE 3 350 000 350 000 350 000
Preference share capital Journals / SOCIE 4 100 000 100 000 100 000
Current liabilities
Preference shareholders for dividends Journals 10 000 0 0

Chapter 23 1121
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Glow Limited
Statement of changes in equity (extracts)
For the year ended 31 Dec 20X3
Ordinary Preference Retained Total
share capital share capital earnings
C C C C
Opening balance ± 20X3 350 000 (1) 100 000 (2) xxx xxx
Ordinary dividends declared (xxx) (xxx)
Preference dividends declared (10 000) (10 000)
Total comprehensive income xxx
Closing balance ± 20X3 350 000 100 000 xxx xxx
Calculations: (1) ordinary shares: 100 000 shares x C3,50 each (2) preference shares: 50 000 x C2

Glow Limited
Notes to the financial statements (extracts)
For the year ended 31 December 20X3
20X3 20X2 20X1
3. Ordinary share capital Number Number Number
Authorised:
Ordinary shares of no-par value Comment 200 000 200 000 200 000
Issued:
Shares in issue: opening balance 100 000 100 000 0
Issued during the year 0 0 100 000
Shares in issue: closing balance 100 000 100 000 100 000

20X3 20X2 20X1

4. Preference share capital Number Number Number
Authorised:
10% non-redeemable non-cumulative preference shares 100 000 100 000 100 000
of no-par value Comment
Issued:
Shares in issue: opening balance 50 000 50 000 0
Issued during the year 0 0 50 000
Shares in issue: closing balance 50 000 50 000 50 000

Comment: All shares in South Africa are now issued at no-par value (see section 3.1). However, IAS 1
requires disclosure of whether the shares have a par value or not. In this regard, please note that some
companies in South Africa will still be disclosing shares that have a par value: these will be the shares
that were issued by South African companies prior to the SA Companies Act of 2008. See IAS 1.79(a)(iii)

Solution 2C: Discussion of perpetual instruments

If the non-redeemable preference shares offered mandatory dividends, this would mean that the
shareholder had a µcontractual right to receive payments on account of interest at fixed dates extending
into the indefinite future¶, and with no right to receive a return of the principal. See IAS 32.AG6
This situation would mean the preference shares are µperpetual instruments¶, meaning that the holder of
the share has a financial asset (contractual right to receive cash) and the issuer (Glow) has a financial
liability (contractual obligation to deliver cash). Thus, in this case, the issue of these shares would be
recognised as a financial liability (not equity), measured at fair value, calculated as the present value of the
future dividend payments (perpetual annuity of C10 000), discounted at the market interest rate of 8%.
The mandatory dividends would be recognised as interest expense on the effective interest rate method
(i.e. the dividends would not be recognised as dividends, which are a distribution of equity). The
journals would thus be as follows

1 January 20X1 Debit Credit

Bank(A) Given 100 000
Day-one loss on pref shares (E) Balancing 25 000
Preference share liability (L) Annuity (50 000 x C2 x 10%) ÷ Mkt int rate 8% 125 000
Preference shares issued: 50 000 at C2 each, 10% mandatory dividends, non-
redeemable (perpetual instrument thus pure liability), measured at the present
value of the annuity (10 000), discounted at the market interest rate of 8%.

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31 December 20X1 Debit Credit

Interest expense C125 000 x market interest rate 8% 10 000
Preference share liability (L) 10 000
Accrual of mandatory dividends recognised as interest expense (EIR method)
Preference share liability (L) Face value (50 000 x C2) x coupon rate 10% 10 000
Bank 10 000
Payment of mandatory dividends at the coupon rate (EIR method)

Example 3: Issue of redeemable preference shares

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 20X3, 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 from the share issue were market-related (i.e. a reflection of the fair value of the shares).
The effective interest rate on the preference share liability is 12,93699016%.
Other information:
x There is 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 20X2 was C150 000.
x An ordinary dividend of C10 000 was declared in 20X2.
x These preference shares are subsequently measured using the amortised cost method.
x Total comprehensive income (after taking into account the above) was C80 000 in 20X2.
Required:
A. Prepare all journal entries from the date of issue to the date of redemption of the preference shares
(excluding the redemption journal).
B. Prepare all disclosure relating to the ordinary and preference shares in the financial statements for
all years affected, excluding 20X3 (the year of redemption). Comparatives for the statement of
changes in equity are not required.
For your interest: the redemption journal and the disclosure in 20X3 are shown in example 16.

Solution 3A: Journals

1 January 20X1 Debit Credit
Bank (A) 50 000 x C2 100 000
Preference share liability (L) 100 000
Issue of preference shares: 50 000 at C2 each, 10%, redeemable
31 December 20X1
Interest expense (E) W1; Or 12 937
Preference share liability (L) 100 000 x 12,93699016% 12 937
Interest on preference shares: incurred at effective interest rate
Preference share liability (L) 50 000 x C2 x 10% 10 000
Bank 10 000
Dividends on preference shares: paid mandatory dividend at coupon rate
31 December 20X2
Interest expense (E) W1; Or 13 317
Preference share liability (L) 102 937 x 12,93699016% 13 317
Interest on preference shares: incurred at effective interest rate
Preference share liability (L) 50 000 x C2 x 10% 10 000
Bank 10 000
Dividends on preference shares: paid mandatory dividend at coupon rate
31 December 20X3
Interest expense (E) W1; Or 13 746
Preference share liability (L) 106 254 x 12,93699016% 13 746
Interest on preference shares: incurred at effective interest rate

Chapter 23 1123
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31 December 20X3 continued « Debit Credit

Preference share liability (L) 50 000 x C2 x 10% 10 000
Bank 10 000
Dividends on preference shares: paid mandatory dividend at coupon rate
Preference share liability (L) 50 000 x C2 x (100% + 10%) 110 000
Bank 110 000
Redemption of preference shares at a premium

W1: Effective interest rate table: Interest Payments Liability

@12,93699016% balance
01/01/20X1 (100 000)
31/12/20X1 12 937 (10 000) (102 937)
31/12/20X2 13 317 (10 000) (106 254)
31/12/20X3 13 746 (10 000) (110 000)
31/12/20X3 (110 000) 0
40 000 (140 000) -
Notice: Total interest of C40 000 can be checked in two ways:
x Total payments ± Original liability = 140 000 ± 100 000 = 40 000
x Dividends: C30 000 (C10 000 x 3 yrs) + Premium on redemption: C10 000 (50 000 x C0.20) = 40 000
Effective interest rate: Interest is calculated using the effective interest rate = 12,93699016% (given)
This rate could have been calculated as the internal rate of return using a financial calculator:
PV = 100 000 (C2 x 50 000 shares) FV = -110 000 (C2,20 x 50 000 shares)
PMT = -10 000 (50 000 x C2 x 10%) n=3
COMP i = 12,93699016%

Solution 3B: Disclosure

Company name
Statement of financial position (extracts)
As at 31 December 20X2
Note 20X2 20X1
Equity and Liabilities C C
Issued share capital and reserves 570 000 xxx
Ordinary share capital From SOCIE 3 350 000 350 000
Retained earnings From SOCIE 220 000 xxx
Non-current liabilities
Redeemable preference shares W1 or Journals 4 0 102 937
Current liabilities
Redeemable preference shares W1 or Journals 4 106 254 0
For your interest: If the dividend for 20X1 had been declared before year-end but only paid after year-end, the
total liability balance at 31 December 20X1 would have been C112 937 (C102 937 + C10 000), instead of
C102 937, but the C10 000 dividend payable would be presented as a ‘current liability’.

Company name
Statement of changes in equity (extracts)
For the year ended 31 December 20X2
Ordinary Retained Total
share capital earnings
C C C
Opening balance ± 20X2 Given 350 000 150 000 500 000
Total comprehensive income From SOCIE 80 000 80 000
Ordinary dividends declared Journals (10 000) (10 000)
Closing balance ± 20X2 350 000 220 000 570 000
Comment relating to statement of changes in equity:
x 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.
x 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.

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Company name
Statement of comprehensive income (extracts) 20X2 20X1
For the year ended 31 December 20X2 C C
Profit before finance charges xxx xxx
Finance charges W1 or Journals (13 317) (12 937)
Profit before tax xxx
« xxx xxx
Total comprehensive income for the year 80 000 xxx

Company name
Notes to the financial statements (extracts)
For the year ended 31 December 20X2
2. Accounting policies
2.8 Preference shares Preference shares that are mandatorily redeemable on a specific date, or at the
option of the shareholder, are recognised as liabilities, because, in substance, they are borrowings. The
dividends on these preference shares are mandatory and thus the mandatory dividend stream is also
recognised as a liability. This means these dividends are included in profit or loss as part of the interest
expense that is recognised when unwinding both these liabilities using the effective interest rate method.
20X2 20X1
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 0
Issued during the year 0 100 000
Shares in issue: closing balance 100 000 100 000

20X2 20X1
4. Redeemable preference share liability Number Number
Authorised:
10% redeemable preference shares 100 000 100 000
Issued:
Shares in issue: opening balance 50 000 0
Issued during the year 0 50 000
Shares in issue: closing balance 50 000 50 000
The redeemable preference shares, of no-par value, are compulsorily redeemable on 31 December 20X3 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 12,93699016%. Per IFRS 7.6 and IFRS 7 Appendix B3
For the purposes of the rest of this chapter, you may assume, unless specifically stated
otherwise, that the preference shares are non-redeemable and the related preference dividends
are discretionary and thus that the preference shares are classified as equity.

2.4 Participating and non-participating preference shares

Non-participating preference shares are those where the Participating pref shares
result in the preference
shareholder does not participate in profits except to the extent shareholder earning an
of the fixed annual dividend, which is based on the coupon rate. extra dividend:
x a variable dividend from
Participating preference shares are those where the profits generated.
shareholders receive, in addition to the fixed annual dividend,
a fluctuating dividend, based on the ordinary dividend.

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.

Chapter 23 1125
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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

25 December 20X5 Debit Credit

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 (based on the coupon rate)
Preference dividends (Distribution of equity) 1 000 x C0,10 x 1/ 5 20
Preference shareholders for dividends (L) 20
Participating preference dividend owing (based on the ordinary dividend)
Comment: The ordinary dividend will appear in the statement of changes in equity as a distribution to equity
participants… and 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 presented 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
± Equity (if divs are discretionary)
± Liability (if divs are mandatory) Note 1
x Redemption is mandatory
± Liability
x Redemption is at the option of holder
± Liability
x Redemption is at the option of issuer
± Equity
x Mandatory
± Liability, thus the div will be
recognised as interest as
this L is 'unwound' (P/L)
x Discretionary
± Equity, thus the div will be
recognised as distribution to
equity participants (SOCIE)

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/ or
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

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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 µWKHCompanies $FW¶ . 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 µQRSDU
YDOXH VKDUHV¶ 7KH VDPe 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 With the new Co’s Act:

x only no-par value shares

Since the intention is that all shares in future be µno par value can be issued; but
VKDUHV¶WKLV WH[t focuses on no par value shares. However, since x par value shares still exist
par value shares still exist in South Africa and in many countries around the world, a brief explanation
and example is included to 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 thaWFRXQWU\¶VOHJLVODWLon).

Example 5: Issues at par value and above par value

X Ltd issued 100 ordinary shares with a µpar 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’.
%RWKWKHµVKDUe capital accoXQW¶DQGWKHµVKDUe premium accRXQW¶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 1127
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X Limited
Statement of changes in equity (extracts)
For the year endeG«
Ordinary shares Share premium Retained earnings Total
C C C C
Opening balance 0 0 xxx xxx
Ordinary shares issued 100 10 110
Total comprehensive income xxx xxx
Closing balance 100 10 xxx xxx

Example 6: Issue of ordinary shares

On 1 January 20X1, Wallington Limited issued 100 ordinary µno par value¶ shares at C1 each.
Required: Journalise this share issue.

Solution 6: Issue of ordinary shares

1 January 20X1 Debit Credit
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 µOegal 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

Wallington Limited was 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

2 January 20X1 Debit Credit
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

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5 January 20X1 continued .. Debit Credit

Ordinary share capital (Eq) Given 2 000
Bank (A) 2 000
Share issue costs paid deducted from equity

Solution 7B: Share issue costs and preliminary costs

Wallington Limited
Statement of changes in equity
For the year ended 31 December 20X1
Ordinary Retained Total
share capital earnings 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

1 January 20X2 Debit Credit

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
Statement of changes in equity
For the year ended 31 December 20X2
Ordinary Preference Retained Total
share capital share capital earnings
C C C C
Opening balance 1 200 0 Xxx xxx
Conversion of ordinary shares to preference shares (600) 600 0
Total comprehensive income Xxx xxx
Closing balance 600 600 Xxx xxx
Notice: The net balance on these equity accounts remains at C1 200 and total equity is not affected.
Also note that such a change in tKHFRPSDQ\¶VVKDUHFDSLWDOhas no impact on cash reserves.

3.4 Rights issue

Rights issues involve offering 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.

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The lower price provides an incentive to these shareholders to invest more capital in the
company. Note that shareholders are not obliged to purchase the shares offered.

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

Debit Credit
Bank (A) W1 750
Ordinary share capital (Eq) 750
Shares issued to existing shareholders (1:4) at C3 each (market price: C4)

W1: Proceeds received

Number of shares issued 1 000/ 4 x 1 250
Proceeds received 250 x C3 C750

Solution 9B: Rights issue

Company name
Statement of changes in equity
For the year ended «
Ordinary share capital Retained earnings Total
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
Total comprehensive income Xxx xxx
Closing balance 3 250 Xxx xxx

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, because 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, because there are now fewer shares on the
market, yet the coPSDQ\¶VQHWasset value remains the same.

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Example 11: Share consolidation

A company has 1 000 shares, issued at C2 each, which it converts into 500 shares.
Required: Journalise the conversion.

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 (s46 and s47) A capitalisation

issue is defined as:
A capitalisation issue occurs when a company issues free shares on x a free issue of shares to
a pro-rata basis to its existing shareholders. For example, we could shareholders
issue, to our existing shareholders, 3 shares for every 5 shares held. If there were 5 000 shares in
issue before the capitalisation issue, it would mean that we would issue an extra 3 000 shares (5 000 / 5
x 3), after which there would be 8 000 shares in issue (5 000 + 3 000). These free shares may be of
the same class of share currently held by the shareholders, or could be a different class.

Other terms for a capitalisation issue include µbonus issue¶, µscrip issue¶ (or scrip dividends) or µIXOO\
pDLG XS¶ VKDUHV. The most important feature of a capitalisation issue is that the shareholder does
not pay for the shares they receive (i.e. it does not involve the flow of cash).

So, if no cash is involved, you may be wondering how the issue would be journalised. It depends
on the purpose behind the capitalisation issue:
x A company could issue capitalisation shares if it is short of cash but needs to declare a
dividend to keep its shareholders happy (i.e. it give its shareholders shares instead of a cash
dividend« shareholders who need cash can then sell these shares). This is called a scrip
dividend and would be journalised as: debit dividends declared; credit share capital.
x A company could also issue capitalisation shares simply to make use of the compDQ\¶V idle
reserves (i.e. they could issue capitalisation shares in addition to a cash dividend purely to
restructure, or µtidy up¶, its reserves). Since no cash is involved, the share issue is µfunded¶ by
converting reserves into share capital e.g. debit retained earnings and credit share capital).

The Companies Act s40 requires authorised shares (including capitalisation issues) to be issued
for µadequate consideration¶. In many instances the market price of a share is µadequate
consideration¶ for the purposes of measuring the amount of the capitalisation issue journal.
However, it is up to the directors¶ judgement to determine the µadequate consideration¶ for the
capitalisation journal.

Although capitalisation issues often occur because a company is short of cash, the company might
offer their shareholders a choice between receiving a capitalisation share or cash. However, this
cash option may only be offered if it complies with the solvency and liquidity test in s46 of the
Companies Act, which must be applied before making any distribution (the definition of which includes,
amongst other things, dividends and payments in lieu of a capitalisation issue). The application of this
section (s46) requires that the solvency and liquidity test would be satisfied immediately after the
capitalisation issue takes place assuming all shareholders opted to receive the cash payment (see
section 3.10 for a more detailed discussion about s46 and the solvency and liquidity test). See s47 (1) and (2)

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.

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Solution 12A: Capitalisation issue

Debit Credit
Retained earnings (Eq) C1 x 600 600
Ordinary share capital (Eq) 600
Capitalisation issue of 600 ordinary shares to existing shareholders

Solution 12B: Capitalisation issue

Company name
Statement of changes in equity
For the year enGHG«
Ordinary Retained Total
share capital earnings
C C C
Opening balance 1 500 800 2 300
Capitalisation issue 600 (600) 0
Total comprehensive income 150 150
Closing balance 2 100 350 2 450

Note: there is no change in either the total equity or the cash resources of the company.

3.8 Share buy-backs (treasury shares) and other company distributions

(Companies Act s46 and s48 and IAS 32.33 ± 4 and IAS 1.79)
Treasury shares:
x are an entity’s
A company may, in certain situations and for various reasons, buy- shares that it
back its own shares from its own shareholders. When a company buys has bought back;
back its own shares, it reduces the number of shares in issue. x have no voting rights
or dividends;
The reason that a company may decide to buy back its own shares x are no longer
could be because it wanted to, for example: outstanding;
x must be separately
x increase the share price (remember: the laws of supply and disclosed.
demand suggest that if the supply of an item is lower than the See IAS 32.34 & IAS 1.79(a)(vi)

demand for it, the price of the item will increase); or

x prevent a hostile takeover;
x 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).

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 may be re-issued (sold) at a later date.
Issued shares
Treasury shares (i.e. shares that an entity holds in itself) are refers to the:
commonly described as µissued shares that are not outstanding x Total shares
shares¶. The term µoutstanding shares’ is used to describe shares issued by the company,
that are held by investors (as opposed to shares now held by the including treasury
shares.
issuing entity itself).
Outstanding shares
Although treasury shares are referred to as µissued shares that are not x Issued shares held by
shareholders,
outstanding¶, please note that, legally, they µhave the same status as excluding treasury
See Co’s Act s35
shares that have been authorised but not issued’. See Cos¶ Act s35 shares.

In South Africa, a company may buy back its shares only if the Companies Act requirements are met:
x The buy-back must satisfy the requirements of s46 of the Companies Act (which includes the
requirement to meet the solvency and liquidity test in s4: see section 3.10 for details); 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¶V$ct s48

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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 1 requires that, when an entity holds its own shares, the treasury µshares¶ must be separately
disclosed. However, it is not clear from the wording of IAS 1 whether it is the number of treasury
shares or the amount allocated to the treasury shares that is required disclosure, or both. That
said, IAS 32 requires that µthe amount of treasury shares¶ be disclosed, and the wording of this
standard seems to suggest that IAS 1 was also referring to the amount of treasury shares.
However, for the purposes of our users, who need to know the number of issued shares for
purposes of ratio analysis (i.e. they need to know the number of shares held by shareholders
rather than the total shares issued, including shares held by the entity), it is submitted that we
should ideally disclose both the amount allocated to treasury shares and the number of treasury
shares held. 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) and IAS 32.34

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 a buy-back of shares be debited to equity, it does not specify which
equity accounts should be debited. For example, it could be debited to share capital directly or
could be debited to a separate treasury share account (a negative equity account). In this textbook
we will use a treasury share account. See IAS 32.33

Example 13: Share buy-back

Petal Limited'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 at 31 December 20X1.
Petal buys back 250 of these shares at their market price of C3 per share during 20X2.
The retained earnings at 31 December 20X1 were C80 000 and total comprehensive income for 20X2
was C5 000 (none of which was µother comprehensive income¶). There are no other equity items.
Required:
Journalise the buy-back and provide the disclosure for 31 December 20X2. Comparatives are not required.

Solution 13: Share buy-back

Debit Credit
Treasury shares (Eq) C3 per share x 250 shares 750
Bank (A) 750
Buy-back of 250 shares in terms of s4:

Petal Limited
Statement of financial position (extract) 20X2 20X1
As at 31 December 20X2 C C

Issued share capital and reserves Per SOCIE 85 750 xxx

Petal Limited
Statement of changes in equity (extract)
For the year ended 31 December 20X2
Ordinary share Treasury Retained Total
capital shares earnings C
C C C
Opening balance 1 500 0 80 000 81 500
Treasury shares (share buy-back) (s48) (750) (750)
Total comprehensive income 5 000 5 000
Closing balance 1 500 (750) 85 000 85 750

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Petal Limited
Notes to the financial statements (extracts)
For the \HDUHQGHG«

3. Ordinary share capital Number

Authorised shares:
Ordinary shares of no par value 1 750

Issued (outstanding) shares:

Balance outstanding at the beginning of the year 750
Treasury shares (share buy-back) (s48) (250)
Balance outstanding at the end of the year 500
Treasury shares:
Balance at the beginning of the year 0
Treasury shares (share buy-back) (s48) 250
Balance at the end of the year 250
Notice:
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 o/balance: 750); but
x There are now 1 250 shares available for issue (Authorised: 1 750 ± Issued & outstanding c/balance: 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 x combo: rights issue fewer shares: no x adjust retained
journal journal earnings a/c with
difference between
average issue price
and buy-back price.

3.9 Redemption of preference shares (Companies Act: s4 & s46)

Redeemable pref shares
3.9.1 Overview can be liability/ equity

The redemption of a preference share entails the company It depends on the terms of the
redemption:
paying out the preference shareholder for the preference
x compulsory/at option of
share. This redemption could be mandatory, at the option of shareholder: liability
the company or at the option of the shareholder: x at option of company: equity
x If, when the preference shares were originally issued,
the company knew that they would be compulsorily 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 recognised as a liability.
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 µmandatorily redeemable¶ or µredeemable at the option
of the holder¶ are recognised as liabilities, they are still considered to be shares from a legal point
of view and, thus, their redemption must still comply with the Companies Act requirements.

The Companies Act requirements exist because, when a The S&L test
company redeems shares, both its capital and cash reserves must be satisfied
are reduced (debit shares and credit cash), which could put before preference shares can
be redeemed.
the other remaining shareholders and creditors at risk.

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To reduce this risk, the Companies Act requires the company to meet the solvency and liquidity
test and other requirements before the redemption takes place (these requirements are contained
in s46 and s4 of the Companies Act: see section 3.10 for more detail).

3.9.2 Financing of the redemption

How the payment is made is referred to as the µfinancing 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.
x The company has C80 000 in the bank. The directors feel that only C30 000 of this should be used
for the redemption.
x 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).
x If further cash is still required, a bank loan of up to C40 000 (repayable after 4 years) may be raised.
x There is a balance of C150 000 in the retained earnings account.
Consider the following scenarios:
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.

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 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
Cash available through:
- 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

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Solution 14B: Journals

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

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.

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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
Cash available through:
- 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

Example 16: Redemption at a premium ± Preference shares recognised as a liability

On 1 January 20X1 (date of incorporation) Green Glow Limited 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 20X3, 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 12,93699016%.
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 20X3.
In order to finance the redemption:
x it issued the remaining authorised ordinary shares on 20 December 20X3, at C4 each, after which,
x any extra funds needed were to be sourced as follows: if further cash was required, C20 000 cash would first
be taken from the savings account and then a bank overdraft would be arranged if that was not enough.
The accounting policy is to set-off any premium on redemption against retained earnings. The retained
earnings balance is C200 000 immediately before the redemption.
The preference shares have been correctly classified as amortised cost financial liabilities.
The retained earnings on 1 January 20X3 was C220 000.
Total comprehensive income, before considering the above information, was C100 000.
The tax rate is 30%.
Required:
A. Prepare all journals relating to the redemption, including journals relating to the financing thereof.
B. Disclose all information relating to the shares in the financial statements for the year ended
31 December 20X3. Show two years of comparatives wherever possible, except in the statement of
changes in equity, where comparatives are not required.

Chapter 23 1137
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Solution 16A: Redemption at a premium ± shares were recognised as a liability

Comment:
x This example is a continuation of example 3. Calculations of the balDQFH RQ WKH µUedeemable
preference sharH¶ account each year, are shown in example 3.
x The issued preference shares are a pure liability because both the redemption and dividends are mandatory.
x The liability has been classified at amortised cost. This means it will be measured using the effective
interest rate method. (Reminder: 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.

20 December 20X3 Debit Credit

Bank (A) (Authorised 120 000 – Already issued: 100 000) x C4 80 000
Ordinary share capital (Eq) 80 000
Issue of 20 000 ordinary shares at an issue price of C4 each
31 December 20X3
Preference share liability (L) 50 000 x C2.20 110 000
Preference shareholders (current liability) 110 000
Redemption of preference shares falls due (the non-current liability is thus
transferred to a current liability). Note this is an optional journal to facilitate
disclosure requirements.
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
Cash available through:
- 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)

Solution 16B: Redemption at a premium ± shares were recognised as a liability

Green Glow Limited

Statement of financial position (extracts)
As at 31 December 20X3
Note 20X3 20X2 20X1
Equity and liabilities C C C
Issued share capital and reserves
Ordinary share capital Per SOCIE 3 430 000 350 000 350 000
Retained earnings Per SOCIE 310 378 220 000 xxx
Non-current liabilities
Redeemable preference shares Example 3: W1 / Jnls 4 0 0 102 937
Current liabilities
Redeemable preference shares Example 3: W1 / Jnls 4 0 106 254 0
Please note:
x Detailed calculations of the µUHGHHPDble preference sKDUH¶DFFRXQWRYHUWhe years are in example 3.
Comment on the SOFP: Did you notice how the redeemable preference share liability:
x gradually increases over the years until the date of redemption arrives (it grows to 102 937 in 20X1
and then 106 254 in 20X2) and then
x in the year of redemption (20X3), the µUHGHHPDEOHSUHference sKDUHOLDELOLW\¶balance will first grow to
C110 000 (the amount to be redeemed); after which, the redemption reduces the balance to zero«
see reconciliation on the next page.

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Movement on the preference share liability account during 20X3 C

Opening balance ± 20X3 Example 3: W1 106 254
Premium accrued (see example 3) Interest: 13 746 - Coupon payment: 10 000 3 746
Balance immediately before redemption 110 000
Redemption (debit preference share liability and credit bank) (110 000)
0

Green Glow Limited

Statement of changes in equity (extracts)
For the year ended 31 December 20X3
Ordinary Retained Total
share capital earnings
C C C
Opening balance 100 000 x C3.50; Given; Balancing 350 000 220 000 570 000
Ordinary shares issued Jnls, W1 or 20 000 x C4 80 000 80 000
Total comprehensive income From SOCI 90 378 90 378
Closing balance 430 000 310 378 740 378

Comment on the SOCIE:

The preference shares did not appear in the SOCIE as equity because they appear in the SOFP as a liability.

Green Glow Limited

Statement of comprehensive income (extracts)
For the year ended 31 December 20X3
20X3 20X2 20X1
C C C
Profit before finance charges xxx xxx xxx
Finance charges See example 3: W1 or journals 13 746 13 317 12 937
Profit before tax xxx xxx xxx
Tax expense xxx xxx xxx
Profit for the year TCI: 90 378 (below) – OCI: 0 90 378 xxx xxx
Other comprehensive income Given 0 xxx xxx
Total comprehensive income 100 000 – 13 746 x (100% - 30%) 90 378 xxx xxx

Green Glow Limited

Notes to the financial statements (extracts)
For the year ended 31 December 20X3
2. Accounting policies
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 LVµERUURZLQJV¶ 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.
20X3 20X2
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 20X3 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 12,93699016%. Per IFRS 7.6 and IFRS 7 Appendix B3

Chapter 23 1139
Gripping GAAP Share capital: equity instruments and financial liabilities

3.10 Companies Act requirements relating to distributions (s4, s46 & s48)
3.10.1 Overview

In South Africa, the Companies Act has several provisions that control distributions from a
company to its shareholders. These legislative requirements exist because, when a company
makes a distribution to its shareholders, both its equity and assets are reduced (e.g. in the case
of a redemption of shares, we would debit shares and credit cash), thus potentially putting
shareholders and/ or creditors at risk. It is this risk that the legislative requirements are designed
to reduce. We will now consider the requirements in s46, s4 and s48.
The S&L test
3.10.2 Requirements relating to distributions to shareholders (s46) helps to protect:
x the financial interests of
In South Africa, the Companies Act (section 46) states that a company shareholders with
smaller shareholdings, &
may not make any proposed distribution to shareholders (such as a
x creditors
dividend payment, a redemption of preference shares or a buy-back of
ordinary shares) unless:
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 (per s4 of
the Companies Act) immediately after completing the proposed distribution; and
x The board of the company, by resolution, has acknowledged that it has applied the solvency
and liquidity test, and concluded that the company will satisfy the solvency and liquidity test
immediately after completing the proposed distribution. Significantly summarised - see Companies Act s46
A S&L test means
3.10.3 Solvency and liquidity test (s4) satisfying tests of:

The solvency and liquidity test (s4) will be satisfied at a certain point x solvency = A(FV) • L(FV)
x liquidity = ability to pay
in time if, considering all reasonably foreseeable information: current debts as and
x The company¶s assets (fairly valued) equal or exceed its liabilities when they fall due
See Co’s Act s4
(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. Significantly summarised - see Companies Act s4

3.10.4 Requirement relating to share buy-backs (s48)

In the case of a share buy-back (section 3.8), the company would have to comply not only with
s46 and s4 of the Companies Act, but also s48, which requires that, after the buy-back, there
must be shares in existence other than:
x shares that are owned by one or more of its subsidiaries; or
x convertible or redeemable shares. Significantly summarised - see Companies Act s48

1140 Chapter 23
Gripping GAAP Share capital: equity instruments and financial liabilities

4. Summary

Ordinary vs. preference share capital

Ordinary shares Preference shares (have two possible aspects)

Issue: The 'Redemption' Aspect The 'Dividend' Aspect

Equity
x If non-redeemable x If mandatory
Dividend: ± Equity (if divs are discretionary) ± Liability: div is recog. in P/L
Equity ± Liability (if divs are mandatory) Note 1  if Amort. Cost, it’s an
distribution x If redeemable: mandatorily redeemable interest exp. (at EIR)
± Liability  if FVPL, it’s a dividend exp
(at the amount declared)
x If redeemable: at the holder’s option
± Liability x If discretionary
± Equity: div is recognised in
x If redeemable: at the issuer’s option
OCI as a distribution to
± Equity
equity participants (SOCIE)

Other information relevant to preference dividends:

x Cumulative / non-cumulative has no bearing on whether the dividend must 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 attached 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 reduce equity e.g.
existing shares split
x for free: cap issue combined into fewer dr treasury shares & cr
into more shares
x combo: rights issue shares bank

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 Treasury shares) (never recognise a P/L!)
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))

Chapter 23 1141
Gripping GAAP Earnings per share

Chapter 24
Earnings per Share
Reference:
IAS 33; Circular 1/2021, IAS 10 and IFRIC 17 (incl. any amendments to 10 December 2021)

Contents: Page

1. Introduction 1144

2. Types of shareholders 1144

2.1 Ordinary shareholders 1144
2.2 Preference shareholders 1145

3. Basic earnings per share 1146

3.1 Overview 1146
3.2 Basic earnings (the numerator) 1146
3.2.1 The basic calculation 1146
3.2.2 Where there are only ordinary shares 1147
Example 1: Ordinary shares only 1147
3.2.3 Where there are ordinary and preference shares 1147
Example 2: Ordinary and non-participating preference shares 1147
Example 3: Preference shares and preference dividends ± equity versus liability 1148
3.2.4 Where there are ordinary shares and participating preference shares 1148
Example 4: Ordinary and participating preference shares 1149
3.3 Basic number of shares (the denominator) 1150
3.3.1 Overview 1150
3.3.2 Issue for value 1151
3.3.2.1 Issues at the beginning of the current year 1151
Example 5: Issue for value at the beginning of the year 1151
3.3.2.2 Issues at the end of the year or during the year 1152
Example 6: Issue for value at the end of the year 1152
Example 7: Issue for value during the year 1152
3.3.3 Issue for no value 1153
Example 8: Issue for no value 1153
Example 9: Issue for no value after an issue for value 1154
3.3.4 Combination issues 1155
Example 10: Rights issue 1155
Example 11: Various issues over three years 1156
3.3.5 Contingently issuable shares and deferred shares 1158
Example 12: Contingently issuable shares 1158
Example 13: Deferred shares 1159
3.3.6 Contingently returnable shares 1160
3.3.7 Share buy-back 1160
Example 14: Share buy-back 1160
3.3.8 Reverse share split (share consolidation) 1160
Example 15: Reverse share split (share consolidation) 1161
3.3.9 Retrospective adjustments 1161

1142 Chapter 24
Gripping GAAP Earnings per share

&RQWHQWVFRQWLQXHG« Page

4. Headline earnings per share 1161

4.1 Overview 1161
4.2 Measurement of the headline earnings per share 1163
4.2.1 Headline earnings (the numerator) 1163
Example 16: Conversion: basic earnings to headline earnings 1164
4.2.2 Number of shares (the denominator) 1164
Example 17: Headline earnings per share 1165
4.3 Disclosure of the headline earnings per share 1165
Example 18: Headline earnings per share - disclosure 1165

5. Diluted earnings per share 1166

5.1 Overview 1166
Example 19: Diluted earnings per share: simple example 1166
5.2 Potential shares 1167
5.2.1 Options 1168
Example 20: Options to acquire shares 1168
5.2.2 Purchased options and written put options 1169
5.2.3 Convertible instruments 1169
Example 21: Convertible debentures 1170
Example 22: Convertible preference shares 1171
5.2.4 Contingent shares and deferred shares 1172
5.2.4.1 Where time is the only condition 1172
5.2.4.2 Where there are multiple conditions including time 1172
Example 23: Contingent shares 1172
5.3 Multiple dilutive instruments 1173
Example 24: Multiple dilutive instruments 1173

6. Presentation and disclosure 1174

6.1 Overview 1174
6.1.1 Statement of comprehensive income 1175
6.1.2 Notes to the financial statements 1175
6.1.3 Sample note disclosure involving earnings per share 1176
6.2 Disclosure of further variations of earnings per share 1177
Example 25: Disclosure of rights issue, basic and headline earnings per share 1177
Example 26: Disclosure involving multiple dilutive instruments 1179

7. Summary 1181

Chapter 24 1143
Gripping GAAP Earnings per share

1. Introduction

µ(DUQLQJV SHU VKDUH¶ LV a ratio that involves

IAS 33 Earnings per share sets
FDOFXODWLQJ WKH HQWLW\¶V HDUQLQJV being the µprofit for out how to calculate:
the year¶, adjusted for certain items) and dividing it by
the number of issued shares. The fact that the x The numerator: earnings
x The denominator: the number of shares
earnings (numerator) are divided by the number of
x for each class of equity share (where
shares (denominator) enables more effective each class has a varying right to
comparisons to be made. Its usefulness to users of receive dividends).
financial statements made it so popular that the standard, IAS 33, had to be developed to
control the method by which it was calculated

Since it is a ratio used in the analysis of a set of financial statements, you will notice that it is
also referred to in the chapter on financial analysis.
An ordinary share is defined as:
IAS 33 requires µearnings per share¶ WR be presented
x an equity instrument
for each different class of ordinary share. Shares are x that is subordinate
considered to be of a different class when they have x to all other classes of equity
different rights to dividends. See IAS 33.66 instruments. IAS 33.5

There are two different types of earnings per share referred to in IAS 33: basic earnings per
share and diluted earnings per share. It allows other variations of earnings per share to be
presented as well (although these µother earnings per share¶ figures may not be presented on
the face of the statement of comprehensive income, but must 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: these include the requirement that headline
earnings per share be presented.

Earnings per share:

A summary of the different types

Basic Diluted Headline Other variations

(IAS 33) (IAS 33) (Circular 01/2021) (IAS 33)
Required by IFRS Required by IFRS if Not required by IFRSs; Allowed if given
the entity had but is required for all SA in addition to the
dilutive potential companies wishing to BEPS (and DEPS
ordinary shares list/ be listed on the JSE where applicable)
See IAS 33.73
(a JSE Listing Requirement)

7KHµEDVLFHDUQLQJVSHUVKDUH¶ILJXUHPD\EHextremely volatile since all income and expense

items are included in the calculation thereof. To compensate for this volatility, the calculation
RI µKHDGOLQH HDUQLQJV SHU VKDUH¶ was introduced, which excludes income and expenses of a
FDSLWDOQDWXUHDQGWKRVHWKDWDUHµKLJKO\ DEQRUPDO¶. Headline earnings are therefore a better
LQGLFDWRURI µPDLQWDLQDEOH HDUQLQJV¶ µ'LOXWHGHDUQLQJV SHU VKDUH¶ LV also covered by IAS 33.
All these aspects are covered in this chapter.

2. Types of Shareholders

2.1 Ordinary shareholders

Ordinary shareholders buy a share in a company for capital growth and to earn dividends. These
dividends fluctuate annually depending on profits and available cash reserves etc. As the terms
µRUGLQDU\¶DQGµSUHIHUHQFH¶LPSOLHVWKHRUGLQDU\VKDUHKROGHUVKDYHIHZHUULJKWVWKDQWKHSUHIHUHQFH
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.

1144 Chapter 24
Gripping GAAP Earnings per share

Preference share capital may be:

2.2 Preference shareholders 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
RQWKHVKDUH¶VFRXSRQUDWH HJ $VKDUHKROGHURZQLQJ 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
The classification is based on assessing all not 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
x If the preference dividend is cumulative, never 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
preference shares: the shares may be
fixed dividend & a share in the profits
termed participating or non-participating: x Non-participating: the shareholder gets
x Most preference shareholders are non- a 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
WHUPHGµparticipating preference shareholders¶ See section 3.2.4 and example 4.

Chapter 24 1145
Gripping GAAP Earnings per share

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
ZLWK WKH µSURILW IRU WKH SHULRG¶ SHU WKH 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
NOTE 1
Less fixed preference dividend (coupon rate) (equity distributions only) (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
SHULRG LQDFFRUGDQFHZLWKWKHSUHIHUHQFHVKDUH¶VFRXSRQUDWH , 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 KDYH DOUHDG\ EHHQ GHGXFWHG LQ WKH FDOFXODWLRQ RI µSURILW or loss for the
SHULRG¶ DQG thus they must obviously not EH GHGXFWHG DJDLQ ZKHQ FDOFXODWLQJ µHDUQLQJV
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.

1146 Chapter 24
Gripping GAAP Earnings per share

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 di